Credit Analysis and Procedures

November 25, 2021
Credit Analysis

Credit analysis is the process of examining a borrower’s loan request or a company’s debt problem to see if the borrower will be able to meet his or her commitments.

In other terms, credit analysis is the process of determining an individual’s or organization’s creditworthiness.

Credit analysis entails a wide range of financial analysis tools, such as ratio and trend analysis, predictions, and a thorough examination of cash flows. Examining collateral and alternative sources of repayment, as well as a credit history and management abilities, are all part of credit analysis.

Analysts try to forecast the likelihood of a borrower defaulting on their debts, as well as the severity of losses if they do.

Steps to Take During the Information Gathering Stage

Obtaining background information on the applicant

The first phase in credit analysis is to gather information on the applicant’s loan payback history, character, individual and organizational reputation, financial solvency, ability to use the load (if granted), and so on.

The bank may look into the applicant’s transaction history with the bank and other banks. In this sense, the repayment history of earlier loans may also provide useful information.

Obtaining information on the company that need a loan

The loan officer should be aware of the loan’s objective, the loan amount, and if the project can be completed with that amount. The banker must ensure that the proposal is viable.

The project must have a lot of promise, and the applicant must have a solid plan in place to carry it forward.

Information on the recovery procedure is being gathered

The loan officer should gather information on the borrower’s potential sources of repayment. The profitability of the project, the payback period, the sensitivity of the project cash flow to various economic circumstances, and other data may be used for this purpose.

Information on security is being gathered

The majority of the time, banks lend money against personal and non-personal assets. A bank would always prefer to have the loan repaid by the borrower rather than realizing the debt from the security sale proceeds.

Should the borrower fail to repay the loan, the lender will be forced to rely on the security. As a result, knowing information like price stability and security before increasing the loan is always a good idea.

Collecting additional information if necessary

When a bank is considering a large loan, it may find it necessary to gather additional information such as the economy’s overall business activities, the country’s likely political and economic condition, the management team’s efficiency and candor, the likely effect of local and international competition on the project, and so on.

Steps to Take During the Data Analysis Stage

Analyzing the information’s accuracy

The accuracy of the information provided in and with the application is assessed.

The analyst would look over the national identification card, driver’s license, trade license, partnership deed, business charters, resolutions, and other legal papers attached to the application in this respect.

Examining the applicant’s financial situation

The applicant’s financial capability is taken into account at this stage. The applicant’s financial solvency, as well as his expertise and capability, are key considerations.

The analyst calculates and evaluates historical financial ratios, pro forma income statements, balance sheets, cash flow statements, and other applicants’ financial statements to determine their financial capability.

Analyzing the project’s efficacy

The quality, purpose, and prospect of the project for which the loan has been applied is one part of credit analysis. If the project is productive, expandable, and profitable, the banker will be more willing to lend money.

The bank, on the other hand, is likely to be hesitant to give any credit if the project is in a declining stage, is up against severe competition, or is facing harsh conditions.

Examining the likelihood of loan repayment

The analyst considers how the proposed loan will affect the applicant’s liquidity and income. The applicant’s net cash flow is a solid sign of his or her capacity to repay the loan, plus interest and other fees, on time.

The applicant’s interest load and fixed charge burden may also be of interest to an analyst.

Stage of Decision-Making

The analyst identifies and measures the credit risk associated with a loan application based on the analysis and concludes whether the degree of risk is acceptable or not.

If the analyst believes the risk is acceptable and that the loan will be repaid, he or she develops and submits a recommendation for the loan to be sanctioned to the appropriate loan approval body.

Credit Risk: An Overview

The danger of loss stemming from a borrower’s failure to return the principal and interest owed to the leader is known as credit risk. To compensate for the risk of prospective losses, the lender uses the loan’s interest payments.

When a borrower fails to fulfill his or her obligations, the lender’s cash flow is disrupted.

Credit risk analysis allows a lender to assess a borrower’s ability to satisfy debt commitments in order to protect itself against cash flow losses and minimize the severity of losses. To compensate the lender for the high chance of default, borrowers that present a high level of credit risk are charged a high interest rate on the loan.

Lenders examine the “5 Cs of Credit” when determining a borrower’s credit risk, which comprise the borrower’s capacity to repay credit, character, capital, conditions, and collateral. The criteria are used by the lender to assess the borrower’s characteristics and loan terms in order to determine the likelihood of default and the resulting risk of financial loss.

The 5 Cs of Credit include both qualitative and quantitative financial metrics, and the lender may examine a variety of papers, including the borrower’s income statement, balance sheet, credit reports, and other financial records.

The Purpose of Credit Risk Analysis in General

To acquire measurable data that quantify the credit loss, credit analysts may employ several financial analysis techniques such as ratio analysis and trend analysis. The procedures assess the risk of loan loss as a result of changes in borrowers’ creditworthiness.

We consider both losses from counterparty default and decreasing credit risk ratings when calculating credit loss.

Default probability

The risk that a borrower would be unable to make planned principal and interest payments over a specific period of time, usually one year, is known as the probability of default. The likelihood of default is determined by the borrower’s attributes as well as the economic situation.

The FICO score determines the likelihood of default for individuals, and lenders use the score to assess whether or not to extend credit. The credit rating indicates the likelihood of default for commercial enterprises.

Credit rating companies are typically mandated to offer credit ratings to entities that issue debt instruments like bonds. Borrowers with a high risk of default pay a higher interest rate to compensate the lender for the increased risk of default.

Loss given default

The amount of money that a lender stands to lose if a borrower defaults on their loan commitments is known as loss given default. While there is no universally acknowledged technique for calculating loss given default per loan, most lenders compute it as a proportion of overall exposure to loss across their whole loan portfolio.

If ABC Bank lends 1,000 to Borrower A and 10,000 to Borrower B, for example, the bank will lose more money if Borrower B defaults on repayments.

Exposure at default

The amount of loss a lender is exposed to at any given time owing to loan defaults is measured by exposure at default. Internal risk management models are frequently used by financial organizations to predict the extent of exposure at default.

The exposure is determined per loan at first, and the value is then used by banks to evaluate the overall default risk for the entire loan portfolio. The value of exposure to default decreases over time when borrowers make loan repayments.

Final Thoughts

A complete credit analysis procedure is necessary to protect your company’s financial health, but it may be time-consuming and labor-intensive if done manually (without the aid of automated resources and tools).

Smaller firms with a small number of clients may prefer to keep the credit analysis process manual, which can take anywhere from one day to several days to make a sound credit judgment.

Companies that process a high volume of credit applications often use more complex credit risk management software and solutions to monitor their accounts. Automated decision-making using credit scorecards, personalized credit scores (depending on your risk tolerance), integrated online credit applications, and the ability to support worldwide credit consumers are all features of these sorts of solutions.

Credit analysis is an important part of risk management since it allows you to make informed lending decisions while also preserving your company’s cash flow. While it’s impossible to completely remove risk, the amount of data and risk management tools at your disposal can help you avoid bad debt and financial loss.