Decoding Credit Risks: Innovations in Underwriting for Buy Now, Pay Later industries

Executive Summary:

The Buy Now, Pay Later (BNPL) industry is rapidly expanding, offering unique challenges and opportunities for credit underwriters. This publication explores a structured approach to underwriting BNPL companies, focusing on identifying inherent risks and the necessary precautions underwriters must take. Through the analysis of financial and non-financial metrics of a hypothetical company (referred to as "Company X"), this article aims to showcase the application of comprehensive credit analysis principles tailored to the BNPL sector

Introduction:

In the evolving landscape of consumer finance, BNPL services have emerged as a popular alternative to traditional credit, allowing consumers to defer payments with minimal upfront costs This surge in popularity also brings forth complex credit risk considerations, demanding a nuanced approach to credit underwriting.

Credit Underwriting Framework for BNPL:

Financial Health Assessment:

Income Statement Analysis: Observations on Company X reveal a significant revenue growth yet a declining gross profit margin over two fiscal years. Such trends necessitate an in-depth look at operational efficiency and cost management strategies.

Balance Sheet Review: Company X displayed liquidity constraints, evidenced by a current ratio of less than 1 for consecutive years, pointing to challenges in covering short-term obligations Additionally, the reliance on loans, particularly from its ultimate parent company, introduces heightened financial risk

Risk Identification and Mitigation:

● Credit Risk: Analyzing the quality and duration of receivables is crucial, as seen in Company X’s average collection period and customer payment behaviors

● Operational Risks: Evaluation of operational strength through metrics such as customer satisfaction and net promoter scores can provide insights into the company’s market positioning and operational efficiency.

● Regulatory and Compliance Risks: BNPL companies must navigate a complex regulatory landscape, ensuring compliance with applicable laws and standards to mitigate potential legal and operational risks

Peer Comparison:

Comparing Company X with established players like Affirm, the largest BNPL in the US, highlights the need for a robust financial foundation, demonstrating the disparity in financial health through key ratios such as gross margin and debt-to-equity

Case Study Application:

Using Company X's financial data, the analysis delves into the specifics of evaluating a BNPL company's viability and the strategic considerations for mitigating associated risks This includes a detailed look at profitability adjustments, liquidity management, and solvency ratios.

Conclusion:

Effective underwriting in the BNPL sector requires a multifaceted approach, encompassing not only financial analysis but also an acute awareness of the broader industry challenges and regulatory environment. This publication aims to equip credit underwriters and financial professionals with the analytical tools and insights needed for making informed decisions in this dynamic field

Appendices:

Appendix 1: Financial Metrics Overview of Company X

Appendix 2: Non-Financial Metrics and Operational Strength Evaluation

Appendix 3: Detailed Requests for Additional Information to Enhance Risk Assessment

Solvency Debt to Equity Ratio -1 98 -4 37

Additional Information Needed

Strong revenue increased YoY,indicating a growing market acceptance and increased usage of their BNPL platform N/A

Gross Profit Increase but GP% drops, suggesting increased sales volume but lower operational efficiency Company X has Operating losses in both periods, with a substantial increase in FY 2022 Other reasons include:

Increased Costs:The decrease in gross margin percentage is notable Since BNPL operations do not incur costs from purchasing or storing goods due to the absence of inventories, their primary costs are associated with transaction fees to card networks, fraud detection fees, software licenses or higher funding sources

Pricing Pressure: Company X might lower their price to stay competitive Company X may change in Revenue Mix

Substantial operating losses relative to revenue highlight operational inefficiencies, significantly influenced by high employee benefit expenses and professional fee

A ratio <1 1 suggests difficulties in covering short-term obligations.

Improved YoY CR ratio in FY22 was mainly due to surging increases on “ Other receivables” , which usually refers to non core business receivables Potential examples include accrued income, rebates, commission received from partners or direct loan to merchants It can imply the changes in operational focus or strategy

For BNPL companies that rely heavily on debt financing, a debt ratio below 50% is typically considered healthy Although it has improved to 1 3, this figure remains on the high side Suring 3rd party loans increased its financial risk

Equity Position also deteriorated.High negative debt-to-equity ratios indicate a risky financial structure characterized by liabilities exceeding equity.

Impairment loss Ratio Impairment loss Ratio -32 3% -25 7% It suggests improved efficiency in managing credit risk or an increase in revenue outpacing impairment losses

Profitability ROA Negative Negative

Profitability ROE Negative Negative

BNPL companies typically have negative ROA due to their growth focused strategies

BNPL companies typically have negative ROE due to their growth focused strategies

Year-on-Year (YoY) change ratio analysis

-Request a COGS breakdown to determine if cost changes are justifiable and if profitability can be maintained moving forward.

-Ask for revised financial projections that incorporate the expected improvements in GP%

Obtain an explanation from the merchant regarding the surge in employee benefit expenses, understand whether it is a one-off or recurring issue, and request projections for margins over the next three years Obtain total number of employees and their age breakdown

-Obtain more info on “Other receivables” to understand if it is related to change of company strategy

-Monitor liquidity closely and explore options to improve short-term asset management and understand the fund flow

Advise the merchant to repay third-party loans to improve financial health and solvency

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Metrics Details

Receivable Quality & Duration

Operational Strength

Aging Schedule of Receivables, Average Days Delinquent, customer payment trends,Collection Effectiveness Index (CEI), customer Concentration Risk

Customer Satisfaction (CSAT), Net Promoter score.Order Volume and ticket size, Chargeback Rate

Funding Source & Cost of Capital Diversity of fund source ( parent, VC, banks), credit terms flexibility, reputation among investors, credit rating agencies, FIs. Strategic Partnership.

Industry Risk Regulatory environment change, Fraud and chargeback rates

Business Model and Strategy CSAT, media feedback, technology infrastructure and development

Regulatory Compliance & Data Security

Data breach incident, Certification status: up-to-date certifications, e g PCI DSS for payment security, ISO/IEC 27001 , Regulatory Audit Findings, Consumer Credit regulations development, Data Projection and Privacy Law changes, Compliance Training Completion Rates