TRADITIONAL CREDIT ANALYSIS
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TRADITIONAL CREDIT ANALYSIS The traditional approach to credit analysis calls for assessing a prospective customer in the terms of “five C’s of credit”. 1. Character – The willingness of the customer to honour his obligations. It reflects integrity, a moral attribute that is considered very important by credit managers. 2. Capacity – The ability of the customer to meet credit obligations from the operating cash flows. 3. Capital – The financial reserves of the customer. If the customer has difficulty in meeting his credit obligations from its operating cash flow, the focus shifts to its capital. 4. Collateral – The security offered by the customer in the form of pledged assets. 5. Conditions – The general economic conditions that affect the customer. To get information on the five C’s, a firm may rely on the following: 1. Financial Statements – Financial statements contain a wealth of information. A searching analysis of the customer’s financial statements can provide useful insights into the creditworthiness of the customer. The following ratios seem particularly helpful in this context: current ratio, acid-test ratio, debt-equity ratio, EBIT to total assets ratio, and return on equity. 2. Bank References – The banker of the prospective customer may be another source of information. To ensure a higher degree of candour, the customer’s banker may be approached indirectly through the bank of the firm granting credit. 3. Experience of the Firm – Consulting one’s own experience is very important. If the firm has previous dealings with the customer, then it is worth asking:
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Transcript of TRADITIONAL CREDIT ANALYSIS
TRADITIONAL CREDIT ANALYSIS
The traditional approach to credit analysis calls for assessing a prospective customer in the terms of “five C’s of credit”.
1. Character – The willingness of the customer to honour his obligations. It reflects integrity, a moral attribute that is considered very important by credit managers.
2. Capacity – The ability of the customer to meet credit obligations from the operating cash flows.
3. Capital – The financial reserves of the customer. If the customer has difficulty in meeting his credit obligations from its operating cash flow, the focus shifts to its capital.
4. Collateral – The security offered by the customer in the form of pledged assets.5. Conditions – The general economic conditions that affect the customer.
To get information on the five C’s, a firm may rely on the following:
1. Financial Statements – Financial statements contain a wealth of information. A searching analysis of the customer’s financial statements can provide useful insights into the creditworthiness of the customer. The following ratios seem particularly helpful in this context: current ratio, acid-test ratio, debt-equity ratio, EBIT to total assets ratio, and return on equity.
2. Bank References – The banker of the prospective customer may be another source of information. To ensure a higher degree of candour, the customer’s banker may be approached indirectly through the bank of the firm granting credit.
3. Experience of the Firm – Consulting one’s own experience is very important. If the firm has previous dealings with the customer, then it is worth asking: How prompt has the customer been in making payments? How well has the customer honoured his word in the past? Where the customer is being approached for the first time, the impression of the company’s sales personnel is useful.
4. Prices and Yeilds on Securities – For listed companies, valuable inferences can be derived from stock market data. Higher the price-earnings multiple and lower the yield on bonds, other things being equal, lower will be the credit risk.
