Is Business Credit Scoring a Killer Application or Application Killer?

By George A. Parker

In his 1968 seminal novel, 2001: A Space Odyssey, Arthur Clark introduced HAL, a spaceship computer with artificial intelligence. Mission engineers designed HAL to carry out an array of technical orders to safeguard the ship’s mission. HAL operated flawlessly until it reported the failed operation of a ship system that was operating perfectly. Rather than correct the mistake, HAL’s logic dictated that it would be more efficient to kill the ship’s crew. Ever the polite computer, HAL killed quickly and quietly until it was unplugged by the sole remaining crewmember, Dave Bowman.

Many small business owners believe that HAL’s progeny are carrying out HAL’s murderous mission in the small business credit arena. Computers now make important credit decisions for major banks and financing companies. Each day in the U.S., computers with fancy algorithms score thousands of small business credit transactions. Though credit-scoring models work well for most small companies, many believe these systems, like HAL, have run amuck. Routinely, transactions with low scores are turned down and applicants are notified of the decision by computer-generated rejection letters.

By gaining a better understanding of the credit scoring process, you may be able to help your firm maneuver in the new world of credit scoring. Here are some key points about business credit scoring worth noting:

1. Credit scoring automates the credit evaluation process. Credit providers use these systems to speed up loan processing, to cut processing costs, to quickly adjust rates and terms to match credit risks, and to add a high degree of objectivity to credit decisions.

2. Credit scoring is a predictive system based on statistical modeling. Scoring systems are designed to forecast whether borrowers will be successful in repaying loans. Many systems use up to 20 factors to evaluate credit worthiness.

3. Many lenders and leasing companies use credit scoring for business transactions under $100,000. Over 90% of major credit providers use credit-scoring systems on transactions below $ 50,000.

4. A pioneer and leading credit scoring service, Fair Isaac and Company, researched statistical credit modeling in the 1980s. They determined that the personal credit behavior of a company’s key principals/owners is a strong predictor of their business credit behavior. Simply stated, a business owner who pays personal bills on time generally will cause his/her company to pay bills on time.

5. The Fair Isaac scoring model produces business credit scores ranging from 50 to 350. Credit providers usually consider a business credit score above 220 to be a good risk. They consider a score of less than 175 to be a high risk.

6. The overriding factor in business credit scoring is the credit history of the business owners or the key principals. In addition, there are other factors related to the owners’/principals’ personal credit profiles used to score small business transactions

7. Business-related credit factors scored include: the company’s time in business; company size; industry; form of company organization; history of paying bills on time; business net worth; average bank balances; ratio of debt service to cash flow; and recent judgments, bankruptcies or agency collections.

8. Many large lenders, such as Well Fargo Bank and Bank of America, have developed their own predictive business credit models. Several have even fine-tuned the Fair Isaac model to better meet their needs and preferences.

9. If your firm is rejected for credit based on a scoring model, ask the lender to explain the rejection. Some lenders will reconsider if requested, but may require additional credit information.

10. Some lenders have special pools for higher risk credits. They usually charge higher rates and offer terms that are less advantageous than for high-scoring transactions. Others may ask for credit enhancements to grant approval, such as additional collateral or outside guarantees.

11. Here are ten ways to improve business credit scores:

* Improve the credit habits and profiles of the key principals or business owners

* Pay all back taxes

* Settle outstanding liens and judgments

* Pay bills on time and be consistent with payments

* Eliminate supplier disputes by settling with any suppliers or former employees

* Sell or factor accounts receivable to improve cash flow

* Establish your firm’s credit record by registering with the Secretary of State where your business is incorporated

* Try to improve individual and company credit for at least twelve months

* Buy from vendors who report activity to the major credit bureaus

* Set up automatic account debiting with creditors to help eliminate the possibility of paying slow

Credit scoring is not designed to predict individual loan performance with certainty. Rather, these systems do a great job of quantifying risks for groups of borrowers with similar characteristics. A disadvantage of credit scoring systems is that they are easy to misapply. If the lender’s customers don’t share characteristics and behavior patterns with the model’s underlying base group of credits, then reminiscent of HAL, many transactions with great potential may be eliminated.

If your firm doesn’t score well under a scoring model used by a major lender, you may face an uphill battle for credit approval. Some smaller credit providers try to differentiate themselves by not using scoring models. Instead, they actually listen to borrowers, sort out unusual circumstances and use old-fashion human judgment to make credit decisions. One of these lenders might make sense for your firm.

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