How creditors can estimate how much cash you have

One of the first steps you can take in the business world to assess the health of a public company is to peruse its prospectus, a document that details important facts about a company including financial statements.  By reading a company’s prospectus, you can determine how much cash it has and how well it manages cash flow.  Investors know that successful management of cash flow is often an indication of success.  On the other hand, poor management of cash flow, perhaps with a large amount of debt as well, often is an indication of failure.  

The concept of cash flow isn’t difficult.  We experience it everyday.  In simpler terms, good cash flow means you have more than enough cash to pay in full your bills or debts during a given time period.  Conversely, bad cash flow frequently means borrowing from Peter to pay Paul.  In other words, you don’t have enough cash to service your debt.  People who teeter on the end of their financial tether by living month to month are good examples of poor cash flow managers; people who have a high savings rate and earn more than they spend are good examples of good cash flow managers.  Of course, there are nuances, but this explanation gives the basics.  

In many cases, credit card companies have a better idea of your cash flow than you do.  They know that this vital, personal information is the key to assessing your solvency just like it is important to assessing a major public company’s profit.  With the unique capabilities of Experian and some basic statistics, here is how they can do it.  

If you have ever taken the time to compare your three major credit reports, you will discover that Experian, unlike the other two bureaus, shows your balance history, not just your balance for the current month.  This advantage gives more insight into your financial life.  For example, if you have a line of credit for $15,000, Experian will show your balance history for that line.  Let’s say for the last four months your balance history is $14,555, $15,100, $14,700, and $14,995.  Creditors can see that you consistently carry a high balance.  Your utilization rate for the time period is 99%, well above the 7% rate that people with high credit scores average.  Knowing this, companies that are looking for new customers who will make them lots of money on interest and over-the-limit fees may target you through pre-approved offers in the mail. But that’s beside the focus on cash flow.  

Creditors know that if you tend to carry high balances, you are likely short on cash, an indication of poor cash flow. In addition to this reasonable assumption, the companies know your annual income.  For instance, if your annual income in this case is $40,000, you will likely have a hard time making the minimum payment at 29% APR (about an extra $360), especially when you add in a car payment, a mortgage, a health insurance premium, and other common monthly expenses.  

In short, make sure you watch your cash flow because the companies most certainly are. I suppose you could sum up this example by saying: keep your credit card balances very low and if you can, pay them off every month.  

In an upcoming post, we will see how creditors track and interpret the spending patterns of your spouse. It gets much more intrusive, so much so that you may get sick to your stomach.  =)  

Comments

[Linda]

How right you are Terry...the ones who pay their bills are the ones who are paying for the crisis.

[Terry]

Risk management is illegal when it looks more like a ponzi scheme than sound and prudent risk management practices. These financial institutions created this mess!!! They are now increasing their rates and fees in an effort to recoup their losses, as their house of cards collapsed. Since when is it legal to reach into the pocket of those who have prudently managed their finances to pay for the losses of those same institutions who created this financial crisis? No, Daniel, we are not spending their money, they are now spending our money!!!!

[Daniel B.]

Crystal, since when is risk management illegal? Credit is a privilege NOT a right. You are spending their money, they have the right to write the rules.

[Crystal B.]

Is that illegal somehow?

[FLM]

that's a good way of thinking about it. i knew they had the capability but i just didn't quite understand how. basically we give these companies all the information they want and then we get upset. we just need to pay more attention to the fine print and say no when they want too much information. i do think that some people just don't understand how this information can be used against them. great insight. keep it up kj