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Financial Management and Business Data Analytics · Receivable Management

Credit Evaluation and Credit Granting Decision

Updated 10 October 2026 · Fact-checked

Credit evaluation is the process of judging whether a customer will pay on time before you sell on credit. You collect information, analyse character, capacity, capital, collateral and conditions, give a credit score, then set a credit limit or reject. Marginal profit versus expected bad debt and carrying cost drives the decision.

Understand Credit Evaluation and Credit Granting Decision

When a firm sells on credit, it lends money to the customer without a formal loan. If the customer does not pay, the firm loses the sale value and the cost of goods. So the firm must check the customer before granting credit. This checking is credit evaluation.

Credit evaluation has three parts. First, collect information about the customer. Second, analyse it to judge creditworthiness. Third, decide: grant credit or not, and up to what amount. The amount is the credit limit.

The classic framework is the 5 Cs of credit: Character (willingness to pay, payment history, reputation), Capacity (ability to pay from cash flows and liquidity), Capital (net worth and financial strength), Collateral (assets offered as security) and Conditions (the economy, the industry and the terms of the deal). Character is judged mostly by experience; the others are judged from numbers.

Sources of credit information include the customer's financial statements, bank references, trade references from other suppliers, the firm's own past sales and payment records, credit rating agencies, credit bureaus, reports of salespeople and published news. Internal records are cheapest. Bank and agency reports cost more but add outside views.

Credit scoring turns the analysis into one number. You pick factors such as current ratio, years in business, payment record and net worth. Each gets a weight, and each customer is rated on each factor. The weighted total is the score. A cut-off score separates accept, review and reject. Scoring is fast and consistent, so it suits many small accounts. Large accounts get a deeper, case-by-case analysis.

The final decision is economic. Extend credit if the extra profit from the sale is more than the extra costs: bad debts, the cost of funds locked in receivables, and collection and administration cost. A customer with a small risk of default can still be worth serving if the margin is high.

Key rules to remember

Credit score
Score = Σ (weight × rating) for all factors
Weights usually add to 100% or 1. Compare the total with the cut-off score given in the question.
Expected bad debt
Expected bad debt = Credit sales × Probability of default
If the question gives a percentage of sales as bad debt, use it directly. Use sales value, not cost, unless told otherwise.
Carrying cost of receivables
Cost = Average receivables at cost × Required rate of return, where Average receivables = Credit sales × Collection period ÷ 365
Use cost of sales (variable cost) as the investment base if the question says so. Use 360 days only if the question says so.
Net benefit of granting credit
Net benefit = Contribution (or profit) on extra sales − Bad debts − Carrying cost − Collection cost
Grant credit if the net benefit is positive. For expected value problems, weight each outcome by its probability.
Expected profit on a credit order
Expected profit = p × (Sales − Cost) − (1 − p) × Cost, where p = probability of payment
This applies when a non-paying customer pays nothing and the firm loses the whole cost. Adjust if part payment is expected.

How to solve Credit Evaluation and Credit Granting Decision questions

Use this method for numerical and theory questions on credit evaluation and granting credit.

  1. 1Read what is asked: a score, a limit, accept or reject, or a list of factors and sources.
  2. 2For theory, structure the answer around the 5 Cs, then information sources, then analysis and decision. Give one line on each point.
  3. 3For a scoring problem, multiply each rating by its weight, add them, and compare the total with the cut-off.
  4. 4For a profit-based decision, list incremental sales, incremental cost, bad debts, carrying cost and collection cost separately.
  5. 5Compute average receivables from credit period and sales, using the base (sales or cost) the question implies.
  6. 6Find the net benefit or the expected profit. A positive result means grant credit.
  7. 7If asked for a limit, base it on the customer's capacity, such as a share of net worth or working capital, or on the net benefit, and state the assumption.
  8. 8Write a one-line conclusion: grant, refuse or grant a reduced limit, with the reason.

Quickest way: Weighted score and net benefit shortcut

When to use it: Use this for numerical questions with ratings, probabilities or a customer proposal, when time is short.

  1. Underline weights, ratings, cut-off, probability of default and credit period in the question.
  2. Compute the score in one line: add each weight × rating.
  3. For profit decisions, build a three-line table: contribution, minus bad debts, minus carrying cost.
  4. Avoid detailed ledger-style working. Show only the formula and the numbers.
  5. State the decision against the cut-off or against zero net benefit.

Common mistakes in Credit Evaluation and Credit Granting Decision

  • Listing the 5 Cs without explaining them

    Students memorise the words and skip the meaning.

    Fix: Write one line per C saying what is judged and how, for example Capacity is judged from cash flows and liquidity ratios.

  • Using sales value instead of cost to compute carrying cost

    Students apply the formula without reading the data on cost percentage.

    Fix: Check if the question gives variable cost or cost of sales. The firm's investment in receivables is at cost, so use it when given.

  • Ignoring the weights in a credit scoring problem

    Students add the ratings directly.

    Fix: Always multiply each rating by its weight first. Check that the weights sum to the stated total.

  • Treating a high score as an automatic grant

    Students stop after scoring and skip the economic comparison.

    Fix: Compare the score with the cut-off, then check profitability. Mention both in your conclusion.

  • Applying bad debt percentage to the wrong base

    Students are unsure whether it applies to total sales or only to credit sales.

    Fix: Apply it to the credit sales under review unless the question says otherwise, and state your assumption.

Worked examples

Example 1

Sharma Traders scores customers on four factors with weights: payment record 40%, current ratio 30%, years in business 20%, net worth 10%. Each factor is rated out of 10. Customer Kavita Stores is rated 8, 6, 5 and 7 respectively. The firm grants credit if the score is at least 6.5 out of 10. Should credit be granted?

Show the solution
  1. Payment record: 0.40 × 8 = 3.20
  2. Current ratio: 0.30 × 6 = 1.80
  3. Years in business: 0.20 × 5 = 1.00
  4. Net worth: 0.10 × 7 = 0.70
  5. Total score = 3.20 + 1.80 + 1.00 + 0.70 = 6.70
  6. Compare: 6.70 is above the cut-off of 6.5.

Answer: The score is 6.70, above the cut-off of 6.5, so credit can be granted.

Example 2

Anand Ltd sells a product at ₹100 per unit with variable cost ₹70 per unit. A new customer wants credit on 10,000 units a year. Expected bad debts are 4% of the credit sales. The average collection period is 60 days. The firm's required return is 15% and a year has 360 days. There are no extra collection costs. Should Anand Ltd grant credit?

Show the solution
  1. Credit sales = 10,000 × ₹100 = ₹10,00,000
  2. Contribution = 10,000 × (₹100 − ₹70) = ₹3,00,000
  3. Bad debts = 4% × ₹10,00,000 = ₹40,000
  4. Variable cost of sales = 10,000 × ₹70 = ₹7,00,000
  5. Average receivables at cost = ₹7,00,000 × 60 ÷ 360 = ₹1,16,667 (rounded)
  6. Carrying cost = 15% × ₹1,16,667 = ₹17,500
  7. Net benefit = ₹3,00,000 − ₹40,000 − ₹17,500 = ₹2,42,500

Answer: The net benefit is ₹2,42,500, which is positive, so Anand Ltd should grant credit.

Exam tips

  • In theory answers, name the 5 Cs, then information sources, then scoring, then decision. This order covers most marking points.
  • In numericals, state your assumptions on days in the year and the base for carrying cost. Examiners give marks for clear assumptions.
  • Show the scoring table in rows: factor, weight, rating, weighted score. It earns step marks and avoids errors.
  • For MCQs, note that Character means willingness to pay and Capacity means ability to pay. Options often swap them.
  • End every numerical with a clear decision statement in one line.

Practice questions from Receivable Management

Credit Evaluation and Credit Granting Decision in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Evaluation and Credit Granting Decision: frequently asked questions

What are the 5 Cs of credit?

They are Character, Capacity, Capital, Collateral and Conditions. Together they help judge whether a customer is willing and able to pay. Character is about intention, while Capacity, Capital and Collateral are about financial ability and security.

What are the main sources of credit information?

Common sources are the customer's financial statements, bank references, trade references, your own payment records, credit rating agencies and credit bureaus. Salespeople's reports and news also help. Use internal records first because they cost less.

How does a credit scoring model work?

You choose factors, give each a weight, and rate the customer on each. The weighted sum is the score. You compare it with a cut-off to accept, review or reject the customer.

How is a credit limit decided?

A limit is set from the customer's capacity to pay, such as a share of net worth or working capital, and from the expected net benefit of the sales. It is reviewed regularly against payment behaviour.