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The key to credit scoring - the difference between unlocking the rate you want and the rate you settle for

Posted by Keir Cox on Oct 31, 2018 7:14:34 AM

It seems the world of finance has developed into a “computer says no” environment, both in a personal and commercial capacity, where old school underwriting and case-by-case common sense approach has been replaced by algorithms, referencing and an increasing dependence on other fintech tools to assist a decision.

I read a few weeks ago that China is planning to introduce a citizen credit scoring system, which is almost a way of correlating a human being with the political agenda. This will affect a citizens’ ability to get promotions, credit or even to leave the country to go on holiday! Scores will improve for good behaviour, having a job in a nationalised industry, buying Chinese goods and will decrease based on bad public behaviour, purchase of foreign goods or even how many units of alcohol you consume. One beer too many and you could get refused for a mortgage or get overlooked for that promotion you wanted!

The fact of the mater is credit score is such a huge part of our ability to achieve so many things in day to day life it is vital that you know how to manage it. Ultimately this could be the difference between getting the finance you want and settling for a rate because there was simply no other option to achieve your goal.

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For many SMEs, Directors managing their commercial credit scores can prove a real challenge due to the number of factors that are considered during the calculation. It would be useful to identify some key areas of focus for commercial credit scoring and then explain how you can work with these factors to optimise your business’ score.

1. Trade Sector:

Credit referencing agencies rate heavily on trade sector and impact your score depending on the rate of insolvency in that sector. This is done through identifying your SIC code, correlating this with the number of insolvencies within the same SIC code and then applying a deduction or increase to your score depending on the sector. Construction, Recruitment and Retail based businesses are already up against it before considering balance sheet position and the score is dampened as a result of the attached sector.

A quick fix for this is to avoid generic SIC codes that broadly cover your company’s activities and go for something more specific. The more companies with the same SIC code with a poor rate of insolvency the bigger the impact on your credit score so speak to your accountant and make sure the SIC code is right for your business

2. Invoice Payment Record:

Industry sectors have an average payment term record for invoices recorded within a specific industry. Depending on the number of days beyond the average industry payment terms Days Beyond Terms ("DBT") this will affect the credit score position. If the industry average DBT for construction is 18 DBT and your payment record is 21 DBT then this will have a significant impact on the credit score for the business.

The best way to deal with this is to have a proactive cashflow management processes in place for the business. Set your invoice payment terms for the business to suit the current cash flow cycle for the businesses. If there is limited flexibility for payment terms with suppliers, the other option is to ensure that you have an invoice finance facility or flexible revolving credit facility to ensure that company invoices are realised within terms and not subject to the payment terms of the clients contained within the debtor book.

The payment term of industry invoices is the most changeable factor on credit scores for SME businesses on a day-to-day basis. If you can encourage your clients to share your efficient invoice payment record with credit reference agencies then this will further improve the credit score position of the business short term.

3. Shareholders' Funds:

This is the net asset position for the business and a quick tool for most lenders to assess the fortunes of the business over a 12 month accounting period. A reduction in Shareholders' Funds is likely to decrease the credit score position of the business once accounts are filed, which is the single biggest credit score impact event of the fiscal year.

If there has been a bad trading year for the business, there is little that can be done to hide this in the net balance sheet position of the business.

It is best to provide clear accounts rather than attempt to prop up the balance sheet artificially, work with your accountant to present the accounts in the best light possible. Explain any reductions in equity to a prudent underwriter clearly to assist an underwriting decision. Avoid taking large dividends out of the company from modest profits if it can be helped, consistency in Shareholders' Funds is key to maintaining a good credit score. This can be tricky if this is a lifestyle business but could hurt your ability to get the right finance to see your business succeed.

4. Funding of Company Assets - Debt vs. Equity:

Credit referencing companies actively monitor the relation of short term and long-term debt vs the tangible fixed asset/stock position of the business, which is primarily calculated through the gearing ratio of the company. If you hear the term “highly geared” this means that most company assets are financed rather than purchased. If fixed assets like property, machinery or slow re-sale items like stock are purchased through reinvested earnings from the fiscal year then the credit score position of the business should improve.

If the business has paid for a multitude of long-term fixed assets or stock through finance then this can negatively impact the credit score.

It may be worth consolidating multiple short-term finance you have used to acquire fixed assets or stock onto one long term finance agreement to reduce the impact of the debt equity question on the credit score position of the business. You will also probably end up paying less in interest this way. The best practice is to avoid using too much credit and try and set aside a portion of profits to either clear finance quickly or reduce the dependency on credit.

5. Working Capital Position:

A negative net working capital position can severely affect the ability to obtain new credit and has a big impact on credit score. This is calculated by the total current asset position of the business minus total short term liabilities - amounts owed by the business within a one year period.

This is a quick way for a lender to assess the solvency position of a business they are underwriting against and by extension the likelihood of on time repayments against the loan.

This can be managed effectively by ensuring an efficient cash flow management system along whilst avoiding high rate short term finance in favour of more stable long-term finance. The interest saving will benefit the business and can be reported beyond a 1 year period depending on the loan term, which avoids affecting the net working capital position of the business.

6. Board Member Resignations:

There are a wide range of reasons why a Director can leave a Board, retirement, other commitments, bad blood and believe it or not this can impact a credit score position significantly for up to 6 months. An exodus of Board members is usually a predictor of insolvency and can reduce a score by up to 30 points (out of 100).

The best practice is to consider a replacement Board member promptly to neutralise the impact and succession planning, but this is obviously subjective to the circumstances of the resignation.

7. CCJs & Winding Up Petitions:

This will seem an obvious one to avoid by paying your bills on time but not every business knows how to deal with a CCJ once registered to avoid it affecting the long term credit score. The worst approach is to bury your head in the sand as time is of the essence to get this off the company credit file.

If you pay a CCJ within 30 days of receipt then you can apply for a certificate of satisfaction from the court, this is removed from your credit file and your report goes back to normal. If the amount in question is disputed then you need to contact the courts as soon as possible to arrange a hearing.

If your case is successful the CCJ will be rescinded, if not then you should try to arrange payment within 30 days to avoid it sticking on your file.

If a CCJ is paid outside of 30 days then this shows on your record as satisfied. This still affects the score but not as much as if it is outstanding. The impact will reduce over time.

If a CCJ is left unresolved for an extended period then the creditor may opt to issue a winding up petition against the business, which means your company could cease to exist within 28 days of the notice being served if the matter is not dealt with. This is severely detrimental to the credit score of the business entirely and again speed is the key factor in dealing with the issue.

8. Multiple Searches:

Avoid making too many applications for credit in a short space of time as this will reduce the credit score position and suggests to the lenders that the business is desperate for credit, which is not a good look.

Best practice is to use a professional broker or do your own research beforehand and shortlist the 3 lenders that best suit your needs if planning to approach directly.

In conclusion ... 

It may be an obvious conclusion but the better the credit score, the better the terms of the deal and the quicker you can get access to the finance you need to achieve your business goals.

Often the lender will look to support your application by making an assessment of your personal net worth and finances with a view to securing the deal with a Personal Guarantee ("PG").

This is probably the most worrying commitment a Director will make in their business life and, if things go wrong, it is not just the business on the line but the family home, the car, savings, even retirement plans and provisions.  

The Directors’ personal liability is no longer limited which almost renders incorporation pointless.

Even if things are going to plan the cloud of a PG can still cast a shadow of doubt in a Directors mind, not to mention the spouse who have had to put their finances entirely in the hands of their partner with absolutely no control over the very business upon which their fortunes depend.

Personal Guarantee Insurance ("PGI") exists to mitigate this worry for Directors and gives them the confidence to take the risks they need without having to give up their homes if things do not go to plan. Premiums are paid by the business that has taken the finance and are tailored based on individual circumstances, indemnifying the lender in the event the business becomes insolvent and the PG is called in.

We cater for both existing PGs and PGs signed in connection with new finance. Get in touch with one of our underwriters on 0208 004 7250 to find out more.

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Topics: #personalguarantee, #Directors, #SMEs

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