What Should the Businesses know About Credit Scoring in the Current Business Environment

The economic challenges which the COVID-19 brought with it have made many businesses looking anxiously at their credit ratings/ scores. With this in mind and the exceptional circumstances which many businesses are facing at present, it is important to discuss the impact COVID-19 had on Small and Medium Sized Entities (SMEs) credit referencing.

Credit reference agencies and credit ratings agencies balance a combination of leading and lagging indicators to draw a conclusion regarding an entity’s credit risk. 

With reference to financial information, many credit referencing agencies (CRAs) mainly focus on the statement of financial position (also known as balance sheet) and the statement of comprehensive income (also known as profit and loss account) as historically audit reports especially for many small business entities, have not always included additional data/ information that would help the CRAs in further improving the scoring exercise.

The pandemic has had and is still having an impact on audit reports of various business entities, with audit firms putting more emphasis of matter paragraphs, material uncertainty paragraphs and modified audit opinions. This means that CRAs must evaluate and assess whether this additional information source can provide incremental information about the business and its operations and could be treated as a leading indicator during the scoring exercise. The approach taken and methods used will most probably differ from one referencing agency to another.

According to many CRAs, certain specific disclosures given in an audit report are accounted for during an entity’s scoring process. For example, a material uncertainty surrounding an entity’s ability to continue as a going concern due to the impact caused by COVID-19 pandemic would be assessed alongside a number of other indicators about the business entity and its operations. CRAs use many different information sources within its commercial credit services and products, with the main objective of providing its clients with as much insight as possible to enable fair and accurate credit decisions. The scores and reports by CRAs do include information that is taken from audit reports as that information helps agencies in assessing commercial credit risk of an entity, but many CRAs and financial experts around the world recognize that the ongoing pandemic is an extraordinary situation and therefore many CRAs have tailored their approach and methods to reflect this.

CRAs also include comments of auditors in its scoring algorithm as part of the general process of capturing financial statement data/information. The impact of this data/information will remain until a new set of financials and audit opinion is captured.

Credit referencing agencies also use many other information sources, apart from the annual accounts, to assess business entities. Predictive information to assess and evaluate the financial position of a business may include:

• Overall company’s accounting records maintained by in house accountants or bookkeeping firms
• Comparison of payment to industry averages;
• Average days settlement beyond invoice terms; 
• Whether days in which an invoice gets settled are decreasing (even if within the invoice terms);
• Unpaid invoices;
• Arrears on historical and current commercial credit arrangements;
• Defaults on historical credit agreements;
• Data/ information from business entities with which the directors are associated;
• Credit scores of an entity’s directors;
• Any court judgments; and
• Current cash flows management. 

The inclusion and use of additional information is dependent on the depth and breadth of the information held by each credit referencing agency. Many credit risk and financial experts believe that businesses should be aware as well as consider a number of different factors which may influence the credit rating/score, and the relationship of credit scores of an entity’s directors with that to the entity’s business score, especially in case of small businesses.

As uncertainty surrounding the business world due to COVID-19 continues, credit agencies are keen to ensure that lenders as well as other stakeholders retain a clear and an accurate picture of all the possible risks involved in order to facilitate responsible lending, while being careful with regards to the unique circumstances and challenges which many businesses are facing currently.