Blended scores are better scores: small-business study finds role for both personal, business information.(Small Business Corner)

Obtaining timely, accurate information on the credit risk profile of any small business can be elusive. In the past, risk models suffered from a dearth of historical data and rules that were based more on best guesses than statistical analysis. And information that is outdated, wrong or simply not there can leave a creditor holding the bag should a small business fail.

In a recent study, Experian[R] analyzed credit report and other information on roughly 50,000 small businesses and, using its proprietary Business Owner Link, the owners of those same businesses. The goal was to find the best tool for predicting small-business failure. Many credit issuers still size up the potential performance and risk of small businesses with one limited measure: the owners' consumer credit information. Other small-business creditors track credit reports on the actual business to watch for signs of trouble. The study found that neither approach is optimal. The best view on judging the creditworthiness of a small business comes from a sophisticated melding of personal credit information of business owners along with credit information on the business itself.

The weakness of relying on a consumer score alone is clear in the data. The study revealed that when trouble hit the business, commercial and blended scores each dropped an average of 25 percent over four quarters. Meanwhile, business owner consumer scores showed no statistically significant decline over the same period. Those creditors relying on a consumer score alone would remain blissfully unaware that anything was amiss with that small business in their portfolio.

But solely tracking business credit is no panacea. The study found that of businesses that experienced significant credit problems, about 53 percent, revealed their first signs of credit problems through their business credit report. However, nearly half the time, 46 percent, problems showed up first on an owner's personal credit report. Moreover, very rarely, in only a fraction of 1 percent of the studied cases, problems surfaced on both commercial and personal credit fronts in the same quarter. Hence, creditors using blended information have the best early warning system for business credit problems.

One might ask why trouble sometimes shows itself first with the owner's personal credit profile and other times on the business's credit. For owners with four or fewer employees, it appears personal and business credit activities are far more intertwined than for small businesses with five or more employees. Whether it is because these "micro-business" owners have not separated their business and personal finances enough or whether they try to save their micro-business through their personal credit resources, the result is that personal credit issues arise first more often among the owners of these smallest businesses.

Of all the small companies that showed the first signs of credit issues through consumer credit report blemishes, nearly 70 percent were micro-businesses of four or fewer employees. However, when looking at larger small businesses, those with five or more employees, the first signs of trouble consistently are shown through their business credit.

Similar to smaller businesses, younger businesses tend to show the first signs of trouble through the owners' consumer credit problems. Again, it appears the separation between personal and business credit simply is not as well defined. Plus, it is in this stage that the owners are pouring money into the business, so the strain on their personal assets is greatest.