Credit Risk Analysis and Credit Scoring-Now and in the Future

Article excerpt

Computers and the Internet have dramatically changed the way business is conducted, and credit departments are no exception. Credit risk analysis, through the use of credit scoring models, is becoming more automated with the use of computers and the utilization of the Internet to obtain and compile financial data. Credit scoring provides a way to quickly and easily numerically rate a company's credit risk so that assessments of individual buyers, or those in the same industry, are made on the same criteria. Automated credit scoring also has the advantage of reducing manpower by eliminating accounts that don't need individual review. This is becoming increasingly important as many credit departments are shrinking in personnel size.

Another advantage of automated or computerized credit scoring is it provides a way to document the criteria used in making credit decisions. Credit scoring systems can also plug into the accounts receivable data of a company to quickly assess the overall risk levels within its mix of accounts receivables and indicate collections procedures for risky or overdue accounts. The passage of the Sarbanes-Oxley Act of 2002 requires that chief executive and financial officers attest to the accuracy of financial statements. This law has made it more important than ever, from a legal standpoint, for executives of publicly traded companies to know and attest to the realistic value of accounts receivables, and other reported financial data. Credit scoring can be utilized as a vehicle to ensure accurate valuations.

Credit managers of smaller companies or those that transact business with a small number of buyers, may not have to automate their credit functions. They can rely on financial data about buyers from financial credit reports from firms such as D&B and Experian, and other sources such as trade group data, public records--such as liens and judgments-and internal company records. PAYDEX scores on D&B reports, for example, indicate the status of the payment history of a company. This type of score, however, does not give a more comprehensive picture of the creditworthiness of a company. While credit scoring does not give a comprehensive view of creditworthiness either, it can indicate which companies need further, more detailed analysis of their credit status.

Some organizations, such as NACM affiliates, are equipped to provide specific payment history information on certain industries in a specific geographical area. NACM Houston President Kathleen Quilt, CAE said her organization could provide "All pieces of information that you can use to verify that a company can pay you once you take an order." She said some sales really don't require the use of a credit score. "You can get fallacious scores ... and it's why we don't score." She said her organization is set up "to give information to a credit professional that they might not get on their own."

Quill's organization gathers credit information on companies in a 40-county area in South Texas. She said her credit reports are timely and affordable. "My average credit report price is $18. We have the ability to provide timely information because we're dealing in a smaller area. We consider a credit report to be out of date if 50 percent of the trade lines are six months old or older. If you buy it from me, I'm going to update it for free before I send it to you."

For companies with a large number of buyers that buy in smaller volumes, automated credit scoring is a cost-effective way to qualify buyers. This is especially helpful for companies that allow purchasing of their products and credit approvals through the Internet. There are two basic types of credit-scoring models which give credit risk evaluations for prospective buyers: rules-based and statistically-based. Rules-based systems are based on subjective judgments made from past experience on the relative importance of many variables such as customer payment history, bank and trade references, credit agency ratings, and other information gleaned from various financial statements. …