Annual Credit Review

What is an Annual Credit Review?

Annual Credit Review is a review process that a lender or company's top management takes to check and update the company's financial health and creditworthiness on current accounts with outstanding credit and future lending.

Creditors, credit bureaus, and financial services companies assess individual and corporate customers to ascertain risk level and their ability to repay their outstanding and ability to take new loans. 

Corporations themselves sometimes calculate and evaluate their annual credit review. 

The creditor then decides on whether to extend or cease the credit and the scope of restructuring the credit terms and payment. This gives great advantage and credit risk assessment and helps lower the risk and increase the chances of profitable operations.  

The review takes place periodically, either quarterly, half-annual, or annually, depending upon the scope of risk involved in the Creditor or Financial Services company's access to the review. To know the creditworthiness of the corporation.

Purpose of Annual Credit Review

Lenders often use a credit review to assess your overall financial situation, particularly when applying for higher loan amounts like a mortgage. 

Lenders examine your credit and financial history and elements that affect your capacity to repay a loan, such as your income and credit utilization.

a. Creditworthiness

Lenders need to analyze the borrower's ability to repay debt (principal and interest payment obligation) on time without delays or defaults. Such an analysis is drawn from the credit review.

A creditor is interested in knowing whether the creditor can still repay its payment obligations and if its financial circumstances could have been changed. This helps in knowing whether the line of credit credit could be further extended or reduced as per the review.  

b. Examine Credit History 

Clients' credit history and payment of an obligation, whether on time or after a few delays or any defaults, are recorded with the creditors to review the client's account.  

This history is used to evaluate the credit report of the client, this history is recorded with the creditors, credit bureau (Experian, Equifax in the US, and CIBIL in India), and other financial services institutions to allow or disallow credit to its clients.  

Credit history becomes a critical part of the evaluation for review of one's credit on which the allowance of credit and risk associated with it can be assessed. 

It has a critical drawback as a person with a bad history might pay the credit extended to him on time might not be extended with credit.   

c. Potentially Negative Information  

Scrutinizing the history and credit reports unearths potential risks that may arise in lending the amount to the individual, for instance, filing of bankruptcy multiple times by the lenders for recovering their ended money or monetary judgments.  

Based on the risk involved, the credit company may decide not to extend the line of credit or extend with an extremely high interest rate to award itself for taking such a high risk. 

d. Determine The Size Of The Debt Burden Relative To Earnings

The eligibility of a person or a corporation for qualifying for credit depends upon the debt-to-income ratio (DTI). It calculates the % of income that goes toward your monthly bills. The higher the %, the higher a person's earnings for paying off debt. 

Generally, an industry prefers 43% of DTI, as it is a person's highest DTI ratio and can still get a qualified mortgage. Lower the DTI higher the chances of getting a qualified and cheaper mortgage. 

e. Others

Lenders regularly review their client's accounts every 6-12 months, and some institutions provide monthly credit reviews. This led the banks to offer their clients extended credit and provide other credit facilities to support their operations and efficiency.  

This increases the lenders' income, attracts potentially great assets, and promotes a good credit history.

Sometimes in banking, real estate, and financial services, companies offer employment only to people having good credit scores and reject others. Increasing the chances of a job for the one with a great score.

A creditor also establishes control over the operations of a person to fulfill the loan criteria and standards. 

Information Collected During Annual Credit Review

The objective is to assess the potential credit risk you pose to the lender. To put it another way, a credit review aids a lender in determining whether or not you can afford to repay the loan amount you are requesting. 

Your loan application will either be approved or denied by the lender when they have finished reviewing your credit.

Banks and financial institutions usually collect similar data to evaluate the borrower and prepare a report. For example, when assessing a salaried person, their income and job stability are considered for accessing credit risk and preparing a credit review.  

A business evaluation is primarily done by analyzing the borrower's balance sheet, cash flow statement, inventory turnover rates, debt structure, management performance, and current market conditions. 

Information about the loan's stability, condition, and purpose is collected and evaluated. In addition, capital and capital adequacy are also collected and assessed along with these areas.

Adequacy of Collateral  

Collateral is an asset on whose grantee the lender advances money to a borrower for pledging its collateral, I.e., his security to secure the creditor for loans or credit line that the lender is going to advance the borrower. 

Usually, the value of the collateral is more than the amount lent to compensate for the losses of non-payment with the assets pledged. The lender can institute his valuation for the asset if the valuation provided by the borrower is not satisfactory. 

The lender also verifies the true ownership of the security by providing proof of ownership documents and supporting government documents to know whether the ownership belongs to the client.

The lender also checks the originality of the documents provided to verify whether the documents are original. The originality of a document is important to achieve what is expected from collateral and eliminate the risk. 

Capital  

Lenders also consider the capital in investment, savings, and other accounts during a credit evaluation. This enables lenders to determine whether you have the resources to weather difficult times.

The capital of a company which is the retained earnings, investments, and real estate, contributes to the company's capital. Therefore, any company having such high capital gets more preference for getting easy and cheaper loans. 

In years of losses, reserves and retained earnings are the most prominent sources of fulfilling these payment obligations, so one with high retained earnings gets a better credit chance.

Loans to an individual whose income is not dependent on a single source and has different sources of income get a better chance of securing credit as the debtor has multiple sources of income from which that person could pay off the obligations.

Purpose 

There must be a particular need for securing credit. In addition, the lender must give a purpose for deciding to grant a loan. There are various reasons an individual wants to lend money, including traveling abroad, study purposes, business expansion, and many more.

A lender is interested in lending its money to feasible projects that could earn enough returns to pay out the financial obligations to the lenders, knowing the gestation period and how beneficial the project would be in earnings. 

Lenders want to lend to the best and least risky projects to have a stable income and pay out their financial obligations to the savers who trust the banks.

Sometimes it is not socially viable for some industries to grow, and the government and society don't want these industries to be motivated as producers of single-use plastic. 

So, the banks discourage loaning these industries even though they have great credit reviews. Demotivating them monetarily from growing and polluting the environment and provoking them to develop other environmentally friendly alternatives. 

Conditions

Lenders impose various conditions for borrowers that must be completed by them, like interest rates, payment schedule, the amount of money you are borrowing, any processing fees and taxes associated with it, and even how one plans to use it.   

Under the conditions, the lender provides a proper payment schedule stating from the date the payment obligation will start. 

According to which period the payment will be made - monthly, quarterly, or even annually, how much portion of interest and principal payment will be paid in each installment, including the processing fees levied by the bank and taxes on the processing fees. 

Sometimes these payments become a hindrance for people as these expenses can be high for huge debt and terms for the payments are inflexible.

Institutions consider even the economic impact on the whole and different industries. Also, the lending trends in different industries with the impact and scenario of future lending are considered. 

Stability

Stability is one of the important factors usually ignored by others but is prevalent in consideration before a lender advances the credit. Lenders consider the stability of the firm and its long-term performance to know whether the firm or an individual will be able to repay.

The corporation has to be stable enough that it would be able to fulfill payment obligations, including interest and principal, on time. If not, the lender may not provide the amount demanded by the corporation. 

In the long run, stability plays a crucial role, and a lot of analysis is put under this to know whether the company will achieve its stability, but there is less focus on the short-term.

Lender mostly uses the earnings and expected future earnings to evaluate the firm's stability with the income plans projection made by the firm. Then, after proper evaluation, the credit is granted to the borrower.  

Why Perform An Annual Credit Review?

It is important to check and evaluate credit reports regularly. Annual credit reviews has various advantages:

1. Informs important decisions  

Financial history can affect your decisions about buying a new plant for expansion, the interest that will be levied, and how easily you can buy or rent a house or make high-end purchases.

Maintaining good credit standing requires consistency with the operations and attention to detail. Checking reports regularly helps to ensure that you can manage your finances.  

2. Mitigates negative surprises 

It is essential to examine credit reports and check whether there are any discrepancies and if there are any errors in the reports that they can correct with the credit bureaus.

Annual credit reviews prevent any surprises with lenders and foster a healthy and growth-oriented relationship.

If the negative statements in the report are true, then the company must be ready to explain it and ensure that such an event would not take place again to mitigate negative consequences with lenders.

Credit scores

A credit score is a numerical expression of an analysis of one's credit files, evaluating its payment history.

The score is provided for credit evaluation by the credit bureau. Different credit bureaus have different scoring conditions and standards for scoring credit scores. Credit score generally ranges from 300-900. 

FICO score is a credit score created by Fair Isaac Corporation, which records business and individuals' credit history and borrowings—giving a numerical expression in 300-850.   

FICO score takes five factors into consideration to determine creditworthiness: 

• Payment history  
• The current level of indebtedness  
• Types of credit used  
• Length of credit history,  
• New credit accounts 

The better the credit reports of a person, the higher the score. Generally, scores from 670-719 are considered good credit.  

The factors are given the following weights to determine the final score:

• Payment History – 35% 
• Amount of debt relative to credit limits – 30% 
• Age of credit – 15% 
• Recent applications for credit – 10% 
• Whether you have more than one type of credit – 10%   

FICO scores are used in more than 90% of credit decisions in the US. Consumers can review their credit reports and improve their scores by studying and analyzing them and taking corrective actions. 

Even tenants use the FICO score to evaluate whether to give you a house for rent. The use of the FICO score in their decision making helps reduce their risk and know their client's creditworthiness.  

Just like the FICO score, there is the CIBIL score which is prominent in India. CIBIL is prepared by TransUnion CIBIL credit bureau, scoring between 300-900. It is a part of TransUnion Group, an American multinational group.  

Creditors often make their lending decisions based on credit scores. Higher scores translate into better availability, wider choices, and cheaper loans. With the rising use of credit scores, evaluating them from time to time is important to have a perfect picture of your financials.

Researched and authored by Aman Bansal | LinkedIn

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