Credit: Assessment, Policy and Credit Risk Control
Core credit concepts
Credit questions require you to assess whether a customer or borrower can and will pay. Understand the five Cs, normally character, capacity, capital, collateral and conditions; credit scoring and scorecard cut-offs; credit terms such as 2/10 net 30; the cost of offering a discount; credit limits; covenants; security; monitoring; ageing analysis; and provisioning for expected credit losses. Distinguish credit risk from liquidity risk and concentration risk.
Traps to watch
- Confusing capacity, the ability to generate cash to repay, with collateral, the fallback if repayment fails.
- Calculating the cost of a trade discount as 2% rather than as an annualised opportunity cost.
- Ignoring the effect of a longer credit period in tying up working capital and increasing bad-debt risk.
- Assuming a high credit score removes the need for monitoring. Scores are point-in-time estimates.
- Treating a personal guarantee or collateral as a substitute for repayment capacity rather than a mitigant.
- Overlooking concentration risk when a small number of customers or sectors dominate exposure.
- Forgetting that credit policy has four variables: terms, standards, limits and collection effort.
Worked example: cost of forgoing a discount
Terms are 2/10 net 30. A customer who does not take the discount pays 98 after 10 days instead of 100 after 30 days. The extra 20 days cost 2/98 = 2.0408%. Annualised cost = 2.0408% x 365/20 = 37.24%. If the firm's short-term borrowing cost is below 37.24%, borrowing to take the discount is cheaper than forgoing it.
Rule of thumb
Credit is granted only when expected incremental contribution exceeds expected credit losses, collection costs and the cost of funds tied up. Review limits whenever payment behaviour or financial condition changes.