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Strategic Finance

The power of knowledge

Monday, 27 November 2006

Most of us are aware of the phrase 'knowledge is power' yet, conversely, we've all learned from life's experience that a little knowledge can be a dangerous thing. Martin Williams explains how knowledge is really only potential power in today's world of commercial credit information.
As in any other area of corporate activity, making credit risk decisions without the full facts will generally lead to a high number of mistakes and bad judgement calls. Fortunately, the majority of large and medium-sized companies in the UK now believe in preventative medicine when it comes to formulating credit policies. In credit risk management parlance, this means credit vetting new applications and reassessing existing credit lines are commonplace activities within credit departments nowadays. Analysts and risk assessors sit comfortably alongside colleagues engaged in the collection of overdue cash from trade debtors.

So, managers whose departments undertake credit checks are doing everything they can to protect their organisations from experiencing bad debt and slow payments, right? Well, not necessarily, is the immediate answer. It all depends on how those checks are carried out and, perhaps more importantly, where they are carried out.

Graph 1. Days between accounts filling date and financial year end date

It may surprise some that there are only an estimated 50,000 companies in the UK market that buy credit reports on a regular basis from credit reference agencies (CRAs). This is out of a total of approximately four million businesses. These raw statistics beg the question, what do the large majority do before releasing goods on credit? Some go to Companies House to seek out public record information. Many write to trade referees whose names have been provided by the prospective client - action that won't necessarily reveal the full facts about an organisation's true creditworthiness. Others, particularly SME businesses, may do no credit vetting at all and certainly won't be big enough to employ credit managers either.

So, if references, particularly the cultivated sort, leave gaps in a credit manager's knowledge, will credit reports do the job?

Like their clients, CRAs are in the business of trying to predict the future payment behaviour and probability of default of a trade debtor. There is no guarantee that all credit ratings and scores provided by CRAs will prove to be correct. After all, this peering into the future can hardly be viewed as an exact science. However, it would be fair to say that access to computer processing power and advanced statistical analysis software has given CRAs the tools to deliver very predictive credit scoring systems nowadays.

The level of predictiveness will vary depending on the number of corroborating data sources used by the agency to formulate scoring models. Those CRAs engaged primarily in the collection and dissemination of data from the Companies Registry Office (CRO) may be able to offer the market low-priced products but will the offering minimise a client's credit risk?

The problems for the users of regurgitators of Companies House data start at the CRO itself. Visitors to its website (www.companies-house.gov.uk ) will read a disclaimer nowadays relating to the information available to the public there.

It reads: "Companies House is a registry of company information. We carry out basic checks to make sure that documents have been fully completed and signed, but we do not have the statutory power or capability to verify the accuracy of the information that companies send to us. We accept all information that companies deliver to us in good faith and place it on the public record. The fact that the information has been placed on the public record should not be taken to indicate that Companies House has verified or validated it in any way.

This is a relatively new thing, prompted by the increasing number of fraudulent documents being filed there by unscrupulous individuals. Criminals, bent on perpetrating frauds, are filing fictitious documents at the CRO knowing they will be passed on to CRAs, who will load that data onto their systems to produce automatic credit scores. The better the fictitious results of a company, the better the credit rating produced.

At the best credit reference agencies in the UK, intelligence units have been operating for years to track this type of fraudulent activity and have developed services aimed at companies constantly targeted by fraud such as telecommunications organisations, insurers and financial lenders. This type of service is designed to flag all UK companies where unusual patterns of corporate activity or business behaviour have been identified.

For example, one characteristic that may be tracked is the extremely early filing of audited accounts after a fiscal year end.

"A company that can file its audited accounts a week after its financial year end may not necessarily be fraudulent but it is exceptional and may be worthy of closer scrutiny before credit is extended," says Graydon's Database Manager, Chris Oatts.

Another characteristic being monitored is the number of registered office changes in a short period of time. Chris Oatts says: "A registered office can change for many reasons. An accountant may move office, for instance, but four times in one year?"

This may be perfectly above board but it is exceptional nonetheless. Graph 2 shows the frequency of registered office changes recorded at Companies House in a year.

Credit reference agencies with experience of running intelligence units on behalf of industry sectors particularly vulnerable to fraud can assess what is exceptional and what is not. At the very least, a risk manager may just want to understand the reasons behind a high number of moves of registered office before exposing his organisation to unnecessary risk.

Traditional credit reference agencies see themselves as protectors of credit and risk managers, filling the void left by Companies House and the police.

Speaking about the Fraud Squad, a unit within the Economic and Specialist Crime department at the Metropolitan Police, OCU Commander Detective Chief Superintendent James Perry states on the police website (www.met.police.uk ) that: "The Fraud Squad's brief stipulates that it takes on investigations only for frauds in excess of £750,000. However, in exceptional circumstances, it may take on cases that do not reach that level of loss."

This is not very comforting for the majority of companies hit by lesser frauds, which see their profit margins being eroded by this type of criminal activity.

Of course, police resources are fully stretched and the general public would rather have extra bobbies on the beat than see the Fraud Squad allocated additional manpower.

Graph 2. registered office chande frequency in 2003

It's also understandable that Companies House argues it is not in its remit to verify and validate all documents being filed there by law. That would be an impossible job since most of the information filed is in hard-copy format and therefore impossible to analyse.

Some CRAs, however, do turn that raw information into computerised data so that it can be made available online to their clients.

Chris Oatts says: "In this format in our database, data can be scrutinised and programmes written to identify the exceptional cases in order to protect our clients and to produce the most accurate credit ratings. On its own, this information from the Companies Registry sometimes isn't too suspicious or exceptional but, when seen alongside other information from proprietary sources such as trade payment data donated by clients, the fuller picture becomes a lot clearer to interpret."

Some CRAs allow customers access to these flagged exceptional cases through Internet services where reports can be obtained.

While understanding the commercial and legal reasons behind the Companies House decision to include a disclaimer on its website, the worry is that its very presence will attract the attention of other criminals setting out to obtain goods on the back of a good credit score without intending to pay for them.

The message in this climate is very clear. When deciding on how best to undertake credit checking on commercial risks in the future, use a source that aims to obtain the full facts in order to assess the creditworthiness of a company. Only then can you be sure the potential power of knowledge can be realised.

Martin Williams is the Managing Director of credit reference agency Graydon UK Ltd.