Credit Evaluation: Proper assessment of credit risks is important as it helps in establishing credit limits.

In assessing credit risks, two types of errors occur: Type I error : a good customer is misclassified with poor credit standing. Type II error : a bad customer is misclassified with good standing. Both the errors are costly. Type I error leads to loss of profit on sales to good customers Who are denied credit .Type ii error results in bad debt losses on credit sales made to risky customers. While misclassification errors cannot be eliminated wholly, a firm can mitigate their occurrence by doing proper credit evaluation. Three broad approaches are used for credit evaluation, 1. Traditional Credit Analysis 2. Numerical Credit Scoring 3. Discriminant Analysis. 1. Traditional Credit Analysis: calls for assessing a prospective customer in terms of the five Cs of credit. Character : The willingness of the customer to honour his obligations .It reflects integrity, a moral attribute that is considered very important by credit managers. Capacity : The ability of the customer to meet credit obligations from the operating cash flows. Capital : The financial reserves of the customer. If the customer has problems in meeting credit obligations from operating cash flow, the focus shifts to its capital. Collateral :The security offered by the customer in the form of pledged assets. Conditions : The general economic conditions that affect the customers. To get information on 5 Cs , a firm may rely on the following: 1. Financial Statements: provide useful insights into the creditworthiness of the customer. Firms may analyze the balance sheets in terms of calculation of different ratios,

important being; current ratio, acid test ratio, debt equity ratio, EBIT to total assets etc. 2. Bank References: The banker of the prospective customer may be approached to gather information. 3. Experience of the firm: Consulting the firms own previous experience with respect to a customer & analyzing past trend of payment is also essential. 4. Prices & Yields on Securities: For listed companies, valuable information can be derived from stock market data. Sequential Credit Analysis: A sequential credit analysis is undertaken under the traditional credit analysis approach. Credit analyst proceeds from stage one variable to stage two only if the first stage criteria is found positive, Likewise, the credit analyst goes from stage two to sage three only if internal credit analysis suggests that the customer poses a medium risk .