Factors considered in credit analysis

Ownership of assets

Ownership of assets is similar to capital and collateral in the cs

of the credit . Manufacturer must have modern machinery and
equipment if they are to be competitive producers.
Retailers must have a stock of merchandise and attractive
buildings and fixtures if they are to attract customers
Credit will not be supplied to business concerns unless capital
has been supplied by the owners to support the debt . The net
worth of a firm is one measure of its financial strength
It is often one of the principal determinant of the amount of
credit a bank is willing to make available to a business borrower
Consumer loans are frequently secured by assets of the borrower
.
If the value of the pledged assets has not depreciated below the
unpaid balance of the loan , the borrower has a strong incentive
to continue

Economic conditions
Economic conditions affect the ability of the borrower
and the lender.
borrower may have good character , an apparent
ability to create income , and sufficient assets , but
economic conditions can render the extension of credit
unwise
The economy is subject to short and long run
fluctuations that vary in intensity and duration
A knowledge of what is happening in the industry is
very important changes in competitive conditions ,
technology, the demand for the product , and
distribution methods
If a loan applicant is not performing a function basic to
the operation of the economy , the lender will less likely
to act favorably on credit application

Character
The concept of character ,as it relates to
credit transactions , means not only the
willingness to repay debt but also a strong
desire to settle all obligations within the
term of contract
A person of character usually possesses
attributes such as honesty , integrity ,
industry , and morality , but character is a
difficult to evaluate
The past record of a borrower in meeting
his or her obligation is usually weighted
heavily in evaluating his or her character
for credit purposes

Capacity
It refers to the ability of the potential borrower to
repay the debt when it falls due , and is indicative of
the borrowers competence to utilize the loan
effectively and profitability
This is a very important variable of credit analysis ,
for the customer s ability to repay is primarily
dependent upon his earning capacity .
The repayment of loan may be made by the sale of
the assets , by borrowing funds from others , and by
earning s. banks are always interested in loan
repayment out of earnings because the repayment
of the debt by sale of assets is an expensive and
time consuming process, and may strain the banks
relations with the borrower

Capital
It represent the general financial position of the
potential borrowers firm , with special emphasis
on tangible net worth and profitability . The net
worth figure of the business enterprise is the key
factor that would determine the amount of credit
that would be made available to the borrower
The lending officer has to determine the amount of
immediate liabilities liabilities that are due for
retirement and the relation these bear to the
firms available assets
A true estimate of capital can be made if the
market value rather than the book value of assets
is taken into account

Collateral

it is represented by the assets that may

be offered as a pledge against the loan .
Collateral , thus , serve as a cushion or
shock absorber if one or several of the first
three c s are insufficient to give a
reasonable assurance of repayment of the
loan on maturity .
The collateral in the form of pledged
assets serves to compensate for a
deficiency in one or several of the fisrt
three c

Condition
It refers to the economic and business conditions
which affect the borrower s ability to earn and
repay the debt and which are , or may be ,
beyond the control of the borrower
Economic conditions include all those factors
which have a bearing on the economic processes
of production , distribution and consumption .
Borrowers may have a high credit character and
potential ability to produce income ; but the
existing or ensuring conditions may be such as to
render the extension of credit imprudent

Ability to create income

If a loan is to be repaid from earnings , it is
essential to evaluate the borrower ability to earn a
sufficient amount to make the payment
Debt are paid from 4 sources : income , sale of
assets , sale of stock , and borrowing from another
source
An individual power to generate income also
depends on such factors such as education , health
and energy , skill , stability of employment and
resourcefulness

Relative importance of the credit factors

Although all the factors mentioned earlier are
important in credit analysis , most bankers agree
that the collateral available for a loan is generally
the least important
Security is taken in most instances to strengthen a
weakness found in one or more of the credit factors ,
such as ability to create income
Over the entire spectrum of credit analysis , however
, character emerges as the most important factor
If the borrower is of poor character , the probability
is high that at some time he or she will not comply
with the terms of a loan agreement

Scope of credit investigation

The scope of credit investigation will vary depending on the such
determinant as the size and maturity of the loan , the operating
record of the business ,the security offered , and previous
relation s with the borrower.
The objective is to accumulate information that can be used to
evaluate the applicant character , ability to create assets and
income , and the probable economic environment for his or her
business
Banks should know about the nature and operations of the
business : what types of products are handled or produced , what
type of services are rendered
Bank also want information on concerns financial condition . The
trends of sales and profits may be of considerable importance in
evaluating the firms future

Sources of credit information

Interview of loan applicant
If the interview with the applicant , the lending
officer learns the reason for the loan and whether
the loan request meets various requirements
established in the loan policies of the bank .
From the interview , the lending officer can also
get some idea as to an applicants honesty and
ability and may form an opinion as to whether
security
In the interview , the lending officer will also
advise the applicant as to what additional
financial information will be needed for evaluating
the proposed loan

Banks own records

A bank may maintain a central file of all of its
depositors and borrowers from which credit
information can be obtained
Even if the applicant has never been a customer of
the bank , the central file may contain some
information if the applicant has been solicited by
the new business department
It will show the payment record on previous loans ,
balances carried in checking and saving accounts ,
whether the applicant has a habit of overdrawing his or
her account

Inspection of applicants places of

business
Businesses applying for loans should be willing to
allow a loan officer to visit and tour their places of
business . An experienced loan officer will learn a
significant amount about how productive and well
managed a business is from a tour of facilities
The loan officer should note how well the business is
organized and whether or not employees seem to be
performing effectively
If a firm is a retailer , a visit during a normally busy
period may indicate the strength of the firms
business as well as the proficiency of the sale staff
In the case of visiting a manufacturing firm ,
particular note should be made of the equipment
and the production layout

Gathering credit information

The credit department of a bank gathers from
different sources the requisite information on
which customer evaluation must necessarily be
based
Two important factors should be kept in mind while
searching for credit information cost and time .
A bank cannot afford to spend a lot of money in
the investigation of some loan applicants,
particularly the smaller ones
Spending a lot of time on investigation may be
justified in cases of new and large credit
customers

Interview
An interview with the applicant enables the bank
to secure the information about the history of the
borrowers business its record of growth , types
of product made the services rendered , the
competitive position of the firm and its market
and check it against other sources
In an interview, the lending officer discovers the
purpose of the loan sought and the applicants
plan for repayment
If the applicant does not sastify the credit norm ,
the lending officer ay stop making a further probe
into his creditworthiness.

Financial statements
the financial statements , including the balance
sheet and the profit and loss account of the
prospective borrower , are invaluable sources of
credit information .
Such statements are most readily available from
the applicant himself . An analysis of these
financial statements would provide an insight into
the borrowers financial position , fund
management capacity , liquidity , profitability and
loan repaying capacity.
The balance sheet enable the banker to judge the
creditworthiness of the borrower;

Reports of credit rating

agencies

Commercial bank can gather information on the

creditworthiness of the applicant by procuring
financial reports from credit rating agencies ,
wherever they exist
These agencies collect information on the
financial , managerial and other aspects of a
large number of business concerns and keep it
up- to- date
This will provide individual as well as corporate
investor a useful tool in making investment
decision

Credit analysis

Credit decision
After determining the creditworthiness of the
applicant , the lending officer has to decide whether
or not credit facilities should be provided to him .
The creditworthiness of the applicant should be
matched against the credit standard set out in loan
policy
The difficultly in taking a credit decision arises where
the applicant is marginally creditworthy against the
cost of the debt loss.
The applicant who does not satisfy the standard of
acceptability may be told of the banks helplessness
in view of its loan policy
The bank may advise such firm to approach term
financing institutions whose terms and conditions
might be fulfilled by the firm