Cause-and-Effect Ratio Analysis Adds Decision-Making Value to Credit Scoring Models

Article excerpt

Financial statement analysis is more than a clerical "number-crunching" exercise, so credit decision-makers must be prepared to go beyond the mechanical application of mathematical scoring models. The ability to understand the causes of a current or prospective customer's numerical rating--whether comparatively strong or relatively weak--is essential in developing an effective sales and credit strategy. The additional knowledge and effort involved in tailoring that strategy to the characteristics of each major customer distinguishes credit professionals from button-pushers and scribes. Scoring models are valuable in separating companies into one of three broad categories of financial condition (from the credit grantor's perspective): definitely favorable, definitely unfavorable, or somewhere in between. The mix of favorable and unfavorable characteristics exhibited by many firms in most lines of business severely restricts the utility of scoring formulas as absolute yes/no decision devices--particularly when a significant sales relationship is under consideration.

Experience-based scoring models can help to streamline and systematize the initial credit classification process. In some cases, the results of this first overview will clearly point to outright rejection or severe credit restrictions, on the one hand, or immediate acceptance of the pending order or proposed credit line, on the other. For many customers, however, an undistinguished or mixed rating produced by the scoring model necessarily suggests further analysis. Because a variety of company characteristics can yield the same aggregate score, the wise credit grantor will evaluate the underlying factors that produced the numerical rating before reaching a firm conclusion. Cause-and-effect ratio analysis, described in the February 1993 issue of Business Credit, enables credit professionals to gain greater insight from any scoring model ("Mastering Cause-and-Effect Ratio Analysis," pp 24-27). By uncovering the fundamental reasons for a low or mixed numerical rating through this proven, step-by-step system, credit evaluators can make better judgments about a company's essential financial soundness. For example, when considering a prospective customer with a somewhat unfavorable financial rating that results from a weak working capital position, an experienced credit decision-maker will seek to determine the basic cause or causes in order to establish the proper terms of sale. Terms that apply to a company whose underlying problem is a mismatch between long-term financing and fixed assets may well be different from those of a firm (with an identical score) that is managing its assets in an unsatisfactory manner. Still other terms may be appropriate for another company (also with an identical score) that has deficient working capital because of inadequate owners' equity to support sales volume. Tables 1 and 2 provide a step-by-step outline of the relationship between the key factors found in most widely recognized scoring models and the multiple causes of an unfavorable rating for each factor.

The ratios employed in credit scoring models summarize financial effects, not causes. Unfavorable financial leverage (a high debt-to-equity ratio) is the effect of inadequate owners' equity and/or unsatisfactory asset management. Unfavorable working capital balance (a low current ratio) can be traced to insufficient working capital in proportion to sales volume and/or poor utilization of current assets. Unfavorable profit in relation to shareholders' investment (a low return on equity ratio) results from low profit on sales and/or a comparatively high level of owners' equity, which is ordinarily a favorable factor to a creditor.

Recognizing the fundamental causes of a company's low or mixed credit score is a critical element in the creative problem-solving needed to maximize sales opportunities while reducing risk. Can the customer's working capital weakness be cured simply by bringing long-term liabilities up to a moderate level in relation to non-current assets? …