One of our readers wanted to understand Credit Limit and ways how to define it.
We had shared stuff and parameters in some of our earlier posts as to what really defines a credit limit. Just to reiterate, this is not an easy exercise, and will be defined on each customer of your client.
There is a website, which provides tools (provided you or your client is ready to invest into the same.
Over the past decade credit reporting companies have made a subtle shift in their product focus. In the past, you bought a credit report or signed up with a monitoring service and were delivered credit information. Now, their stated intention is to deliver credit decisions along with the supporting information.
A few years ago, D&B, following this concept to its logical conclusion, stated that their goal was to pass credit decisions through the credit department right to the sales representative in the field. In this paradigm, the credit department sets the parameters, but the credit bureau provides the technology to automate the decision and deliver it to the front lines where the sale is being made, not just to the credit executive’s back-office desktop.”
Both D&B and Experian have introduced products that help automate the credit decision process: Decision Express, Global DecisionMaker and RAM from D&B, as well as Decision Insight and Commercial Intelliscore from Experian.
These products all facilitate the use of risk scores to support the decision process. You can translate credit scores into credit limit recommendations by using either an automated rules engine or by creating what scoring experts refer to as a “heuristic scorecard.” (Heuristic means that the scoring model is based on experiential knowledge rather than statistical modeling.)
Now, what upstart credit reporting service CreditRiskMonitor has done with their new “Credit Limit Service” is to take credit decision support a step or two further. They have built an automated credit limit tool on top of a foundation of analytics, scoring and financial information.
Using credit ratings and downloaded financial data from SEC filings, CreditRiskMonitor calculates the Altman Z-Score for each public company in their database.
The Merton Credit Risk Model, popular with bond traders and banks, is also applied to each company. The Merton Model takes into account a company’s leverage (debt to worth) and uses stock price volatility to help predict whether a company is at risk. It has the advantage of providing a daily estimate of credit risk by leveraging the knowledge of the market.
In addition, CRM’s new product also captures Standard & Poor’s and Moody’s credit ratings. All this information is then used to statistically calculate a blended probability of default.
Credit limits are then determined using three distinct methods that address profitability, expected losses, and sales volumes. These calculated credit limits also take into account your company’s:
- Expected sales volume to the customer under consideration
- The gross profit margin on those sales
- Expected bad debt losses (ideally this will be based on your historical loss percentage for the type of account being considered)
- Cost of Capital
- Risk Appetite (conservative, neutral, aggressive)
After performing the three distinct credit limit calculations, the system automatically throws out the highest limit, assigns the lowest limit as the recommended limit and uses the median limit as the maximum recommendation. Interestingly, most often the Sales Balance.
Limit is the recommended limit, reflecting the typical conservatism of most credit pros. Credit limits are typically set so that customers may only obtain a month or two of additional sales if their account goes past due. The exceptions are usually companies that are in financial difficulty.
Credit analysts are able to see which credit limit calculation determined the recommended limit. They can also drill down into the data to see which factors were critical determinants. In addition, they can perform some “what if” exercises by changing the inputs related to their company’s situation.
Users can also monitor changing credit limit recommendations by setting upper and lower thresholds and including the customer in their portfolio. Changes in data, ratings or scores over time can result in changes to the recommended limits.
Credit limit alerts generated by these changes are emailed daily and are also reflected in the “my current news” page of CRM’s fundamental service. Moreover, CreditRiskMonitor documents all credit limit activity for Sarbanes-Oxley compliance purposes.
The CreditRiskMonitor Credit Limit Service is integrated with their fundamental service ($3950 per year for unlimited access to the CreditRiskMonitor database). The Credit Limit Service costs an additional $2000.
The company turned to Camilo Gomez, PhD (MIT), president and founder of Lone Pine Mesa, LLC, a consulting firm specializing in financial analysis and statistical modeling, to help develop this credit limit tool. The result is a data-rich decision support tool that will not only help credit analysts standardize the setting of credit limits, but also give them the means to better educate sales and upper management about the overall credit risk environment.
As such, credit analysts will be better able to identify opportunities to increase sales without loading on additional risk, as well to examine the trade-offs from increasing or decreasing risk.
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