Published on 7 May 2024
Creditworthiness is the likelihood that an individual or company will repay credit. This is a key business concept. Extending any form of credit comes with some risk of non-payment. Good financial management can help mitigate this risk.
This article contains
Key takeaways
- Creditworthiness is a measure of how likely a customer is to repay credit
- The creditworthiness of a company is calculated by assessing several factors
- A company’s creditworthiness can get better or worse over time
- Understanding creditworthiness is key to confidently extending credit
The basics of company creditworthiness
When you apply for a mortgage or other line of credit from a bank, the bank will assess your creditworthiness by trying to answer questions such as ‘How likely are you to repay your loan?’ ‘What is your payment history?’ ‘Is your salary sufficient to cover repayments?’ etc.
When it comes to a business extending credit to its customers, similar things must be considered.
Extending credit can be vital for a business to attract new customers and build trust and loyalty. But giving credit to customers is never risk-free. It is essential for the creditor to mitigate the risk of repayments not being made on time.
A creditworthiness check is an assessment of how likely a potential debtor is to repay credit.
Key factors in assessing company creditworthiness
A creditworthiness check covers several factors often represented by a simple quality score assessed using a framework known as the “5Cs".
Capacity
The first of these five factors is “capacity.” In other words, it is the customer’s ability to repay the credit.
Usually, capacity is estimated based on the customer's available cash flow information. In the simplest of terms, do they have sufficient resources? In technical terms, this calculation is referred to as the borrower’s “debt-to-income” (DTI) ratio.
The DTI ratio is a measure of a business’s total monthly debt payments divided by its gross monthly income. What percentage of gross monthly income goes towards paying off debts? The lower a company’s DTI ratio, the better the credit risk they represent.
Capital
It is also important to consider how the credit would be repaid if the business suddenly hit a rough patch. If cash flow dried up, does the company have Capital (other funds or assets) that could cover the credit repayments?
Collateral
“Collateral” may also influence the creditworthiness of a business. This often includes items which could be repossessed in the event of the credit not being repaid. For example, if a company fails to repay the credit line on a large stock of printers, the printers themselves could be considered as collateral and repossessed by the creditor.
Character
The “character” of a business refers to how dependable and trustworthy it is. Reviewing its credit history can show how reliable it has been in the past. The length of time in business and any history of bankruptcy or bad debt can also be good indicators of character. A high credit score provides reassurance that the customer represents a reasonable risk.
Conditions
Once you have taken character, collateral, capital, and capacity into account, you should consider external conditions. This includes the state of the market, geographic location of the business, currency fluctuations, interest rates, and even local or national politics. A customer operating in a stable environment is likely to be a safer credit risk than one operating in a highly unstable or unpredictable sector.
Find out more about sector risks and the information Allianz Trade can provide to help you reach an informed decision.
How to conduct a creditworthiness assessment
It can be challenging to carry out a comprehensive creditworthiness check. Several resources are available to help you to build a clearer picture.
Collect as much relevant information as you can about your customer. This includes general information about their business and their credit history.
Credit reports contain financial information on annual sales, invoices and credit limits, and the business credit score. These reports can be purchased from reliable credit bureaus..
Annual reports often contain vital information on cash flow and financial health. Look at the balance sheet, the income statement, and cash flow statements to identify any areas for concern.
Seek out “soft” information on a company’s reputation from Chambers of Commerce or other players in the industry.
For more information on calculating a new customer’s creditworthiness, see here.
It is possible to calculate a customer’s creditworthiness yourself, but it can be a complex task! You may prefer to concentrate on your core business and seek professional advice on this matter.
Allianz Trade can help calculate creditworthiness. Based on our extensive databases containing financial information on millions of companies worldwide, we can provide you with detailed insights. This can help you reach an accurate and informed decision before extending credit to a new partner.
Red flags and warning signs
A creditworthiness check may flag up several issues. Consider them to minimize the risk of incurring bad debt.
If a company shows signs of declining profitability, this may be an indication of instability. This should be a cause for concern. Equally, if a creditworthiness check reveals insufficient cash flow or liquidity, you may ask whether this will impact upon the company’s ability to repay its short-term debts.
Finally, if a company has a high DTI ratio, this is an indication that the company is not generating enough income to cover all its debts.
A poor credit score can be an indication of a business being unreliable. However, this is not necessarily the case. Care should be taken to avoid jumping to conclusions or making generalisations.
Creditworthiness can change quickly. It may improve of course, but it may also deteriorate, and it is important to track any such changes closely. Professional financial services can help monitor even subtle changes in creditworthiness.
The importance of creditworthiness in business relationships
Extending credit to reliable customers is one way of establishing and maintaining good business relationships. The foundation of any healthy business relationship must be accurate information. By carrying out a creditworthiness check, lenders can make informed decisions and minimise the risk of incurring bad debts.
A creditworthy company will find it easier and cheaper to access credit. A company with a poor credit rating will find it harder and more expensive to do so.
Mitigating credit risk
Carrying out a creditworthiness check is one way of mitigating credit risk. A thorough analysis of capacity, character, capital, and collateral, coupled with a review of the market conditions, can reduce risk.
If a customer has low creditworthiness, you may still decide to extend credit to them, but with lower credit limits, or shorter payment terms.
Trade credit insurance can provide further reassurance against credit risk. Allianz Trade offers a wide range of trade credit insurance options which can form an integral part of your credit risk management strategy.
Conclusion
It is essential to understand the importance of creditworthiness. Extending credit to customers can be mutually beneficial but should only be done based on a complete and reliable financial analysis.
Credit scores and credit reports can contain valuable data. This can help you make fully informed decisions about the risk of extending credit.
Professional advice on carrying out creditworthiness checks is often invaluable.
Allianz Trade can provide accurate information on creditworthiness. Take the guesswork out of credit risk calculations and make confident decisions based on reliable, in-depth information.
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