CHAPTER 3: CHECKING CREDITWORTHINESS AND EVALUATION Credit Risk Management Process- this involves the judicious, timely and

*Credit Investigator has an easier task because over the years, sources prudent checking of the five basis of credit, character, capacity, capital
of credit information have steadily increased, such growth was based condition, collateral in applicable cases
on the relationship of mutual confidence and respect between and Causes of Credit Risk
among credit men and customers. - Adverse macroeconomics, business cycle, product cycle, health,
*The relationship that should exist must be based on two factors: financial condition of debtor
1. Confidentiality- credit information is confidential, it is intended solely - Capacity to absorb disturbances caused by aberrations in cash
to assist a prospective creditor in reaching a decision in a genuine credit flow, leverage, capital, management experience
problem. - Competition and industry trends
2. Completeness- an inquiry should clearly describe the subject state its - Integrity and reputation problems
object and scope and show that it is made responsibly. - Law and regulatory developments
*The Code of Credit Information Exchange: (FNIAE) - Credit performance
1. The first and cardinal principle in credit investigation is to respect the *Customer’s/Debtor’s Risk Rating
confidential nature of the information received. Creditors must in earnest develop evaluation and assessment yardsticks
2. The name of the inquirer in whose behalf the inquiry is made should to profile or categorize their debtors as to the ff:
not be disclosed without permission - Profitability of default in performing or paying credit obligation
3. In answering inquiries, the source of the information should not be - Use of financial capacity or performance to arrive at a credit score
disclosed without permission rating
4. Any betrayal of confidence stamps the offender unworthy of future - Quantitative financial modeling vis-à-vis, default models in
consideration developing economy
5. Each letter of inquiry should indicate specifically the object and scope - Credit risk measure adjustable to meet exigencies by using
of the inquiry qualitative credit risk criteria
Credit Investigation and Evaluation (GAD) *Debtors may be assigned risk ratings for:
*The work of a credit investigator may be divided into 3 major phases: - Credit Allocation
1. Gathering of credit information- *credit investigator - Credit Pricing
2. Analysis of credit information- *credit analyst - Credit Approval Level
3. Dissemination of credit information- *credit investigator - Credit Covenant or conditionalities
*More specifically, the investigation report should consist of: (WAPCSN) - Average, credit loss standards for estimating cost of credit or bad,
1. Who is requesting for credit accommodation? debt write offs
2. Amount and type of the credit applied for 3. Period or Term Of Payment- refers to the length of time within which
3. Purpose the debtor must pay the credit, whether this credit be in money, goods,
4. Collateral or services.
5. Sources and Mode of Payment 4. Exchange of Value- for the credit transaction to have meaning and
6. Nature of the Business attain its purpose.
*More specifically, the step by step process can be described in the Basis of Credit- Standard Basis of Credit:
following manner: (SCDI) 1. Character- comprises of inherent integrity and personal character.
1. The Sales Department receives a credit application 2. Capital- is the property the credit applicant owns in his name
2. The Credit Department studies in detail the merits of the application whether movable or immovable
3. During the Credit Investigation the Investigator studies the request 3. Capacity- is the ability of the credit applicant to earn enough to
in greater detail repay credit obtained
4. If the application is supported by collateral, an inspection and 4. Condition- is a very intangible basis for extending credit. It refers to
appraisal of the collateral must be conducted. the debtor’s existing physical, economic, financial, and political
*Elements of Credit (TRPE) situation in his place of residence.
1. Trust or Confidence 5. Collateral (Security)- are the other properties whether personally
- Trustworthiness: implies confidence in the debtor’s integrity and in his owned or owned by another person that the credit applicant is able
ability to pay the loan or credit on the date stipulated and according to to give as security for the credit obtained.
the terms agreed upon 6. Connection- this is unscientific basis for granting credit which is
2. Risks- this element can cause a creditor sleepless night, especially based due on our traditional “hiya” and “utang na loob” practices
when he begins having second thoughts about his Financial Factors to Check on Credit Applicant
-Credit Granting- is a risk. This risk increases proportionately to the size 1. Liquidity Ratios- measures the ability of the firm to meet its
of the credit applied for. maturing short-term obligations
*The analysis of credit risk involves five factors: (PPERS) Ratios Formula Relevance
1. Personal Factor Current Ratio Current Assets/ Measure adequacy
2. Performance Factor Current Liab. of working capital
3. Economic Factor Quick Ratio Quick Assets/ Measures ability to
4. Risks Factor Current Liab. immediately meet
5. Security Factor short-term
Managing the Risk- All businesses have risk. Credit risk is the principal obligations
problem of selling on terms. Cash Flow to Current Cash Flow fr. Measure ability to
*It comes about when the obligor/debtor fails to: (PFFF) Debt Service Optns/ Debt generate enough
- Pay the obligation secured Service cash from regular
- Failure of Proper documentation operations to
- Failure to Register document service short-term
- Financial Failure of co-obligor; as well as the spouse of the contracting requirements
obligor
* Credit Risk is Composed of: (PLP) 2. Leverage Ratios- measures the extent to which credit applicant has
- Performance Risk been financed by debt
- Liquidity Risk Ratios Formula Relevance
- Policy and Systems Risk Debt to Equity Ratio Total Liab./ SHE Measures how much
*Among the areas one has to check and evaluate are: debt was incurred in
- The debtor’s/co-debtor’s personal/business principles or practices relation to the
- Integrity and moral standing owner’s investment
- Capacity, capability to earn, save and pay financial obligations
- Economic, financial analysis of the debtor/company
 Debt Ratio Total Liab/Total Measures
Assets percentage of assets
financed by debt
Time Interest Earned EBIT/ Interest Measures the extent
Ratio Payments to which interest is
covered by earnings

3. Profitability Ratios- measures management’s effectiveness as

shown in returns generated from sales and investments
Ratios Formula Relevance
Net Profit Margiin Net Income/Sales Measures the
proportion of
revenue that find its
way into profits
Return on Assets Net Income/ Measures how much
Average Total Assets profits are
generated from
investment
resources
Return on Equity Net Income to Measure returns
Common Stock/ Ave. generated by
Common Equity common
shareholders
Earnings per Share Net income to Determines earnings
comm. Stk./No. of generated per share
outstanding comm. of common stock
Shares

4. Efficiency Ratios- measures how efficient is the credit applicant in

using its resources
Ratios Formula Relevance
Asset Turnover Ratio Sales/Average Total Shows how hard the
Assets firm’s assets are
being put to use
Average Collection Ave. Receivables/ Measures the speed
Period Ave. Daily Sales which customers
pay their bills
Inventory Turnover COGS/ Ave. Monitors the rate at
Ration Inventory which the company
replaces the
inventory

Non-Financial Factors of Credit Evaluation

- Payment Performance
- General Experience or Background
- Age of Business and Evidence of Sound Growth Potential
- Impression of the Applicant and its Management
- Adequacy of Resources/Availability of Financing
- Trend
Bonus Non- Financial Factors to Check
- Security/Collateral
- Confirmed Payment Arrangement
- Performance of Related Companies/Joint Several Obligor
- Form of Business Organization
Non-Financial Penalty Factors to Check
- Recent Litigation
- Recent Distressful Condition/Illiquidity
- Age of Credit Applicant/Owner
- Distributive Weakness
The Credit Scorecard- is a credit rating system used to assess, evaluate
individual credit applicants for ordinary short or medium term credit
application.