Using Solvency Scores to Determine Loan Amount: A Credit Manager’s Guide

Credit managers is often using solvency scores to determine loan amount, as it provides insight into the borrower’s financial health and ability to repay the loan.

When a credit manager is considering lending money to a borrower, one of the most important factors they consider is the borrower’s ability to repay the loan. Solvency scores to determine loan amount and it’s one of the key tools that credit managers use to assess a borrower’s ability to repay the loan. In this article, we will discuss how credit managers use solvability scores to determine how much money to lend to a borrower.

What is Solvency Score?

A solvency or solvability score is a measure of a borrower’s ability to meet their financial obligations. It is calculated using various financial ratios that provide insight into the borrower’s financial health. These ratios include debt-to-equity ratio, debt-to-income ratio, and current ratio, among others. The solvability score is typically expressed as a percentage or a score out of 100.

Formula to Calculate Solvability Score:

Solvability Score = (Total Assets – Total Liabilities) / Total Assets * 100

Example:
Let’s say a small business has total assets of $500,000 and total liabilities of $200,000. Using the formula above, we can calculate the solvability score as follows:

Solvability Score = ($500,000 – $200,000) / $500,000 * 100 = 60%

This means that the small business has a solvability score of 60 out of 100.

How a credit manager might use solvency scores to determine how much money to lend to a borrower?

Let’s say a credit manager is considering lending money to a small business. They use a credit scoring system to assess the business’s creditworthiness and determine a solvability score of 85 out of 100. Based on the credit manager’s lending policies, they require a minimum solvability score of 80 to consider lending money to a business.

The credit manager would then consider other factors, such as the business’s cash flow, debt-to-equity ratio, and collateral, to determine how much money to lend. They might decide to lend $50,000 to the business, as long as the business meets all the credit manager’s requirements.

In this example, the solvability score of 85 was just one factor considered by the credit manager in making their lending decision. The credit manager also took into account other factors to determine the appropriate amount of money to lend.

How Credit Managers Use Solvency Scores?

Credit managers use solvency or solvability scores to determine how much money to lend to a borrower. A higher solvability score indicates that the borrower is more likely to repay the loan, while a lower score indicates that the borrower may have difficulty repaying the loan. In general, credit managers prefer to lend to borrowers with higher solvability scores.

Credit managers also consider other factors when determining how much money to lend, such as the borrower’s cash flow, collateral, and credit history. However, the solvability score is a key factor that can help credit managers make informed lending decisions.

Example:

Let’s say a credit manager is considering lending money to a small business. The business has a solvability score of 80 out of 100, which meets the credit manager’s minimum requirement for lending. However, the credit manager also considers other factors, such as the business’s cash flow and collateral. Based on these factors, the credit manager decides to lend $100,000 to the small business.

Conclusion:

Solvability scores are a critical tool that credit managers use to assess a borrower’s ability to repay a loan. By using solvability scores, credit managers can make informed lending decisions and reduce the risk of loan defaults. While solvability scores are just one factor that credit managers consider when determining how much money to lend, they are a key factor that can help credit managers make sound lending decisions.

Read also: Personal Finance Advice | Tips for (well) managing your budget are too rarely applied

Factors to Consider When Determining Loan Amount

There are several factors to consider when determining the appropriate loan amount for a borrower. To use solvency scores to determine loan amount, credit managers need to follow these steps:

Solvency score (for business loan)

A solvability score is a measure of a borrower’s ability to meet their financial obligations. It is calculated using various financial ratios that provide insight into the borrower’s financial health. Consider the minimum solvability score requirement for lending set by the credit manager’s lending policy. Calculate the solvability score of the borrower using financial ratios such as debt-to-equity ratio, debt-to-income ratio, and current ratio.

Debt-to-income ratio

If a borrower has a high debt-to-income ratio, credit managers may offer a lower loan amount or require the borrower to provide additional collateral, as they may be at a higher risk of defaulting on the loan. If a borrower has a debt-to-income ratio of 40%, a credit manager may offer them a loan of $20,000 for a car purchase or require them to provide additional collateral.

Cash flow (for business loan)

Credit managers assess the borrower’s cash flow to determine whether they have sufficient income to repay the loan. Assess other factors such as cash flow, collateral, and credit history to determine the appropriate loan amount.

Collateral

Credit managers may require collateral to secure the loan, which can reduce the risk of loan default. Determine the loan amount based on the borrower’s solvability score and other factors. A higher solvability score indicates a lower risk of loan default and may lead to a higher loan amount, while a lower solvability score may result in a lower loan amount. They may consider factors such as late payments, missed payments, and defaults on previous loans.

If a borrower owns a valuable piece of property, such as a home worth $500,000, a credit manager may offer them a loan of $200,000 for a business expansion.

Credit score

If a borrower has a high credit score of 750 or above, a credit manager may be willing to offer them a loan of $50,000 for a home renovation project.

Credit history

Credit managers evaluate the borrower’s credit history to determine their past repayment behavior. Monitor the borrower’s solvability score and financial health over time to ensure continued repayment capacity.

Payment history

If a borrower has a history of making timely payments on previous loans and credit cards, a credit manager may be willing to offer them a loan of $10,000 for a medical expense.

Employment and income (for personal loan)

Credit managers also consider a borrower’s employment history and income level when determining the loan amount. They may look at factors such as job stability, salary, and employment history to determine the borrower’s ability to repay the loan.

If a borrower has a stable job and a high income of $100,000 per year, a credit manager may offer them a loan of $30,000 for a family vacation.

Loan purpose

Finally, credit managers may consider the purpose of the loan when determining the loan amount. For example, a loan for a business venture may require a larger loan amount than a loan for personal expenses.

If a borrower is seeking a loan of $100,000 for a business venture, a credit manager may be willing to offer them the full amount if they believe the investment has a high potential for returns. However, if the borrower is seeking a loan of $100,000 for personal expenses, the credit manager may offer them a lower loan amount of $50,000.

By using solvability scores to determine loan amount, credit managers can make informed lending decisions, reduce the risk of loan default, and ensure that borrowers receive the appropriate amount of funding based on their financial health and ability to repay the loan.

Difference between solvency and solvability

Solvency and solvability are both terms related to a borrower’s ability to meet financial obligations, but they refer to different concepts.

Solvency refers to a borrower’s ability to meet their financial obligations in the long term. It is a measure of whether a borrower has sufficient assets to cover their debts and expenses, and whether they are generating enough income to meet their financial obligations over time. In other words, solvency measures a borrower’s overall financial health and stability.

On the other hand, solvability refers to a borrower’s ability to meet their financial obligations in the short term. It is a measure of whether a borrower has enough cash flow or liquid assets to meet their immediate financial obligations, such as paying bills or making loan payments. Solvability is important in assessing a borrower’s ability to handle unexpected expenses or financial shocks.

In summary, solvency measures a borrower’s long-term financial health and stability, while solvability measures their short-term ability to meet financial obligations. Credit managers may use both solvency and solvability when assessing a borrower’s creditworthiness and ability to repay loans.

Sources: CleverlySmart, PinterPandai, AccountingTools

Photo credit: ds_30 via Pixabay

Financial Analysis | Measuring performance and profitability

Ready to get started?

Are you a consultant? If you are a consultant and wish to contact us for any reason, we invite you to click the ‘Let’s Get in Touch’ button to connect with our team and receive the necessary assistance.