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(^238) Financial Management
unaudited reports. The financial statements are useful for calculating various liquidity,
leverage, efficiency, and profitability ratios that may be used in evaluating credit risk. If
the firm is using a credit scoring model (discussed later) or if the applicant is requesting
a large amount of credit, financial statements are essential.
Credit Bureaus: Credit bureaus specialise in consolidating the experiences of other
firms with the applicant. Credit bureaus compile a history of the applicantís credit
payment performance as reported by the credit-granted firms. Financial information on
a credit applicant may be obtained by credit bureau member firms who agree to provide
credit bureaus with information on their clients.
In addition to these information sources, a firm may try to compile its own information.
It may have its sales personnel prepare a report on the credit applicant. Alternatively, if
the credit request is large enough, it may send a credit department employee to visit
personally with the credit applicant and garner as much financial information as possible.
Credit Analysis and Credit Limit
A firm reviewing a request for credit needs to judge the credit applicantís willingness
and ability to pay. If either of these two factors is missing, the firm would increase its
chances of suffering losses on credit extended to the applicant. Willingness to pay is
judged by the firmís past financial performance. Its ability to pay is judged by the
strength of its financial statements in relation to the amount of credit desired. Either
heuristic or statistical procedures could be utilised in credit analysis.
Heuristic Approach: The heuristic approach described here is based on a manufacturing
companyís actual experience. The formula or procedure described here has the weight
of managerial experience and intuition behind it and therefore is heuristic in nature.
There are eight factors that need to be considered in the decision to establish a credit
limit and grant credit. The credit limit is the maximum amount of credit purchases
allowed the credit applicant at any one time and is stated as a per cent of tangible net
worth. The lower limit is minus 15 per cent and is tantamount to denying new credit to
the applicant. The upper limit is 80 per cent and is equivalent to the sum of the maximum
percentage points on the eight credit-granting factors.
Credit Requirements; The first factors is applicant credit requirements, (C). This
factor is a measure of the applicantís dependency on the creditor. If the applicant plans
to buy less than 25 per cent of his requirements from the creditor, he gets 0 perm cent
toward his credit line. If he plans to buy between 25 and 50 per cent, he gets a 5 per
cent allowance. If the plans to buy over 50 per cent he gets a 10 per cent allowance
(see Table 5).
Pay Habits: The second factor is pay habits (P) and is a measure of the willingness