The credit analysis process involves a thorough review of a business to determine its perceived ability to pay. To do this, business credit managers must evaluate the information provided in the credit application by analyzing financial statements, applying credit analysis ratios, and reviewing trade references. In addition to the information requested in the application, it is important to consult a business credit report from a reputable third party. The information gathered during this process allows companies to decide whether or not to offer the customer credit, and if so, precisely how much credit to extend.
The credit analysis process refers to evaluating a borrower’s loan application to determine the financial health of an entity and its ability to generate sufficient cash flows to service the debt. In simple terms, a lender conducts credit analysis on potential borrowers to determine their creditworthiness and the level of credit risk associated with extending credit to them.
Stages in the Credit Analysis Process
The credit analysis process is a lengthy one, lasting from a few weeks to months. It starts from the information-collection stage up to the decision-making stage when the lender decides whether to approve the loan application and, if approved, how much credit to extend to the borrower.
The following are the key stages in the credit analysis process:
- Information collection
The first stage in the credit analysis process is to collect information about the applicant’s credit history. Specifically, the lender is interested in the past repayment record of the customer, organizational reputation, financial solvency, as well as their transaction records with the bank and other financial institutions. The lender may also assess the ability of the borrower to generate additional cash flows for the entity by looking at how effectively they utilized past credit to grow its core business activities.
The lender also collects information about the purpose of the loan and its feasibility. The lender is interested in knowing if the project to be funded is viable and its potential to generate sufficient cash flows. The credit analyst assigned to the borrower is required to determine the adequacy of the loan amount to implement the project to completion and the existence of a good plan to undertake the project successfully.
The bank also collects information about the collateral of the loan, which acts as security for the loan in the event that the borrower defaults on its debt obligations. Usually, lenders prefer getting the loan repaid from the proceeds of the project that is being funded, and only use the security as a fall back in the event that the borrower defaults.
- Information analysis
The information collected in the first stage is analyzed to determine if the information is accurate and truthful. Personal and corporate documents, such as the passport, corporate charter, trade licenses, corporate resolutions, agreements with customers and suppliers, and other legal documents are scrutinized to determine if they are accurate and genuine.
The credit analyst also evaluates the financial statements, such as the income statement, balance sheet, cash flow statement, and other related documents to assess the financial ability of the borrower. The bank also considers the experience and qualifications of the borrower in the project to determine their competence in implementing the project successfully.
Another aspect that the lender considers is the effectiveness of the project. The lender analyzes the purpose and future prospects of the project being funded. The lender is interested in knowing if the project is viable enough to produce adequate cash flows to service the debt and pay operating expenses of the business. A profitable project will easily secure credit facilities from the lender.
On the downside, if a project is facing stiff competition from other entities or is on a decline, the bank may be reluctant to extend credit due to the high probability of incurring losses in the event of default. However, if the bank is satisfied that the borrower’s level of risk is acceptable, it can extend credit at a high interest rate to compensate for the high risk of default.
- Approval (or rejection) of the loan application
The final stage in the credit analysis process is the decision-making stage. After obtaining and analyzing the appropriate financial data from the borrower, the lender makes a decision on whether the assessed level of risk is acceptable or not.
If the credit analyst assigned to the specific borrower is convinced that the assessed level of risk is acceptable and that the lender will not face any challenge servicing the credit, they will submit a recommendation report to the credit committee on the findings of the review and the final decision.
However, if the credit analyst finds that the borrower’s level of risk is too high for the lender to accommodate, they are required to write a report to the credit committee detailing the findings on the borrower’s creditworthiness. The committee or other appropriate approval body reserves the final decision on whether to approve or reject the loan.
The process of assessing whether or not to lend to a particular entity is known as the credit process. It involves evaluating the mindset of the potential borrower, underwriting of the risk, the pricing of the instrument and the fit with the lender’s portfolio. It encompasses setting objectives and guidelines based on the lender’s credit culture, gathering necessary information of the applicant, analyzing the information including cash flows and financial statements and presenting and documenting information in such a manner so that a credit decision may be made.
Your commercial banking officer will review your business loan package based on criteria known as the “Five C’s of Credit.”
Character: It involves a review of your personal honesty, integrity, trustworthiness and management skills. A banking officer also makes a judgment of character based on your business plan, credit history and the quality of your presentation.
Capitalization: The capital structure of your company is important to Bank of Ann Arbor because it helps determine the level of risk associated with your loan request. An analysis of capitalization includes a review of equity, total debt, the value of assets and permanent working capital.
Cash Flow: This is the cash your business has to pay the debt. A cash flow analysis helps us determine if you have the ability to repay the loan.
Collateral: This provides a secondary source of repayment, thereby minimizing the risk for Bank of Ann Arbor. The amount and type of collateral required depends on the type and purpose of the loan.
Conditions: This refers to outside conditions that may affect the ability of your business to repay the loan. Factors such as general economic conditions or a large concentration of sales to a single customer are evaluated during our review of your loan application.
Credit administration and documentation are two of the critical components in managing credit and supporting the credit process. Following proper credit administrative and documentation process allow credit analysts to monitor accounts and identify ways to reduce default risk.
Credit Document means any of this Agreement, the Notes, if any, the Collateral Documents, any documents or certificates executed by Company in favour of Issuing Bank relating to Letters of Credit, and all other documents, instruments or agreements executed and delivered by a Credit Party for the benefit of any Agent, Issuing Bank or any Lender in connection herewith.