Changes Ahead for How You Handle Credit Evaluations

The traditional method of checking credit has always been to have a prospect fill out a credit application and submit its latest financial report. A credit analyst then typically orders a credit report, requests trade and bank references, and analyzes the firm's financial statements before reaching a credit decision. Any discrepancies in the facts, anomalies in the data, or items that don't meet accepted standards for the amount of credit required may require additional due diligence.

This method of credit approval has remained fairly standard across most industries for the better part of the last century. Automation has helped with the collection, analysis, and presentation of the data, including peer-to-peer and period-to-period comparisons, but it has not dramatically changed the process. Despite the established standards for credit evaluation, several major forces driven by modern commerce are causing changes in the credit lifecycle. They are:

1. The Need for Insight, Not Information
To a certain extent, traditional credit evaluations have been focused on gathering information. The more information you have on an account, the better off you are. Technology is making it easier to gather information; as a result, some credit departments are awash in data. But now, technology is allowing us to focus more on the result rather than the means. The purpose of the information is to provide insight, and technology helps us collect only relevant information and convert it into decisional intelligence.

2. Outsourcing Is Gaining Broader Acceptance
While most credit departments are not willing to outsource their credit approval processes, they are increasingly willing to turn to external services for insight. So-called "boutique" credit agencies closely monitor many of the large public and private corporations (especially chain stores and other retailers), gathering information and sharing insight with their credit department customers. In addition, Software-as-a-Service solutions (essentially technology delivered via the Internet) are also gaining popularity. These solutions no longer just deliver information, but also tools so credit analysts can gain additional insights on their customers and receivables portfolio.

3. Portfolio Risk Analysis Is Becoming Easier and More Formal
For the past two decades, software solutions have increasingly made it easier to look at your A/R portfolio as a whole (portfolio analysis). At the same time, commercial credit scoring has been evolving. Now that the technologies supporting portfolio analysis have passed through their developmental phase and matured, best practices are emerging that will become the standard for years to come.

4. The Pricing of Risk Is Now Attainable
Closely aligned with formal portfolio analysis are new tools and protocols for the pricing of risk. Once we are able to consistently wrap our receivables in risk-defining metrics, we can then determine the true value of our receivables. This insight enables creditors to adjust their pricing schedule based on their customers' risk category (the lower the risk, the better the pricing you could offer and vice versa). Sharing your risk analysis metrics with financial institutions also facilitates new opportunities in receivables financing, including the sale and securitization of receivables. The pricing of risk and the commoditization of accounts receivables (using securitization portfolios of accounts receivables can be sold as bonds in the capital markets) has the potential to unleash a huge amount of corporate liquidity now tied up in working capital, and in so doing dramatically change the world of corporate credit. As a result, the things a credit analyst does today will change and technology will be the enabler. Risk assessment, credit decisions, customer management, and default analysis are the four primary tasks that will be affected.

Risk Assessment
As previously noted, credit analysts have traditionally focused on company risk analysis. While some attention has been paid to industry risk analysis, it has usually been limited to comparisons with industry norms. What has been lacking are industry-to-industry comparisons within the receivables portfolio. Both industry norms and the quantitative relationship of your customers taken as a whole and as individuals within a specific industry to those norms should be considered.

"Efficient Frontier"
If your A/R system can quantify your portfolio risk from both a company and industry perspective, you will be able to figure out the most profitable way to set risk and manage your receivables. Credit consultants refer to this as your "efficient frontier," which is defined as the level of risk that facilitates maximum profits. Either failing to achieve or exceeding your efficient frontier will result in lower profits.

For example, lowering your standards to sell to riskier accounts will increase your risk, but it may also increase your sales and profits. And, the additional diversification in your customer base may tend to lower your risk. Keep in mind that risk is not just losing money, but also the loss of opportunity (sales).

Because we have not traditionally calculated credit risk very well, most creditors have no idea what their efficient frontier is. And unless you can approximate your efficient frontier, the context for making credit decisions is at best incomplete. The solution is a much more structured analysis of receivables portfolios than is currently performed. Fortunately, with the maturation of portfolio analysis tools, this is now possible.

Credit Decisioning
Imagine two companies, for example, Merck and Pfizer, selling to the same buyer. The steps they go through to reach a credit decision will parallel each other in most respects. There is a tremendous amount of redundancy in the credit approval process from one company to the next, probably upwards of 80 percent, and this 80 percent can be standardized.

In other words, there is an opportunity for a service that provides not just background information, as with a traditional credit report, but rather the insight that a credit analyst derives from evaluating all the information gathered during the credit approval process.

Again, technology is making this possible. Software is capable of comprehensive financial analysis including ratio analysis, period-to-period comparisons, and industry benchmarking. Furthermore, custom credit scoring adds a whole new dimension to risk analysis. Add to the technology an independent analyst whose sole job is to closely monitor a portfolio of companies within a specific industry, and you come up with a company risk report that is similar to those provided by equity research firms.

Businesses are emerging that rate companies worldwide along these lines. This leaves us to answer the question, "How much value can a credit manager add to these ratings?" For the most part, credit pros will be freed from doing all the legwork associated with the credit approval process so they can make higher-level credit decisions within the context of their own firm's efficient frontier. That's the added value credit pros will provide, the next generation of credit reporting services having provided the underlying insights. There will typically be no need for credit pros to duplicate the grunt work involved in the analysis process.

Customer Management
Most credit departments have schedules for reviewing the credit of their existing accounts, but few are able to stick to it, despite the fact that 80 percent of bad-debt losses are attributable to accounts that have been customers for a year or more. Credit departments allocate substantial resources to new account credit evaluations, but not enough for monitoring active customers. This is a clear opportunity for third parties to provide customer monitoring that is periodic and event-based. Such a service should also allow the creditor to specify the sources to be monitored, just as if they were doing the job themselves.

The nature of ongoing Customer Management is such that a dedicated outsourcing partner should be able to cost-effectively provide administrative support. In addition, by combining external data with your own internal details (such as payments and order history), an outsourcing partner should be able to provide forward-looking insights regarding your receivables portfolio.

You cannot measure what you cannot see, and you cannot control what you cannot understand. A customer management process that provides greater visibility and predictability will allow you to contribute substantial insights to the sales planning and needs assessment processes within their organizations. So, in addition to potential cost savings in terms of administration, an outsourcing partner can also help the credit function add considerable value in the area of customer management.

Default Analysis
When a customer declares bankruptcy or otherwise defaults, the typical credit department goes through a drill that involves little more than filing a claim and hoping for the best. Because trade creditors are strongly reliant on payment data for identifying downturns, little attention is given to what might be learned from the situation other than to identify the red flags, now obvious in retrospect, that might have been missed. And, factors other than trade payments may be better predictors of default. Payment data will eventually turn negative, but only after other indicators have identified a high-risk situation. In addition, the payment data collected by the credit bureaus or credit industry groups may represent only a small and not necessarily statistically significant sample of a company's payment data.

Fundamental analysis is, therefore, more important than payment data. What is needed is an analysis of what could have been done differently in dealing with the bankrupt entity. In other words, what did we leave out of our monitoring process? This will require looking for default patterns within the context of your entire receivables portfolio. It will also require an analysis of the opportunities for recovery from bankruptcy or default. In other words, when have we been successful in recouping some of our losses?

If you can answer these questions, you will gain valuable insight for evaluating the effectiveness of risk mitigation tools such as credit insurance, puts, and other hedging strategies.

How This Will Play Out
The combination of technology and next-generation service bureaus will clearly help credit pros improve the quality, timeliness, and depth of the credit lifecycle. Credit evaluations will be comprehensive, on both a portfolio and an account analysis basis, without wasting time, money, and resources on irrelevant information. All this will also significantly lower the cost of credit operations.

Best practice processing of credit evaluations will also be standardized. A parallel is collection software, which has had the effect of standardizing collection workflow along best practice guidelines. The key benefits from a credit evaluation perspective will be:

• The identification of optimal risk levels
• A greater ability to identify opportunities to hedge risk, primarily due to greater amounts of information and more insight into customer and portfolio risk
• The ability to accept higher perceived levels of risk, which is facilitated by such things as diversification and risk-based pricing
• Improved regulatory compliance

For credit pros, these tools offer a clear opportunity to use the efficiencies and insights from a more robust and dynamic credit evaluation process to raise the visibility and value of the credit function within your companies.

Editors Note: The genesis of this article comes from "The Future of Credit Evaluation," a presentation by Dr. Venkat Srinivasan, CEO of Creditpointe, Inc., at the Western Regional Credit Congress in Las Vegas, Nevada last Fall.