How Is Credit Risk Determined for a Small Business?
It is usually the personal credit record of the small business owners that makes or breaks the deal with a lender. Fair Isaacs Corporation, a publicly traded company, created a scoring model that has become the industry standard for evaluating consumer credit.
This score, called the FICO® Credit Score, is based on proprietary formulas that include a composite analysis of an individual’s payment history, amounts owed, length of credit history, new credit, and types of credit used.
A score of 720–850 is the highest (best) category, while 500–559 is the lowest. Today, a score of 640 appears to be a common cut-off point for many commercial lenders. The underlying specifics of FICO Credit Score formulas are as secret as the recipe for Coca Cola®. The credit score’s impact on a loan transaction’s interest rate is substantial, with the lowest score costing double or more than the best score.
According to the Fair Isaac Corporation, owner of the FICO brand:
“FICO Scores are calculated from a lot of different credit data in [your] credit report. This data can be grouped into five categories [as shown in the chart above]. The percentages in the chart reflect how important each of the categories is in determining your FICO score. Those percentages are based on the importance of the five categories for the general population. For particular groups—for example, people who have not been using credit long—the importance of these categories may be somewhat different.” (Source: myFICO)
The three primary business or commercial bureau credit repositories in the United States are Dun & Bradstreet (D&B), Experian Business, and Equifax Small Business Financial Exchange (SBFE). D&B is the oldest and most commonly used credit service for business; the D&B rating system appears in the chart below.
The D&B Financial Strength rating is based on the net worth or issued capital of the company. The D&B Composite Credit Appraisal is important to lenders as it provides insight into the risk of lending to (or the financial condition of) the company. A company rated “1” is considered minimal risk; “2” is low risk; “3” is greater than average risk; “4” represents significant risk; and “5” means there is insufficient information available to assign a risk category. In addition, D&B uses a model called Paydex® that tracks a company’s payment history with its vendors. A Paydex score of 80 means that the customer pays promptly. Less than 80 means that the customer pays beyond the terms (slow), and more than 80 indicates that the customer anticipates payments (e.g., takes discounts on invoices).
Experian Business Reports uses a similar system, called a Credit Ranking Score, to predict payment behavior. Customers are rated between 0 (high risk) and 100 (low risk). Equifax offers a Small Business Credit Risk Score, designed for use by the financial services industry. It uses a numeric score between 101 and 992, with a lower score indicating higher risk for serious delinquency.