Creditworthiness Analysis. Instruments and Methods

Table of Contents

1 Preface

2 Essentials of the creditworthiness analysis
2.1 Credit
2.2 Credit-granting institutions and credit users
2.3 Creditworthiness and creditworthiness analysis
2.4 Differences of rating and creditworthiness analysis
2.4.1 Internal Rating
2.4.2 External Rating
2.5 Basel II/III

3. Instruments and methods of the creditworthiness analysis
3.1 Personal and economic creditworthiness
3.1.1 Personal creditworthiness analysis
3.1.2 Economic creditworthiness analysis
3.2 The 6 C’s approach as an alternative to the personal/economic creditworthiness

4 Application of the creditworthiness analysis for the start-up companies (Case Study)

5 Closing words

6 Bibliography

1 Preface

Finance is one of the main fields within the economics and the cornerstone both for the domestic and global businesses. Finance studies and investigates the opportunities in which individuals and enterprises source, allocate and use monetary funds and resources over time, considering the risks and the monetary developments such as inflation. It is a discipline that provides the monetary basis and structure for every kind of business. Finance is one the most path breaking and strategically essential business sectors. In order to comprehend the finance and the financial structure of the company an individual or a manager has to be capable to conceive the complete business structure of the enterprise.

The importance of finance for the international and local business environment but also for private persons is therefore crucial. It is important to mention that finance is a very manifold doctrine with diverse variations, manifestations and a long historical development.

Because of the previous mentioned manifoldness of finance it should be consequently said that there is a massive amount of strategies to manage and to acquire the necessary financial or monetary basis either for a corporate or for a private need. One of the most common and popular possibilities to acquire money for financing an investment, to pay the corporate debts or for the private purposes of a person, is to apply for a credit.

Following to this fact it is relevant to emphasize that the credit-granting process is a very specific and complex procedure. The complexity of this process could be explained by different economic and political reasons. In order to maintain the stability of the financial markets, to protect the money-granting institutions or persons and the whole economic environment a credit cannot be granted without any guarantee and safeness for the back-paying. Henceforth the credit providing institutions and authorities use an analysis with the task to control the creditworthiness of credit users.

The creditworthiness analysis was created within decades, shaped by different cultures and nations, affected by historical and economic mistakes and crises.

This seminar paper is dedicated to investigate and to describe the creditworthiness analysis and to present the most significant steps, main tasks and methods or forms within the analyzing process.

2 Essentials of the creditworthiness analysis

The following chapter addresses the main terms and definitions within the topic, but also concerns the relevant tasks of the creditworthiness analysis and the differences to the definition of a rating in order to clarify the contents.

2.1 Credit

The main object of the creditworthiness analysis is to analyze whether a credit could be granted. The word credit has Latin origins and is descended from the word “credere” which means trusting. On the other hand the word “creditum” stands for a loan (see Dicken 1997, p. 8). Comprising the translations a credit is a loan, mostly in the form of funds which a credit-institution is granting to the credit-applicant under the criteria of trust.

Depending on the circumstances and the conditions but also on the credit issuing subjects different types of credit exist. The most common among these types are:

- Bank credit (a credit granted by a bank to different types of credit users; this type of credit could be issued in diverse manifestations, such as money, increased credit lines and warranties)
- Trade credit (a credit granted by the vendors/companies which gives a possibility to delay payments for purchased goods, considering the associated interest rates)
- Consumer credit (granted to private persons, e.g. credit cards, consumer lines of credit, personal loans)
- Public credit (granted to states and governments by diverse credit lenders)
- Tax credit (granted by the financial authorities to a company in form of deducted taxes in order to encourage e.g. an investment) (see Hartmann-Wendels 2010, p. 182 et seq.)

2.2 Credit-granting institutions and credit users

A credit could be granted by various types of institutions. The most relevant examples are the banks, such as private, corporate and governmental banks, but also governments, credit institutions and organizations, for example capital venture organizations. Besides, usual companies and even private persons could grant a credit. However the most common institution for granting a credit is to this day a bank.

A bank is a synonym for the word credit institution and is divided into two subgroups, the commercial and the investment banks. The relevant bank type for this seminar paper is the commercial bank, as it deals with the deposit banking and the credit businesses. (see Hartmann-Wendels 2010, p. 11) The banking business is traditionally numbered among the most risky business, especially because of the taking over of the above describes risks. In defiance of the risk, the credit business still counts as the core business of a lot of banks. Averagely 60% of the assets and 65% of the revenues fall back to the credit business. (see Grunwald 2001, p. 1)

On the other hand the potential credit users are governments, companies, both start-ups and existing enterprises, but also private persons. Besides the term of the credit user is defined by the German law. According the §19 KWG, a credit user could be one or several natural or corporate bodies. (see Hartmann-Wendels 2010, p. 515) Thus it is crucial firstly to determine the credit user in order to be able to evaluate the person or the group of users realistically.

Figure 1: Mutual relationships within the money raising process (Source: Hartmann-Wendels 2001, p. 12)

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2.3 Creditworthiness and creditworthiness analysis

Creditworthiness analysis is defined as “the analysis and the control of the economic, personal and social circumstances of a potential credit-borrower with the task to assess the risks which are included to the credit-granting process.” (Sigler 2011, p. 9). Consequently the creditworthiness is the economic and personal ability of a credit-borrower to pay back the interests and the credit amount without any defaults.

It is “an assessment of the likelihood that a borrower will default on their debt obligations. It is based upon factors, such as their history of repayment and their credit score. Lending institutions also consider the availability of assets and extent of liabilities to determine the probability of default.” (http://riskencyclopedia.com/articles/credit_risk/, retrieved on 02.04.2014)

As mentioned in the definition a credit is characterized by diverse types of risks. The creditworthiness analysis has the task to assess and to avoid the risks.

The typical risks of a credit which have to be analyzed by the creditworthiness analysis are:

1) The risk of loss, the risk which describes the possibility to lose the interests of a credit or even the whole or a part of the credit amount. (see Dicken 1997, p. 9)
2) The risk of liquidity, the risk which describes the danger of the delayed paying of the credit amount or the interests. (see Dicken 1997, p. 9)
3) The risk of security, the risk which emphasizes the danger that the securities and guarantees the credit-applicant has given in order to receive the credit may lose their value. (see Dicken 1997, p. 9)

Considering the 3 types of the previously mentioned risks the primary aim of the creditworthiness analysis is the control and the assurance of the repayment of the granted credit and the interests by the credit-borrower. (see Dicken 1997, p. 11)

The second task of the creditworthiness analysis is to examine the adequacy of the necessary credit amount and the adequate interest rates. This task is straightly connected to the repayment ability because there is a danger of the unwanted compulsion to increase the credit amount during the credit duration period. (see Bönkhoff 1983, p. 15)

The third aim (not directly connected with the creditworthiness analysis) is the risk-oriented characterization of the credit-borrower. The characterization of the credit user is also called the credit rating. The main aim of the credit rating (see chapter 2.4) is to classify the credit user into risk categories. (see Schierenbeck 1987, p. 303) The system of risk categories and ratings is commonly used to restrict, assess and to control the risks using diverse instruments such as the adaptation of the interest rates and the credit durations or the increase of the credit user assurances. (see Droste 1983, p. 319). As the consequence the whole subsequent treatment, assessment and management of the credit is based on the rating and risk classifying system.

Besides it is significant to mention the general economic importance of the creditworthiness analysis, considering the 3 previously mentioned tasks, as it stabilizes the financial circulation within the economic environment. The maintenance of the financial circulation is influential for the wealth, stability and peaceful development of the world economy.

Moreover it is significant to highlight, that the creditworthiness analysis is not a onetime made analysis. A good deal more the credit granting institutions have to consider and to observe the current economic situation and the position of the credit borrowers and continuously adjust the changes of the current and future situations. (see Hartmann-Wendels 2010, p. 515) Therefore the creditworthiness analysis is an ongoing process. Comprising the mentioned aims and tasks, the main purpose of the creditworthiness analysis is to determine the creditworthiness of the credit borrower and to enable the credit granting decision.

2.4 Differences of rating and creditworthiness analysis

The Rating is defined as “the assessment of the financial standing and therefore the creditworthiness of the company. Ratings are assessments which describe the ability of the credit user to repay his or her financial obligations.” (Gleißner 2003, p. 11) Following this definition it is to say that a rating is a procedure to determine the general personal or/and financial situation and solvency of the credit user and thus to determine the risks and the probability of a default regarding the credit granting procedure.

Here it is important to notice the similarities of the definition of rating to the definition of the creditworthiness. In fact, these two procedures are chiefly the two sides of the same coin. The main difference is however the way of the representation of the results of these procedures. On the one side the creditworthiness delivers the answer for the credit granting decision in form of a “yes or no” in simplified terms. Besides the creditworthiness analysis doesn’t contain the environmental assurances and pledges, as it only analyzes the person of the credit applicant and not the environment of the applicant. In comparison a rating allocates a certain grade with a certain meaning in order to symbolize the creditworthiness of the credit applicant. It includes both the pledges and the collateral information of the credit user. (see Ehrmann 2005, p. 186 et seq.) The methods and instruments which are used to analyze the person of the applicant have however the same character.

There are different systems and types of ratings depending on the rating users and creators. The types and the structure of ratings will be described in this chapter.

The credit business is growing continuously within the credit institution sector. Therefore the importance of ratings/ creditworthiness analyzes is also growing collaterally. The rating system could be divided into two main approaches, the standard approach/external rating and the IRB (international ratings based) approach. The main difference between the approaches is the evaluation. In case of an external rating the evaluation is made by an external rating agency, whereas the internal rating is made by the credit-granting institution itself. (see Ehrmann 2005, p. 186)

Figure 2: Types of ratings (Source Ehrmann 2005, p.180)

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2.4.1 Internal Rating

Regarding to the previous information the internal rating is made by the credit institution itself. The criteria for the creation of an internal rating are predefined by the governmental authorities and financial law of the concerned country. The main juristic criteria basis for the European ratings and creditworthiness analyses is the BASEL II/III (see chapter 2.5). Moreover an internal rating has to be approved by an official controlling authority, before it will be used. (see Ehrmann 2005, p. 186)

According to Basel II there is a frame for the preparation of an internal rating by the bank. The following criteria have to be considered:

- Analysis of the financial standing of the applicant
- Calculation of risks connected to the credit-granting
- Systematic, realistic and consequent weighting of the results
- Determination of rating classes and types (see Ehrmann 2005, p.189)

Regarding to the given frame the internal rating includes both the economic and the personal data of the applicant. (see Ehrmann 2005, p. 191) Thus a rating is a compilation of different creditworthiness analysis instruments, especially the financial and statistical (see chapter 3), in order to control the creditworthiness of the applicant using a combination of methods and controlling both the personal and the economic situation of the credit user. The compilation is made by the predefined criteria and frames made by the officials.

Furthermore the foundation (F-IRB) and the advanced (A-IRB) approaches have to be distinguished. The F-IRB is the more established form of rating, as it allows the banks to develop their own empirical credit default expectations model, whereas the A-IRB additionally involves diverse types of qualitative analysis models in order to specify the results. (see Ehrmann 2005, p. 191) Thus the A-IRB is related to a higher time and personal resources exposure.

Using diverse analysis instruments of the financial standing analysis and the methods of the empirical and statistical analysis different figures are calculated. These figures have to be weighted in order to receive the rating. Hence to weight the figures a grading system is implemented. The calculated financial and statistical information and the received personal information are therefore converted into a certain value which has to be represented by a grade.

Figure 3: Examples for the grading system of the selected German banks (Source: n.a., Finanzstandort Deutschland-Rating Broschüre, p. 11)

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The grades are given according to the importance of the figures to the credit default risks, future prognosis for the creditworthiness and back payment ability of the credit-applicant and to the internal assessment of the bank, considering the juristic frame.

Exemplary the following compilation of the information and rating structure is given:

Figure 4: BVR-II Rating of German people’s banks/”Volskbanken” (Source: Sigler 2011, p. 67)

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Regarding to this example it is to mention that an internal rating uses the data and figures calculated by the creditworthiness analysis instruments and weights the data according to the internal banking allocation. Consequently the following process of the rating creation can be presented:

Figure 5: Rating creation process

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After the process is passed through, the scores are summarized and a creditworthiness rating is issued for the credit-applicant.

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