"Industry Insight" articles like this one below are submitted to NASBP by those knowledgeable of important industry topics who are providing their insight for the benefit of NASBP members, affiliates, and associates.
Industry Insight: A Guide to the Banker's Fundamental Credit Analysis
The basic objective of credit analysis is to assess the risks involved in extending credit (making a loan). As used here, “risk” refers to the volatility in earnings needed to repay the loan. Lenders are particularly concerned with adverse fluctuations in net income (or more importantly, cash flow), which hinder a borrower’s ability to service or repay a loan. Such risk manifests itself to the bank by a borrower defaulting, or not making timely interest and/or principal payments. Credit analysis assigns a probability to the likelihood of default based on quantitative and qualitative factors. Some risks can be measured with historical and projected financial data. Other risks, such as those associated with the borrower’s character and willingness to repay a loan, are not directly measurable. When deciding whether or not to approve a loan, the bank ultimately compares the various risks with the potential benefits to the bank (income).
When evaluating loan requests, bankers can make two “general” types of errors in judgment. The first is extending credit to a customer who ultimately defaults. The second is denying a loan to a customer who ultimately would repay the debt. In both cases, the bank loses a customer and its profits are less. Many bankers focus on eliminating the first type of error, applying rigid credit evaluation criteria and rejecting applicants who do not fit the mold of the ideal borrower. A well-known axiom in banking is that the only time borrowers can get financing is when they really do not need the funds. Unfortunately, as many bankers have discovered, turning down good loans is unprofitable as well. The purpose of credit analysis is to identify the meaningful, probable circumstances under which the bank might lose.
The foremost issue in assessing credit risk is determining a borrower’s commitment and ability to repay debts in accordance with the terms of a loan agreement. An individual’s honesty, integrity, and work ethic typically evidence commitment. For a business, commitment is evidenced by the owners and senior management. Bankers who argue that they make many quick credit decisions implicitly state that many potential borrowers are of dubious character. Even if the numbers look acceptable, a bank should lend nothing if the borrower appears dishonest. Whenever there is deception or a lack of credibility, a bank should not do business with the borrower.
It is often difficult to identify dishonest borrowers. The best indicators are the borrower’s financial history as well as personal and business references. When a borrower has missed past debt service payments or been involved in a default or bankruptcy, a lender will carefully document and evaluate the underlining reasons, to determine if the causes were reasonable. Borrowers with a history of credit problems are more likely to see the same problems arise later. Similarly, borrowers with a good credit history will have established personal and banking relationships that indicate whether they fully disclose meaningful information and deal with subordinates and suppliers honestly. A loan officer will begin the credit analysis by analyzing the firm’s prior banking relationships, dealings with suppliers and customers, and current record from appropriate credit bureaus.
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nature of the loan request specifically addresses the legitimacy of the loan for the intended purpose. Banks will not lend money on highly speculative projects. They generally appreciate borrowers with proven records of accomplishment and highly competent management. Financial institutions generally do not like to lend money with high loan-to-value ratios, for extremely long periods, or on unknown or unproven technologies. They generally do not lend if there is inadequate capital or illiquid principals in the business venture. Some banks will not lend to certain industries either due to a history of unsuccessful ventures or possibly due to a lack of bank staff expertise in the industry.
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quality of data used in the analysis is critical. Audited financial statements are required for larger loans because accounting rules are well established so that an analyst can better understand the underlying factors that affect the entries. Just because a company has audited financial statements, however, does not mean the reported data are not manipulated. Management has considerable discretion within the guidelines of generally accepted accounting principles and thus can “window dress” financial statements to make the results look better. The analyst will review the following to assess accounting data quality:
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Areas of accounting choices in which estimates and judgments are required inputs
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Periods in which a change in account principle, method, or key assumption has occurred
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Extraordinary and discretionary expenditures, as well as nonrecurring transactions
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Income and expense recognition that do not closely track cash flow
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Nonoperating income, gains, and losses
In addition to character and assessment of data quality, a lender must resolve four additional fundamental issues prior to extending credit: the use of loan proceeds, loan amount, source and timing of repayment, and collateral. These issues draw attention to specific features of each loan that can be addressed when structuring the loan agreement terms.
The range of business loan needs is unlimited. Firms may need cash for operating purposes to pay overdue suppliers, make a tax payment, or pay employee salaries. Similarly, they may need funds to pay off maturing debt obligations or to acquire new fixed assets. Although the question of what the borrowed funds will be used for seems simple enough, frequently a firm recognizes that it is short of cash but cannot identify specifically why.
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loan proceeds should be used for legitimate business operating purposes, including seasonal and permanent working capital needs, the purchase of depreciable assets, physical plant expansion, acquisition of other firms, and extraordinary operating expenses. Speculative asset purchases and debt substitutions should be avoided. Banks prefer loans that enhance or increase the borrower’s ability to repay to the loan. As such, loans to build infrastructure such as roads, water and sewer systems to a new housing development are much more speculative than lending money to actually build a new house. In Texas the trend is towards building toll roads. Toll roads provide governments a means of building large highway projects without incurring debt while at the same time provide the company building the toll road a future earnings stream to repay the loans incurred, hence reducing the risk of loan to the bank.
So the use of the loan proceeds can either enhance the ability of the firm to repay the loan or make it more risky. Financing illegal activities or unprofitable operations can actually increase the losses of the firm and hence reduce the possibility of repayment. The true need and use of the loan proceeds determines the loan maturity, the anticipated source and timing of repayment, and the appropriate collateral.
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total amount of credit required depends on the use of the proceeds and the availability of internal sources of funds. One important issue lenders look for is that borrowers often ask for too little in a loan request and return later for more funds. The lender will not only estimate how much the borrower will need at the beginning of the project, but also in the future. Inexperienced lenders often make the mistake of failing to recognize that lending only a portion of the funds needed may actually reduce the borrower’s ability to pay the loan back. A half-built warehouse will not produce revenue but rather will be a revenue drain. The lender’s job is to help determine the correct amount, such that a borrower has enough cash to operate effectively but not too much to spend wastefully.
Loans are repaid from cash flows. The four basic sources of cash are the liquidation of assets, cash flow from normal operations, new debt issues, and new equity issues. Credit analysis evaluates the risk that a borrower’s future cash flows will not be sufficient to meet mandatory expenditures for continued operations and interest and principal payments on the loan.
Specific sources of cash are generally associated with certain types of loans. Term loans are typically repaid out of cash flows from operations. Unless specifically identified in the loan agreement, it is inappropriate to rely on new equity from investors or new debt from other creditors for repayment. Too often these external sources of cash disappear if the firm’s profitability declines or economic conditions deteriorate. So, bankers consider interim construction loans, for example, without a contractual obligation from a permanent financing source, risky. Although bankers make these types of interim loans, terms are better for those projects which have secured permanent financing.
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primary source of repayment on the loan can also determine the risk of the loan. The general rule is not to rely on the acquired asset or underlying collateral as the primary source of repayment. If you lend money for someone to buy rental property and the leases on the rental property will be the primary source of repayment (that is, they have no other source of income to pay you back) means the primary source of repayment is the acquired asset. If the rental property does well, the borrower makes money and repays the loan. If the rental property does poorly, the borrower declares bankruptcy; and the bank will not be fully repaid. Obviously, this is not a loan but venture capital disguised as a loan. This does not, however, mean a banker will not consider the income generated from the acquired assets; the greater the reliance on the acquired assets to generate income, the riskier the loan.
It is not by chance that the question of collateral is the last question to be addressed. If something goes wrong, a bank wants all the collateral it can get; but it generally does not want to take possession of the collateral. Taking the collateral means that the borrower is unable to continue operations. More importantly, it means the borrower was unable to sell the collateral, so why would the bank be better able to liquidate the assets than the managers who know the industry? More importantly, often the borrower will file for bankruptcy protection, which means the bankruptcy judge will not “give” the collateral to the banker. Bankers know that in bankruptcy court the bankruptcy judge not the loan contract, will decide, who gets paid and how much.
Banks can, however, lower the risk of loss on a loan by requiring backup support beyond normal cash flow. This can take the form of assets held by the borrower or an explicit guarantee by a related firm or key individual. Collateral is the security a bank has in assets owned and pledged by the borrower against a debt in the event of default. Banks look to collateral as a secondary source of repayment when primary cash flows are insufficient to meet debt service requirements.
Fundamentally banks lend money to companies with proven track records and on projects that will enhance the company’s ability to repay the loan. They do not lend money for borrowers to speculate with nor do they lend money based purely on collateral values. Bankers do not want to have to collect on the collateral; hence borrowers must demonstrate how the loan will be repaid without a bank resorting to collection of the collateral.
Copyright © 2014, 2010 and 2007, S. Scott MacDonald, Ph.D. and South-Western Cengage Learning. All rights reserved. Adapted from Koch, Timothy W. and S. Scott MacDonald, Bank Management, South-Western Cengage Learning, © 2010, Mason, OH.
The author of this article is S. Scott MacDonald, Ph.D. S. Scott MacDonald, Ph.D. (scott@bankmgt.com) is President and CEO, SW Graduate School of Banking Foundation; Director, Assemblies for Bank Directors; and Adjunct Professor, Edwin L. Cox School of Business, Southern Methodist University, as well as founder and principle of BFS Consultants Group, Frisco, TX. MacDonald presented a NASBP Virtual Seminar on January 14 titled, “2014 Economic Update: The Economy is Looking Up, But the Fed Must Balance Two Bad Choices.” To purchase the audio recording of his Virtual Seminar, contact Cathrine Nelson at cnelson@nasbp.org.
This article is provided to NASBP members, affiliates, and associates solely for educational and informational purposes. It is not to be considered the rendering of legal advice in specific cases or to create a lawyer-client relationship. Readers are responsible for obtaining legal advice from their own counsels, and should not act upon any information contained in this article without such advice.