Loan Request Evaluation This report introduces a procedure that can be used to analyze the quantifiable aspects of commercial credit requests. The procedure incorporates a systematic interpretation of basic financial data and focuses on issues that typically arise when determining creditworthiness. Cash flow information is equally important when evaluating a firms prospects. Reported earnings and EPS can be manipulated by management debts, are repaid out of cash flow not earnings. The basic objective of credit analysis is to assess the risk involved in credit extension to banks customers. Risk refers to the volatility in earnings.
Lenders are concerned with net income or the cash flow that hinders a borrower ability to service a loan. Credit analysis assigns some probability to default. Some risks can be measured with historical and projected financial data. The key issues include the following: 1. For what are the loan proceeds going to be used? 2.
How much does the customer need to borrow? 3. What is the primary source of repayment, and when will the loan be repaid? 4. What collateral is available? Fundamental credit issues: Virtually every business has a credit relationship with a financial institution. But regardless of the type of loan, all credit request mandate a systematic analysis of the borrowers ability to repay. When evaluating a loan a bank can make two types of errors: 1.
Extending credit to a consumer who ultimately would repay the debt. 2. Denying a loan request to a customer who ultimately would repay the debt. In both cases the bank loses a customer and its profit decreases. For this reason, the purpose of credit analysis is to identify the meaningful and probable circumstances under which the bank might lose.
So a credit analyst should analyze the following items: *Character: The foremost issue in assessing credit risk is determining a borrowers commitment and ability to repay debts in accordance with the terms of a loan agreement. An individuals honesty, integrity, and work ethic typically evidence commitment. Whenever there is deception or a lack of credibility, a bank should not do business with the borrower. It is often difficult to identify dishonest borrowers. The best indicators are the borrowers financial history and personal references.
When a borrower has missed past debt service payments or has been involved in default or bankruptcy a lender should carefully document why to see if the causes were reasonable. Similarly, borrowers with good credit history will have established personal and banking relationship that indicate whether they fully disclose meaningful information and deal with subordinates and suppliers honestly. Lenders look at negative signals of a borrower condition beyond balance sheet and income statement. For example: ? A borrowers name consistently appears on the list of bank customers who have overdrawn their account. ? A borrower makes a significant change in the structure of business. ? A borrower appears to be consistently short of cash.
? A borrowers personal habits have changed for the worse. A firms goals are incompatible with those of stockholders, employees, and customers. *Use of loan proceeds: The range of business loan needs is unlimited. The first issue facing the credit analyst is what the loan proceeds are going to be used for. Loan proceeds should be used for legitimate business operations purposes, including seasonal and permanent working capital needs, the purchase of depreciable asset, physical plant expansion, acquisition of other firms.
Speculative asset purchases and debt substitutions should be avoided. The true need and use determines the loan maturity, the anticipated source and timing of repayment and the appropriate collateral. A careful review of a firm financial data typically reveals why a company deeds financing. *Loan amount: Borrowers request a loan before they clearly understand how much external financing is actually needed and how much is available internally. The amount of credit required depends on the use of proceeds and the availability of internal sources of funds.
The lender job is to determine the correct amount such that a borrower has enough cash to operate effectively but not too much to spend wastefully. Once a loan is approved the amount of credit actually extended depends on the borrower future performance. If the borrower cash flow is insufficient to meet operating expenses and the debt service on the loan it will be called upon to lend more and possibly to lengthen the loan maturity. If cash flows are substantial, the initial loan outstanding might decline rapidly and even be repaid early. The required loan amount is thus a function of the initial cash deficiency and the pattern of future cash flows.
*The primary source and timing of repayment: The primary source of repayment of loans is the cash flows. The four basic sources of cash flow are the liquidation of assets, cash flow from normal operations, new debt issues, and new equity issues. Credit analysis evaluates the risk that a borrower future cash flow will not be sufficient to meet expenditures for operations and interest and principal payments on the loan. Specific sources of cash are typically associated with certain types of loans. Short-term, seasonal working capital loans are normally repaid from the liquidation of receivables or reduction in inventory. Term loans are normally repaid out of cash flows from operations.
A comparison of projected cash flows with interest and principal payments on prospective loans indicates how much debt can be serviced and the appropriate maturity. *Collateral: Banks can lower the risk of loss on a loan by requiring back up support beyond normal cash flow. Collateral is the security a bank has in assets owned and pledged by the borrower against a debt in the event of default. Banks look to collateral as a secondary source of repayment when primary cash flows are insufficient to meet debt service requirements. Having an asset that the bank seize and liquidate when a borrower defaults reduce loss, but it does not justify lending proceeds when the credit decision is originally made. From a lender perspective, collateral must exhibit three features: -First, its value should always exceed the outstanding principle on a loan.
-Second, a lender should be able to easily take possession of collateral and have a ready market for sale. Highly illiquid assets are worth far less because they are not portable and often are of real value only to the original borrower. -Third, a lender must be able to clearly mark collateral as its own. When physical collateral is not readily available, banks often ask for personal guarantees. On the other hand, liquidating collateral is a second-best source of repayment for three reasons: 1- there are significant transaction costs associated with foreclosure.
2- bankruptcy laws allow borrowers to retain possession of the collateral long after they have defaulted. 3- when the bank takes possession of the collateral, it deprives the borrower of the opportunity to salvage the company. At last, a loan should not be approved on the basis of collateral alone. Unless the loan is secured by collateral held by the bank, such as bank CDs, there is risk involved in collection. A PROCEDURE FOR FINANCIAL ANALYSIS The purpose of credit analysis is to identify and define the lenders risk in making a loan.
There is four stages process for evaluating the financial aspects of commercial loans: 1. Overview of management and operations. 2. Financial ratio analysis. 3.
Cash flow analysis. 4. Financial projections. During all phases the analysts should examine facts that are relevant to the credit decision and recognize information that is important but unavailable. 1.
Overview of management and operations: Before analyzing financial data, an analyst should gather background information on the firms operations. This evaluation usually begins with an analysis of the organizational and business structure of the borrower. The evaluation should also identify the products or services provided and the firms competitive position in the marketplace. This inquiry leads to a brief analysis of industry trends. Moreover, particular attention should be focused on management quality. This helps identify motivating factors underlying their decisions. Finally the overview should recognize the nature of the borrower loan request and the quality of the financial data provided.
2. Financial ratio analysis: Most banks initiate the data analysis with statement spread forms, which array the firms balance sheet and income statement items in a consistent format for comparison over time and against industry standards. The next step is to calculate a series of ratios that indicate performance variances. This analysis should differentiate among at least four categories of ratios: A-Liquidity ratio: indicates the firms ability to meet its short-term obligations and continue operations. Measures of net working capital, current and quick ratios, inventory turnover, the average receivables collection period, the days payable outstanding, and the days cash-to-cash cycle help indicate whether current assets will support current liabilities. B-Activity ratios: signal how effectively a firm is using assets to generate sales.
(Sales-to-asset ratios). The key ratios include accounts receivable turnover, inventory turnover and fixed asset turnover. C-Leverage ratio: indicate the mix of the firms financing between debt and equity, hence potential earnings volatility. The greater a firms leverage, the more volatile its net profit (or losses). Ratios that should be examined include debt to total assets, times interest earned, fixed charge coverage, net fixed asset to tangible net worth, and the dividend payout %. D-Profitability ratios: provide evidence of the firms sales and earnings performance.
Basic ratios include the firms ROE, ROA, profit margin, and asset utilization. Finally, an analyst should evaluate these ratios with a critical eye, trying to identify firm strengths and weaknesses. 3.Cash flow analysis: Most analysts focus on cash flow when evaluating a non-financial firms performance. Cash flow estimates are subsequently compared to principal and interest payments and discretionary expenditures to assess a firms borrowing capacity and financial strength. The importance of cash flow has recently been emphasized by the introduction of the statement of financial accounting standards (SFAS). The cash-based income statement is a modified form of statement of cash flows.
It is essentially a statement of changes reconciled to cash that combine elements of the income statement and balance sheet. It records changes in balance sheet accounts over a specific time period. Its purpose is to indicate how new assets are financed or how liabilities are repaid. The statement of changes is summarized here: Sources of cash Uses of cash -Increase in liability -Decrease in Liability -Decrease in non-cash asset -Increase in non- cash asset -New issue of stock -Cash expenses/cash dividend -Additions to surplus -Taxes -Revenues -Deduction from surplus -Repayment/refund of stock Additional two ratios are useful for evaluating a firm cash flow: 1- Cash flow from operations divided by the sum of dividends paid and last periods current maturities of long term debt. 2- Cash flow from operations divided by the same two terms plus short-term debt outstanding at the beginning of the year. If these ratios exceed one, then the firm cash flow can pay off existing debt and support new borrowing.
4. Financial projections: The three-stage process described previously enables a credit analyst to evaluate the his …