How to calculate Credit Scorecards

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Credit Scorecards are quantitative models that aim to provide measurement of the probability that a customer can demonstrate a defined behavior with regard to his or her proposed or present credit standing with a lender.

Credit scoring is commonly and historically derived from a data base developed with the use of the last observation on previous clients who have had loan defaults. It is also based on most recent observation taken from the historical database. Default probabilities are scaled to a credit score. The credit score ranks the clients by order of risk without openly pointing out their default probability.

Credit scorecards are gradually being replaced by a method which is called by several names such as hazard rate modeling, logistic regression or reduced form credit models. The main difference from credit scorecards includes the database as well as the ability to compute the loan’s financial value, given its risk level from a credit viewpoint. The database consists of all possible observations on clients, whether they are defaulted or non-defaulted, making it easier to identify the results of macro-economic elements such as auto prices, interest rates, stock prices as well as home values on retail loan default rates that are secured by homes or automobiles.

A credit scorecard is a straightforward approach to assess a business’s credit risk. When calculating credit scorecard, you can try this approach. First is to get the most recent copy of your company accounts and then compute diverse financial ratios. Factors may include current ratio, net profit rate or profit before tax, gearing or long term creditors, stock turn, trade debtors or debtor days and the interest cover.

Depending on the expected average values for every factor, the said factors can be used to identify the score on the credit scorecard. A matrix of per industry average values can help you assign a score for every factor such as 5 points if the liquid ratio is equal to or higher than minimum value; 4 points if the current ratio is equal to or higher than a minimum value; 3 points if the gearing is equal to or less than the maximum value but zero points if there is no interest cover; 3 points if the interest cover is equal to or more than minimum value; 2 points if the net profit rate is equal to or above minimum value; 2 points if the stock turn is less than or equal to a maximum; 1 point if the debtor days are less than or equal to a maximum.

Then, sum up all points to make a scorecard value and know whether a minimum, maximum or a fair credit guideline may be used. If the scorecard value is equal to or higher than 15, then a maximum credit guideline is allowed. If it is between 10 and 14, then it is fair and if it is between 5 or 9, then it is at a minimum. However, you cannot set any credit guideline if the scorecard value equal to or less than 4. Credit guidelines are measured from the company’s net worth based on the latest accounts. Calculation of credit scorecards is based on the current or liquid ratio depending on the type of industry.

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