Bank Credit Analysis

What is Bank Credit Analysis?

Bank credit analysis entails banks evaluating and ranking each loan application based on its merits. They assess each person's or firm's creditworthiness to determine how much risk they are taking by lending to that person or firm.

High-risk buyers are less suitable as they are more likely to fall behind on loan payments. Customers who offer less risk to creditors are accepted, preferably.

Credit analysis comprises a broad range of financial analysis methods, like ratio and trend analysis, in addition to developing comprehensive cash flow estimates and projections.

Credit analysis also includes a review of collateral and other sources of repayment, as well as credit history and management. As mentioned, analysts try to predict the likelihood of a borrower defaulting on a loan and the severity of the damage due to a default. 

Credit spreads are the interest rate differentials between theoretically "risk-free" investments such as US Treasuries or LIBOR and investments with default risk - reflecting the credit analysis of investors in financial markets. 

It benefits banks, corporations, investors, etc. Regarding business expansion, corporations need capital that can be met by issuing bonds, stocks, or borrowing money. 

From the lender's point of view, it is essential to have some security and be particular against lending. 

For this, credit analysis helps both the company and the lender as it will assure the lender by providing the company's creditworthiness, and the lender can invest in money depending on the level of risk.

How Do Banks Analyze the Credit Needs?

A credit analyst may employ a range of methodologies during the credit analysis process, including cash flow, risk, trend, ratio, and financial predictions.

The methodologies are used to examine a borrower's financial performance data to determine the entity's level of risk and the number of losses the lender would incur in the case of default.

The collateral presented for the mortgage is a significant issue for banks. The asset must be the same or greater than the debt amount.

The bank may seize the collateral to reimburse the borrower for the incapacity to repay the loan on the agreed-upon terms. Using the software, a credit analyst can appraise accessible data regarding a customer's financial history.

The software generates financial and credit reports that detail the borrower's risk level, allowing lenders to make informed judgments. Credit analysts make final decisions based on the information and current situations.

Some of the most important criteria to evaluate are a customer's financial history, payment conditions met, and the quantity of revenue earned by the firm.

Stages In Bank Credit Analysis

Credit assessment might take a few weeks to months. Then, it moves from the information accumulation step to the judgment stage, when the lender decides whether to grant the loan application and, if approved, how much loan the borrower will give.

The main steps in the credit analysis process are as follows: 

Information Collection

The first phase of the credit analysis technique is to collect data about the applicant's credit history.

Lenders pay close attention to a customer's payback history, the institution's reputation, financial soundness, and transaction history with banks and other financial institutions.

Lenders can also assess a borrower's ability to produce additional cash flows for the firm by examining how effectively earlier financing has been used to build key operations - the division's fundamental.

Information Analysis

It is assessed to ascertain the correctness and authenticity of the data acquired in the first step.

Legal papers include passports, company charters, business licenses, company resolutions, customer and supplier agreements, and other legal records for individuals and businesses. They are reviewed to verify if they are genuine and authentic.

Quantitative statements such as income statements, balance sheets, cash flow statements, and other related documents are also examined by credit analysts to establish the borrower's financial soundness.

The Bank evaluates the borrower's experience and credentials to determine the capacity to complete the project effectively. Another element that the lender evaluates is the project's effectiveness.

The lender investigates the project's goals and possibilities. The lender wants to determine if the project will create significant cash flow to pay off the debt and meet the operating expenses.

Lenders will readily provide financing for a project that succeeds. However, suppose a project faces competitive pressures from other businesses or is experiencing a downturn. In that case, the Bank may be cautious about continuing financing owing to the high chance of loss in the case of failure.

If the Bank considers the borrower's risk level appropriate, it may offer high interest rates to offset the high default risk.

Approve (or Deny) Loan Application 

Decision-making is the final phase in the credit analysis process. The lender determines if the degree of risk is acceptable after obtaining and assessing the required financial documents from the borrower.

The loan officer will deliver a recommendation report to the credit committee.

Thus by summarising the assessment results and the eventual judgment regarding the termination of the loan.

The credit analyst must prepare a report describing the borrower's creditworthiness to the credit committee if the credit analyst decides that the borrower's level of risk is too high for the lender to accept.

The committee or other authorized approving authority reserves the final discretion to approve or refuse the loan.

Factors Quantifying the Risks

When analyzing credit risk, many significant criteria are considered:

• The borrower's profitability ratio

• The severity of the repercussions of default (for both borrowers and lenders)

• The amount of credit granted

• Historical patterns in default rates

Of all the possible factors that have been consistently identified as being more strongly correlated with credit risk: are the probability of default, default loss, and default risk in debt. 

Probability Of Default

The probability of default (also known as POD or PD) calculates the risk that a borrower won't be able to make all of the agreed-upon repayments.

Individual debtors' default risk is often indicated by a combination of factors: debt-to-equity ratio and credit score.

Rating agencies predict whether a corporation or issuer of debt securities, such as corporate bonds, will default.

Higher PODs are generally associated with higher interest rates and smaller loan payments. Borrowers can assist in sharing the risk of loan default by pledging a loan.

Losses Due To Default

Consider two borrowers with equal credit scores and debt ratios. The first borrower takes a $5,000 loan, and the second takes $500,000. Even if the second guy earns 100 times as much as the first, his loan is riskier.

Indeed, in the case of a $500k failure, the lender will lose more money. This concept supports the default loss, or LGD, element in risk quantification.

Although default loss appears to be a simple concept, no widely accepted method for determining LGD exists. Usually, lenders do not compute LGD for each loan individually. Rather, they assess the total loan portfolio and calculate the total loss.

LGD can be influenced by various factors, including loan security and the legal authority to seek default monies through bankruptcy processes.

Default Exposure

Default Exposure, or EAD, measures a lender's total loss at any particular point comparable to LGD.

Although the word EAD is usually linked with a banking institution, total risk is an interesting issue for any individual or business with an extended credit facility.

The EAD idea is based on the notion that the remaining balance built before default influences the degree of risk.

The risk assessment for loans with lines of credit, such as credit cards, considers the account's present amount and potential future rise in balance before the borrower defaults.

5Cs Of Credit Analysis

Lenders' credit analysis determines the risk involved in granting a loan. Regardless of the type of financing required, a bank or lending institution will take care of your business and finances. 

Credit analysis is governed by the "5 Cs": characteristics, capacity, conditions, capital, and collateral. 

Characteristics

Lenders should know that borrowers and guarantors are trustworthy individuals. Furthermore, the lender must always be convinced that the client has the requisite background, education, industry understanding, and competence to run the firm successfully.

Lending institutions may require management or ownership knowledge. They will also inquire about your driver's license and criminal history.

Since the past is the best indicator of the future, the personal credit of all borrowers and guarantors will be reviewed by lenders. Personal and business credit ratings must be outstanding.

Before phoning your lender, review both statements; if there are any overdue payments, be prepared to explain. Lenders may make allowances for those with poor credit.

Capacity (Cash Flow)

Lenders want to understand if your business can repay the loan. The company needs to have enough funds to cover its costs and debts comfortably and give its directors compensation that covers their expenses and liabilities.

A borrower's assurance in repaying a loan can be gauged by reviewing loan payment history and outstanding bills.

Conditions

Lenders will need to understand the business, industry, and economic realities, which is why working with WCB-experienced lenders is vital.

Lenders will likely know if the current business circumstances will persist, improve, or worsen. Furthermore, the lender will want to see how the loan will be utilized - working capital, renovations, new equipment, etc. 

Capital

You can demonstrate a willingness to accept personal risks for the company's sake by investing private funds in it. 

Your lender will inquire about any personal investments you want to make in the firm and if you have "skin in the game."

Collateral

As a backup source of repayment, lenders will consider the guarantor's individual and business assets.

Collateral is a crucial subject, although its importance changes based on the kind of loan. Therefore, your lender should be able to explain the various forms of collateral required for your loan.

The five credit analysis components help lenders understand owners and businesses and estimate loan eligibility. In addition, understanding the "5 Cs" might assist you in determining what you require and how to prepare for the loan application process.

Credit Analysis Ratios

Each lender has its standardized technique for completing diligence and assessing the borrower's credit risk. The inability of the borrower to satisfy its financial commitments on time, known as default risk, is the most troubling consequence for lenders.

Because of the unpredictability, the significance of in-depth credit research grows when a borrower's downside risk is significantly bigger than that of ordinary borrowers.

If the lender decides to extend a loan, the price and debt conditions should reflect the amount of risk involved with lending to the specific borrower on the opposite side of the transaction.

Credit analysis ratios are techniques that help with credit evaluation. These indicators help investors and analysts determine whether people or corporations can fulfill their financial obligations.

Credit analysis involves both qualitative and quantitative aspects. The ratios include the quantitative part of the analysis. Ratios can mainly be divided into four groups: 

• Profitability
• Leverage
• Coverage
• Liquidity

Liquidity Ratio 

The liquidity Ratio measures how easily current assets may be transformed into liquidity. Liquidity refers to a company's capacity to satisfy current commitments using cash or other assets that can be converted to cash quickly.

Current Ratio = Current Assets ÷ Current Liabilities 

Here, Current Assets mean Inventory, Receivables, Cash and Banking, Loans and Advances, and Other Current Assets. 

Current Liabilities mean Creditors, Short-Term Loans, Bank Overdrafts, Unpaid Expenses, and Other Short-Term Liabilities.  

Quick Ratio = [Current Assets – Inventory Prepaid expenses] ÷ Current Liabilities 

Quick Assets means Current Assets Inventory Prepaid Expenses. 

(Quick Ratio is also called the acid test ratio. It measures a business’ liquidity)

Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities 

Working capital = Current Assets + Current Liabilities 

Leverage Ratios 

This ratio concerns the company's long-term solvency regarding how much capital comes in financing or gauging its ability to meet its financial responsibilities. 

Equity Ratio = Shareholder's Equity ÷ Capital Employed 

Shareholder’s Equity = Share Capital + General Reserves + Surplus + Retained Earnings 

Capital Employed = Total Assets Current Liabilities (or) Fixed Assets Working Capital 

Debt Ratio= Total Debt/ Total Capital Employed 

Total Debt means Short Term and Long-Term Borrowings, Debentures, and Bonds.

Debt-to-Assets Ratio = Total Debt ÷ Total Assets (Or) Total Outside Liabilities ÷ Total Assets 

Here, Total Assets = Current Assets + Non-current Assets

Debt-to-Equity Ratio = Total Debt ÷ Total Equity 

Debt-to-Capital Ratio = Today Debt ÷ (Total Debt + Total Equity) 

Debt-to-EBITDA Ratio = Total Debt ÷ Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) 

Asset-to-Equity Ratio = Total Assets ÷ Total Equity 

Coverage Ratios 

Coverage ratios evaluate a business's ability to pay its debt. Coverage ratios indicate that a company can carry on as a functioning organization, in contrast to the liquidity ratios focused on what would occur in a liquidation. 

Interest Coverage Ratio = EBIT (Earnings before interest and tax) ÷ Interest  

Debt Service Coverage Ratio = (Earnings available for Debt Services) ÷ (Interest liabilities Installments) 

Preference Dividend Coverage Ratio = EAT (Earnings after tax) ÷ Preference dividend liability 

Fixed Charges Coverage Ratio = (EBIT Fixed charges before tax) ÷ (Interest Fixed charges before tax) 

Asset Coverage Ratio = ((Total Assets Intangible Assets) (Current Liabilities Short-term Portion of LT Debt)) ÷ Total Debt  

Cash Coverage Ratio Formula = (EBIT + Non-Cash Expense) ÷ Interest Expense

Profitability Ratios

The profitability ratio evaluates a company's capacity to create money concerning its expenditures and other costs associated with earning revenue over a specific period. As a result, this ratio shows the company's bottom line. 

a. Margin Ratio 

Gross Margin Ratio = (Gross Profit ÷ Net Sales) x 100 

Gross Profit = Sales + Closing Inventory or Inventory Direct Costs

Operating Profit Margin Activity = (Cost of Revenue from Operations + Operating Expenses ÷ Operating Revenue) x 100 

Net Profit Margin = (Net Profit ÷ Sales) x 100  

Net Profit = Operating Profit + Non-Operating Income - Non-Operating Expenses

b. Rate of Return Ratio

Return on Assets Ratio = Net income ÷ Average assets

Return on equity = Profit after tax ÷ Net worth

Net worth means equity, reserves, and surplus.

Return on capital employed = (Net Operating Profit ÷ Capital Employed) x 100

Capital employed means the proportion of capital, reserves and surplus, long-term liabilities, and borrowings.

Employed capital = Total assets - Current Liabilities

Return on Investment = (Net profit before interest, taxes, and dividends ÷ capital employed) x 100

Researched and authored by Kavya Sharma | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources 

• Accounts Payable
• Cash Equivalents
• Current Assets
• Deferred Tax Liabilities
• Net Tangible Assets