It is common knowledge in the industry that the credit risk assessment of a consumer applying for credit is far less complex than that of a business that is applying for credit.

Why is this the case?

Simply put, consumers are usually very similar in their requirements and risks (homogenous) whilst businesses have far more varying risk elements (heterogeneous).

In this blog, we will look at all the different risk elements within a business (here SME) credit application. These are:

1. Risk of proprietors
2. Risk of business
3. Reason for loan
4. Financial ratios
5. Size of loan
6. Risk industry
7. Risk of region

Before we delve into this list, it is worth noting that all of these factors need to be deployable as assessment tools within your originations system so it is key that you ensure your system can manage them. If you are on the look out for a loans origination system, then look no further than Principa’s AppSmart. If you are looking for a decision engine to manage your scorecards, policy rules and terms of business then take a look at our DecisionSmart business rules engine.

AppSmart and DecisionSmart are part of Principa’s FinSmart Universe allowing for effective credit management across the customer life-cycle.

 The different risk elements within a business credit application

1) Risk of proprietors

For smaller organisations the risk of the business is inextricably linked to the financial well-being of the proprietors.

How small is small? The rule of thumb is companies with up to two to three proprietors should have their proprietors assessed for risk too. This fits in with the SME segment.

What data should be looked at? Generally, in countries with mature credit bureaux, credit data is looked at including the score (there is normally a score cut-off) and then negative information such as the existence of judgements or defaults; these are typically used within policy rules.

Those businesses with proprietors with excessive numbers of “negatives” may be disqualified from the loan application.

Some credit bureaux offer a score of an individual based on the performance of all the businesses with which they are associated. This can also be useful in the credit risk assessment process.

Another innovation being adopted internationally is the use of psychometrics in credit evaluation of the proprietors.

To find out more about adopting credit scoring, read our blog on how to adopt credit scoring.

2) Risk of business

The risk of the business should be managed through both scores and policy rules. Lenders will look at information such as the age of the company, the experience of directors and the size of the company etc. within a score. Alternatively, many lenders utilise the business score offered by credit bureaux. These scores are typically not as strong as consumer scores as the underlying data is limited and sometimes problematic. For example, large successful organisations may have judgements registered against their name which, unlike for consumers, is not necessarily a direct indication of the inability to service debt.

3) Reason for loan

The reason for a loan is used more widely in business lending as opposed to unsecured consumer lending. Venture capital, working capital, invoice discounting and bridging finance are just some of the many types of loan/facilities available and lenders need to equip themselves with the ability to manage each of these customers types whether it is within originations or collections. Prudent lenders venturing into the SME space for the first time often focus on one or two of these loan types and then expand later – as the operational implication for each type of loan is complex.

4) Financial ratios

Financial ratios are core to commercial credit risk assessment. The main challenge here is to ensure that reliable financials are available from the customer. Small businesses may not be audited and thus the financials may be less trustworthy.

Financial ratios can be divided into four categories:

• Profitability
• Leverage
• Coverage
• Liquidity

Profitability can be further divided into margin ratios and return ratios. Lenders are frequently interested in gross profit margins; this is normally explicit on the income statement. The EBIDTA margin and operating profit margins are also used as well as return ratios such as return on assets, return on equity and risk-adjusted returns.

Leverage ratios are useful to lenders as they reflect the portion of the business that is financed by debt. Lower leverage ratios indicate stability. Leverage ratios assessed often incorporate debt-to-asset, debt-to-equity and asset-to-equity.

Coverage ratios indicate the coverage that income or assets provide for the servicing of debt or interest expenses. The higher the coverage ratio the better it is for the lender. Coverage ratios are worked out considering the loan/facility that is being applied for.

Finally, liquidity ratios indicate the ability of a company to convert its assets into cash. There are a variety of ratios used here. The current ratio is simply the ratio of assets to liabilities. The quick ratio is the ability of the business to pay its current debts off with readily available assets. The higher the liquidity ratios the better.

Ratios are used both within credit scorecards as well as within policy rules. You can read more about these ratios here.

5) Size of loan

When assessing credit risk for a consumer, the risk of the consumer does not normally change with the change of loan amount or facility (subject to the consumer passing affordability criteria). With business loans, loan amounts can range quite dramatically, and the risk of the applicant is normally tied to the loan amount requested. The loan/facility amount will of course change the ratios (mentioned in the last section) which could affect a positive/negative outcome. The outcome of the loan application is usually directly linked to a loan amount and any marked change to this loan amount would change the risk profile of the application.

6) Risk of industry

The risk of an industry in which the SME operates can have a strong deterministic relationship with the entity being able to service the debt. Some lenders use this and those who do not normally identify this as a missing element in their risk assessment process. The identification of industry is always important. If you are in manufacturing, but your clients are the mines, then you are perhaps better identified as operating in mining as opposed to manufacturing. Most lenders who assess the industry, will periodically rule out certain industries and perhaps also incorporate industry within their scorecard. Others take a more scientific approach.

In the graph below the performance of an industry is tracked for two years and then projected over the next 6 months; this is then compared to the country’s GDP. As the industry appears to track above the projected GDP, a positive outlook is given to this applicant and this may affect them favourably in the credit application.

7) Risk of Region