Credit evaluation and approval is the process a business or an individual must go through to become eligible for a loan or to pay for goods and services over an extended period. It also refers to the process businesses or lenders undertake when evaluating a request for credit. Granting credit approval depends on the willingness of the creditor to lend money in the current economy and that same lender’s assessment of the ability and willingness of the borrower to return the money or pay for the goods obtained—plus interest—in a timely fashion. Typically, small businesses must seek credit approval to obtain funds from lenders, investors, and vendors, and also grant credit approval to their customers.
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Evaluating Credit Worthiness
In general, the granting of credit depends on the confidence the lender has in the borrower’s credit worthiness.
Credit worthiness—which encompasses the borrower’s ability and willingness to pay—is one of many factors defining a lender’s credit policies. Creditors and lenders utilize a number of financial tools to evaluate the credit worthiness of a potential borrower. When both lender and borrower are businesses, much of the evaluation relies on analyzing the borrower’s balance sheet, cash flow statements, inventory turnover rates, debt structure, management performance, and market conditions. Creditors favor borrowers who generate net earnings in excess of debt obligations and any contingencies that may arise.
Following are some of the factors lenders 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.
Obtaining Credit Approval From Lenders
Many small businesses must rely on loans or other forms of credit to finance day-to-day purchases or long-term investments in facilities and equipment. Credit is one of the foundations of the American economy, and small businesses often must obtain credit in order to compete.
To establish credentials for any credit approval process, from short-term loans to equity funding, a small business needs to have a business plan and a good credit history.
The company must be able to show that it can repay the loan at the established interest rate. It must also demonstrate that the outlook for its type of business supports planned future projects and the reasons for borrowing.
In applying for credit, small business owners should realize that potential creditors—whether banks, vendors, or investors—will seek to evaluate both their ability and willingness to pay the amount owed. This means that the creditor will examine the character of the borrower as well as his or her ability to run a successful business.
Creditors will also look at the size of the loan needed, the company’s purpose in obtaining funds, and the means of repayment. Ideally, lenders evaluating a small business for credit approval like to see up-to-date books and business records, a large customer base, a history of prompt payment of obligations, and adequate insurance coverage.
The process of granting loans to businesses is regulated by the Federal Trade Commission (FTC) to ensure fairness and guarantee nondiscrimination and disclosure of all aspects of the process. The Small Business Administration (SBA) publishes a series of pamphlets and other information designed to assist businesses in obtaining loans. These publications advise businesses on a range of credit approval topics, including describing assets, preparing a business plan, and determining what questions to expect and how to prepare responses to those questions.
Granting Credit Approval To Customers
Credit approval is also something that a small business is likely to provide for its customers, whether those customers are primarily individual consumers or other businesses. The process by which a small business grants credit to individuals is governed by a series of laws administered by the Federal Trade Commission that guarantee nondiscrimination and other benefits. These laws include the Equal Credit Opportunity Act, Fair Credit Reporting Act, Truth in Lending Act, Fair Debt Collection Practices Act, and Fair and Accurate Credit Transactions Act.
Experts recommend that small businesses develop credit policies that are consistent with overall company goals. In other words, a company’s approach toward extending credit should be as conservative as its approach toward other business activities. While granting credit to customers can offer a small business a number of advantages, and in fact is a necessary arrangement for many types of business enterprises, it also involves risks.
Some of the disadvantages of providing customers with credit include increasing the cost of operations and tying up capital that could be used elsewhere. There is also the risk of incurring losses due to nonpayment, and of eroding cash flow to an extent that requires borrowing. But granting credit does offer the advantage of creating a strong base of regular customers. In addition, credit applications provide important information about these customers that can be used in mailing lists and promotional activities. In the retail trade, furthermore, credit purchasers have proven to be less concerned with prices and inclined to buy more goods at one time.
When developing credit policies, small businesses must consider the cost involved in granting credit and the impact allowing credit purchases will have on cash flow. Before beginning to grant credit to customers, companies need to be sure that they can maintain enough working capital to pay operating expenses while carrying accounts receivable. If a small business does decide to grant credit, it should not merely adopt the policies that are typical of its industry. Blindly using the same credit policies as competitors does not offer a small business any advantage, and can even prove harmful if the company’s situation is atypical. Instead, small businesses should develop a detailed credit policy that is compatible with their long-term goals.
The decision about whether to grant credit to a certain customer must be evaluated on a case-by-case basis. Each small business that grapples with this issue needs to gather and evaluate financial information, decide whether to grant credit and if so how much, and communicate the decision to the customer in a timely manner. At a minimum, the information gathered about a credit applicant should include its name and address, Social Security number (for individuals), bank and/or trade references, employment and income information (for individuals), and financial statements (for companies). The goal is to form an assessment of the character, reputation, financial situation, and collateral circumstances of the applicant.
Credit Programs for Business Customers There are many avenues available to small businesses for gathering information about credit applicants. In the case of business customers, a small business’s sales force can often collect trade references and financial statements from potential customers. The small business can also contact local attorneys to find out about liens, claims, or actions pending against the applicant, and can hire independent accountants to verify financial information. An analysis of a company’s debts, assets, and investments can provide a solid picture of its credit worthiness, particularly when the data are compared to a composite of companies of similar size in similar industries. It is important to note that all information gathered in the credit approval process should be held strictly confidential.
Credit Programs for Individual Consumers Consumer credit bureaus are a useful resource for small businesses in evaluating the credit worthiness of individual customers.
These bureaus maintain records of consumers’ experiences with banks, retailers, doctors, hospitals, finance companies, automobile dealers, etc. They are able to provide this information in the form of a computerized credit report, often with a weighted score. Still, credit bureau reports do have some potential for error, so small businesses should not necessarily use them as the only source of consumer credit information. It is also important to note that credit granted to consumers is subject to the federal Truth in Lending Law, as well as a number of other federal statutes.
Many small businesses, particularly in the retail trade, choose to participate in major credit card plans.
Allowing customers to pay with credit cards offers businesses a number of advantages. Since most large retailers provide this service to customers, accepting credit cards helps small businesses compete for new customers and retain old ones. In addition, customers are often tempted to spend more when they do not have to pay cash. The convenience of credit card purchases may also attract new business from travelers who do not wish to carry large sums of cash. Finally, credit card programs enable small businesses to receive payment more quickly than they could with an individual credit account system. The main disadvantage to participating in credit card plans is cost, which may include card reading and verification machinery, fees, and a percentage of sales. Credit cards also make it easier for customers to return merchandise or refuse to pay for items with which they are dissatisfied.
Still, in this technological age, few small businesses (or large ones, for that matter) can afford to forsake membership in some sort of credit card plan.
Another common type of consumer credit is an installment plan, which is commonly offered by sellers of durable goods such as furniture or appliances. After credit approval, the customer makes a down payment and takes delivery of the merchandise, then makes monthly payments to pay off the balance. The down payment should always be large enough to make the purchaser feel like an owner rather than a renter, and the payments should be timed so that the item is paid off at a faster rate than it is likely to depreciate from use. The merchandise acts as collateral and can be repossessed in the case of nonpayment. Although installment plans can tie up a small business’s capital for a relatively long period of time, it is possible to transfer such contracts to a sales finance company for cash.
See also: Cash Flow Management