Creditworthiness

What is creditworthiness?

Creditworthiness (German Bonität or Kreditwürdigkeit) refers to a debtor's ability and willingness to meet its payment obligations in full and on time. For companies, it is derived from annual financial statements, current business performance, payment behaviour and qualitative characteristics. The result is condensed into a rating or credit index, that is, a classification into classes or scores. Behind each level stands an estimated probability of default: the probability that the debtor will no longer make its payments within a given period, usually one year. In private life, the principle is familiar from the score of a credit agency, which landlords or mobile phone providers query before a contract is signed.

It is not only banks that assess creditworthiness. Suppliers use it to decide on payment terms. Trade credit insurers protect suppliers against the default of their customers and use creditworthiness to set the amount up to which they insure deliveries. Leasing and factoring companies and landlords base their terms and collateral requirements on it, and business information agencies make their assessments available to third parties. In funding rounds and company sales, creditworthiness is relevant in two directions. It is an examination point for the target company in due diligence, the review before an investment or purchase, and a question for the acquirer when parts of the purchase price are paid only later.

Credit assessment by banks and credit agencies

Bank-internal rating

Banks are required under banking supervision rules to classify their borrowers using a risk classification procedure. Above a certain loan amount, they must, under Section 18 of the German Banking Act (Kreditwesengesetz, KWG), have the borrower's economic circumstances disclosed to them on an ongoing basis, in particular by submission of the annual financial statements. The internal rating assigns each company to a rating class that corresponds to an estimated probability of default for the next twelve months. Three groups of characteristics go into the rating:

• Financial key figures: equity ratio, debt ratio (debt in relation to equity or earnings), earning power, cash flow and debt service capacity (the ability to pay interest and repayments from ongoing business). The bank derives them from the annual financial statements under the German Commercial Code (Handelsgesetzbuch, HGB) and from in-year figures.
• Account conduct: use of credit lines, overdrafts, returned direct debits and the development of account turnover. The bank has this data on an ongoing basis, and it reacts faster than balance sheet ratios.
• Qualitative characteristics: experience of the management, market and competitive position, dependence on individual customers or suppliers, quality of planning and reporting, succession arrangements.

Business information agencies and external ratings

Business information agencies evaluate commercial and company registers, published annual financial statements, insolvency announcements and suppliers' payment experiences and calculate a credit index from them. Their credit report, also called a credit check, combines company data, payment experiences, negative features and the index. As proof of creditworthiness, landlords, suppliers or public contracting authorities require such a report, a bank reference or current annual financial statements.

Under Section 325 HGB, corporations must disclose their annual financial statements, that is, file them with the German Company Register (Unternehmensregister), at the latest one year after the reporting date. Credit agencies and credit insurers often view late disclosure negatively, because current figures are missing. External ratings from rating agencies play a role mainly for bonds and larger companies. The agencies classify on letter scales, for example from AAA for the highest creditworthiness to D for default; classifications from AAA to BBB count as investment grade.

Creditworthiness, loan interest and access to debt capital

Creditworthiness decides whether a loan is granted and at what price. Banks calculate the interest rate from funding costs (what the bank itself pays for the money), operating costs, cost of equity and standard risk costs. The standard risk costs correspond to the expected loss, that is, the probability of default multiplied by the loss rate at default. The loss rate is the share of the loan that is lost after the collateral has been realised. The probability of default follows from creditworthiness; the loss rate depends on the collateral. For banks that base their capital requirements on internal ratings, weaker rating classes tie up more equity.

Beyond the interest rate, creditworthiness affects the credit limit, collateral requirements, the number and strictness of covenants (loan conditions), term and reporting obligations. For many development loans, the company's house bank assigns it to a price category according to creditworthiness and collateralisation. Suppliers shorten payment terms or demand prepayment when creditworthiness is weak, and trade credit insurers reduce the limits up to which they insure deliveries to the company. In growth phases with high prefinancing needs, weak creditworthiness thus narrows room for manoeuvre from several sides at once.

Creditworthiness of young technology companies

Classic rating procedures are geared to companies with an earnings history. A young technology company with start-up losses regularly scores poorly in them. The result is negative, the equity ratio fluctuates with every funding round and every loss year, and annual financial statements exist for only a few years. The rating then says more about the stage of development than about actual ability to pay.

Lenders therefore supplement the look at key figures with the liquidity reach from equity, the experience of the investors, the stability of recurring revenue and customer retention. Specialised forms of financing start elsewhere. Factoring relies mainly on the creditworthiness of the customers whose receivables are purchased. Venture debt, a form of loan for venture-capital-financed companies, builds on the equity providers and the prospect of further rounds. Equity improves creditworthiness directly, which is why a funding round often opens access to bank loans in the first place.

Creditworthiness in due diligence and company sales

In due diligence, investors and acquirers examine credit agency data, payment behaviour towards suppliers, ongoing dunning and enforcement proceedings and the correspondence with the banks. Overdue liabilities, credit lines that are permanently fully drawn and late disclosures raise questions about financial discipline, even if the figures are otherwise sound.

In a company sale, the question is reversed. If parts of the purchase price fall due only after closing, for example through an earn-out or a vendor loan, the sellers bear the acquirer's default risk. The acquirer's creditworthiness and the financing of the transaction then belong in the review; depending on the result, safeguards such as a bank guarantee, a guarantee from the parent company or an escrow account are agreed.

Worked example: how creditworthiness determines the loan interest rate

A company applies for a loan of EUR 2 million. The bank calculates the interest rate from four components: an assumed 3.0% funding costs, 1.0% operating costs including profit margin, and cost of equity and risk costs that depend on the rating class. The cost of equity here is the cost of the equity that the bank itself must hold for the loan. The loss rate at default is assumed to be 45%.

• Good creditworthiness, probability of default 0.4%: standard risk costs 0.4% × 45% = 0.18%; cost of equity assumed at 0.5%
• Interest rate with good creditworthiness: 3.0% + 1.0% + 0.5% + 0.18% = 4.68%, that is, EUR 2 million × 4.68% = EUR 93,600 per year
• Weak creditworthiness, probability of default 2.5%: standard risk costs 2.5% × 45% = 1.125%; cost of equity assumed at 1.0%
• Interest rate with weak creditworthiness: 3.0% + 1.0% + 1.0% + 1.125% = 6.125%, that is, EUR 2 million × 6.125% = EUR 122,500 per year
• Additional cost of weaker creditworthiness: EUR 122,500 minus EUR 93,600 = EUR 28,900 per year
• Weak creditworthiness with additional collateral that reduces the loss rate to 25%: standard risk costs 2.5% × 25% = 0.625%
• Interest rate with this collateral: 3.0% + 1.0% + 1.0% + 0.625% = 5.625%, that is, EUR 2 million × 5.625% = EUR 112,500 per year

The calculation is simplified but shows the mechanics: collateral lowers the loss rate and thus part of the mark-up, but does not offset weak creditworthiness. Over five years, the difference between good and weak creditworthiness at an unchanged loan amount adds up to 5 × EUR 28,900 = EUR 144,500.

Distinction: creditworthiness, liquidity, debt service capacity and rating

• Liquidity: the ability to make due payments today. Creditworthiness looks forward; a company with a high bank balance can have weak creditworthiness if its funds will foreseeably run out.
• Debt service capacity: a single key figure in the credit assessment that is particularly important to banks, relating to interest and repayments. Creditworthiness additionally covers the asset position, payment behaviour and qualitative characteristics.
• Rating: the result of a credit assessment as a class or grade. Bank-internal ratings remain confidential; credit agency indices are accessible to third parties with a legitimate interest.

Common mistakes

• Disclosure missed. An annual financial statement published late acts as a warning signal for credit agencies, regardless of how good the figures are.
• Own entries never checked. Incorrect or outdated information at credit agencies flows unchecked into the decisions of suppliers, landlords and lenders.
• Payment terms exceeded unilaterally. Late payments to suppliers enter credit indices through payment experiences faster than any balance sheet ratio.
• Bank informed only in a crisis. Anyone who supplies the bank only with annual financial statements and gets in touch only when bottlenecks arise loses the chance to influence the assessment with plans and explanations.
• Plans without reconciliation. Plans that deviate from year to year without explanation worsen the qualitative assessment, even when actual figures are good.

Frequently asked questions

How can one check one's own creditworthiness?

Through a self-disclosure request to the major business information agencies. It shows the stored data and the index calculated from it; incorrect information can be corrected. Private individuals and sole traders receive a free copy of their stored data under Article 15 of the General Data Protection Regulation (GDPR, in German DSGVO); the GDPR does not apply to a GmbH (German limited liability company). The bank-internal rating is generally explained by the bank on request in the credit discussion.

How quickly can creditworthiness be improved?

Payment behaviour has the fastest effect, often within a few months. Balance sheet ratios change only with the next annual financial statements. A capital injection during the year can be demonstrated to the bank with an interim balance sheet or proof of payment, long before it appears in the published financial statements.

What do "subject to creditworthiness" and "dependent on creditworthiness" mean?

Both notes make an offer depend on creditworthiness. "Subject to creditworthiness" means that the provider commits only after a positive check; there is no entitlement to the advertised offer. "Dependent on creditworthiness" means that the interest rate or terms depend on the result of the check and are not the same for every customer.

Does creditworthiness play a role in an equity round?

Yes, indirectly. Investors receive neither interest nor collateral, but they check whether payment behaviour and bank relationships are in order and whether debt capital is available alongside the round. Open dunning proceedings or a terminated credit line can weigh on negotiating position and valuation.

Does the private creditworthiness of the shareholders count?

For smaller companies, often yes. If shareholders give personal guarantees or the management strongly shapes the company, the bank includes their economic circumstances in the assessment. As the company grows larger and the shareholder base broadens, this aspect recedes.

The Roemer Capital view

Before a client speaks with banks or investors, we look at the company through the eyes of a lender. We check whether the annual financial statements have been disclosed on time and whether the entries at the credit agencies are correct. In addition, we reconcile the current plan with the previous one and look at the account conduct of the last months. Corrections take time, because credit agencies and banks update data with a delay; they belong at the start of a financing process.

As a fractional CFO, that is, in the role of a finance chief for a limited period, we set up regular reporting to the banks, usually quarterly with an explanation of the deviations. In a company sale, we examine the acquirer's creditworthiness when parts of the purchase price fall due later, and we agree with the law firm which security is appropriate for this.