credit rating

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Numerical Credit Scoring
A variety of factors influence a customer’s creditworthiness. This makes credit investigation a difficult task. A firm can use numerical credit scoring to appraise credit application when it is dealing with a large number of small customers. The firms, based on its past experience or empirical study may identify both financial and non-financial attributes that measure the credit standing of a customer. The numerical credit scoring models may include: 1. Ad hoc approach 2. Simple discriminant analysis 3. Multiple discriminant analysis Ad hoc approach A firm may develop its own ad hoc approach of numerical credit scoring to determine the creditworthiness of customers. The attributes identified by the firm may be assigned weights depending on their importance and be confined to create an overall (simple or weighted) score or index. Simple discriminant analysis A firm can use more objective methods of differentiating between good and bad customers. For example, empirical analysis may show that the ratio of earnings before depreciation, interest and taxes (EBDIT) to sales is a significant factor in discriminating goods customers from bad customers. How can the firm determine the cut-off EBDIT to sales ratio? The following steps are involved. First, arrange the paying (good) and non-paying (bad) customers by the magnitude of EBDIT to sales ratio. Second, select a cut-off point to divide the array into two parts with a minimum number of misclassification. The cut-off point is selected by visual inspection. The firm can consider granting credit to those customers who have EBDIT to sales ratio above the cut-off point. In our example, the discriminant index is: Z = 30 EBDIT/S ratio + 16 OCF/S ratio = 1.88EBDIT/S ratio + 1 OCF/S ratio A customer will be considered creditworthy if his z score is 30 or more. Multiple-discriminant analysis In practice, the credit worthiness of a customer will depend on many factors that may interact with each other. The technique of multiple-discriminant analysis combines many factors

according to the importance (weight) to be given to each factor and determines a composite score to differentiate good customers from bad customers. Altman, focusing on the financial attributes of firms in the USA, used multiple-discriminant analysis to predict bankruptcy of firms. Credit-granting decision Once a firm has assessed the creditworthiness of a customer, it has to decide whether or not credit should be granted. The firm should use the NPV rule to make the decision. If the NPV is positive, credit should be granted, shows the choice in a credit granting decision. If the firm chooses not to grant any credit, the firm avoids the possibility. On the other hand, if it grants credit, then it will benefit if the customer pays. There is some probability that the customer will default, and then the firm may lose its investment. The expected net pay off of the firm is the difference between the present value of net benefit and present value of the expected loss. Credit terms The stipulations under which the firm sells on credit to customers are called credit terms. These stipulations include: (a) the credit period, and (b) the cash discount. Credit period The length of time for which credit is extended to customers is called the credit period. It is generally stated in terms of a net date. For example, if the firm’s credit terms are net 35 it is expected that customers will repay credit obligation not later than 35 days. A firm’s credit period may be governed by the industry norms. Nut depending on its objective, the firm can lengthen the credit period if customers are defaulting too frequently and bad-debt losses are building up. Cash discounts A cash discount is a reduction in payment offered to customer to induce them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. Cash discount terms indicate the rate of discount and the period for which it is available. If the customer does not avail the offer, the must make payment within the normal credit period, in practice, credit terms would include: (a) the rate of cash discount, (b) the cash discount period, and (c) the net credit period. For example, credit terms may be expressed as 2/10,net 30 this means that a 2 per cent discount will be granted if the customer pays within 10 days; if he does not avail the offer he must make payment within 30 days.

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