In this article we will speak about evaluating commercial loan requests and managing credit risk. We start with the chapter objectives which are the introduction of a procedure for analyzing the quantifiable aspects of commercial loan request, the fundamental credit issues when analyzing a loan request, and managing risk with loan sales and credit derivatives. In the process of evaluating a possible loan bank should obtain satisfactory answers to at least these few questions like what the character of the borrower and quality of information is, the proceeds that are being used, the amount of the loan, primary source of repayment, and secondary source of repayment or collateral available for the loan. The main emphasis is that credit analysis is risk analysis with no definite answers and only an assessment of risk associated with lending funds. We will discuss the basic questions that must be answered appropriately before the lender should advance funds to a borrower and the answer should determine the risk of the loan request, which will affect the terms and pricing of the eventual loan agreement if the loan is made.
Almost all the business in United States has a credit relationship with a financial institution, some of them are using backup credit lines in support for commercial paper issues, others are using periodic short-term loans for working capital needs, and others are using primarily term loans with a maturity longer than a year.
Before we do anything, we should understand what commercial credit analysis is. This is the evaluation of a company’s ability to meet its financial obligations, and the objective of the analysis is to determine the level of risk associated with an entity. If we look at a company that issues bonds, an investor can analyze the audited financial statements of the issuer to determine its default risk. Banks also review the financial statements of potential borrowers to determine their ability to make timely principal and interest payments. At the conclusion of the evaluation is obtain a risk rating which is done by estimating the borrower risk of default at a given confidence level and the amount of loss that the lender will suffer in the event of a default. The risk rating determines if the lender will provide credit to the borrower, and the amount of credit will be provided. When conducting credit analysis, investors, banks, and analysts may use a variety of tools such as ratio analysis, cash flow analysis, and trend analysis to determine the default risk of a company.
Sometimes, credit analysis may conduct a review of the collateral provided, credit history, and management ability. The analysis aims to predict the probability that the borrower will default on their financial obligations and the level of losses that the lender will suffer in the event of default. When the bank is looking at a loan application the main emphasis will be on the cash flows generated by the borrower. The main ratio used to measure the repayment ability of the borrower is the debt services coverage ratio (DSCR). This is obtained by dividing the entity’s total cash flows by the debt service (annual interest and principal payments). The debt service coverage ratio may be expressed as a minimum ratio, below which the lender will not accept to extend credit. A DSCR of less than one indicates an entity’s cash flow is negative and the cash flow generated is not enough to cover the debt payments. A DSCR of one means that the entity generates enough revenue to cover the debt payments. A DSCR of 1.5 is preferred and it means that the entity generates enough cash flows to pay all the debt payments and an additional 50% cash flows above what is required to service its debt.
Another important aspect is the quality of information provided. The analyst should view the areas of accounting choices that then make estimates and judgement according to the required inputs. Information regarding the income and expenses that do not closely track the cash flow, information regarding the gains, losses, and nonoperating income. Information regarding the unusual and discretionary expenditures and information regarding the nonrecurring transactions. Information regarding the period when the accounting policies, methods, or principles have been changed. Standard ratio analysis distinguishes between four categories of ratio which are very important financial information for the business when they are dealing with a loan, or they are looking for investors.
References:
Bank Management, 8th Edition By: Koch, Timmy W. (2014)
https://www.investopedia.com accessed June 29, 2021.
https://corporatefinanceinstitute.com Accessed June 30, 2021.
