Chapter

4 Analysis
Credit
Chapter Objectives
• To understand the credit process
• To describe steps involved in the credit
process
• To explore the five Basic C’s of Lending
• To explain the credit analysis path
• To understand how banks assess companies
based on SWOT analysis
THE CREDIT PROCESS
• Credit analysis or credit assessment is the
process of assessing risk as measured by a
borrower’s ability to repay the loan.
• Analysts also consider possible recovery in
the case of default and evaluate the support
collateral and other credit support tools that
bear on the bank’s final decision to develop a
creditor relationship.
Creditworthiness
• An assessment of the
likelihood that a borrower will
default on their debt
obligations.

• Based Upon:
• History of Repayment
• Credit Score
Steps Involved In The Credit
Process
Identifying the Credit
Opportunity
• In the credit process, the loan officer or
relationship manager initiates contact with
the potential borrower.
• In many banks, the chief function of the loan
officer is marketing: to seek out new business
opportunities and present them for
evaluation.
• After a loan officer identifies an opportunity,
the officer will gather all required information
from the borrower and present it to the credit
analyst.
Credit Evaluation
• The credit analyst collects and reviews information
about the potential borrower, including:
−Internal bank records and account performance
−Historical and current financial accounts (normally
data captured in spreadsheets)
−Management projections
−External ratings of the borrower as provided by
independent rating firms such as Dun & Bradstreet or
similar (smaller businesses), Moody’s, S&P, Fitch
Ratings (large firms)
−Company websites and brochures
−Group structure, ownership, and management
information, including information on the board of
directors
The Credit Analysis Path
• The key to a successful credit evaluation is to
assess accurately the creditworthiness of each
prospect.
• To accomplish this, credit analysts review the
key business, financial, and structural risks.
• These three areas form part of a focused
analytical tool referred to as the credit analysis
path.
• In the credit analysis path, the focus is to
analyze the various risks that may impact the
borrower.
Business Risks
• The business risks reflect both the bank’s and
the borrower’s respective environments
• The credit analyst is able to determine the
borrower’s operating environment by looking:
1. Macroeconomic drivers
• Level of economic activity
• Global changes in inflation
• Worldwide price of energy
2. Competitive factors
• Government regulation
• Changes in technology
Financial Risks
• The financial risk assessment reviews the
company’s management and especially how
it handles the company’s operating and
financial environment.
• Credit analysts primarily focus on
management strategies and their ability to
manage the business in conjunction with an
in-depth analysis of the company’s historical,
current, and pro forma financial statements.
• The overall assessment and results are then
compared to the company’s peers.
Structural Risk
• The analysis of structural risk focuses on loan
pricing and mitigation.
• Credit analyst must evaluate both the borrower and
borrowing:
• Type of Borrower
• Holding company
• Subsidiary
• Type of Borrowing
• Secured
• Unsecured
• Long-term
• Short-term
• Subordinated
Business, financial, and structural
risks
Credit Decision Making
• Often, credit decisions are made by the loan officer in
conjunction with the credit analyst or by a committee.
• Loan officers are generally compensated by the
number of loans generated.
• This creates a potential conflict of interest and,
therefore, poses a risk when the loan officer makes
the loan decision.
• To guard against this problem, banks implement
processes that require all loans to be reviewed by an
independent senior manager or credit analyst.
• Decisions on larger and specialized loans are
generally made by senior bank officers or a
committee of senior bankers or, in some cases, by the
bank’s board
Credit Decision Making
• A core consideration in credit decision making
is the pricing of credit—the fees and interest
rates the bank charges the borrower.
• This interest rate may be determined by a
loan pricing model that sets the minimum
rate the loan should carry and incorporates
various pricing factors.
• Generally, the greater the risk the bank takes
when lending to the particular borrower, the
higher price—interest rate—it charges.
Credit Disbursement
• Once the credit request has been approved, the
loan agreement is prepared for signature.
• The loan agreement is a legal contract between
the bank and the borrower and includes a
description of undertakings and understandings,
such as:
− The principal,
− The stated interest rate and its calculation,
− The schedule of payments and repayments,
− The use of collateral, covenants, etc.
• Once the contract is signed, funds are made
available to the borrower
Credit Monitoring
• The bank continues to monitor the financial
performance of the borrower
• The contract usually has hard and soft covenants
or provisions
− An example of a hard covenant is a
requirement that the borrower maintains
certain key financial
ratios throughout the life of the loan.
− An example of a soft covenant is the
requirement
that the borrower delivers its financial
statements to the lender in a timely manner.
THE CREDIT ANALYSIS
PROCESS
• The Five Cs of Credit provide a basic
framework for good lending, which is
particularly relevant to small business lending
and to the SME sector.
• Bank financing is the primary option for small
or recently established firms, because these
firms do not have access to the financial
markets to issue stocks or bonds
The Five Cs of Credit
 The Five Cs of Credit: No. 1—
Character
• In analyzing character, the bank looks the
management for the following areas:
 The reputation of the company’s management in the
industry and in the greater business community
 The immaculate credentials and references for the
management
 The quality of management’s relationship with its
employees as well as with its customers
 The management’s ability to administer the company’s
future.
 Indicators of management capabilities include the level
of engagement in day-to-day operations, flexibility in
embracing current technologies, understanding prevailing
industry trends, and, most importantly, its ability to
contain costs and seek efficiencies.
Character
Honesty to pay a debt when it is due.
How past debt obligations were handled
The Five Cs of Credit: No. 2—
Capital
• When analyzing capital, the bank seeks to
gain an understanding for the following parts:
How is the company currently financed?
What is its level of leverage?
The relationship between equity and debt is
critical, and the higher the level of equity relative
to debt, the healthier the company will appear
from a credit risk
perspective
The lower the leverage of the company, reveals
the financial commitment of the company’s
owners and indicates how much they have put
themselves at risk
Capital
• Refers to a person’s ability to pay a debt when it is
due
• How much debt can a person handle
The Five Cs of Credit: No. 3—
Conditions
• When analyzing conditions, the bank seeks
to answer the following questions:
What is the economic situation in the
country or countries in which a company
operates?
What are the economic conditions of the
industry in which it operates?
What outside risks might cause the
company’s
financial condition to deteriorate.
Conditions
Economic Conditions Faced By
Borrower
The Five Cs of Credit: No. 4—
Capacity
• When analyzing capacity, the bank seeks to
answer the following questions:
How much cash does the company generate,
and
Are the cash flows sustainable, repeatable, and
predicable?
The credit analyst must evaluate the company’s
ability to generate sufficient cash flows as well
as management’s ability to run its operations
efficiently and effectively.
Capacity
Ability to Generate Enough Cash to
Repay Loan
The Five Cs of Credit: No. 5—
Collateral
• When analyzing collateral, the bank seeks to
answer the following question:
In the event the borrower cannot honor its obligations,
what assets does it have that the bank can lay claim to
satisfy the debt?
The analyst should confirm that the company’s
primary source of loan repayment, cash flow or assets,
is, and will be, sufficient to meet all its obligations as
they fall due.
But, a lender has a responsibility to its shareholders
and depositors to ensure a secondary or
complementary source of repayment.
The secondary source of repayment is other assets
owned by the borrower (most commonly referred to as
collateral).
Collateral
Adequate Assets to Support the Loan
SWOT ANALYSIS