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Measuring SME Credit Risk

The underlying financial health of Small Mid-Size Enterprises (SME) has always been difficult to determine, hard to identify and its never been more important.

To manage risk in the credit and capital markets it is critical for lenders and credit suppliers to understand the relative financial health of counter-parties, customers and suppliers. Effective credit extension decisions cannot be made without superior analysis generated by forward-looking, unbiased tools.

The credit crisis and recession has devastated small and mid-sized businesses. Getting a bank loan or securing capital from investors is a big challenge for small businesses. Banks have become extremely cautious in lending to small businesses. To be successful in securing credit you’ll have to demonstrate that you are a good credit risk, that your company’s prospects for growth are strong and that your business model is sound.

Why Credit Score is important?The quality of your credit rating and financial health form the basis for decisions other businesses make about you. Managing your business to improve your Credit Score will improve your company’s financial health. A strong Credit Score indicates good financial health and is used by lenders, capital providers, customers and suppliers to determine:

  •     How much business credit a supplier will extend to you
  •     What interest rates you will pay
  •     How much money lending institutions will loan you
  •     How your customers view you
  •     What your insurance premiums will be
  •     The level of potential investor interest

Sum2 utilizes Altman’s Z Score method to determine fundamental financial health ratings.  The Z Score credit rating is valid measure of financial health for any public or privately held corporation. The Z Score rating methodology is a proven credit risk indicator that is widely used by banks, investment managers, Fortune 1000 companies and small to medium sized enterprises to determine and manage risk. Sum2’s clients use the Z Score rating products to determine financial health, remain in compliance with loan covenants, and assess credit worthiness of clients and mission critical suppliers.

Altman’s Z score method examines fundamental financial data derived from a company’s balance sheet and income statements.  A credit rating is generated by the use of ratio analysis that yields valid comparative results regardless of the currency utilized. Working capital, earnings, reinvested earnings and leverage are integrated into a composite credit rating score. The components and standards are similar to those used by traditional lenders. It is an easily understood approach that provides comprehensive financial details not available with the standard agency reports.

Click here to access Sum2’s Z Score Input Template.

Click here to access zip file of sample reports. Palm Corp Z Score Report.

We recommend supplementing the analysis with trade reports from firms like the Credit Management Association (CMA) or Experian and others for their pertinent data and services.Businesses that extend credit can determine cutoff scores needed to qualify for credit as their risk tolerance and economic conditions change. Lower scores and classifications indicate higher probabilities of default.

Credit ratings must include a careful analysis of the income statement, balance sheet, changes in financial position and key metrics along with consideration of trends, economic conditions and other available data.

Credit|Redi is a set of business assessment tools that helps businesses determine credit worthiness.  It is a critical business tool SME’s need to incorporate to better manage and assess credit risk.

More information on how to manage credit risk can be found here: Credit|Redi

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June 11, 2013 Posted by | banking, credit, Credit Redi, recession, small business, SME | , , , , | Leave a comment

SMEs Still Starved for Credit

Greenwich Associates highly regarded Market Pulse Study on SME credit availability reports that two-thirds of small businesses and 55% of middle market companies indicate that banks are failing to meet the needs of creditworthy companies.  Half of the 221 small businesses participating in the latest Greenwich Market Pulse Study say it is harder to secure credit today than it was at this time last year including roughly 33% of businesses that say it is much harder to obtain loans today.

The Small Business Lending Fund (SBLF) a $30 billion program established by the Treasury Department to encourage Community Banks to step up lending to SMEs is still trying to get some traction in the marketplace.  The SBLF injects capital into community banks that demonstrate an active SME lending  program will take another quarter to determine its effectiveness.

Community Banks are still transitioning its small business lending focus from an over dependency on real estate development.  SMEs seeking loans for capital improvements, fund operations or business expansion must provide lenders some added assurances about the financial health of the business.

SMEs can take steps to improve their credit standing and get approvals from lenders for loans and expansion for credit.  SMEs must demonstrate they have an excellent understanding of the condition of their firm’s financial health, what they must do to improve profitability and how they will use the credit extended by lenders to produce an acceptable return.

Credit Redi helps SME’s demonstrate the condition of the firms financial health, the risks and opportunities that SMEs must address to improve the firms financial health and identify the initiatives that need to be  funded to achieve desired profitability and growth.  These are the keys bankers look for on applications for loans.  Being able to demonstrate credit worthiness with an industry standard rating methodology determines weather a lender will grant you a loan, what rates you will pay and how much lending institutions will lend.

Since 2002, Sum2 has been helping SME’s manage risk and seize opportunities to grow and prosper under the most competitive market conditions.  Credit Redit is the latest addition to Sum2’s series of SME risk management products.

To determine the condition of your company’s financial health click here: 

Risk: credit, SME, capital allocation, credit rating

January 13, 2011 Posted by | banking, credit, Credit Redi, government, risk management, Small Business Lending Fund, Sum2, Treasury | , , , , , , , , , , | Leave a comment

Using the Z Score to Manage Corporate Financial Health

We use Altman’s Z Score as our measurement tool to assess a company’s financial condition. It incorporates fundamental financial analysis, offers a consistent measurement methodology across all business segments, and an enhanced level of transparency by use of fully disclosed and open calculation model.

Z Score Advantages

The Z Score provides a quantitative measurement into a company’s financial health. The Z Score highlights factors contributing to a company’s financial health and uncovers emerging trends that indicate improvements or deterioration in financial condition.

The Z Score is a critical tool business managers use to assess financial health. It helps managers align business strategies with capital allocation decisions and provide transparency of financial condition to lenders and equity capital providers. Business managers use the Z Score to raise capital and secure credit. The Z Score is an effective tool to demonstrate credit worthiness to bankers and soundness of business model to investors.

The Z Score is based on actual financial information derived from the operating performance of the business enterprise. It avoids biases of subjective assessments, conflicts of interest, brand and large company bias. The Z Score employs no theoretical assumptions or market inputs external to the company’s financial statements. This provides users of the Z Score with a consistent view and understanding of a company’s true financial health.

Background

The Z Score was first developed by NYU Professor Edward Altman. The Z Score methodology was developed to provide a more effective financial assessment tool for credit risk analysts and lenders. It is employed by credit professionals to mitigate risk in debt portfolios and by lenders to extend loans. It is widely utilized because it uses multiple variables to measure the financial health and credit worthiness of a borrower. The Z Score is an open system. This allows users of the Z Score to understand the variables employed in the algorithm. All the mysteries and added cost of “proprietary black box” systems are avoided empowering users to enjoy the benefits of a proven credit decision tool based solely on solid financial analysis.

The Z Score is also an effective tool to analyze the financial health and credit worthiness of private companies. It has gained wide acceptance from auditors, management accountants, courts, and database systems used for loan evaluation. The formula’s approach has been used in a variety of contexts and countries. Forty years of public scrutiny speaks highly of its validity.

Z Score Formula

The Z Score method examines liquidity, profitability, reinvested earnings and leverage which are integrated into a single composite score. It can be used with past, current or projected data as it requires no external inputs such as GDP or Market Price.

The Z Score uses a series of data points from a company’s balance sheet. It uses the data points to create and score ratios. These ratios are weighted and aggregated to compile a Z Score.

Z Score = 3.25 + 6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4) where

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = Earnings Before Interest & Tax / Total Assets
X4 = Total Book Equity /Total Liabilities

If you divide 1 by X4 then add 1 the result is the company’s total leverage.

The higher the score the more financially sound the company.

Z Score Ratings cutoff scores used in classifications:

AAA     8.15             AA        7.30

A          6.65              BBB     5.85

BB        4.95             B            4.15

CCC     3.20             D           3.19

Credit Worthiness and Cost Of Capital

Lenders and credit analysts use Z Scores because they are effective indicators and predictors of loan defaults. it is an important risk mitigation tool and helps them to better price credit products based on borrowers credit worthiness.

Utilizing a 10 year corporate mortality table demonstrates how Z Score ratings correlate to defaults. Those with a rating of A or better have a 10 year failure rate that ranges from .03% to .082%. The failure rate for those with a BBB rating jumps to 9.63%. BB, B and CCC failure rates are 19.69%, 37.26% and 58.63% respectively. These tables will differ slightly as each producer uses different criteria but overall they are quite similar.

Borrowers with higher Z Scores ratings will have a better chance of obtaining financing and secure a lower cost of capital and preferred interest rates because lenders will have greater confidence in being paid back their principal and interest. Financial wellness is an indication of strong company management and that effective governance controls are in place.

Managing Business Decisions to Improve Financial Health

The Z Score is also a critical business tool managers utilize to make informed business decisions to improve the financial health of the business. The Z Score helps managers assess the factors contributing to poor financial health. Z Score factors that contribute to under-performance; working capital, earnings retention, profitability and leverage can be isolated. This enables managers to initiate actions to improve the score of these factors contributing to financial distress. Targeting actions to specific under-performing stress factors allows managers to make capital allocation decisions that mitigate principal risk factors and produce optimal returns.

Focus areas for managers to improve Z Score are transactions that effect earnings/(losses), capital expenditures, equity and debt transactions.

The most common transactions include:

  1. Earnings (Net Earnings) increases working capital and equity.
  2. Adjust EBIT by adding back interest expense.
  3. Adjust EBIT by adding back income tax expense.
  4. Depreciation and amortization expense is already included in the earnings number so it won’t have an additional effect on earnings or equity but it will increase working capital as noncash items previously deducted.
  5. Capital Expenditures (fixed asset purchases) decrease working capital as cash is used to pay for them (whether the source is existing cash or new cash acquired from debt).
  6. Short term debt transactions have no effect on working capital as there are offsetting changes in both current assets and liabilities but does change total liabilities and total assets.
  7. Acquiring new long term debt increases working capital, total liabilities and total assets.
  8. Typical equity transactions (other than earnings, which we have already accounted for) are dividends paid to stockholders resulting in decreases to working capital and equity.
  9. New contributed capital increases working capital and equity.

Scenario Analysis

Using the Z Score financial managers can actively manage their balance sheet by considering transactions and initiatives designed to impact financial wellness. Considerable attention needs to be placed on how losses, sale of fixed assets and long term debt payments effect financial condition.

In the above we included the basic transactions that would likely occur but you can do the same for any scenario by applying the same concept. It may take a little practice to think in these groupings but you’ll shortly find yourself with the ability to project any event. The effects can be measured and revised as necessary by adjusting the contemplated transactions. Remember that several variables exist and that a combination of choices might be necessary to keep your financial strength at the desired level.

Any projection should include the calculation and comparison of key metrics to historical results to ensure that assumptions have been correctly calculated. Significant deviations from prior results should have adequate explanations. Maintaining a strong working capital position can offset the negative effects from increased debt, increased assets and minor earning declines.

Sum2′s Profit|Optimizer

Sum2 publishes the Profit|Optimizer.  The Profit|Optimizer is a risk assessment and opportunity discovery tool for small and mid-sized businesses.  It assists managers to identify and manage risk factors confronting their business. The goal of the Profit|Optimizer is to help business mangers demonstrate creditworthiness to lenders and make make informed capital allocation decisions.

Sum2 boasts a worldwide clientele of small and mid-sized business managers, bankers, CPA’s and risk management consultants that utilize the Profit|Optimizer to help their clients raise capital with effective risk governance.

Cautions

Financial models are not infallible and should be used in conjunction with common sense and with an awareness of market conditions. It is important to understand your model so that other considerations can be incorporated when necessary. Note that most models (Z score included) use a proxy (working capital) for liquidity which works well until there are severe disruptions in credit markets as recently encountered. Use caution with all models. Use extreme caution when using a proprietary black box system where you can’t understand all the components. Are these users aware or ignorant of possible issues?

Trust but verify seems like a prudent policy.

Conclusions

The Z Score is a valuable management tool to proactively assess the financial condition of the company’s balance sheet, uncover factors that are stressing the balance sheet and initiate actions to improve the financial wellness and credit worthiness of the firm. All business decisions and actions are ultimately revealed in the company’s balance sheet. The Z Score measures the effectiveness of business decisions. It empowers managers to anticipate changes occurring in credit worthiness and proactively manage changes in financial condition.

Armed with a tool to calculate future financial positions managers have the latitude to better manage outstanding receivables, improve liquidity and lower their cost of capital. Calls for capital, negotiations for funding or decisions in setting credit policy can now be made from a knowledgeable position with a set of supporting facts.

The Z Score gives business managers an important negotiating tool to defend their credit rating during capital raises when excess leverage or deficient levels of working capital and equity are present.

This post was authored by CreditAides.

This post was edited by Sum2llc

Risk: small business lending, credit risk, commercial lending, SME

July 22, 2010 Posted by | Uncategorized | , , , , , , , , , , , , , , , | 3 Comments

The Profitability of Patriotism: SME Lending

What a  difference a year makes.  A year ago the banks came crawling to Washington begging for a massive capital infusion to avoid an Armageddon of the global financial system.  They sent out an urgent SOS for a $750 billion life preserver of tax payers money to keep the banking system liquid.  Our country’s chief bursar Hank Paulson, designed a craft that would help the banks remain afloat.  Into the market maelstrom Mr. Paulson launched the USS TARP as the vehicle to save our  distressed ship of state.  The TARP would prove itself to be our arc of national economic salvation.  The success of the TARP has allowed the banks to generate profits in one of the most prolific turnarounds since Rocky Balboa’s heartbreaking split decision loss to Apollo Creed.  Some of the banks have repaid the TARP loans to the Fed.  Now as Christmas approaches and this incredible year closes bankers have visions of sugar plum fairies dancing in their heads as they dream about how they will spend this years bonus payments based on record breaking profitability.   President Obama wants the banks to show some love and return the favor by sharing more of their recapitalized balance sheets by lending money to small and mid-size enterprises (SME).

Yesterday President Obama held a banking summit in Washington DC.  Mr. Obama wanted to use the occasion to shame the “fat cat bankers” to expand their lending activities to SMEs.  A few of the bigger cats were no shows.  They got fogged in at Kennedy Airport.  They called in to attend the summit by phone.    Clearly shame was not the correct motivational devise to encourage the bankers to begin lending to  SMEs.    Perhaps the President should have appealed to the bankers sense of patriotism; because now is the time that all good bankers must come to the aid of their country.  Failing that, perhaps Mr. Obama should make a business case that SME lending  is good for profits.   A vibrant SME sector is a powerful driver for wealth creation and economic recovery.    A beneficial and perhaps unintended consequence of this endeavor is  the economic security and political stability of the nation.  These  are the  worthy concerns of all true patriots and form a common ground where bankers and government can engage the issues that undermine our national security.

The President had a full agenda to cover with the bank executives.  Executive compensation, residential mortgage defaults, TARP repayment plans, bank capitalization and small business lending were some of the key topics.  Mr. Obama was intent on chastising the reprobate bankers about their penny pinching credit policies toward small businesses.  Mr. Obama conveyed to bankers that the country was still confronted with major economic problems.  Now that the banks capital  base has been stabilized with Treasury supplied funding they must get some skin into the game and belly up to the bar by making more loans to SMEs.

According to the FDIC, lending by U.S. banks fell by 2.8 percent in the third quarter.  This is the largest drop since 1984 and the fifth consecutive quarter in which banks have reduced lending.   The decline in lending is a serious  barrier to economic recovery.  Banks reduced the amount of money extended to their customers by $210.4 billion between July and September, cutting back in almost every category, from mortgage lending to funding for corporations.  The TARP was intended to spur new lending and the FDIC observed that the largest recipients of aid  were responsible for a disproportionate share of the decline in lending. FDIC Chairman Sheila C. Bair stated,   “We need to see banks making more loans to their business customers.”

The withdrawal of $210 billion in credit from the market is a major impediment for economic growth.  The trend to delever credit exposures is a consequence of the credit bubble and is a sign of prudent management of credit risk.  But the reduction of lending activity impedes economic activity and poses barriers to SME capital formation.  If the third quarter reduction in credit withdrawal were annualized the amount of capital removed from the credit markets is about 7% of GDP.  This coupled with the declining business revenues due to recession creates a huge headwind for SMEs.  It is believed that 14% of SMEs are in distress and without expanded access to credit, defaults and  bankruptcies will continue to rise.  Massive business failures by SMEs shrinks market opportunities for banks and threatens their financial health  and long term sustainability.

The number one reason why financial institutions turn down a SME for business loans is due to risk assessment. A bank will look at a number of factors to determine how likely a business will or will not be able to return the money it has borrowed.

SME business managers must conduct a thorough risk assessment if it wishes to attract loan capital from banks.  Uncovering the risks and opportunities associated with products and markets, business functions, macroeconomic risks and understanding the critical success factors and measurements that create competitive advantage are cornerstones of effective risk management.  Bankers need assurances that managers understand the market dynamics and risk factors present in their business and how they will be managed to repay credit providers. Bankers need confidence that managers have identified the key initiatives that maintain profitability.  Bankers will gladly extend credit to SMEs that can validate that credit capital is being deployed effectively by astute managers.  Bankers will approve loans when they are confident that SME managers are making prudent capital allocation decisions that are based on a diligent risk/reward assessment.

Sum2 offers products that combine qualitative risk assessment applications with Z-Score quantitative metrics to assess the risk profile and financial health of SMEs.   The Profit|Optimizer calibrates qualitative and quantitative risk scoring  tools; placing a powerful business management tool into the hands of SME  managers.   SME managers  can  demonstrate  to bankers that their requests for credit capital is based on a thorough risk assessment and opportunity discovery exercise and will be effective stewards of loan capital.

On a macro level SME managers must vastly improve their risk management and corporate governance cultures to attract the credit capital of banks.  Through programs like the Profit|Optimizer,  SME’s can position themselves to participate in credit markets with the full faith of friendly bankers.  SME lending is a critical pillar to a sustained economic recovery and stability of our banking system.  Now is the time for all bankers  to come to the aid of their country by opening up credit channels to SMEs to restore  economic growth and the wealth of our  nation.

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Risk: banking, credit, SME

December 15, 2009 Posted by | banking, credit crisis, economics, FDIC, government, SME, TARP | , , , , , , , , , , , , , , , , , , , , , | Leave a comment