CMCP Module 3 Chapter 7 Credit Evaluation PDF

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Pamantasan ng Lungsod ng Maynila PLM Business School A.Y. 2020-2021 First Semester FIN 3104: CREDIT MANAGEMENT AND COLLECTION POLICIES

Module 3: Chapter 7 Credit Evaluation

TOPICS OUTLINE Credit Evaluation a. Credit Information: Sources and Code of Ethics b. Traditional and Other Bases of Credit c. Credit Rating System: Credit Rating Agencies (Domestic and International) ; Credit Management Association of the Philippines (CMAP) d. Internal and External Audit LEARNING OBJECTIVES • Identify the multifarious sources from which a credit investigator could find and secure credit information. • Study the CMAP adopted Code of Ethics that guide credit man in the gathering and use of credit information. •

Know the different credit factors to be evaluated as reported in the Credit Investigation Report.

• Understand the relevance and process of conducting a proper and thorough analysis and evaluation of credit risks of applicants for credit.

CMCP Adviser: Prof. Ragrciel G.

FOR READING PURPOSES

Introduction Imagine how things would have been in case lenders would be approving every application they receive. It would be impossible for business to be sustained. In business, specifically, in credit, the chance that the borrower will fail to pay the obligation is always there. For this reason, lenders test the eligibility of the borrowers before they approve loans. It is vital to assess borrowers and their ability not only to repay the loan but also to do that within the required time. Credit Evaluation • Credit evaluation refers to the process borrowers are subjected to for them to be eligible for funding, or to pay for products within a specified period. • Evaluating a borrower’s loan application to determine the financial health of an entity and its ability to generate sufficient cash flows to service the debt. In simple terms, a lender conducts credit analysis on potential borrowers to determine their creditworthiness and the level of credit risk associated with extending credit to them. • It involves collecting information from the borrower, analyzing the information provided, and making a decision on whether or not to approve the loan. Why do we need to perform credit evaluation to clients? ✓ To establish the veracity of information disclosed by the client in the application form ✓ To gather credit information that will aid as a tool to establish the credit worthiness of prospective and existing clients ✓ To keep management constantly informed of developments relative to existing customers. But what is involved in the assessment process? In this discussion, we are going to examine the concept credit evaluation process and the significance of the C’s of credit. Basically, Credit evaluation process is composed of 3 steps: Gathering of information, analyzing the information gathered and making decision. First Step: Gathering of Information • The process begins with the collection of data and information relevant to the client. • In this step, lenders collect necessary credit information that will help them in determining the creditworthiness of the borrower. Credit Information • Information about a person's or company's ability to pay debt, examined especially by banks before they decide to lend money. • Credit information includes public information, your credit card, car loans, and mortgages. However, it does not emphasize information such as race, gender, religion, sexual orientation. • If we see a sample of a credit report, information are divided into different sections: o Personal Information – which includes name, past and present addresses, social security number and of course, your employment history and sources of income. o Public Information – This includes items such as tax liens or court judgments against the subject.

▪ Tax liens – tax lien is the government’s legal claim against your property when you neglect or fail to pay a tax debt. The lien protects the government’s interest in all your property, including real estate, personal property and financial assets. ✓ It happens when an individual has unpaid, legally enforceable tax debt. ▪ Court judgment – is a court order that is the decision in a lawsuit. If a judgment is entered against you, a debt collector will have stronger tools, like garnishment, to collect the debt. o Account History – An account history may be referred to when a record of transactions by an individual or organization. ▪ Whether you pay timely payments on your credit cards, mortgage, auto loans, etc. ▪ It can also include your purchasing habit, how often you use credit in supermarket to pay for groceries, your shopping behavior, irregular transactions in your account, etc. o Inquiries by creditors – this includes all inquiries in your credit history that occur when you apply for new credit. • As discussed in the chapter 5, there are lots of credit information that are being collected specifically for an individual and business borrower. Where do lenders find this information? SOURCES OF CREDIT INFORMATION There are multifarious sources from which a credit investigator could find and secure this credit information. Some of these sources are the following: 1. Salesman's Reports The company's first contact with a new customer is the salesman. If all goes well, the salesman will have the most frequent contacts with an established customer. It is, therefore, necessary that salesmen should be trained to submit credit applications on all prospective and/or new customers, and when necessary to obtain current financial statements. Most firms and individuals are conditioned to the necessity of furnishing credit information to support credit transaction. Without asking questions, the salesman can obtain a great deal of information by keeping his eyes and ears open. He can judge the location and appearance of the place of business and presence or absence of competition. He can note down the names of other products carried and even observe the personalities of employees and of management. To obtain the full benefit of the salesman's observation, a spirit of mutual confidence and cooperation must be developed between the sales and credit departments. Through the frequent calls of the salesman may receive early news of changes in sales trends, collections, movements of inventory and other matters. Since the salesman knows his account personally, his information can be of great value to the credit manager. Due to the regularity of his visits, the salesman can be trained to develop facts and impressions on a continuing basis to make a report on this.

2. Customer Supplied Information In the final analysis, the principals of the company being investigated have many answers not obtainable in any other quarter. Indeed, there is no better source of information about the operation and financial condition of a business than the business itself. Therefore, it is reasonable to expect that direct contact with a customer can provide the credit man with available financial details, banks and trade references, and other information of importance of the credit exposure, and the degree of the cooperation which can be obtained from the customer. Direct contact between the credit department and the customer offers many advantages. Regardless of the method used, such contacts can be invaluable in establishing a close and friendly working relationship and inspiring mutual respect and confidence. They can be used to clarify terms of sale, thereby obviating possible dissatisfaction on the part of the buyer. Particularly, at the early state of the relationship, direct contact can assist in developing a sound basis for continued credit granting. In all customer contacts, whether by letter, by telephone or in person, the credit manager should remember that he is the representative of his company and that sound credit administration is undoubtedly one of its finest tools. A credit department which builds goodwill with its company's customers will also gain the fullest cooperation and respect from the sales department. Contact with the customer may take the form of a personal visit, a phone call, or by direct correspondence. 3. Bank Information Banks are usually quite knowledgeable about marginal companies. The larger banks in the metropolitan areas have files which contain a wealth of information. Having obtained the name of the customer's bank by means of direct inquiry or by noting the bank on which his checks are drawn, the credit manager or representative is in a position to secure from the bank further helpful information. A letter of inquiry to the customer's bank usually will bring a reply indicating the customer's bank balance expressed in such terms as "medium four figure balance or "low figure balance” together with information concerning the customer's line of credit, if any, and the manner in which payments on bank loans are handled. The best means of obtaining complete information from a bank, as from any other sources, is by personal contact. The credit manager should make a special point of becoming well-acquainted with members of the credit department in his bank. 4. Credit Interchange Direct interchange of credit information is also one of the most valuable sources of information. The credit analyst should not overlook the possibility of directly exchanging ledger and other pertinent information with credit representatives of other concerns known to be supplying the customer under review. He should keep in mind, however, that this is probably the most costly method of obtaining the information desired. Hence, direct interchange should generally be limited to those cases in

which there is a substantial exposure for the inquiring company, or in which the interchange bureau is, for some

reason, inadequate, or when group interchange is not practicable because of the distant location of suppliers. When it is decided that direct interchange is desirable, the experienced credit man will not confine his inquiries to trade references" given by the customer, but will also check with others who would logically be providing an important portion of the firm's requirements. 5. Credit Reporting Agencies The service of one or more agencies or bureaus may be availed of by the credit department of the company. This, of course, depends upon the number of accounts the company has. The mercantile agency report usually attempts to cover all the major factors involved in the credit decision, from history through operations, including the background of the principal financial conditions, and payment records. When properly analyzed, information which can be secured from this source may be sufficient to eliminate the need for further investigation. In some instances, information from this source may serve to point the areas which should be further explored, thus enabling the credit analyst to determine what specific information must be secured from other sources. One of the largest credit reporting agencies is the TransUnion East Asia. It has been operating in the Philippines since 2011. It is partnered with BPI, Banco de Oro, Metrobank, HSBC, and Citibank. The partnership created a centralized credit-information system that collects credit data. However, banks who have not partnered with TransUnion don’t have access to the reports they provide. They had started to gather personal information on credit card borrowers, their educational background, credit record, employment history and other data that would allow banks and financial institutions to manage risks associated with lending. TransUnion gets data from its partner institutions as well as public records. Partner banks can request TransUnion’s information, and along with your other records, they use that information to make decisions. TransUnion does not make credit decisions — that’s 100% up to the banks themselves — they just give information. 6. Other Sources of Information a. Interchange Bureaus - The ledger interchange bureau of the Credit Management Association of the Philippines (CMAP) is a source of information regarding the manner in which a customer meets his trade obligations. The association provides the most economical means of obtaining the ledger experience of other suppliers and often eliminates the need for other more expensive methods of investigating the customer's trade payment habits. b. Court and Securities and Exchange Commission (SEC) listings - The CMAP sends out to its members court and SEC listings. There, you will find customers with cases in court and corporations newly organized those with increased capitalization and those which are dissolved. This is so also with partnership. c. Securities and Exchange Commission - Copies of the Articles of Incorporation and By-Laws could be secured from this government agency. Articles of Partnership and financial statements of corporations are also filed with this government office. By checking these sources carefully, the credit representative can confirm information about which there may be doubt and can obtain other useful information regarding his customers.

d. Miscellaneous Sources - Daily newspapers are also important sources of information. Even the obituary columns should not be bypassed since immediate knowledge of the demise of the guiding principle of a business can be of great value to a creditor. Announcement or recent promotions, branch openings and the like are matters of important interest to us. Accountants and attorneys are also important sources of information. With computerization, all the data and credit information gathered could be compiled and stored in a credit data bank for future reference. Second Step: Analyzing the Information Gathered - After gathering the information relative to the borrower, the lender or bank analyzes obtained data to determine the applicant’s creditworthiness. TRADITIONAL AND OTHER BASES OF CREDIT Traditional: C’s of Credit of Credit Analysis Credit analysis by a lender is used to determine the risk associated with making a loan. Regardless of the type of financing needed, a bank or lending institution will be interested in both your business and personal financials. Credit analysis is governed by the “5 Cs:” character, capacity, condition, capital and collateral. •

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Character: What Your Credit History & Background Are. ✓ Lenders need to know the borrower and guarantors are honest and have integrity. Additionally, the lender needs to be confident the applicant has the background, education, industry knowledge and experience required to successfully operate the business. Lending institutions may require a certain amount of management and/or ownership experience. They will also ask about your licensing and whether or not you have a criminal record. As history is the best predictor of the future, a lender will examine the personal credit of all borrowers and guarantors involved in the loan. Sound business and personal credits are a must. Check both reports before calling your lender; if there are any delinquencies, be prepared to explain. The lender may be able to make exceptions for low credit scores. Capacity (Cash flow): What Your Ability to Repay Your Debt Obligations Is ✓ The lender wants to know that your business is able to repay the loan. The business should have sufficient cash flow to support its business expenses and debts comfortably while also providing principals’ salaries sufficient to support personal expenses and debts. Examining the payment history of current loans and expenses is an indicator of the borrower’s reliability to make loan payments. Condition: What the Market, Economic, Industry & Other Factors Are ✓ The lender will need to understand the condition of the business, the industry, and the economy, which is why it is important to work with a lender who understands the WCB industry. The lender will want to know if the current conditions of the business will continue, improve or deteriorate. Furthermore, the lender will want to know how the loan proceeds will be used- working capital, renovations, additional equipment, etc.

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Capital: What Your Level of Leverage Is ✓ Your lender will ask what personal investment you plan to make in the business. Not only does injecting capital decrease the chance of default, but contributing personal assets also indicates that you are willing to take a personal risk for the sake of your business; it shows that you have ‘skin in the game.’ Collateral: What Assets Are Available to the Lender ✓ A lender will consider the value of the business’ assets and the personal assets of the guarantors as a secondary source of repayment. Collateral is an important consideration, but its significance varies depending on the type of loan. A lender will be able to explain the types of collateral needed for your loan.

The five components that make up a credit analysis help the lender understand the owner and the business and determine credit worthiness. By knowing each of the “5 Cs,” you will have a better understanding of what is needed and how to prepare for the loan application process. Other bases of Credit: Factors to Consider The Following are some of the factors that lenders need consider when evaluating an individual or business that is seeking credit: • Credit worthiness. A history of trustworthiness, a moral character, and expectations of continued performance demonstrate a debtor's ability to pay. Creditors give more favorable terms to those with high credit ratings via lower point structures and interest costs. • Size of debt burden. Creditors seek borrowers whose earning power exceeds the demands of the payment schedule. The size of the debt is necessarily limited by the available resources. Creditors prefer to maintain a safe ratio of debt to capital. • Loan size. Creditors prefer large loans because the administrative costs decrease proportionately to the size of the loan. However, legal and practical limitations recognize the need to spread the risk either by making a larger number of loans or by having other lenders participate. Participating lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to ingest a large sum of money. • Frequency of borrowing. Customers who are frequent borrowers establish a reputation which directly impacts on their ability to secure debt at advantageous terms. • Length of commitment. Lenders accept additional risk as the time horizon increases. To cover some of the risk, lenders charge higher interest rates for longer term loans. • Social and community considerations. Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. Examples might include banks participating in low-income housing projects or business incubator programs. Third Step: Making Decision - In this step, the lender will now decide whether to approve the loan or not. But it will be discussed further by the succeeding reporter. What is Credit score? • Credit score is the number used to determine someone’s capability to manage debt. Credit companies measure several factors including your credit payment history, the amount loaned or credit utilization ratio, length of credit history, types of credit used, and new credit.

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In countries outside the Philippines, credit scores normally range from 350-800. The higher the score, the better chances you have to acquire a loan. Unlike other countries like the United States and Canada, the Philippines currently does not have a unified system of credit reporting. While there is no standard system of credit reporting, the Credit Information Corporation is in charge of credit scoring in the country. Concurrently, banks resort to a myriad of available private credit report providers in order to determine if an individual is eligible for a loan or not.

What are the factors considered in credit scoring? Length of credit history - This includes the length of time you had credit. If you own credit cards, they will average the age of your oldest card, your newest, and all other credit cards you hold. Payment history - This is made up ...