F E A T U R E
A R T I C L E
Credit Scoring And
The Next Step
NTRODUCTION
Albert Fensterstock is
Managing Director of
Albert Fensterstock
Associates, a
consulting firm that
I The use of credit scoring for evaluating
credit risk is at an all-time high in
American businesses. This is probably due
to several factors inherent in the use of this technol-
specializes in the ogy. Among them, credit scoring is more efficient
application of the than having credit department personnel evaluate
Internet and the every potential sale, which saves money—a major
utilization of decision consideration for corporate America these days.
support technology
for improving credit
Additionally, Sarbanes-Oxley and its requirements
department risk point to the use of credit scoring as a good method
analysis capability and for improving internal control over risk-based deci-
collection department sions. For the most part, however, regardless of the
efficiency. He can type of scoring system in place, businesses are not
be reached at getting everything they can from the implementa-
516.313.1020
tion of a credit scoring system.
or via e-mail at
albie@afassociates.org.
So, there is more that can be done, however, before
we get into what it is, and why it should be done,
let’s briefly review what types of credit scoring
systems are available and the differences between
them. If the reader needs more than a brief review,
you may want to take a look at an article I wrote,
Credit Scoring Basics, that appeared in the March
2003 issue of Business Credit. This article covers the
nature of a credit scoring model, credit scorecards,
the requirements for maintaining a credit scoring
system, and how to determine whether to build or
buy, subjects that will not be covered here.
What Is Credit Scoring?
Essentially, credit scoring is a systematic method
for evaluating credit risk that provides a consistent
analysis of the factors that have been determined
to cause or affect the level of risk. Factors are
usually determined through an analysis of histori-
cal bill payment activity as well as various descrip-
tive parameters that may be used to classify an
account into one of several defined categories or
customer classes.
Once the analysis necessary to create the credit scor-
BUSINESS CREDIT MARCH 2005
ing model—or in most instances models—has been
accomplished, information about an applicant
company and its credit experiences are entered into
the model, when a credit decision is needed. Then,
credit scoring software, usually provided by a
company that specializes in this type of analysis,
helps to predict:
46
ALBERT FENSTERSTOCK
• Whether the debtor company is likely to pay its
debts on time, and/or
• The likelihood the debtor company will file for
bankruptcy or default on the debt.
What Are The Different Types
Of Credit Scoring Systems?
The different types of credit scoring systems most
usually used to evaluate credit risk in B2B situa-
tions are:
• Judgmental/Rules-Based Systems
• Neural Network-Based Systems
• Statistical-Based Systems
• Genetic Algorithm-Based Systems
They all have strengths and weaknesses and the
nature of your business, the amount of risk you are
willing to take, and the funds available to develop
and implement the scoring system will play a major
part in determining which technology is best for
your company to employ. To be sure that you employ
the one that is best for your company, you should
review all of the options before you make a decision.
Judgmental/Rules-Based Systems
Judgmental/rules-based systems evaluate credit
worthiness using a formula or a set of rules based
upon internal and external credit experience. The
determination of the rules used and their associated
values is a manual process that is dependent upon
certain individuals’ intuition and past experience.
Some of the strengths of this procedure are:
• It is based on accepted credit risk standards
(judgment) and takes such items into
consideration as:
- Customer payment history
- Bank and trade references
- Credit agency ratings
- Financial statements
- Various financial ratios
• Past experience is the basis of the factors and
weights used
• Provides a consistent alternative for evaluating
new credit applications
Some of its weaknesses are:

• It is inefficient to build as all of the work is done manually
• The factor weights can be biased towards data elements
that may not be mathematically relevant to risk
• The effect of a specific factor can not be accurately meas-
ured and, therefore, the sensitivity to a change in that
factor can not be accurately determined
• Risk cannot be quantified as expressed by the probability
of payment within a specific time period or of default
• It is difficult, if not impossible, to determine the source of
error if the system’s predictions are not accurate, therefore,
updating the system in an effort to improve results is a hit
and miss proposition
Neural Network-Based Systems
These systems utilize artificial intelligence algorithms applied
to historical data to find relationships between account char-
acteristics and the probability of default. They have the capa-
bility to classify accounts into various credit risk classes such
as: good, indeterminate, delinquent, charge-off and bankrupt.
Some of the strengths of this procedure are:
• Has the ability to determine the characteristics that are
most important in predicting credit risk
• In some circumstances, may be more flexible than standard
statistical techniques as no assumptions are made about
the relationships of the risk factors prior to analysis
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F E A T U R E A R T I C L E
• Can deal with non-linear relationships
• Correlations between factors are accounted for
• Models are adaptive in that the nature of forecast errors
(i.e., bad model decisions) can be easily evaluated and the
models improved accordingly
Some of its weaknesses are:
• Results are essentially a “black box”
• Credit personnel have no idea of the structure of the credit
scoring model, i.e., the weights connecting nodes between
model layers and, therefore, cannot properly evaluate the
model’s decisions
• Model output must be accepted by credit personnel based
on the word of an “expert”, i.e., the consultant who devel-
oped the model, who is rarely a competent credit analyst.
• Almost all applications in the credit industry have been in
consumer-based risk evaluation
Statistical-Based Scoring Systems
Statistical-based scoring systems utilize statistical analysis,
usually in the form of a multivariate non-linear regression
model, (remember Y = a + bX, only with more variables, hence
multivariate), to estimate the probability a customer will
default or become delinquent. These systems are very similar in
operation to judgmental systems except that the factors used
and their assigned weights are based on statistical analysis—
BUSINESS CREDIT MARCH 2005
Strength in Numbers
47
 F E A T U R E A R T I C L E
not human judgment—of a company’s past operations together
with other data considered by the analyst as pertinent.
Some of the strengths of this procedure are:
• Can use and evaluate any internal and external data to
score accounts
• Many factors are considered individually and simultaneously
• The model development process calculates and analyzes the
correlation between all of the variables to identify factor
tradeoffs and eliminate redundant relationships
• Variables can be chosen by the statistical analyst to ensure
the relationships makes financial sense (e.g., older firms
are less risky then younger firms)
• Users are able to identify sources of estimation error and
improve model accuracy
Some of its weaknesses are:
• Need someone with a statistics background and experi-
ence with credit information to build and implement
the model
• Bulk of analyst’s time may be spent in data preparation
and analysis of statistical relationships, rather than in
model building
• If there are a lot of variables to consider, an analyst may
need to predetermine the important variables based on a
separate analysis
• Some statistical models can be difficult to implement
Genetic Algorithm-Based Systems
This is the new guy on the block and may offer, in certain
situations, a superior solution to any other method. Genetic
Algorithms (GA) are based on the principle of “survival of the
fittest” ala Darwin. Like selective breeding, a GA breeds an
initial “generation” of random predictive models. The models
are tested for fitness against user-defined criteria. The better
models are more likely to be selected for breeding. Following
fitness evaluation, the GA will apply the basic principles of
genetics to breed the next generation of models. These
consist of cloning, mating, mutating and the introduction of
random models.
An extensive “trial and error” process is utilized that may breed
millions of models resulting in a final model that can be used
to estimate the probability of payment within a given time
horizon. Basically, GAs are very sophisticated search algorithms
that by means of an iterative procedure search through all of
the possible scoring models in an attempt to locate the best
scoring model.
Some of the strengths of this procedure are:
• Can use and evaluate any internal and external data to
score accounts
• GAs can use 100% of the available data rather than an
BUSINESS CREDIT MARCH 2005
analyst selected subset
• The interaction between variables is not a problem
• As with statistical-based systems, users are able to identify
sources of estimation error and improve model accuracy
Some of its weaknesses are:
48
• Extremely limited knowledge of this technology within
the business community, almost all practitioners are
university-based
• The few business-based practitioners have little experience
in applying GAs to credit risk analysis
• In-house statisticians may resist the implementation of a
technology they do not know or understand
Why Use Scientific-Based Credit Scoring?
With respect to neural, statistical and genetic algorithm-
based credit scoring systems, the main reasons for using one
of them are:
• They provide a significantly more accurate analysis by
delivering 10 percent to 30 percent—or more—improve-
ment in predicting customer credit risk over non-scientific
methods
• The cause of prediction error in scientific-based models
can be identified and these models can be improved and
kept current. Updates can be scheduled on a regular basis,
or as needed
• They can provide the basis for meeting certain require-
ments of Sarbanes-Oxley
Providing the work discussed in the next section is accomplished:
• They can help in the development of optimal strategies for
dealing with at-risk account.
• Scientific-based credit scoring can dramatically increase
credit and collection department productivity
The Next Step
We submit that the implementation of a scientific-based credit
scoring system is only the first step in improving credit and
collection department efficiency. To really achieve the maxi-
mum benefits available from these technologies you need to go
the next step, and sadly very few companies have.
Consider the obvious. Credit scores in a given B2B environment
will range from very low (high risk) to very high (low risk). Yet,
in most instances, the collection procedures applied within a
company are very much the same for all accounts shipped, until
an account starts falling behind in their expected payments.
Then, the collectors spring into action to do that which they
should have expected they would have to do at the time the
account was shipped.
We propose a different strategy, whereby a given score prede-
termines the collection strategy to be applied from the time of
shipment. If different scores indicate a different level of
risk, doesn’t it make sense that they also imply that differ-
ent collection procedures be utilized?
A Procedure For Achieving The Next Step
Assume that the new scientific-based scoring system has been
developed and implemented; here is one approach to finishing
the job:
1. Determine a set of collection procedures that might range
from mild to very aggressive. Let’s assume that you have
defined three different strategies, where one of the strate-
gies is what you currently do.

2. Score all of your accounts using the new system, and clas-
sify them into homogeneous groups or strata. If we assume
scores can range from 0 to 100, then perhaps one strata
contains all of the accounts that scored from 0 – 25; a
second strata might contain all of the accounts that scored
from 26 – 50, and so on. You may also want to segment
the strata if there are different divisions, i.e., even though
accounts have the same score there is another characteris-
tic that you believe makes them different; such that they
might respond differently to the same collection strategy.
3. Within each stratum, select a random sample of some
percentage of the accounts. The size of the sample can be
determined based upon the variance within the strata.
I would suggest that this variance be based upon a
discounted cash flow (DCF) analysis of the accounts past
payment history converted into a percentage of the maxi-
mum DCF possible, where the maximum DCF occurs if the
invoice is paid at the time of shipment. Realistically, this
is the statistic you are trying to improve in that it meas-
ures the time-value of money. The sooner after shipment
an invoice is paid; the greater the percentage of the
maximum possible DCF is achieved. Your credit scoring
systems provider can help you with this.
4. Next, divide the sample within each stratum into three
groups. You can do this by assigning every third account
to a different group.
For one of the groups, within each stratum, apply your
normal collection procedures. For each of the other
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groups, apply one of the other procedures you determined
in 1. above.
5. Ninety to 120 days after you have started the test,
compute the percentage of DCF achieved for each group
and compare it to the historical group average. You can
also compare the percentage DCF on an account-by-account
basis. There is a standard statistical test you can utilize to
perform this comparison that will determine whether the
difference between your history and the current results are
significant, i.e., the alternative procedures have produced a
measurable change.
6. If the alternative collection procedures have produced a
meaningful change in the bill payment activity of certain
classes of accounts, you’ll need to consider whether you
should change your collection activities relative to all of
the types of accounts where a more favorable percentage of
DCF has been realized. A simple rule-based program that
can determine the type of collection procedure required on
an account-by-account basis and then direct the personnel
assigned to these accounts how and when to handle them
can be readily designed and implemented into an inhouse
or ASP based computer system.
If you want to achieve all of the benefits promised by scien-
tific-based credit scoring, an analysis similar to the one
described above should be part of any credit scoring project.
While this procedure may seem a little complicated, anybody
with a basic knowledge of statistical sampling should be able
to help you.
Strength in Numbers
BUSINESS CREDIT MARCH 2005
The Right Way
49