No company does blindly sell on credit to every customer approaching it. The company has to evaluate the capability of the customer and his strengths to fulfill the promise of paying the bills in time. The companies ignoring adequate analysis of their customers would soon find themselves in a situation not generating sufficient resources for day-to-day operation of the business. The company .must therefore analyze the risk of paying late or risk of default before extending credit.
The credit analysis would broadly involve the following three steps:
Analyzing the credit worthiness of the customer is the most difficult task. The financial and non-financial information may provide some insights into credit worthiness of the customer, with the help of this information and other insights the company has to assess the following six Cs of credit worthiness:
The analysis of credit worthiness begins with the assessment of the customer’s willingness to pay the bill of the company.
Capacity is the ability of the customer to meet the obligations whenever they are due. In this regard, it would be important for the company to see that the obligations are met through the funds generated from the operations of the customer. That would reflect the long-term ability of the customer to meet the obligations. In case the customer is not in position to meet his obligation out of operation n some abnormal year, the company should examine the capital base of the company. This would indicate the capability of the company to face the problems in case of some difficulty. The company should examine the net worth of the customer to assess the capital base. The market conditions play an important role when one is doing credit analysis. The expected necessary trends in the market, a growing competition and other market factors should be taken into account when doing credit analysis of the customer. Given a particular set of conditions, the costs associated with extending the credit may sometimes be high. The cost may get reflected in high bad debt expenses or the default in payments. And finally, the company has to examine the kind of security, collateral in the form of assets, the customer is providing.
There will always be a problem in obtaining financial and qualitative information about the customers. This problem arises because there is no systematic source of information, particularly about the small sized customers. It may not be possible for most of the companies to administer the collection of information about the customers. The costs in terms of time and money resources involved in such experience would outweigh the benefits. But at the same time the company has to come to the conclusion and satisfy itself that the customer to whom it is extending credit is worthy of it and the risks involved commensurate with the return.
In order to undertake credit analysis, the company may analyze the financial statements of the customer. For the companies which are listed on stock exchanges, obtaining their financial statements is not difficult, as the same are available with the exchanges. Some of the major stock exchanges regularly publish summarized financial statement in their directories. In case the customer to whom the company is thinking to extend the credit is not listed and the financial information is not available, the option left is to jettison the idea of granting a credit facility.
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