CHAPTER8 CREDIT ANALYSIS LEARNING OUTCOMES Define credit information; Know the different financial statement; . Identify the various bases of credit; 1. List down other bases; Know the different bank’s credit rating system; and Prepare credit investigation report. ay Ree Everyone who grants credit has an important task and responsibility not only to himself but to the economic society as well, ie,, only those entitled to the use of credit should be conferred such privilege. For this reason, there is both a pressing and compelling need to conduct a proper and thorough analysis and evaluation of credit risks of applicants for credit. This is sine qua non to the determination of proper credit rating. Thus, among others, it is necessary and important that sources of information be tapped to the fullest extent and placed under careful scrutiny and, moreover, studied thoroughly just as a physician examines very carefully the specimen placed under the microscope so as to ascertain what possibly is the cause of the ailment of the patient. As may be noted, the physician does not stop there. Rather he continues on his painstaking search, trying to find the unknown through whatever means that are available at his command, For this reason, he tries to acquaint himself with the medical history of the patient as well as the various symptoms he observes from his physical and medical examination of the patient. Not infrequently, he consults fellow physicians in order to arrive at a correct diagnosis. Those who run the credit department cannot do otherwise. The credit manager, for instance, must avail of the services of the credit investigator, the appraisers, salesmen, and others who could be of help to him, He may even enlist the services of private credit agencies in order to supplement the various information he has already at hand. In the case of properties which are offered as securities, the credit manager may hire the services of independent ani expert appraisers as to their correct market value and not rely solely upon the appraisal of his own men. 25CREDIT & COLLECTION Scope of Credit Analysis Financial analysis for credit purposes is a complex process. Not only does it involve a thorough study and understanding of financial facts recorded in balance sheets, income statements, trial balances, and separate schedules but moreover the economics of a line of business, of a trade, or of industry. Financial analysis is part of the complete process known as credit checking or credit granting. From the ¢redit man’s point of view, credit analysis of a firm is generally undertaken to help determine liquidity. Through going analysis every known fact regarding the affairs of a business concern will be taken into consideration when examining the financial report. In actual practice, however, wide extremes are found in the scope and intensiveness of financial inspection and analysis. Depending on the credit policies established by his firm and the scope of his activity, a credit grantor may be superficial in his analysis or he may be purely mathematical, or he may not be satisfied with nothing less than understanding of the conditions and trends disclosed by his analysis. It should be pointed out that comprehensive analysis requires that the trend 6f earnings and of economic conditions be compared with the experiences of a representative group of companies in the same line of industry. It should be noted, however, that the statement analysis is not the sole basis of the credit decision. It is only one part of larger process known as credit analysis. CREDIT INFORMATION First things first. Sine qua non to any credit analysis is the gathering of all available information about the applicant. Owing to the complexity if not the number of facts and data sought, the task of gathering credit information is far from an easy task. The principal sources of credit information may be observed as follows: A. From internal sources 1, Debtor's previous credit record with the business firm. 2. Credit man’s personal knowledge of debtor's character and reputation. 3, Personal contacts with debtor, © Through correspondence * Through personal visits by credit man or his representatives. © Reports of salesmen(CREDIT & COLLECTION 4, Analysis of debtor's financial statement 5. Audits or surveys of the business B. From internal sources Mercantile agencies Trade references Banks Newspaper clippings Court cases Reports from competitors of the borrower (in the case of a business firm). SF Fee Personal Interviews A personal interview is initially started when a prospective borrower applies for a loan: (or for the purchase of goods and/or services on credit in the case of a business firm). The most prudent credit extension is based upon complete investigation and competent analysis. Each application for a loan requires a different type of investigation. Not only does the personal interview result in a more accurate and detailed information, it likewise provides for a more complete information. This is so since a personal investigator can explain various perplexing questions in their different shades of meaning and thus use a certain degree of salesmanship to persuade the applicant for credit, who is being interviewed, to reply accurately and more fully. Then, too, in the personal interview, there is observed to be less likelihood for any room for facetious and. deliberate misleading information than when information is sought merely from the standard to be accomplished by the applicant for credit. Personal interviews may be conducted with or without the assistance of carefully-prepared questionnaire. In some instances, the interviewer may be armed with a certain degree of authority with respect to how he should conduct the interview in accordance with the type of information desired. An experienced interviewer can easily detect whether the party being interviewed is sincere, straightforward or evasive and untruthful. Ocular Inspection An interview with the seeker of credit may be followed by conducting an ocular inspection of the plant, equipment, and other assets which are offered as collateral security at the place of business of the applicant. Moreover, title to property may be inspected to determine in whose name the property is registered as well as any annotations, if any, (as to past or present mortgages), attachments, and notices of its pendens.CREDIT & COLLECTION FINANCIAL STATEMENT While finan nevertheless, its analysi ial statement represents not only one source of credit information, Nportance deserve utmost attention in respect to its study and Financial Statement, defined. A financial statement may be described as “any presentation of financial data from accounting records.” This definition is a bit broad to permit an approach to the subject in its proper perspective. Financial statement of the individual firm is the most important financial data. Varying numbers of statements, schedules, and exhibits are presented but three are fundamental, such as: 1. The balance sheet which depicts the financial condition of the business firm at the end of a specified period. 2. The profit-and-loss statement which summarizes the financial operations over a period of time; and 3. The reconciliation of the capital accounts and summary changes. In addition to showing the amount of net profit after income taxes retained in the business and amount paid out in dividends, its importance is anchored on pinpointing out changes resulting from revaluation of assets or investment of additional funds. A number of other schedules, exhibits, footnotes, and textual material may be included in the more comprehensive financial statements. Among those found within some degree of frequency are ones giving more details on. * The auditor's opinion or statement of the scope of the audit. + Individual items (such as cash and investments) and liabilities (such as notes or bonds payable) given as a total in the balance sheet. * Insurance coverage * Sources and application of funds. This is one of the most useful of all tools available to the credit analyst. In it are summarized all the activities of the firm which increased or decreased its cash position. Sources of funds include net profits after payment of income taxes, non-cash consuming expenses such as depreciation and depletion, a decrease in working capital indicating a greater increase (or smaller decrease) in current liabilities than in current assets, an increase in long-term debt, gains on the disposition of assets, and sale of additional capital stock. Uses of funds include payment of dividends, an increase in working capital, reduction of long-term debt, losses in the disposition of assets, and acquisition of treasury stock. This statement, then, 128- (CREDIT & COLLECTION is very important summary of past operations and a source of leads for further investigation by the credit analyst. * Cost of goods manufactured, selling expenses, administrative expenses, and other income and expense data summarized in the profit-and-loss statement. 4. Explanatory text or footnotes by the auditor explaining any of the figures in the financial statement. Reliability The values of these statements supporting application of loans filed with Commercial banks varies directly with the degree of confidence the loan officer can place in their accuracy. Statements prepared by outside accountants generally are given more credence than those prepared internally by the borrower's own staff. Interest of Commercial Banks ‘Commercial banks are interested in the accuracy and reliability of the various financial statements. Occasionally, banks are presented with financial statements that are not accurate and dependable because they have been deliberately falsified, prepared by those who do not follow acceptable accounting practice, or made by those who are over-optimistic in valuing assets and underestimating, liabilities. Because of these factors, commercial banks insist that financial statements, especially in large concerns, be prepared by disinterested party, preferably by a certified public accountant who follow accepted methods and principles of accounting. Banks sometimes insist that some applicants use financial statement forms prepared by them. Such a practice doubtless help facilitate the procuring of statements and moreover results in standardization. The date of the statements in a factor that must be recognized. Balance sheets, for example, that are prepared when the business is at its low point or when indebtedness is not great will show a much different picture than if prepared when indebtedness is high and business activity is at its highest point. Since many financial statements such as balance sheets and statements of income, are historical in nature, it is highly desirable that the credit analyst has at his convenience and reach financial statements for several periods if they are available. This will enable the credit analyst to make a comparison and thereby be able to obtain a good picture of what has occurred over a period of years. Obviously, a bank credit analyst must have some knowledge of the applicant's business who is applying for credit on the amount and quality of the data available. In analyzing the financial statement, the reliability of the audited balance sheet is initially examined after which a summary of financial ratios and statistics is subsequently prepared to ascertain the profitability, liquidity as well as solvency positions of the business enterprise under consideration.‘CREDIT & COLLECTION Gathering, Collating, and Sources of Sorting of Credit In- Credit Infor- formation Investigation, Analysis, Evaluation, Appraisal and Credit | Recommendations Department Collections and Follow-ups Mercantile agencies Banks Sales Agents Financial statements Newspaper clippings Court records Trade firms Interviews Recording, Filing, Indexing. Keeping eredit files up to date Studying activity of each account Billing Follow-ups Crediting payments Classifying debtors by paying habits Correspondence with Customers and others MAJOR FUNCTIONS AND RESPONSIBILITIES OF THE CREDIT DEPARTMENT Profitability It is measured by the success of a business in maintaining and increasing the owner's equity. The nature and amount of earnings as well as their regularity and trend are all significant in this appraisal. Liquidity Itis gauged through the ability return of checks due to insufficiency of funds. In fact, the credit file will give a good picture of the true standing of applicant with respect to previous borrowings, amounts involved, and the time of payment, ive., whether they were repaid on time or not. 130"(CREDIT & COLLECTION Trade References As a standard practice, the credit-granting concern generally request the loan-applicant that it be furnished with a list of the banks and business firms with which the applicant has business dealings at the moment as well as those with which it has dealt with in the past. Basically, there are two major reasons which justify the need for references. First, it is customary for all businessmen to satisfy themselves with respect to the integrity, reputation, and financial standing of prospective customers. This holds with particular application to banks and banking institutions inasmuch as checks in the hands of unscrupulous individuals could-become potent and dangerous weapons in that such individuals will not hesitate to open current accounts with different banks and, with check forms in their possession, they could fill them up in amounts far in excess of what they have in their accounts and thus use them to defraud others, if not the banks themselves. Second. Trade references showing established business connection during the years past while not conclusive insofar as unblemished reputation and financial ability to pay on the part of the applicant are concerned, nevertheless, could serve as a good index regarding the experience of previous business firms and trading companies with respect to transactions made by the financial managers of a business to increase current assets and holds them in the form of cash or securities as are reasonably necessary under the circumstances. Such method confers upon the business firm the following advantages: 1. The business firm will be better situated to face unforeseen emergencies or unexpected business reverses. : 2. Funds being readily available could be tapped and utilized for any attractive business opportunities that may crop up in the future. 3. Purchases can be made in large economic lot sizes. As such, this will enable the business firm to take advantage and obtain some discounts. From the point of view of sound business management, for a business firm to be described correctly as solvent, it is necessary that it is able to meet its liabilities as they mature. Perhaps, it may be correctly mentioned that if a thorough analysis is desired but the data are far from complete or not available, the financial analyst must somehow act no different from a private detective. The same step should apply in cases where some suspicion exists, as when the business firm is trying to hide or present a different financial picture from what actually it is. The financial analyst should scout for the full facts and piece them together, as in a jigsaw puzzle, and obtain the true picture of the firm which is the subject of study. 131CREDIT & COLLECTION Bank's Own Records It is scarcely necessary to point out the fact that the bank always keeps records of whatever transactions it has with its customers. From such records, through a proper study and analysis, the bank is able to ascertain the average balance kept on deposit by the applicant as well as cases involving subject applicant together with the degree of promptness of repayment and many others. The following form letter is an example of a request for business reference: Sir Re: Request for Business Reference This customer of yours has given us your name as a reference. As such, we would like to appeal to your kind cooperation for whatever valuable information you could furnish us which would be of help in the consideration of his application for credit 1. ‘How long has the applicant been buying from you? How much credit do you allow him? How promptly does he settle his obligations with your company? |. What is your opinion of the applicant as a credit risk? ‘Any remarks you might care to make. In connection with our request, please be informed that we will treat it in absolute and strict confidence. Your cooperation on the matter will be highly appreciated. With sincere thanks, John Swift 132‘CREDIT & COLLECTION Salesmen as Sources of Credit Information Not infrequently, salesmen are good sources of credit information because they have direct contact with the buyers in the field of their operation. The salesman is in a favored position, if properly instructed, to collect an immense wealth of information about the applicant which perhaps is scarcely available elsewhere, He can do this through conversation and questioning of the applicant. Sometimes, even gossip could be of some help. Asa keen observer, he can evaluate the importance of the location of the business firm, the methods employed (whether ethical or unethical) and its reputation in the community where it operates. In as much as it takes certain qualities of good judgment, training and experience to be able to gather the needed information, not every salesman can furnish specific information that is desired by the company. To be of great value to the company, the salesman must be thoroughly trained in the broader aspect of his company’s selling policy ~ that “it is better not to make a sale than be able to sell one for which no payment will ever be made by the buyer.” Moreover, the salesman must also be made to understand and remember that “no policy could be more detrimental to the interest of the business firm than to offer special concessions not in consonance with the terms of the selling concern.” Market Research Department While not many companies maintain its own market research department, nevertheless, in cases where they do, such department could provide a good source of credit information. This is due to the observation that research men engaged in the collection of needed information enjoy a certain latitude of freedom from any bias or prejudice. Indeed, they are trained to size up the merchant, his store, his method of conducting business and others - with absolute impartiality. On top of this, their reports enjoy the distinct advantage of being free from the uncertainty and impersonality that oftentimes characterize most stereotyped credit reports. Market research does not only delve into the potentialities of a particular product or the degree of market demand but, at the same time, it will provide other information such as business houses that will handle the product - and, of course, their business and financial standing. However, one major drawback against a market research department is the outlay that is involved not only in putting such department but its continuous maintenance. Credit Agencies At least partial information about the credit standing of an applicant for credit may be obtained from certain established credit agencies. 133CREDIT & COLLECTION By definition, a credit agency may be described simply as that company which gathers and distributes information about the credit position of individuals, firms, and corporations. Generally speaking, two types of credit rating agencies may be noted: (a) agencies that provide credit information with regard to businessmen and companies, and (b) agencies that provide credit information with regard to individual purchasers. Private credit agencies make a profit by collecting information and publishing confidential reports for the benefit of their subscribers. Each subscriber contributes to these reports by furnishing information and periodic ratings. Additional information is gathered from local newspapers, notices of change in address, death notices, and court records. ‘The most important facts contained in the reports furnished by credit agencies, are those which pertain to the business histories of individuals as well as those of business firms. This may be explained from the fact that such histories could include all available information on bankruptcies, lawsuits, composition settlement with creditors, and other data, whether favorable or unfavorable. Credit Management Association of the Philippines The Association of Credit Men, Inc, came into being through the joint efforts of some 26 creditmen in 1931. Thirty years later, in 1961, the association. became affiliated with the National Association of Credit Management, keeping this position for the next ten years. The NACM has its headquarters in New York and is the parent organization of state and local credit association throughout the United States. In 1967, it assumed its present name (Credit Management Association of the Philippines) in consonance with the growing recognition and the increasing demands and responsibilities of the credit profession. CMAP which stands for Credit Management Association of the Philippines, for short, is composed of more than 200 members-companies from the banking, trading, manufacturing, financing and insurance communities. Its overall philosophy revolves around three main themes: (1) to inculcate credit consciousness in the public’s mind; (2) to place the credit-man in his proper place as a professional; and (3) to infuse credit discipline to the greater mass of our people. Broadly, its function consists of the collection of every bit of information vital to the credit function which it disseminates to its members for their guidance. Thus, court cases involving dishonesty and immorality do not escape its attention. In the main, most such cases are for estafa,, replevin, and others. Through its assistance, it helps prevent the improper use and abuse of credit on the part of those who are not entitled to such a privilege. Thus, such a safeguard represents service of far-reaching, significance considering the fact that in a developing country like the Philippines, there is utter need for the husbanding of all resources, including capital, to make the economy grow and prosper. And such an objective can only be attained through proper and wise allocation and utilization of financial resources. 134‘CREDIT & COLLECTION Services Offered by CMAP CMAP offers the following services: 1. Quarterly Survey of Credit and Collection Bureau. Member-companies are surveyed by the association office every quarter of the year for their (a) individual comparative experience on the collection situation between two succeeding quarters, that is, whether collection has become easier, tighter or unchanged; reasons which account for the situation; (b) the company’s prevailing terms of sale, equivalent days’ billing of trade receivables, and ratio of bad debts to gross credit sales for a period ending the particular quarter under review and (c) aging of receivables. 2. Listing of Overdue Accounts. This is a periodic activity in which member- companies provide the association with names of accounts overdue the standardized terms of the reporting company. The accounts submitted are consolidated. ing of Court Cases, This is a compiled listing of court cases in the categories of sum of money replevin , and estafa filed in the different courts within the cities and towns of Metro Manila. 4. Listing of Returned Checks. Any interested member-company may submit alist of account names who have paid by checks and for one reason or another cannot be negotiated or returned by the bank. All account names are summarized. 5. Listing of Corporations and Partnerships. From available records, a periodic listing of corporations and partnerships registered or dissolved is compiled. 6. Ledger Interchange. This is an exchange of notes for comparison on experience and opinions extracted from the ledgers of members of accounts selected from time to time for review only by interested and participating member-companies. Other services offered by CMAP consist of holding seminars/workshops, publication of Credit Management Journal and others. BASES OF CREDIT The foundation upon which the system of credit rests has been indicated earlier. Apropos to that, our attention is immediately drawn to the bases of credit which are intertwined with credit analysis and evaluation. 135ewe Traditional C's of Credit The major factors which must be considered and taken into account which affect the decision as to whether credit should be granted or denied are generally termed as the traditional C's of credit. Such C’s of credit are character, capacity, capital, and collateral Character The character of the borrower indicates his willingness to discharge his financial obligation, that is, to pay the loan as promised. While character does not, in any way, indicate his probable ability to do so, nevertheless, one who possesses good character will always endeavor to meet his obligations. Unblemished character makes for good reputation, which is of definite value in credit analysis and evaluation. It goes without saying that honesty, integrity, willingness to meet obligations that have arisen out of past credit transactions as well as willingness to cooperate are qualities that make the buyer a good risk. Conversely, bad habits or tardiness in the discharge of obligations if not to say totally ignoring one’s obligations, should immediately disqualify an applicant for credit. On this subject, the eminent Bishop Fulton Sheen has this to say: “Character is not revealed when life shows its best side but when it shows its worst. The way to tell a print from a tapestry is to look at the seamy side. An inexperienced buyer never turns the chair upside down; an expert always does. The worth of a person, in like manner, is to be judged by how he reacts to the obstacles, the limitations and the crosses of life. Life can be based on either of two assumptions. One is that the obstacles, trials and sorrows are not a part of the pattern of life. There must be all warp and no woof in the fabric of existence. Hence, in the face of annoyances, one must either seek flight from existence through alcohol or barbiturates, or else blame all that happens to others. From this flows discords, revolutions and wars,” “The second assumption is that everything that happens to us must be changed and transmuted by a Divine Vision to that, instead of defeating, it rather aids us to mount to higher levels of peace.” “However, a prospective user of credit should be more than a good man equipped with the best intentions to be deserving of credit. As one credit man aptly stated, “He should also have unquestioned ability to pay.” Capacity As one of the bases of credit, capacity may be viewed from two senses: 136‘CREDIT & COLLECTION 1. Itmay be looked upon as representing the debtor's ability to conduct his business efficiently and profitably. This is reflected by his business experience and personal effort to succeed. Capacity, in this sense, briefly stated, involves business ability, reputation of product (in the case of a manufacturer or producer), soundness of business methods as evidenced by profit-making records. 2. Capacity may be looked upon as the ability to enter into a valid contract. Age and health of the debtor are two important factors to consider. Unless the individual is of legal age, the contract may become invalid and unenforceable. Thus, a contract between a credit-granting concern and a minor is invalid. On the other hand, health is likewise another factor that must be given important consideration. For as is observed, uninterrupted earnings depend largely upon one’s good health. Conversely, ill-health may force the individual to suffer from a decrease in income which might impair his ability to pay. Capital The term capital has many meanings. For instance, for businessmen, money is capital. From an economic sense, capital refers to capital goods, those goods that are used in the further production of more goods. As used in this book, capital represents the firm’s property, like equipment, building and the like. Property which has a ready market, whether used directly in the business or not, which is registered in the name of the prospective debtor constitutes the basis of the property risk. The risk factor increases with the length of loans, meaning to say, the longer the term, the longer is also the risk. It is for this reason, that in many instances, if not always, most long-term loans are secured by pledges of property. Capital is considered by many as the most desirable and perhaps the most important requisite for credit - this, notwithstanding the oft-repeated remark, of J.P. Morgan, a well-known financier during his time, who considered character as the best collateral. However, it is not uncommon to observe that applicants who possess good character and integrity are unable to secure loans on the basis of their character alone. Collateral Collateral refers to the compensating considerations purposely intended to shield the interests of the creditor from bad debts. With the use of collateral, the incidence or risk of bad debt or default becomes minimized. Thus, collateral is of great value when the account is highly uncertain to be paid or the possibility of bad debt or default on the part of the borrower looms large and seemingly foreboding.‘CREDIT & COLLECTION Acollateral may be described as something of value which iseasily convertible into cash, deposited as a pledge with a lender to secure the repayment of the loan. Its value is substantially very much greater than the amount of the loan, generally over 40% of its market value. Such a margin is intended to serve as a safety valve against any unforeseen and sudden fluctuation in the value of the mortgaged property. Generally speaking, if the borrower is unable tomeet the loan obligation when it falls due, in accordance with agreement between the parties, the creditor (lender) may sell the collateral and collect the debt from the proceeds of the sale. However, in the case of real estate, the creditor does not acquire ownership on account of non- payment of the debt within the period agreed upon. But the creditor may petition the court for the payment of debt or the sale of the real estate property. In this case, according to law, foreclosure and sale of mortgaged property shall apply. Collaterals which have been described as something of value may partake of several types, the most important of which are the following: 1. Real estate properties. 2. Machinery and equipment. 3. Merchandise, crops, etc. 4, Corporate securities such as stocks and bonds. 5, Instruments or documents of ownership of commodities or manufactured goods, such as: bills of lading, warehouse receipts, and trust receipts. 6. Other forms like assignment of accounts receivable, etc. In that case of pawnshops as sources of credit, the most common security is jewelry, watches, household articles like refrigerators, freezers, washing machines, and others like cameras, typewriters, etc., are becoming quite common. In passing, mention may be made that no applicant should feel insulted because of a request on the part of the credit-granting concern to furnish it with security. Such is a standard operating practice among creditors and should not be interpreted as to mean that his integrity and financial ability are put to question. In fact, the applicant should have reason to feel that such request for security is not only borrower as well. This is so since the applicant can borrow only that amount which he can support with collateral. This circumstance will prevent the possibility of having a millstone continually hanging around his neck especially so if the expected source of income or means of repayment fails to materialize.Preventing Frauds on Collaterals In order to prevent the commission of frauds, insofar as the use of collateral is concerned, it is necessary that a central collateral register be provided and maintained. This should provide complete and accurate descriptions of all collateral pledged/deposited with the institution, Negotiable collateral should be held under joint custody. All collaterals, as taken from the collateral notes and records, should be physically verified quarterly against the collaterals on hand by a person other than the collaterals’ custodian. A designated employee/officer should inspect the collateral and all related documents. Collaterals should be appraised conservatively to avoid over-appraisal. OTHER BASES Within recent years, many economists and financial experts include other C’s of credit apart from the traditional ones which were mentioned and discussed in the foregoing paragraphs. They are: conditions and country. When business conditions start from bad to worse, sometimes it happens that even those debtors who have shown exceptional business ability and the reputation for discharging their obligations on time become delinquent, if not to say, default in such obligations. That being the case, any prospective creditor becomes wary in extending credit during slack periods. In fact, it may be mentioned that, whenever creditors like banks and other financial institutions observe certain red signals in the financial institutions observe certain red signals in the financial and economic horizon, like the onset of an impending depression, not a few of them demand the immediate payment of obligations from their debtors on loans other than term-loans, Conversely, during periods of business boom, if not to say, periods termed by economists as one of prosperity, creditors are quite liberal in the grant of loans since most businessmen are making good in their businesses which insure their ability to meet their financial obligations even before their due date. Country Since, as had been stated time and again, the sale of goods and services in any part of the world on credit involves risk, it follows that every factor should be carefully considered and scrutinized insofar as they affect credit risk. In the field of international trade, exporters who sell their goods on credit are exposed to certain credit risk not-withstanding the fact that their importers have for years been very religious in the discharge of their obligations. A country whose government is continually threatened with insurrection and rebellion is far from being a desirable place to sell goods on credit. For indeed, when a government‘CREDIT & COLLECTION topples down and anew administration takes over, that could signal a drastic change in policies among others. For instance, payments of international obligations may be stopped altogether, Hence, the exporter may be found holding an empty bag until such time that payment restrictions are lifted, Currency Not only is the stability of the country of importation an important factor to, reckon with in the consideration of credit risk in international trade transactions but, equally so is that which pertains to that of currency. The risk of exchange must also be taken into account. Where the currency of a country fluctuates quite markedly from time to time, such circumstance may prevent the grant of credit to the prospective buyer or importer of goods. For indeed, it could happen that at the time of payment of the obligations, the money paid to the exporter is not worth as much as it used to be when the contract of sale was perfected. Confidence After having indicated and discussed the various bases of credit, one is led to conclude that, in the ultimate analysis, credit is founded on confidence - which by far is the principal C of credit. For any credit transaction to take place, the businessman, whether he be a seller of goods or services on credit must have confidence, * onthe character of the buyer- whether he is trust-worthy and, as such, represents a good moral risk; * onthe capacity of the buyer to enter into a valid contract and conduct his business profitably; * ontheadequacy of the capital possessed by the debtor to support the transactions for which credit is required; * onthe fact that the collateral put up by the debtor is something of value and will not become subject to wide and violent fluctuations in the market; * on the soundness of policies of the government of the country of importation in the case of foreign trade; and of course * on the stability of currency. Briefly observed, then, confidence: is the cornerstone of every credit transaction - the prime mover of credit economy.CREDIT & COLLECTION One last word about bases of credit. Perhaps, it is not uncommon to hear that “connection” is also another basis of credit, that is, the relationship between the creditor and the debtor, While this may be true in certain government financial institutions, where a corrupt official is always thinking in terms of “grease money” as the primary factor that will influence the grant of loan toanother equally unscrupulous private individual, nevertheless, “connection” has no room in established financial institutions manned by competent and morally upright officials. BANK’S CREDIT RATING SYSTEM Tt is logical to expect that the credit rating system of one bank may differ from the others insofar as its requirements are concerned. However, their objectives are more or less the same, such as: 1, To define the relevant areas of credit and serve as a medium for credit analysis and the determination of credit worthiness; 2. To provide the bank a uniform yardstick for credit in evaluating all customers intending to avail of its services, 3. To rank objectively. borrowers as well as prospective clients based on an established risk rating scale and accordingly grade the bank’s investment portfolio in accordance with various levels of credit worthiness; and 4. To standardize the steps and procedures to be followed in the credit rating process. Alternative Approaches to Credit Rating In order to provide alternative approaches to credit rating and thus be able to differentiate sufficiently the considerations involved among varying types of industries and business firms, two basic approaches are made use of under the credit rating system, They are: 1. Inward Approach This type of approach emphasizes a firm's financial performance and its asset position as of a specified date, The main thrust of this approach is on capacity, This approach has value and is used whenever the financial requirements of a business firm are not expected to be affected materially, one way or the other, by outside factors or conditions. 141CREDIT & COLLECTION 2. Outward Approach The use of outward approach lays emphasis on industry conditions, plans, forecasts and general outlook. Unlike the first approach, outward approach assumes that the financial requirements of a concern will be materially affected by outside factor sand conditions. Under the rating system, the weight designs of the two approaches are as follows: Inward Outward Points % of Total Points % of Total Character 75 15.0 75 15.0 Capital 15 15.0 15 15.0 Collateral 50 10.0 50 10.0 Cash Flow 50 10.0 50 10.0 Capacity 160 32.0 90 18.0 Conditions 90 18.0 160 32.0 500 100.00 500 100.00 ‘As may be observed under both approaches, only two factor groups are variable, such as capacity and conditions. Emphasis on capacity and conditions may be explained by the fact that they are both sensitive to changes. Capacity and conditions represent the basic processes and factors which indicate performance. For instance, capacity shows in effect, how the firm utilizes its resources, which may be in terms of money (capital), people (character, attitude, and abilities) and machines (fixed assets) against a background of predetermined goals and objectives. Conditions, on the other hand, will determine to a large extent, given past performance, the resource level and plans as variables, how the firm will perform in the future and what these conditions may require in terms of ability and resources. In certain instances, where the major basis for the credit decision on loans leafts heavily on past performances and asset position, the analytical emphasis is laid on capacity. This is because under conditions where the industry outlook presents no tangible proof for material changes, the expectation is that future firm performance will necessarily depend to a large degree on the firm's past performance, which is a manifestation of the ability of the managing business team, operating efficiency and available resources. . Conversely, where the basis for credit decision is anchored on the expected impact of future conditions or given firm's performance, the analytical stress logically should be focused and concentrated on conditions. 142‘CREDIT & COLLECTION Cash Flow Evaluation Cash flow is the inflow and outflow of cash, But the term cash flow is too often used in a very broad sense and as such may or may not be held to apply literally to the flow of cash, Cash flow may be another term for a flow of net working capital or for a flow of the more liquid current liabilities. Cash is only one of the current assets and is part of the working capital. Hence, the changes in all of the other current assets and in the current liabilities must be carefully analyzed. Cash flow evaluation refers to the analysis of the projected sources and applications of funds to determine the available cash to meet future obligations and contingencies of the subject business firm requesting loan or increase in its credit facility. The forecast to be made should contain at least the following important information: a. Sources and uses of cash on a monthly basis or annual basis depending on the terms of credit accommodation requested; b. A repayment scheme on the accommodation applied for; and c. A disclosure of all pertinent assumptions used in the forecast. Other information included in the evaluation are the nature of request, analysis of future cash receipts and disbursements, other related considerations and of course, the conclusion and recommendation, if any. Handling Credit Investigations In the case of banks as sources of loanable funds, it is scarcely necessary to state that they serve as the guardians of the capital and credit of the industrial world. A bank is, in a very real sense of the world, no less than a public servant. It owes to its depositors the assurance that their interests will be properly protected, and cared for and that no unnecessary risks will be taken. For a bank to protect its interest, it is highly essential that proper credit investigation of every prospective borrower be undertaken to determine the justification behind a loan. However, a good deal of objections has been raised b some businessmen against the inquisitive methods resorted by some banks, | thus important that the banker in investigating a possible customer as well as in checking up an old borrower shall exercise much discretion and tact in order to avoid offending the client, Robert Morris Associates, composed of bank credit men in the United States, has adopted the following principles in handling credit investigations: 43‘CREDIT & COLLECTION 1. The first and cardinal principle of credit investigation is the sacredness of the replies, and any violation of this principle places the violator beyond the pale of consideration of the honest credit man. 2. Every letter of inquiry should indicate in some definite and conspicuous manner the object of that inquiry. : 3. When more than one inquiry on the same subject, is simultaneously sent to the banks in’the same city, the fact should be plainly set forth in the inquiries. 4. Individual consideration by the recipient of a credit inquiry of distinguishing marks therein will increase the efficiency of the credit investigation. 5. Indiscriminate revision of files regardless of the presence of the note in the market is unnecessary, wasteful and undesirable. 6. The continued observance of high ethical principles in the conduct of the credit departments of banks and banking institutions insures the best, results and cooperation in safeguarding banking credits. 7. It is not permissible nor the part of good faith in soliciting accounts from a competitor to seek information from the competitor without frankly stating the object, of the inquiry. 8. In answering, the source of information should not be disclosed without permission and letters written in answer to inquiries should be held inviolable by the recipients. 9. Inseeking information, the name of the inquirer in whose behalf the reference is made should not be disclosed without permission. 10, In answering inquiries itis advisable to disclose all material facts bearing on the credit, of the borrower to the end that the paper offered in the open market be of the same description as that held by the borrower's own bank: (Quoted from Shaw Banking Serious on Credits and Collections). CREDIT INVESTIGATION REPORT Allessential facts gathered by the credit investigator regarding a particular or business entity are summarized in a formal report known as the Credit Investigation Report, This report, prepared in two to four copies depending on the nature of the request, usually contains the following information:(CREDIT & COLLECTION a. Brief biographical sketch of the borrower, if an individual, Business history, if a business firm; b. A breakdown on the capitalization structure of the firm; c. A presentation of the latest audited financial statements in a condensed form; d. A listing of the management principles of the business firm; e. A credit responsibility reported by other creditors, trade suppliers and other banks; and f. Court cases and litigations per Credit Management Association of the Philippines records. The report also contains information as to the name of the subject, address, date the report is prepared, purpose of the report and the requesting officer/ department of the bank. The report is reviewed by the Supervisor of the Credit Investigation and Appraisal Section and copies are usually distributed as follows: 1. Original - requesting department IL Duplicate - Loans Administration Department. Ill. Triplicate - Credit, Research, and Information Department file.