Understanding and maintaining company credit score

20 April 2020 / Insight posted in Article

The amount of credit SMEs can obtain is usually linked to its credit rating. Exactly how credit reference agencies (CRAs) calculate ratings for business has always been a closely guarded secret and results in either joy or frustration depending on rating results.

SMEs know all too well that having a good credit rating should allow a business to secure sufficient credit to help it grow and meet its aspirations. However, with these unprecedented times requiring many businesses to borrow additional funding to secure a future, it is too early to say how CRAs will alter their systems, if at all, for the impact of the Coronavirus. But it is likely to be one the next key concerns for those SMEs that are in a position to consider the future rather than just the present.

The good, the bad and the ugly

CRAs provide credit scores, which are used by banks, credit insurers, alternative finance providers and trade suppliers to arrive at the terms on which they are prepared to do business with a company. Credit scoring assumes that experience can be used as a guide to predicting creditworthiness. The process of developing a credit score generally relies on the analysis of historical data and/or the experience of credit risk professionals.

In other words, it looks at what companies that failed have in common, and how they were different to companies that did not fail. Just how CRAs will make allowance for unprecedented times in this will be interesting to see, given its potential significance.

The most common approach among CRAs is to adopt statistical models where the choice of factors to be scored and weighted is determined by mathematical equations. These identify the relevant trade-offs among factors and assigns the statistically derived weights used in the model.

The statistical scoring model predicts the probability of a case becoming insolvent within a given timeframe, incurring losses for creditors. These statistical models will often be complemented with other judgmental information, such as payment performance or adverse news media.

Liquidity, gearing and movement

The most predictive financial ratios tend to revolve around liquidity and gearing, and most importantly, movements in those ratios. In most circumstances, the trend is as important as the absolute ratio. Businesses are more likely to fail because they run out of cash than failing to generate profits. The liquidity ratio is one of the sternest tests of a company’s ability to convert current assets into cash. A lower liquidity ratio is an indication of potential cash flow/liquidity problems. Details of the most commonly used ratios are at the foot of this article.

Statistical scoring models will normally contain between seven and ten factors or attributes. They will often take account of whether any debt is secured/unsecured and compliance factors, such as adherence to public registry filing deadlines, and detrimental data, such as judgments, insolvency events, adverse auditor opinions and news feed content etc.

Do’s and don’ts

The ability to manage a company’s credit score will depend on the company’s specific circumstances. Not all the tips below can be applied by companies materially affected by the Coronavirus:

  • Don’t take on too much debt too soon. The more highly leveraged the company, the greater the probability of failure and the lower the score.
  • Don’t allow default money judgments, for example, County Court judgments (CCJs), to be registered against the company because the adverse effect on its credit score could be disproportionate. If the company can’t pay, work out an informal arrangement with the creditor or defend the judgment.
  • File the accounts on time, even if the financial situation doesn’t look good. The credit-scoring algorithms pick up on late filings and the CRAs scoring models see it is a sign that something is wrong.
  • Don’t make more than one change in accounting periods in an attempt to buy more time to file accounts. This might avoid the fines imposed by Companies House but the scoring models will identify multiple accounting reference date changes as a precursor to insolvency which will hurt the score.
  • Don’t let a debt get to the stage that a winding-up petition (WUP) is presented. This will adversely affect the company’s score for years to come, even if successfully defended and the winding-up avoided.

Companies with four or more directors are less likely to go into bankruptcy than firms with three or fewer. The number of directors can make a difference in the early days before accounts have been filed. Credit ratings also apply this for partnerships which may have more influence because of the absence of the financial factors.

What the eye doesn’t see

Additionally, there is certain information that the UK CRAs would love to have from HMRC (such as payment data, VAT and corporation tax returns) but it isn’t made available. HMRC only releases a handful of items, like basic VAT registration details and deliberate tax defaulters. They do not release the majority of their data or allow it to be shared, such as the plaintiffs in CCJs, late or skipped filings of returns and payments.

So, a company may have filed its VAT return or corporation tax return but not made the payment, yet the CRAs won’t see the missed payment. They may never see the missed payment, unless it is clearly signalled in the company accounts or results in HMRC issuing a WUP.

Incidentally, in the Republic of Ireland, most of this type of data is available and is definitely included in the scoring algorithms.

Most common ratios calculated from the balance sheet

Liquidity ratio
Deduct stocks and work in progress from the current assets and divide by the current liabilities.

Current ratio
Divide the current assets by current liabilities.
This is used as an absolute ratio or as a percentage change on previous year, and is generally regarded as the benchmark liquidity ratio. Retail businesses generally have a lower current ratio because they purchase stock on credit and sell for cash. A current ratio of less than one is generally regarded as having an elevated risk of incurring cash flow problems.

Shareholders’ funds/Total asset ratio (or similar)
Divide the shareholders’ funds by total assets.
This is used as an absolute ratio or as percentage change on previous year. The higher the number, the better because it indicates a higher proportion of shareholder investment and a lower proportion of loan capital or alternative sources of finance, which might be interest-bearing.

Knowing the score

Knowing the company’s credit score is vital. Don’t just check with one CRA, check them all: Dun & Bradstreet, Experian, Graydon, Creditsafe, Equifax, Company Watch and Vistra.

Clearly the effect of the Coronavirus on trading and debt levels and how this is assessed by the CRAs will evolve over the next few months. We will provide further updates as things become clearer.

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