Your business credit score is the magic number that will dictate the future of your borrowing – and potentially your entire company. This is an incredibly important factor for startup financing. It’s therefore crucial to understand how your score is shaped, so you can take appropriate steps to improve it – resulting in easier access to credit at lower interest rates.
But isn’t the algorithm behind your credit score a closely guarded secret? Yes and no. Whilst none of the major credit bureaus openly reveal their formula, it is known that the FICO algorithm used to calculate it is based on five key factors. One of the most important is credit utilization.
All about credit utilization
As the name suggests, credit utilization measures the level of credit you are actually using in relation to your total credit limits. This can apply to all kinds of business credit, from loans to overdrafts to credit cards. But how is it calculated?
You might, for example, have an overdraft with a limit of $25,000, of which you’ve drawn down $10,000, and a credit card with a limit of $15,000 and spending of $9,000.
Your total limit across these forms of borrowing is therefore $35,000 and the amount you have outstanding is $19,000. As a result, you are utilizing 54.2% of your available credit.
How is your credit score calculated?
To answer this question, we need to look at the FICO algorithm in more depth and how it leads to the calculation of your credit score. Your credit score is compiled from your credit report, which is essentially your company’s timeline of borrowing and repayment. In particular, it will highlight how responsible your financial behavior is – whether, when you borrow money, you repay it on time and in full.
Each of the major credit bureaus collect this information in slightly different ways and at slightly different times, meaning that your credit report will vary somewhat. However, they all utilize the FICO credit score, which distills reams of complex information into a three-figure number between 350 and 800. Potential lenders will use this score to assess your reliability as a borrower.
The algorithm uses the following five factors to calculate your score:
- Payment history. Making up 35% of your score, this assesses whether you pay back your borrowing on time and in full. The more lines of credit you have taken out and repaid, the better.
- Amounts owed. This is where your credit utilization ratio comes in – 54.2% in the case of our scenario above.
- Length of credit history. How long you have been taking out credit contributes 15% to your credit score.
- Credit mix, assessing the different types of borrowing you have (with some being considered riskier than others). This factor contributes 10% to your credit score.
- New credit. The final 10% is based on the number of new credit lines you have open. In other words, if you’ve taken out lots of new borrowing lately, that’s a huge red flag and will damage your credit score.
So how can credit utilization damage your credit score?
Making up 30% of your total credit score, your credit utilization will significantly affect the ways in which you can borrow – not to mention the cost. If you have a high ratio – substantial borrowing compared to your limits – lenders will consider this a warning that you may not be able to service any more debt. As a result, higher credit utilization ratios correlate with lower credit scores (though if you have no credit utilization at all, this will also depress your score).
So what’s the ideal level of credit utilization? Under 20% would be perfect and under 30% reasonably advantageous, so in our example above the business in question is likely to take a significant hit on its score. But if your utilization isn’t where you’d like it to be, what can you do about it?
How to enhance your credit score
The bad news is that there’s no magic bullet for securing a perfect credit score (999 in the UK, 850 in the US). However, in general the lower your utilization ratio – so long as it’s not zero – the better. Sometimes this is easier said than done, so it can make more sense to look at other aspects of your credit score, and in particular your credit mix.
If you have a number of business credit cards, it’s better not to close them – by keeping your limits high and your utilization comparatively low, you will enhance your score. But credit cards are certainly not the only game in town, and some other forms of borrowing are regarded as less risky by credit bureaus.
If you’re facing a sudden cash flow problem, you could turn to an alternative lender for an emergency business loan; these can be almost as instantaneous as using a credit card, with funds inside your account within 24 hours. Alternatively, asset-based finance allows you to borrow against the value of your premises, plant and equipment, making it ideal for longer-term investments. (As an added bonus, since the lending is secured the interest rate should be much lower than that for a credit card.)
Finally, invoice factoring and discounting can solve cash flow challenges for good, without resorting to using your cards. These innovative solutions allow you to borrow against the value of your invoices as soon as you issue them, with repayment being made when your customers pay you. With factoring, the finance company takes control of your debtor ledger and assigns experienced credit control professionals to secure early repayment (thus minimizing the amount of interest you pay) whilst with invoice discounting you retain control of your own debtors.
As can be seen, there are a number of ways you can improve your business credit score, from enhancing your credit utilization ratio by paying down debt to altering your credit mix. Whichever option works for you, the results will pay dividends in the future, allowing easier access to borrowing at more advantageous interest rates.
