This report introduces a procedure that can be used to analyze the quantifiable
aspects of commercial credit requests. The procedure incorporates a systematic
interpretation of basic financial data and focuses on issues that typically
arise when determining creditworthiness. Cash flow information is equally
important when evaluating a firm’s prospects. Reported earnings and EPS can be
manipulated by management debts, are repaid out of cash flow not earnings. The
basic objective of credit analysis is to assess the risk involved in credit
extension to bank’s customers. Risk refers to the volatility in earnings.
Lenders are concerned with net income or the cash flow that hinders a borrower
ability to service a loan. Credit analysis assigns some probability to default.
Some risks can be measured with historical and projected financial data. The key
issues include the following: 1. For what are the loan proceeds going to be
used? 2. How much does the customer need to borrow? 3. What is the primary
source of repayment, and when will the loan be repaid? 4. What collateral is
available? Fundamental credit issues: Virtually every business has a credit
relationship with a financial institution. But regardless of the type of loan,
all credit request mandate a systematic analysis of the borrower’s ability to
repay. When evaluating a loan a bank can make two types of errors: 1. Extending
credit to a consumer who ultimately would repay the debt. 2. Denying a loan
request to a customer who ultimately would repay the debt. In both cases the
bank loses a customer and its profit decreases. For this reason, the purpose of
credit analysis is to identify the meaningful and probable circumstances under
which the bank might lose. So a credit analyst should analyze the following
items: *Character: 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. 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 and personal references. When a borrower has
missed past debt service payments or has been involved in default or bankruptcy
a lender should carefully document why to see if the causes were reasonable.
Similarly, borrower’s with good credit history will have established personal
and banking relationship that indicate whether they fully disclose meaningful
information and deal with subordinates and suppliers honestly. Lenders look at
negative signals of a borrower condition beyond balance sheet and income
statement. For example:  A borrower’s name consistently appears on the
list of bank customers who have overdrawn their account.  A borrower
makes a significant change in the structure of business.  A borrower
appears to be consistently short of cash.  A borrower’s personal
habits have changed for the worse. A firm’s goals are incompatible with those
of stockholders, employees, and customers. *Use of loan proceeds: The range of
business loan needs is unlimited. The first issue facing the credit analyst is
what the loan proceeds are going to be used for. Loan proceeds should be used
for legitimate business operations purposes, including seasonal and permanent
working capital needs, the purchase of depreciable asset, physical plant
expansion, acquisition of other firms. Speculative asset purchases and debt
substitutions should be avoided. The true need and use determines the loan
maturity, the anticipated source and timing of repayment and the appropriate
collateral. A careful review of a firm financial data typically reveals why a
company deeds financing. *Loan amount: Borrowers request a loan before they
clearly understand how much external financing is actually needed and how much
is available internally. The amount of credit required depends on the use of
proceeds and the availability of internal sources of funds. The lender job is to
determine the correct amount such that a borrower has enough cash to operate
effectively but not too much to spend wastefully. Once a loan is approved the
amount of credit actually extended depends on the borrower future performance.
If the borrower cash flow is insufficient to meet operating expenses and the
debt service on the loan it will be called upon to lend more and possibly to
lengthen the loan maturity. If cash flows are substantial, the initial loan
outstanding might decline rapidly and even be repaid early. The required loan
amount is thus a function of the initial cash deficiency and the pattern of
future cash flows. *The primary source and timing of repayment: The primary
source of repayment of loans is the cash flows. The four basic sources of cash
flow 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 future cash flow will not be sufficient to meet expenditures for
operations and interest and principal payments on the loan. Specific sources of
cash are typically associated with certain types of loans. Short-term, seasonal
working capital loans are normally repaid from the liquidation of receivables or
reduction in inventory. Term loans are normally repaid out of cash flows from
operations. A comparison of projected cash flows with interest and principal
payments on prospective loans indicates how much debt can be serviced and the
appropriate maturity. *Collateral: Banks can lower the risk of loss on a loan by
requiring back up support beyond normal cash flow. 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. Having an
asset that the bank seize and liquidate when a borrower defaults reduce loss,
but it does not justify lending proceeds when the credit decision is originally
made. From a lender perspective, collateral must exhibit three features: -First,
its value should always exceed the outstanding principle on a loan. -Second, a
lender should be able to easily take possession of collateral and have a ready
market for sale. Highly illiquid assets are worth far less because they are not
portable and often are of real value only to the original borrower. -Third, a
lender must be able to clearly mark collateral as its own. When physical
collateral is not readily available, banks often ask for personal guarantees. On
the other hand, liquidating collateral is a second-best source of repayment for
three reasons: 1- there are significant transaction costs associated with
foreclosure. 2- bankruptcy laws allow borrowers to retain possession of the
collateral long after they have defaulted. 3- when the bank takes possession of
the collateral, it deprives the borrower of the opportunity to salvage the
company. At last, a loan should not be approved on the basis of collateral
alone. Unless the loan is secured by collateral held by the bank, such as bank
CDs, there is risk involved in collection. A PROCEDURE FOR FINANCIAL ANALYSIS
The purpose of credit analysis is to identify and define the lender’s risk in
making a loan. There is four stages process for evaluating the financial aspects
of commercial loans: 1. Overview of management and operations. 2. Financial
ratio analysis. 3. Cash flow analysis. 4. Financial projections. During all
phases the analysts should examine facts that are relevant to the credit
decision and recognize information that is important but unavailable. 1.
Overview of management and operations: Before analyzing financial data, an
analyst should gather background information on the firm’s operations. This
evaluation usually begins with an analysis of the organizational and business
structure of the borrower. The evaluation should also identify the products or
services provided and the firm’s competitive position in the marketplace. This
inquiry leads to a brief analysis of industry trends. Moreover, particular
attention should be focused on management quality. This helps identify
motivating factors underlying their decisions. Finally the overview should
recognize the nature of the borrower loan request and the quality of the
financial data provided. 2. Financial ratio analysis: Most banks initiate the
data analysis with statement spread forms, which array the firm’s balance
sheet and income statement items in a consistent format for comparison over time
and against industry standards. The next step is to calculate a series of ratios
that indicate performance variances. This analysis should differentiate among at
least four categories of ratios: A-Liquidity ratio: indicates the firm’s
ability to meet its short-term obligations and continue operations. Measures of
net working capital, current and quick ratios, inventory turnover, the average
receivables collection period, the days payable outstanding, and the days
cash-to-cash cycle help indicate whether current assets will support current
liabilities. B-Activity ratios: signal how effectively a firm is using assets to
generate sales. (Sales-to-asset ratios). The key ratios include accounts
receivable turnover, inventory turnover and fixed asset turnover. C-Leverage
ratio: indicate the mix of the firm’s financing between debt and equity, hence
potential earnings volatility. The greater a firm’s leverage, the more
volatile its net profit (or losses). Ratios that should be examined include debt
to total assets, times interest earned, fixed charge coverage, net fixed asset
to tangible net worth, and the dividend payout %. D-Profitability ratios:
provide evidence of the firm’s sales and earnings performance. Basic ratios
include the firm’s ROE, ROA, profit margin, and asset utilization. Finally, an
analyst should evaluate these ratios with a critical eye, trying to identify
firm strengths and weaknesses. 3.Cash flow analysis: Most analysts focus on cash
flow when evaluating a non-financial firm’s performance. Cash flow estimates
are subsequently compared to principal and interest payments and discretionary
expenditures to assess a firm’s borrowing capacity and financial strength. The
importance of cash flow has recently been emphasized by the introduction of the
statement of financial accounting standards (SFAS). The cash-based income
statement is a modified form of statement of cash flows. It is essentially a
statement of changes reconciled to cash that combine elements of the income
statement and balance sheet. It records changes in balance sheet accounts over a
specific time period. Its purpose is to indicate how new assets are financed or
how liabilities are repaid. The statement of changes is summarized here: Sources
of cash Uses of cash -Increase in liability -Decrease in Liability -Decrease in
non-cash asset -Increase in non- cash asset -New issue of stock -Cash
expenses/cash dividend -Additions to surplus -Taxes -Revenues -Deduction from
surplus -Repayment/refund of stock Additional two ratios are useful for
evaluating a firm cash flow: 1- Cash flow from operations divided by the sum of
dividends paid and last periods current maturities of long term debt. 2- Cash
flow from operations divided by the same two terms plus short-term debt
outstanding at the beginning of the year. If these ratios exceed one, then the
firm cash flow can pay off existing debt and support new borrowing. 4. Financial
projections: The three-stage process described previously enables a credit
analyst to evaluate the historical performance of a potential borrower.
Projections of the borrower financial condition reveal how much financing is
required 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 is
a form of sensitivity analysis. Three alternatives scenarios to analyze the
relationship between the balance sheet and the income statement: -Best case
scenario: improvement in planned performance. Worst case scenario: represents
the greatest potential negative impact on sales and earnings. Most-likely
scenario: indicates the most reasonable sequence of economic events and
performance. The three alternative forecasts of loan needs and cash flow
establish a range of likely results that indicates the riskiness of credit. As a
conclusion 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 analyze
the characteristics and profitability of different types of consumer loans and
introduces general credit evaluation techniques to assess risk. Commercial loans
were available in large volume, net yields were high and the loans were highly
visible investments. Consumer loans involved small dollar amounts, a large staff
to 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 in
attracting new business. Even with the high relative default rates, consumer
loans in the aggregate currently produce greater profits than do commercial
loans. This reflects the attraction of consumer deposits as well as consumer
loans. Interest rate deregulation forced banks to pay market rates on virtually
all their liabilities. Corporate cash managers, who are especially price
sensitive, 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 different
maturity time deposits to meet the customer’s needs. From a lender’s
perspective, the analysis of consumer loans differs from that of commercial
loans. First, the quality of financial data is lower. Personal financing
statements are typically unaudited, so it is easy for borrowers to hide other
loans. It is similarly easy to inflate asset values. Second, the primary source
of repayment is current income, primarily from wages, salaries, dividends, and
interest. This may be highly volatile, depending on the nature of individual’s
work experience history. The net effect is that character is more difficult to
assess, but extremely important. Types of consumer loans:  Installment
loans: Installment loans require the periodic payment of principal and interest.
In most cases, a customer borrows to purchase durable goods or cover
extraordinary expenses and agrees to repay the loan in monthly installments.
While the average loan is quite small, some may be much larger, depending on the
use of the proceeds. Installment loans may be either direct or indirect loans. A
direct 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 sells
merchandise to a customer. The retailer takes the credit application, negotiates
terms with the individual, and presents the agreement to the bank. If the bank
approves the loan, it buys the loan from the retailer under prearranged terms.
Installment loans can be extremely profitable. Depending on the size of the
bank, it cost from $140 to $208 to make each installment loan. Acquisition costs
include salaries, occupancy, computer, and marketing expenses associated with
soliciting, approving, and processing loan applications. Even though these costs
are high, banks were able to earn excellent spreads on the average loan.
 Credit cards and other revolving credit: Credit cards are utilized to
purchase goods and services on credit in contrast to debit cards, which are used
to withdraw cash from ATM (Automated Teller Machine). Revolving credit: an
arrangement by which the borrower and repay as needed during a specific time
period, subject to maximum borrowing level. Credit cards and overlines tied to
checking accounts are the two most popular forms of revolving credit
arrangements. Banks offer a variety of credit cards. While some banks issue
cards with there own logo and supported by their own marketing effort, most
operate as franchises of Master Card or Visa. All cards display the Master Card
and Visa logos along with the issuing bank name. The primary advantage of
membership is that an individual bank card is accepted nationally and
internationally at most retail stores without the bank negotiating a separate
agreement with every retailer. Some alternatives to the credit cards exist:
-Debit cards: they are widely available but not attractive to customers. As the
name suggests when an individual uses this card his or her balance at a bank is
immediately debited funds are transferred from the card user account to the
account of the retailer. But there is a disadvantage in using it, the loss of
float, which explains why debit cards are not popular. -Smart cards: is an
extension of the debit card and contains a computer memory chip that stores and
manipulates information. These cards can handle all purchasing that consumer
prefers. -Prepaid cards: are a hybrid debit card in which consumers repay for
services 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 is
little risk. Credit cards are attractive because they provide higher
risk-adjusted returns than do other types of loans. Card issuers earn income
from three sources: -charging card holders annual fees, charging interest on
outstanding loan balances, and discounting the charges that merchants accept on
purchases. Consequently as banks have increased their competitive focus they
have begun to lower loan rates and annual fees such that many customers can
avoid fees entirely and pay interest at rates slightly above NY quoted prime.
Credit card lending involves issuing plastic cards to qualifying customers. The
cards have pre-authorized credit limits that restrict the maximum of debt
outstanding at any time. Many cards can be used in electronic banking devices,
such as automatic teller machines, to make deposits or withdrawals from existing
transaction accounts at a bank. Credit cards are becoming extremely attractive.
Many banks view credit cards as a vehicle to generate a nationwide customer
base. They offer extraordinary incentives to induce consumers to accept cards in
the hope that they can cross-sell mortgages, insurance products, and eventually
securities. Credit cards are profitable because many customers are price
insensitive. However, credit card losses are among the highest of all loan
types. The returns to credit card lending depend on the specific roles that a
bank plays. A bank is called a card bank if it administers its own credit card
plan or serves as the primary regional agent of major credit card operations. A
non-card bank operates under the auspices of a regional card bank and does not
issue its own card. Non-card banks do not generate significant revenues from
credit cards. The credit card transaction process: Once a customer uses a card,
the retail outlet submits the sales receipt to its local merchant bank for
credit. A retailer may physically deposit the slip electronically transfer the
information via a card-reading terminal at the time of sale. The merchant bank
discounts the sales receipt by 2 to 5 percent as its fee. Thus a retailer will
receive only 97$ credit for each 100$ sales receipt if the discount is 3
percent. If the merchant bank did not issue the card, it sends the receipt to
the card-issuing bank then bills the customer for the purchase. Most card
revenues come from issuing the card that a customer uses. The bank earns
interest at rates ranging from 6 to 22 percent and normally charges each
individual 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 net
return on credit card revenues. The remaining 20 percent is merchant discount.
 Overdraft protection and open credit lines: Revolving credit also takes
the form of overdraft protection against checking accounts. The customer must
pay interest on the loan from the date of the draft’s receipt and can repay
the loan either by making direct deposits or by periodic payments. These loans
are functional equivalent of loan commitments to commercial customers. The
maximum credit available typically exceeds that for overdraft lines, and the
interest rate floats with the bank’s base rate.  Home equity loans and
credit cards: Home equity loans meet the tax deductibility requirements because
they are secured by equity in an individual’s home. Many of these loans are
structured as open credit lines where a consumer can borrow up to 75 percent of
the market value of the property less the principle outstanding on the first
mortgage. Individuals borrow simply by writing checks, pay interest only on the
amount borrowed and can repay the principal at a rate of the outstanding
balance. In most cases, the loans carry adjustable rates tied to the banks base
rate. These credit arrangements combine the risk of a second mortgage with the
temptation of credit card, a dangerous combination. Home equity loans place a
second lien on a borrower’s home. If the individual defaults, the creditor can
foreclose so that the borrower loses his or her home.  Non-installment
loans: A limited number of consumer loans require a single principal and
interest payment. The individual borrowing needs are temporary. Credit is
extended 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 amount
anticipated net cash inflow from the sale. Consumer loans: Consumer loans are
extended for a variety of reasons for example, the purchase of an automobile,
mobile homes, home improvements, furniture and appliances, and home equity
loans. Before approving any loan, a lending officer request information
regarding the borrower’s employment status, periodic income, the value of
assets owned, outstanding debt, personal references and specific terms that
generates the loan request. The lending officer collects information regarding
the borrower’s five C’s then he interprets the information in light of the
bank lending guidelines and accepts or rejects the loan. In addition, banks
employ judgmental procedures and quantitative credit scoring procedures when
evaluating consumer’s loans. Recent risk and return characteristics of
consumer loans: Historically, banks viewed themselves as being either wholesale
or retail institutions, focusing on commercial and individual customers
respectively. Recent developments, however, have blurred the distinction, as
traditional wholesale banks have aggressively entered the consumer market. The
attraction is twofold. First, competition for commercial customers narrowed
commercial loan yields so that return fell relative to potential risks. So
consumer loans provide some of the highest met yields for banks. Second,
developing loan and deposit relationships with individuals presumably represents
a strategic response to deregulation.