This report introduces a procedure that can be used to analyze the quantifiableaspects of commercial credit requests. The procedure incorporates a systematicinterpretation of basic financial data and focuses on issues that typicallyarise when determining creditworthiness. Cash flow information is equallyimportant when evaluating a firm’s prospects.
Reported earnings and EPS can bemanipulated by management debts, are repaid out of cash flow not earnings. Thebasic objective of credit analysis is to assess the risk involved in creditextension to bank’s customers. Risk refers to the volatility in earnings. Lenders are concerned with net income or the cash flow that hinders a borrowerability to service a loan.
Credit analysis assigns some probability to default. Some risks can be measured with historical and projected financial data. The keyissues include the following: 1. For what are the loan proceeds going to beused? 2. How much does the customer need to borrow? 3. What is the primarysource of repayment, and when will the loan be repaid? 4.Order now
What collateral isavailable? Fundamental credit issues: Virtually every business has a creditrelationship with a financial institution. But regardless of the type of loan,all credit request mandate a systematic analysis of the borrower’s ability torepay. When evaluating a loan a bank can make two types of errors: 1. Extendingcredit to a consumer who ultimately would repay the debt. 2. Denying a loanrequest to a customer who ultimately would repay the debt.
In both cases thebank loses a customer and its profit decreases. For this reason, the purpose ofcredit analysis is to identify the meaningful and probable circumstances underwhich the bank might lose. So a credit analyst should analyze the followingitems: *Character: The foremost issue in assessing credit risk is determining aborrower’s commitment and ability to repay debts in accordance with the termsof a loan agreement. An individual’s honesty, integrity, and work ethictypically evidence commitment.
Whenever there is deception or a lack ofcredibility, a bank should not do business with the borrower. It is oftendifficult to identify dishonest borrowers. The best indicators are theborrower’s financial history and personal references. When a borrower hasmissed past debt service payments or has been involved in default or bankruptcya lender should carefully document why to see if the causes were reasonable. Similarly, borrower’s with good credit history will have established personaland banking relationship that indicate whether they fully disclose meaningfulinformation and deal with subordinates and suppliers honestly.
Lenders look atnegative signals of a borrower condition beyond balance sheet and incomestatement. For example: ? A borrower’s name consistently appears on thelist of bank customers who have overdrawn their account. ? A borrowermakes a significant change in the structure of business. ? A borrowerappears to be consistently short of cash. ? A borrower’s personalhabits have changed for the worse.
A firm’s goals are incompatible with thoseof stockholders, employees, and customers. *Use of loan proceeds: The range ofbusiness loan needs is unlimited. The first issue facing the credit analyst iswhat the loan proceeds are going to be used for. Loan proceeds should be usedfor legitimate business operations purposes, including seasonal and permanentworking capital needs, the purchase of depreciable asset, physical plantexpansion, acquisition of other firms.
Speculative asset purchases and debtsubstitutions should be avoided. The true need and use determines the loanmaturity, the anticipated source and timing of repayment and the appropriatecollateral. A careful review of a firm financial data typically reveals why acompany deeds financing. *Loan amount: Borrowers request a loan before theyclearly understand how much external financing is actually needed and how muchis available internally. The amount of credit required depends on the use ofproceeds and the availability of internal sources of funds. The lender job is todetermine the correct amount such that a borrower has enough cash to operateeffectively but not too much to spend wastefully.
Once a loan is approved theamount of credit actually extended depends on the borrower future performance. If the borrower cash flow is insufficient to meet operating expenses and thedebt service on the loan it will be called upon to lend more and possibly tolengthen the loan maturity. If cash flows are substantial, the initial loanoutstanding might decline rapidly and even be repaid early. The required loanamount is thus a function of the initial cash deficiency and the pattern offuture cash flows. *The primary source and timing of repayment: The primarysource of repayment of loans is the cash flows. The four basic sources of cashflow are the liquidation of assets, cash flow from normal operations, new debtissues, and new equity issues.
Credit analysis evaluates the risk that aborrower future cash flow will not be sufficient to meet expenditures foroperations and interest and principal payments on the loan. Specific sources ofcash are typically associated with certain types of loans. Short-term, seasonalworking capital loans are normally repaid from the liquidation of receivables orreduction in inventory. Term loans are normally repaid out of cash flows fromoperations.
A comparison of projected cash flows with interest and principalpayments on prospective loans indicates how much debt can be serviced and theappropriate maturity. *Collateral: Banks can lower the risk of loss on a loan byrequiring back up support beyond normal cash flow. Collateral is the security abank has in assets owned and pledged by the borrower against a debt in the eventof default. Banks look to collateral as a secondary source of repayment whenprimary cash flows are insufficient to meet debt service requirements. Having anasset that the bank seize and liquidate when a borrower defaults reduce loss,but it does not justify lending proceeds when the credit decision is originallymade. From a lender perspective, collateral must exhibit three features: -First,its value should always exceed the outstanding principle on a loan.
-Second, alender should be able to easily take possession of collateral and have a readymarket for sale. Highly illiquid assets are worth far less because they are notportable and often are of real value only to the original borrower. -Third, alender must be able to clearly mark collateral as its own. When physicalcollateral is not readily available, banks often ask for personal guarantees.
Onthe other hand, liquidating collateral is a second-best source of repayment forthree reasons: 1- there are significant transaction costs associated withforeclosure. 2- bankruptcy laws allow borrowers to retain possession of thecollateral long after they have defaulted. 3- when the bank takes possession ofthe collateral, it deprives the borrower of the opportunity to salvage thecompany. At last, a loan should not be approved on the basis of collateralalone. Unless the loan is secured by collateral held by the bank, such as bankCDs, there is risk involved in collection. A PROCEDURE FOR FINANCIAL ANALYSISThe purpose of credit analysis is to identify and define the lender’s risk inmaking a loan.
There is four stages process for evaluating the financial aspectsof commercial loans: 1. Overview of management and operations. 2. Financialratio analysis. 3. Cash flow analysis.
4. Financial projections. During allphases the analysts should examine facts that are relevant to the creditdecision and recognize information that is important but unavailable. 1. Overview of management and operations: Before analyzing financial data, ananalyst should gather background information on the firm’s operations.
Thisevaluation usually begins with an analysis of the organizational and businessstructure of the borrower. The evaluation should also identify the products orservices provided and the firm’s competitive position in the marketplace. Thisinquiry leads to a brief analysis of industry trends. Moreover, particularattention should be focused on management quality. This helps identifymotivating factors underlying their decisions. Finally the overview shouldrecognize the nature of the borrower loan request and the quality of thefinancial data provided.
2. Financial ratio analysis: Most banks initiate thedata analysis with statement spread forms, which array the firm’s balancesheet and income statement items in a consistent format for comparison over timeand against industry standards. The next step is to calculate a series of ratiosthat indicate performance variances. This analysis should differentiate among atleast four categories of ratios: A-Liquidity ratio: indicates the firm’sability to meet its short-term obligations and continue operations. Measures ofnet working capital, current and quick ratios, inventory turnover, the averagereceivables collection period, the days payable outstanding, and the dayscash-to-cash cycle help indicate whether current assets will support currentliabilities.
B-Activity ratios: signal how effectively a firm is using assets togenerate sales. (Sales-to-asset ratios). The key ratios include accountsreceivable turnover, inventory turnover and fixed asset turnover. C-Leverageratio: indicate the mix of the firm’s financing between debt and equity, hencepotential earnings volatility. The greater a firm’s leverage, the morevolatile its net profit (or losses).
Ratios that should be examined include debtto total assets, times interest earned, fixed charge coverage, net fixed assetto tangible net worth, and the dividend payout %. D-Profitability ratios:provide evidence of the firm’s sales and earnings performance. Basic ratiosinclude the firm’s ROE, ROA, profit margin, and asset utilization. Finally, ananalyst should evaluate these ratios with a critical eye, trying to identifyfirm strengths and weaknesses. 3.
Cash flow analysis: Most analysts focus on cashflow when evaluating a non-financial firm’s performance. Cash flow estimatesare subsequently compared to principal and interest payments and discretionaryexpenditures to assess a firm’s borrowing capacity and financial strength. Theimportance of cash flow has recently been emphasized by the introduction of thestatement of financial accounting standards (SFAS). The cash-based incomestatement is a modified form of statement of cash flows. It is essentially astatement of changes reconciled to cash that combine elements of the incomestatement and balance sheet. It records changes in balance sheet accounts over aspecific time period.
Its purpose is to indicate how new assets are financed orhow liabilities are repaid. The statement of changes is summarized here: Sourcesof cash Uses of cash -Increase in liability -Decrease in Liability -Decrease innon-cash asset -Increase in non- cash asset -New issue of stock -Cashexpenses/cash dividend -Additions to surplus -Taxes -Revenues -Deduction fromsurplus -Repayment/refund of stock Additional two ratios are useful forevaluating a firm cash flow: 1- Cash flow from operations divided by the sum ofdividends paid and last periods current maturities of long term debt. 2- Cashflow from operations divided by the same two terms plus short-term debtoutstanding at the beginning of the year. If these ratios exceed one, then thefirm cash flow can pay off existing debt and support new borrowing. 4.
Financialprojections: The three-stage process described previously enables a creditanalyst to evaluate the historical performance of a potential borrower. Projections of the borrower financial condition reveal how much financing isrequired and how much cash can be generated from operations to service new debt,and can be used to determine when a loan may be repaid. The proforma analysis isa form of sensitivity analysis. Three alternatives scenarios to analyze therelationship between the balance sheet and the income statement: -Best casescenario: improvement in planned performance.
Worst case scenario: representsthe greatest potential negative impact on sales and earnings. Most-likelyscenario: indicates the most reasonable sequence of economic events andperformance. The three alternative forecasts of loan needs and cash flowestablish a range of likely results that indicates the riskiness of credit. As aconclusion no matter what are the alternatives or the credit analysis adopted,do you think that we will get to have a 100% correct analysis with no risk?Evaluating Consumer Loans Chapter 22 The purpose of this chapter is to analyzethe characteristics and profitability of different types of consumer loans andintroduces general credit evaluation techniques to assess risk.
Commercial loanswere available in large volume, net yields were high and the loans were highlyvisible investments. Consumer loans involved small dollar amounts, a large staffto handle account and a lower prestige associated with lending to individuals. This perception changed with the decline in profitability of commercial loans. Today, many banks target individuals as the primary source of growth inattracting new business. Even with the high relative default rates, consumerloans in the aggregate currently produce greater profits than do commercialloans.
This reflects the attraction of consumer deposits as well as consumerloans. Interest rate deregulation forced banks to pay market rates on virtuallyall their liabilities. Corporate cash managers, who are especially pricesensitive, routinely move their balances in search of higher yields. Individual’s balances are more stable. While individuals are price sensitive,a bank can generally retain deposits by varying rates offered on differentmaturity time deposits to meet the customer’s needs.
From a lender’sperspective, the analysis of consumer loans differs from that of commercialloans. First, the quality of financial data is lower. Personal financingstatements are typically unaudited, so it is easy for borrowers to hide otherloans. It is similarly easy to inflate asset values. Second, the primary sourceof repayment is current income, primarily from wages, salaries, dividends, andinterest. This may be highly volatile, depending on the nature of individual’swork experience history.
The net effect is that character is more difficult toassess, but extremely important. Types of consumer loans: ? Installmentloans: Installment loans require the periodic payment of principal and interest. In most cases, a customer borrows to purchase durable goods or coverextraordinary expenses and agrees to repay the loan in monthly installments. While the average loan is quite small, some may be much larger, depending on theuse of the proceeds. Installment loans may be either direct or indirect loans.
Adirect loan is negotiated between the bank and the ultimate user of the funds. The loan officer analyzes the information and approves or rejects the request. An indirect loan is funded by a bank through a separate retailer that sellsmerchandise to a customer. The retailer takes the credit application, negotiatesterms with the individual, and presents the agreement to the bank. If the bankapproves the loan, it buys the loan from the retailer under prearranged terms.
Installment loans can be extremely profitable. Depending on the size of thebank, it cost from $140 to $208 to make each installment loan. Acquisition costsinclude salaries, occupancy, computer, and marketing expenses associated withsoliciting, approving, and processing loan applications. Even though these costsare high, banks were able to earn excellent spreads on the average loan. ? Credit cards and other revolving credit: Credit cards are utilized topurchase goods and services on credit in contrast to debit cards, which are usedto withdraw cash from ATM (Automated Teller Machine). Revolving credit: anarrangement by which the borrower and repay as needed during a specific timeperiod, subject to maximum borrowing level.
Credit cards and overlines tied tochecking accounts are the two most popular forms of revolving creditarrangements. Banks offer a variety of credit cards. While some banks issuecards with there own logo and supported by their own marketing effort, mostoperate as franchises of Master Card or Visa. All cards display the Master Cardand Visa logos along with the issuing bank name.
The primary advantage ofmembership is that an individual bank card is accepted nationally andinternationally at most retail stores without the bank negotiating a separateagreement with every retailer. Some alternatives to the credit cards exist:-Debit cards: they are widely available but not attractive to customers. As thename suggests when an individual uses this card his or her balance at a bank isimmediately debited funds are transferred from the card user account to theaccount of the retailer. But there is a disadvantage in using it, the loss offloat, which explains why debit cards are not popular.
-Smart cards: is anextension of the debit card and contains a computer memory chip that stores andmanipulates information. These cards can handle all purchasing that consumerprefers. -Prepaid cards: are a hybrid debit card in which consumers repay forservices to be rendered and receive a card again which purchases are charged. The advantage of this card is that the processing costs are low and there islittle risk. Credit cards are attractive because they provide higherrisk-adjusted returns than do other types of loans.
Card issuers earn incomefrom three sources: -charging card holders annual fees, charging interest onoutstanding loan balances, and discounting the charges that merchants accept onpurchases. Consequently as banks have increased their competitive focus theyhave begun to lower loan rates and annual fees such that many customers canavoid fees entirely and pay interest at rates slightly above NY quoted prime. Credit card lending involves issuing plastic cards to qualifying customers. Thecards have pre-authorized credit limits that restrict the maximum of debtoutstanding at any time.
Many cards can be used in electronic banking devices,such as automatic teller machines, to make deposits or withdrawals from existingtransaction accounts at a bank. Credit cards are becoming extremely attractive. Many banks view credit cards as a vehicle to generate a nationwide customerbase. They offer extraordinary incentives to induce consumers to accept cards inthe hope that they can cross-sell mortgages, insurance products, and eventuallysecurities.
Credit cards are profitable because many customers are priceinsensitive. However, credit card losses are among the highest of all loantypes. The returns to credit card lending depend on the specific roles that abank plays. A bank is called a card bank if it administers its own credit cardplan or serves as the primary regional agent of major credit card operations. Anon-card bank operates under the auspices of a regional card bank and does notissue its own card.
Non-card banks do not generate significant revenues fromcredit cards. The credit card transaction process: Once a customer uses a card,the retail outlet submits the sales receipt to its local merchant bank forcredit. A retailer may physically deposit the slip electronically transfer theinformation via a card-reading terminal at the time of sale. The merchant bankdiscounts the sales receipt by 2 to 5 percent as its fee.
Thus a retailer willreceive only 97$ credit for each 100$ sales receipt if the discount is 3percent. If the merchant bank did not issue the card, it sends the receipt tothe card-issuing bank then bills the customer for the purchase. Most cardrevenues come from issuing the card that a customer uses. The bank earnsinterest at rates ranging from 6 to 22 percent and normally charges eachindividual an annual fee for use of the card. Interest rates are sticky.
Thus,when money market rates decline and lower a bank’s cost of funds, the netreturn on credit card revenues. The remaining 20 percent is merchant discount. ? Overdraft protection and open credit lines: Revolving credit also takesthe form of overdraft protection against checking accounts. The customer mustpay interest on the loan from the date of the draft’s receipt and can repaythe loan either by making direct deposits or by periodic payments. These loansare functional equivalent of loan commitments to commercial customers. Themaximum credit available typically exceeds that for overdraft lines, and theinterest rate floats with the bank’s base rate.
? Home equity loans andcredit cards: Home equity loans meet the tax deductibility requirements becausethey are secured by equity in an individual’s home. Many of these loans arestructured as open credit lines where a consumer can borrow up to 75 percent ofthe market value of the property less the principle outstanding on the firstmortgage. Individuals borrow simply by writing checks, pay interest only on theamount borrowed and can repay the principal at a rate of the outstandingbalance. In most cases, the loans carry adjustable rates tied to the banks baserate. These credit arrangements combine the risk of a second mortgage with thetemptation of credit card, a dangerous combination.
Home equity loans place asecond lien on a borrower’s home. If the individual defaults, the creditor canforeclose so that the borrower loses his or her home. ? Non-installmentloans: A limited number of consumer loans require a single principal andinterest payment. The individual borrowing needs are temporary. Credit isextended in anticipation of repayment from a well-defined future cash inflow.
The quality of the loan depends on the certainty of the timing and the amountanticipated net cash inflow from the sale. Consumer loans: Consumer loans areextended for a variety of reasons for example, the purchase of an automobile,mobile homes, home improvements, furniture and appliances, and home equityloans. Before approving any loan, a lending officer request informationregarding the borrower’s employment status, periodic income, the value ofassets owned, outstanding debt, personal references and specific terms thatgenerates the loan request. The lending officer collects information regardingthe borrower’s five C’s then he interprets the information in light of thebank lending guidelines and accepts or rejects the loan. In addition, banksemploy judgmental procedures and quantitative credit scoring procedures whenevaluating consumer’s loans.
Recent risk and return characteristics ofconsumer loans: Historically, banks viewed themselves as being either wholesaleor retail institutions, focusing on commercial and individual customersrespectively. Recent developments, however, have blurred the distinction, astraditional wholesale banks have aggressively entered the consumer market. Theattraction is twofold. First, competition for commercial customers narrowedcommercial loan yields so that return fell relative to potential risks. Soconsumer loans provide some of the highest met yields for banks.
Second,developing loan and deposit relationships with individuals presumably representsa strategic response to deregulation.