Commonwealth of Aust Copsright ct 1965 Notice for paragraph 49 (7A) (c) of the Copyright Act 1968 Warning This material has boon provided to you under section 49 ofthe Capsright Act 1968 (the Ae) for the purposes of research or siudy. The contents of the material may be subject (0 ‘copyright protection under the Act. Further dealings by you with this material may be a copyright infingement. To determine ‘whother sucha communication would be an infringement, eis necessary to have regard 0 the criteria set ont in Division 8 of Part II ofthe Ack.Sathye, M., Bartle, J, Vincent, M., Boffey, R. (2003) Credit Analysis & Lending ‘Management , John Wiley & Sons, Milton, Australia, Jains Bartle University of New Sout Michael Vincent Monash University Raymond Boffey Edith Cowan University ~ee cpt 0 ‘iy ett tt ‘ot koa. mon ot fer in yaya Nlioume © wie Sage, ee Ene, Mie! We nesta coat ah ‘aig aac nian ag Yee nde 4 Siemagemene | Ste Mid igh oer Mo par of pattie seplepet linge ‘ints mecca espn ear {eer tout ep fenioon ‘aoe se ye Wie A Deprnen Corr age © 200 Die Vain Hay ey fie nt ie to ctor a. intl ee Wh iano ar pct fhe al ie nope bp Soporte Red ECU Febrary 2011Part Overview “Te pia rang ad ang baste Part2 Analysis and interpretation of credit risk “F Foanil Sas was 1 Grad song teins 86 4 Croat rskanaysis—an nvedtion 108 Part 3 Consumer londing “EF Cnaimerinaeg 137 6 Resa ong 174 7. Soeuy cone ee ogation a ‘egal apes oflendog 205, Part 4 Corporate and business lending ‘8 Comporate landing 247 8 Sm buses lendin 255, 10, Intemational ndng 317 Part § ‘Assessment and management oti 77, Ged ok mmasranen rd aragaret (a lon patle 535 12 ett fro me equator perspecive 370 13 Poti an wane 38 Part 6 Current issues ‘TA Becton barling andiending 419 15. Natatingotloens 482 1, Fue diectens 79 Part Case studies (aap ey — Don ees PV Case sy 2— rant anal of Boat Bute Py ld 207 ac say 3 — Ol Engine Caroraton us" 512 ase sty 4— Vtrnary Cie Py Lid 518 Case tidy 5 — Croc of mar staan banks 522 lssay 525 Inox 538,Chapter : The principles of tending and lending basics Learning objectives: sr wa ce ou sh al 1. erly the base pis governing bank Teng and expt ha nga 2 ust he anew wit whch eet ana feng desions et aan 2 std tlre roc 4 pan the charac of various yes otk 5. dating tomes ade Spec eosieaton tha ayy them when 6 pain Now abenes a rts 7 exe the impor of reat ature i 2 fn ston {8 undestnt now an adsans pot is sige.proposis. Even ifthe credit anys done by modern methods, however, t ess on the foundation provided by taditeral malsis One cannot exclude tradtonal creat analsi altogether, most be taken into account. Traiional spproaches comprise thre methods of credit assesment: the judgemental rethod (also called the expert systems method), the rating method and the credit scoring method. We wil explain the tadltional approaches to erat sale and then the moder sppraaches ‘Tatitional methods of erodit analysis “The purpose of any crit acesiet or sali fe the measorement of exe risk According to Be Lucia and Peters (2993), borrowers ced assessment is done wsing te folowing criteria, popularly known asthe five Cs of ending: + characte + collier + capacity + conons capital Some authors combine eapicty nd capital, and conditions and collateral to have Just three Cs of lendng, The fact remaie tht credit asssiment onsides all dhe above factors; combining come of the Cs does not exclude them fiom consideration. Also Temember that these five Ce of lending. ae ‘ppliesble whether the losn ss made to a personal borrower or business boc rower, We will refer f9 these Cs of credit asesenientthrowghut this book, Weerssooria (1998) suggests add one more C to the lst compliance This means compliance with varous’staws and regulatons, patcalarly the Uniform Consumer Credit Code, We support Weerasocriyas observation ‘because se pute the credit analysts fa ste proper perspective, The dels of [egal aspects with which lenders have to comply can be found in chapter 7. “We wil now eplain each of the tndtional five Cs and haw their nals Delp «financial asituon in Judging the safes, sutablly and proStbey of san, Character {Character is perhaps the mos important znd atthe same te, dhe most die colt ritesiom to assess, The fams American banker erpoint Morgan, once fide the fet thing I Took for & the borower’ characer 1 onside that more Jmgortant than money or property or even belore maney or property 0 2a. thing cle. Money cannot buy carseat perso 1 do not trsteould not get money fom me om all he bonds in Chisendom ... have known a man to ome ato my og and ave given bin a cheque for amllon dlls when | Tene he had ot cent in the Worl (Weemsooriys 1698, p99). Thre ls ne ‘more powerful sutemencchan this, which highlights the importance of char eter Inthe asessment of cet. Whi is chamneter? Characters the sum total ff human qualses of hones, nteassy morality and eo on. The Macpuaie Dietary defines chararer ab he apgreate of qualities Oat disdnguishes one pptson-of thing fom oils. Lenders want to know whether borrowers are Imeraly honest or tricky, industrious or any, feudent o speculate, they orspend, and whether Shey have other stich qualities. These qualities ‘orobined Const the character ofthe borrower. A petsan who i 20 honest, represents sky propostion for 2 lender, who wil oot know whedher the tnney bortowed has been pt othe stated we, This autos, while wovking = ‘lending banker, encountered s boreower who borwed money for fm Improvement but wed i to constrect a famibouse. The low was to be repaid fut of excess Income to be generated by the farm lpeovement, but i as ‘ietted for unproduetive use, The bortower repeatedly promised that he would Soon repay the loan used for the femme, but which banker would believe such a promise? CClutacrer i lke glass. Once it &s broken, ie cannot be repaired. Bren if repaired the mai of such a sept ae always present, Some pecple with high poston! in publ fe have had to leave the poston when thelr ceter came fewo qestion Dishonesty ean lead ta disgrace For this reason, preserving ones character sia ‘Given the importance of character in general an in len situation in particular, how shovld one asses characee? Character is subjective; further, Feprosentscifeent notions im ferent caltares. What is considered 35 good ‘Gharacer in one culture may not be so regnded im otber culeues. A Vender feeds 40 account for these aspecta while asesing charter, The lending banker i concerned with the financial character ofthe borower — thats does the borrower exhibit honesty and moral integrity in matters of fiance? Many times, it shard eo draw a ine between Sinan character and general char- acter Is ard to believe data person who ts dishonest genetal ie woul be bonet i financial matters, so the taal charcter ofa person does mater for 8 lender. 4 lender aust Jdge which ofthe infomation received sbout a bor rover’ chascer fs material and which canbe ignored. Given this sbjectvy, how do lenders asses character? ‘Charscizr assessment involves eolecting information about the borrowers twice cond of integrity, repayment ablity and spending habits. Sach infor ‘mation i clleted not only in personal lovns, but also m Business loans, 12 ponal loses, character asesiment may Seem quite suaightorsard ecuee foformation is calleted om only one or maybe Owe indivial, For business Toans, character assesment invalves analy of the character of ll he owners snd managers of the busines, In the ese ofsparnership involves aseeing the ciaacerof all the parte ofthe fim, In the care of ont stock companies (called public companies in Australia), Cpe character of the eiectors of the ‘company is asesed, and inthe case of charighle tus, dat ofthe tastes is soowed Assessment of a homrowers track record should nt bea prablem ifthe bor rower isan existing énstomer ofthe bank. If the customer has heen previous Iborower, then hisher performance én losn repayment could be # good indie ‘ion ofthe caracier ofthe borrower. Was the castomer prompt in zepay- rent? Or was the ark requited to fellow up to get repayment? If corporation has taken an overdaf,wete ll the proceeds ofthe busines routed through theoverdaitasount? WF nt, why not? These and other such questions ct help the lender in asesing the character ofthe prospective burrower, Throughout this book, you wil find various types of character elated question asked by lenders of prospecave bortowers, Lending all about asking the righe ques tions and finding the tue answers The character questions that eed &o be sched for persoal loans are sly simple compared wath chose for business Toans, for which many mote issues need o be considered. ‘Assessment of chnacter for personal loons is not hard. Personal loans sach a credit cards, home laa and ea Tome ~ ate granted to sndviduls, 29 ‘racer sessment cents around the honesty and integrity ofthat individ for group of individual. Assesnment is generally undertaken by one ct more af {he folowing meas + Wuhe sd is castomer ofthe bank, then information about hanes alveady with che Danke The edit history and dilings provide an indications ‘ot the indivinals character Has the exstomerprevionsly borrowed from the ‘bank Ifo, did heshe repay dhe loan tz me? Was the lender requed 12 follow upto ensure repayment? How were the customers dealings with the ‘bank generally? ifthe Information resived in response to these questions ‘sitive then the lender wil conchic dat Ue character of the party i oo Where the borowersnew and not» previous cent ofthe ben the lng, officer should elle iaformation frogs the costorters eting bankers, Inthe ease ofan applicant who i a stated enyployer, the lender contacts the applicants employers and seeke confdeutal informacion about the ‘ployee, pariculiy anything averse, The bank most be cxefo wile taking sci a contact and shosid not ceveleny deals about the customer ‘which could consitue » reach of confidentiality snd serecy obligations ‘The lending ofcer should collec information ina more general manner +The bunk nay contac frends and relatives of dhe prospective Borrower to ascerin the character of the bortower. Silas, enders of reqvie Yorrowers to indieate referees, who can be contacted by the lender fo a character reference + Coniidentat reports fom credit rating agencies ate another source, usta, Credit Advantage (lormerly the Cedi Rating Agency of Aust), {or example, proves confidential reports about the character of he borrow ‘2 individual en seek a report on he own credit ating from this agency, fre a charge | + Lendes often abun docomentary evidence sph as slay Satemens, group ‘ofits anda riers ene so ae to establish the identity of the hosrne ‘When the borrower holds valid devin cence, i establishes that fhe has ‘ot been involved in any oflence snd thus confine god charter, Silay, ‘lay statement shows that the estomer has a jh and obviowly if good ‘haficter, of no-one would have employed himfr. Australian banks usually equce the following document ata deny check: adver heence abit eerste, 2 cet etd, a paseport ora ates ouce aeraFor business borrowess, character assesment involtesassssing the cha ster ofthe business owners, the case of companies, the meters of the board Somes of nformation that help lender conduct a characte assesment ‘clade ‘+ Dun & Bradaretjouinals and their company reporting service * hk opinion. If the prospecave borrower & a eusiomer of mother bank, then a repor is usually obtained fom that banks Such a report eae bank ‘opinion 1s carefally worded and general mature. Ica reveal wether the pany (pcapectve borrower) fnanealy sound, not 39 sound or weak + the Ansuaian Securities and Investments Commision (ASIC), which can provide company information for a fee reports from inarkovlocal knowiedge. Information about the prospective ‘rower can be obuined frm supplies and customs of the hanowet ‘Similarly, market inguiies ean be made credit epets fom Credit Advantage the redevant industry association. Integrity ts another quality that is included in the concept of charset. The Macquarie Dictionary dees integrity a8 a soundness of mora principle and character, uprightness ot honest. People often say ake my word for i, which means he/she wil do al thats necessary to keep the word. Thic is imceriyg which is an important attbute tht hanks expect to find in a borrower: ifthe borrower his smegty, then the lender cam be certain that the promise of repayment vil be honoured. Lenders judge inegity by the trac recon of the hornet. Inthe context of business, the incgnity of management (dhe board of diestors) is assessed. In the much-pubiceed corporate collapse cases of HTH und Ove Tel, she integrity ofthe companies ‘management Was questioned. ‘Another attbute of character the ability ofthe borrower. “Ability refers 10 ‘he technical and management Sl ofthe gwness I is quite comaon to Kt that borower has stength in one atea but a weakness m another A motor amechane for example, may possess excellent tedhnteal sis bu lack usinest ranagement sls, In auch cases the borrower has to demonstrate how Belshe proposes to address the ski that fs lacking. ze sultable persons? Admit patter with suitable sks? The lender ls also intrested im knowing whether Secesor is eing roomed to take over from preset ovens when they rere 1 fal aspect of ehareter 6 whether the borrower Is spent, Company rmanagemens are often criteied by otdiary shareholders for extvagant spending, High salaries, high busines expenses, the use of expemsive company ‘irs sd busines class ave re some ofthe indications of extravagant spending, Capacity ‘Capacity the ability to epay the lan together with terest a pe the pue= determined schedule. (Here ‘capaci refer to fnancsl capacity to vepay Loan 1s diene from legal capacity, which refers to capacity or elighlliy to enter, ‘nto a loen contact You wil come arose thie concept i Iter chapters) Ie ney + (Birt te reeset dao ce 3 rT eesullsient et income to service the Tom repayment. To asiess whether the, omower napa postion und, lenders often seck nunca data fom he customer. In the cae of persona loans, howoweas we often regued to give ‘lets of ome and exgeniare and the net sunplsaalable for sepajzient ‘The lender alo setho details of the existing assets and Tables of the borrower. Assets may const of pabpeny,Yyestment in stocks, managed funds snr term deposit Libiies may consist of outstanding balances on loan td eet cara. Tn the cseof business, lenders sally ask for audited Branca statements and projected callow to determine the nancial sourlnes or creditworhi- ess f the business barower. The lender considers the profitably of che new vente proposed by the busines, 25 well a the risks involved. Capac is shout the primary source from which repay f expected to take place. tiz Important t assess the primary sources of loan repayment atthe outset Inthe past bunks lent money cn the smength of secunty thatthe party could oller fr the proposed loan. Over the yeus, however, lenders have shifted eo lending against cashilow vther han lending against security. There are many ean for this shift. If Joan is granted purely on the suength of secur then {he recovery ofthe loan may involve selling the security. This esky peop sition, fist, because dhe market value of secunity may bave depleted in the ‘meantime and, second, beewuse taking posession of security involves a Tong legal pooss, which is often expensive. Further, bank sal have wo spend acon siderable amount of tine and money to realise the security in saslection of the ‘oustanding Jom. Ae ares, lenders have shied deiremhass fom lending against security w lending on the basis of cashflow. Borrowers are usually ‘equte to submit projected cashflows from which the leer can aes wen ‘payment will ocur and dhe sources frm which it will come. This process ‘esupposes a realise constrction of eashlow Capital Capital cles to the capital contebution tha the borrower proposes make ‘nthe total investment An svestinent i usually financed partly hy bank osm tnd parly by the capt comtrbutoa ofthe over, The owner’ contribution is leo called the “owmees margin. Such 2 capital contribution ie imperant from a lenders point of view It estabhes the owner sake inthe project the greater the stake ofthe owner, the greater is the ewes (and thus the lenders) confidence in the project Sach 1 project has «high prokatiley of succes, 20 a lender Fels contident about lending for the projec. Lending Iretiton¢ insist on a [east some eoatrbation frm owners. Even in personal leans sich sx home loans, banks umually require the owner to contribute a {east 20 per cent ofthe total investment Where the owners contribution falls below this share, lenders usually incst on morgage insurance. Morgage Insurance protects che lender in cases where the owner’ financial conan i ot sang and the owner is cantibating les tothe total investment than required, , nae}atte Enns ao Inows asthe secbdary sure of payne. When slaw anna bsp oof tne pinay sou lencs usta take poses Sintra, depore of tan ace he proceds aif he osantng Ia Stout The feral ttatng ofthe word cols slong se A secnty ‘Ss alongside oun, Whe aba pas an veda avery te ieenay cole In eorport as, edg tution general ecto end pst s gual cage on aus a's ted company brace unfreeen Ses ‘clita ete te mttet you oe company and ths endanger Shesecovey of fe owning len pant. Leds tlre gener fod Spuistepreearants is st oped lsnch see sey ‘Ent atte peel vlston of te Company Th bse does ot ore wri ctu forme of bans uch ses ele opacenap 4 prep Shu the owes ne poly eps Tor all dean peso Soetoro Tender nok rte lowing gules ina ean «Thence ofthe sconty shoul be ble or nat sec wide Mcutons Teeder ys be prepared tend ignt gly secs secures omen machinery ad cy aes nen elapse for nc pss ea be cape orem ser able «The matey ofthe cay tote spc at lenders owe the alfmce mci ther th scnty con be Sold quel an he procets st off amet ie ousted len amon Lets ol be Prep ond pint be cip scutes Company sews da on be Sou qui sch ate shu of Quis andthe Cominnesth fa. id Ihe» secey wie queyseceotae pce. se of sca o scan en ents may bese son ts woe Snead may one to ky may be ha for ening sttonon dere tet ale of an sg fo example, bn aon such seit may wiley ier Dural aootaee uty Dal lees ok for in tary he secs Binds deeora over tne expe pesee gonds sch Segui ond ex deerote in ow taps ten ot Rl ay ee ‘Beate Lena ned oe eur coe we dig api sc a ane Sryorcle ewe vies nether mh fe ete ot portable, thet the lender may fd it hard t sell that seit the focal Tarke Land ond bllngs ce estples seus at ae St porable ts bd wna sect dt pres csv rss er i then oped ud tu scopable compose aNd for sang my eS alt over ne bur ao the uals of pei exe tum ands on, lven the ficaly in dtrnng the rte a9 Scary focus wale te Free en approved aeConditions According to Weersooriys (1998), an analysis of conditions covers extertal and itera factors In our view, it also covers the conditions and terms of the Tom, The riskier dhe advance the srcter are de erms and conditions, “Analyse of external anal internal Factors is mportart. The estema endtons| the condiion of the economy, the condition of the eelevant industry, (he «threat of war and so on — do aflct the epayment of 2 loan and need to be ‘considered when a loan granted. A proposal may be sound and the party may De erdiomorthy, Dut the business may noe be proftchle if extemal conditions ste not lavourable-Fxteral events thst may alect business success clade = owntum inthe economy, industy-specie problems and iteratinal even ‘The tourism and allie industy inthe United Stats, for example, experienced ‘slump in demand due to general reluctance to travel fllowing attacks on September 2001 Credit analyse sus alo acount for itera conditions, which may include lending policies, the lending budget and the availabilty of expert staff 10 monitor the loa. A financial insttion may decide to follow a restrictive _ lening policy asa result of «fends constrain, orto expand lending business sn parila segments ofthe market. Credit analysis shoal take sich aspects sen nemcpe EEE epee ej mnt een the imac aes iy ibe Retive bank of Aso (RBA) to tighten De Che dy tases Gg ie to fal eo be IA ene ABET ae red Ord Samay ey wil oe te sap 2 pane tere 7 este ug le plc cing hd for mn han ever or jets tar eck ie ing ade Teen yen bk ave hid she more nd moro com ros endag HEA Ohh te toprol and ote at oer _ ia Te lam Bernt me {Mistress ut toes ve sry Spree tc sl the ene sas oP voter Coleman, gene moger of sess haa see ame {EDC HeAeD le woot by te banking indusuy research group LM oe quits] say the big banks hve los market sare in he ene ae ie mags wo relet higher deeb sk yin he 1Financial statements analysis Learning objectives ‘tar easing tis caper, you shuld be ab: pn to ky noel stoners clan tne enpotance facts Stoners ern doce th asus mths of aris ware projet nce envied scribe he spe hniuts fara where ange avolied sci bow window desing of ani ron whl of he ancl as te rnd borhan acess tn We ntatonsof ancl stoma: rasLenders invariably obtain Gnsncial statements from prospective bones anid analyse them, They may not, however, conduct x detalled analyst (as di {sen ths chapter or every borrawer. The anil statements analysis for 4 sole propnetor ay be Lary baste compared with chat fora pbc lmited ‘ompuny The ancl is» sme consuming process that reqivesconsdeable fl, yet a nancial instiaion will do some asi financial statement analysis forall basics loans, gor small, Why do lenders place so maveh imports ‘on this emai? ‘Why lenders analyse financial statements Tenders analyse financial statements because they help answer the following ‘ree imporamt questions, which ae the subject of any credit analysis 1. Should the bane give the requested loan? 2 Ate loan i given, wll ibe wepaid together with inteves? 5, What the nancial instiuons remedy i the seeamptions abou te loan sor otto be wrong? isles risky fora Tender to give # Toon to a business chat is financially sound, Bat Row ean lender know whether «particular business Giancaliy sound? A sound business possesses the following characterises: “The business has adequate ligudity so it ean bono short-term obigons cell ‘The business i run eficenty. ‘The buses i un profiably. “The propriciors stake inthe business f high; alleraatisy, the basins to not buriened with too mach debe. By appropriately analysing financial statements (for exanple, ratio analss), the lender an know whether the above charters are presen. I thy are prsent, then the busiase wil be considered tobe financially sound sn loan Spproval wil not be a problem. ‘The second question of whether the loan wall be repaid together with imeest ig 2 bit wicky. Financal statements atabeie & eseontilly # post ‘mortem sal esnnot provide an answer to dhis question. The Bnancal st ments belong to 8 period that fas already elapsed, but che loan isto be repaid in the forue and no-one knows what the fsture holds, How can a Tender find an answer to the second question? How cam the lender predict ‘what wil happen? ‘While a lender ent predict the future with absolute certsiny reasonable soess canbe made by analysing the following cts 1 Trend (line serie) analysis. IF the business was sun poltbly for some years, hen it may not be vaersonable to assume the tend will condaue. The past end an the projected sump, the pas rend andthe projected ‘ach surplus, the tend of various rates snd th Helhood of contnking of that we are some factors tt need tobe examined2. Sofa fer. I the bins solange margin of ely Cetecn. acta] suse breakeven sal), then stn ects a boise condos i She forre may ot ex emse for wor: 2. Ses tng The business cam be abject to sensi esti he bonis come © ren prfiable the the nr ea be esonbly cern cat the snes cn ton shocks inthe fase 4. Inde aay What ae ten ad src forthe firm's ty? the tnesty i proving then the ener can empecthc he rn wil abo 5, Erno nays. The ender cm anaes nthe doesti n inter ‘anal coum to gine the pose ipa on the bues The ecniques tht ely tern nals te soe fc nid mjc Sneme and expendi set 4 projected eo, magn of Iiyama sasitay mayen cond anijacy eri, compo, indy aaa econ aaa. Predict he ure the bats jin sat pest by he ler, noone can pedi te fue wh sane cera Given the some amet of rik says involved the bank needs some form of iarurene. Suan fence snd tw on tower'to the tuestion tis the Snel insttoons remedy if the ssmptons thade while giving the lon tm ow to be mrongt — ae provided bythe ioowing 1 Ctrl eveything es wrong, thn the Baker ca Eck onthe Seer ond while pat th an. The bei el he ety Sethe proces ost hess eh : Charge sss Te ler socetmes presets x conto ht hr il Seals hago al he set the bins the proses the cole ar htc, then the Sinan aston cn take cam Goer the theres ofthe huis Canons The lender wil nist on persona unantes company dee tos nthe ose of de he atl ton can eve es em the prod popery ote dectrs Sicha uarane ac to deer the company diets om king actions tet are detrimeta 0 bins {meres Insole proprcrshis al prehipsteownes are peal tal ney, 20 the garni maybe ken ere oo elas of theownes inate The acl ston may plas conan om on, sch {gate pg (as explained im chaps) ene th Pine ing tienda does noe ny ation tae my be devimeatl the Ieee. Foci stents may show what kindof sets ae aval, thi bok vue, beter hy ate unencumbered (tat oe gen a secur or tes tons, andthe hod of thee set bing ie sey forthe proposed loan 31 should be clear © you now that financial statements sualysis and other ‘ypes of analysis ae used to find answers to the evi thre questions hate repeated here for ready reference: 1 should the bank give the requested lean? 2, Whe loa given, will rhe epad together with Ineest 3. What is the nancial instetions remedy che sumpionssbovt the loa tur ost w be wrong? Finacial statements contain » wealth of information, but takes sill and experience to unearth that information f propery analysed, the Guana tte sents can protie valuable insights nto a frm’ performance and financial con- dion. In the following section, we wil dccuss how finance sttements are snalysed o unearth their hidden information content Analysis of financial statements Tiuncial statements analysis is the principal tol of the Tending banker in sessing the Gnancial pesformance ‘nd condition of any busines, Foster (586) distinguishes three brand types of analysis teehmique: * exose ction techniques me series techniques + a combination of nant statement information snd noabiancil statement informanon. ‘We will use the se casfcation in the fllowing dscusion Cross-sectional techniques ‘Cross-sectional analysis techniques analyse nancial statements at 2 ‘pont time. Two commonly used techniques ane financial ratio. analysis and Ratio analysis ‘Arado an atthmescal readonship beeen to figures. When the figures are taken fom the Gane stateients, we ell tinancll rao aay, which i ‘he most widely used eross-setional technique (Faster 1986). 169 financial statemente ate generally used for calcuaing ral: the statement of financial postion and the statement of financial perfomance. From these principal financial statements several tos can Be clelated. “The various rates dat lenders generally use can be grouped ito the following categories + liquidity ratios «+ effilengy ratios + protiabiliy ratios + leverage mits Here, me ll disease cich of head ratio cstegores. To facilitate the decsssion, the following statement of financial perfonmance and sement of financial postion willbe used.Nonopeing res as oe ind pr shane ir is wo Os ae om Chant 2, Fanart Fa apo Ts ‘Seeman nell arin e254 en (69) ‘ove aes 599250, Dens suchen 950 050 gays be tnt Phen a, een tar Narpona Ta amt ethLiquidity ratios Liguiity refer othe aby of frm to met its short-term eligations — that 5, whether the busines ist poston to jay Gnancal obtains tht will ase in, sy, the next year, Liq sam important aspect to he wnt in ay ‘osmness The laure of many business has been due to lack of adequate TiguideyLiguity cam be described the lbricant that helps dhe basins ran smoothly just aa a car needs to have auficlen Iubricating ll engine il breaking oil and soon), a business needs to have adequate liquidity a all nes, To check whether a frm as adesuate liquidity, financial insiutions compute gsiity ratios. Two principal rae that are commonly used to judge the Iigeiity postion of any business ae the creent ato dhe quick ratio, “The earren ratio “The current ratio is the rao of curent assets to current Bailes, Curent sets include cash, marketable securities, debtors, closing stock (ending inven tos), loans and prepaid expenses, Crem lables are bortowings for the Short em, wade Gators aecraed expenses nd provisions Formal ‘The current ntl s cleat by the following formula Curent asses ‘Saree Tabiies For City Sadlery Le, the current ratio was: 2003 2002 ma 15.60 «ay, Tee i060 =" ‘The denominator 174 and 10.60 ape arived at by ang uesecured loans sand current lables and provisions — tht i, 6:90 # 10.30 and 2.50 + 8.10 respectively Benchmark ‘Generally, the benchmarks cunent ratio i 2 Clemens and Dyer (1986) have recommended a ratio of 2 w 1 If the ratio i 15-2, then ts considered tobe stsfactony it le below 1, dhe itis icative of quidty problems, Hits lover 2, then st ndicates excess gui These benchmark ae st rales of ‘hugh and need noc be given une importance. Factors suck 3 indaety pac tice and past uends ofthe firms are more nportant and should be the decsding factors over the rules of thumb. This i true for all sypes of rao. What is the assumption beind his benchmark of 2? The asswmpuon is that even ihe bus ness were sbut down today and current asses cod a half price fie sale), the bbcinest would sl have sfiient funds to pay corent obligations. The erent ato of 2's ee an insurance against short-term isolvencyof the fr.Interpretation ‘A ratio of 2 regazded a5 ideal yet seldom does a business have the lo ceacily at 2. The ratio could Muetuate berween 15 and 2, which & not x 2oue ‘een Att that I too high o¥ toe low however, should be a ecncern. A ¥ery High rsto muy arse due co ane or mere ofthe flowing reasons +A very high ratio indicates excess Lnguidty The business may be losing ‘opportuni 10 make profitable we of current aces +The igh ato could abo be beorse the party (Dorower) i holding excessive Asbo or perhaps because debtor hve not een callected. As esl, the fgane of current assets — thats, dhe nomaator — val be very high, a9 vl ‘ie the ratio. Cheek for these posses: check, fo example the average collection period or the debtor rarnover ratio (discussed Iter. If thes ratios fe not excessive — that is, the collection period i normal (accoring Indostry practice or the past tend ofthe par) — ther we have nullified the oss that excessive ene ratio cve to high trade debtors The party might ave sold some goods just before the date on which financial statements were prepared, 29 the figue of wade debtors may be high, essing the event ratio In sch caer, cacolation show be hase om average debtors during the year. To find the average debtors, ad We debe tthe end of each month in the year and divide the relat gure by twelve ‘A bigh encrent ro may arsed to eacesive inventory ball. wp, For tie reason, the average inventory (ealulated sing the same procedure as indicated carer for debtors) level should be checked and sed nthe >ealculaton of eae ral, ‘As in the ease of debtors, the ending Inventory figure may be excessive ‘beeause some goods were sold just ater the date ofthe statement of Snape poston Chet for sch posabies ad weaverage Sis ae has eared figutes to ave a the caren rato, + Tavenory valuation is another gey area. Overaluing othe ventory can aricially tise the figure of sock held and thus aso the curtent ttl. The ‘ary may change the bass of unventoryvaluacon and thus eta higher ‘alu for the seme quannty of stock The Auswalan Accounting Sandards Toard recommends the we of the “ist i, frst eat (FIFO) method for {inventory valuation, not asi, frst oot (LIFO), Yow may come across these ‘concepts in your stody of cost accounting, Overalation of ice will not only rake the eurent ratio, but also wil overstate profi, ‘A low current rato is indicative of bquiiy (wortang expt) shortage and is 4 chose for concern. In sum, Both low and igh currem ratios need to be ventched carelip The quick ratio Aseler mense of guy isthe quick aia, aluo called te ald test ratio. 1b ts mauch the seme a5 the carent rate except that ventory is excluded fom ‘aleulation [Re eawazeem]“The quick rato 6a ratio of quick assets 1 eument lables, Quick asets snclude all corentasets excep inventory (07 mater, workin process and finished goods. Formula The quik ratio i calculated by the fellowing formula: Quick assets Tarvent abies For City First Sadley Lite, the ac et ro for 2003 and 2002 was 2003 2002 128 yyy 70, 228-07 Fe - 0. (ease note that the gure of inventory fr 2002 s assumed at 8.60, 50 the nominator willbe 15.60 8.607.) Bon loear and iderpretation “The quick rao isa fay stringent measure of oui Ue bed om those cere aces that ae considered tobe highly igo. Inventories are exchided from the numerator ef this rato because hey are considered 10 be the least Liguid component of current asso. The rule of thumb for quick ratio is I ‘many firms Hike ie (aid test rato) at 1:1 or bette CArgeti 1976, p. 139). ‘This mems tha quick sets should be equal to current Habilies. Sling of inventory may bers elfcalt proces and the lender wants to ensure the bus nes ca met einrent lilies oot of qulek assets alone (cureent ase her ‘han inventory) Ifthe mato is unity (aual © 1), chen the busines can easily nel the current lables out of quick ses Efficiency ratios We stated eater that one of tbe characteristics of «financially sound bust snes is that st 6 run elclenly To measure elfiiency, financial analyst c culate the efclency ranos. The elicieney ratios measure how efficiently the business has employed its assets. These ratios ae based on the relationship Dereon the level of activity (represented by sales oF the cost of goods sold) and the levels of various eset. Elicieney ratios are leo called tumover Ios, acdvty rados oF asset management ratios. The important efficiency tne ventory tumove ato + the average collection period, “The Inventory turnover ratio “The inventory turnover rato shows the effcency of management of sven tory The rato of tet sles 10 knventory i called the fuventory turnoverFormula ‘The savertny tumorer rato is ealelaed by the following formula Necsales Inventory or City First Saddlery Limited, the ventory turnover rato was 2003 2002 623 2 on $2 wom (ae inventory for 2002 has heen assume at 812) The number of days for which inventory is ted up can be calculated by the following formats 1 Days in eae Tnvemtoryurnover tao For our example, the days for which money ws Sed ups investry in 2002 equaled 365 divided by 6.11, or 59 days, For 2003, the mumber of days qualed 365 divided by 683, 07 3 days. Benchmark ‘There is mo benchmark for dis ratio Because the ype of tavemory dete mines what the ratio should be, Where items ae fast moving, the rato cowl the a high as 12; oer cases, coud he a low as 3 or 4 the business is producing and selling daily neessices (perishable goods) — sa, wholemeal tnead — then che ratio wil be very high. On the other hand, the business {s producing and sling durable goods — say, relrigerators — hen the move= rent of sventony will not be tht fost AU le of thar cold be that the rls equal to 4. merresation ‘high za would indicate thatthe inventory s fast mong and hat he eo ‘cts of the snes aren high demand. The higher the ato, the beter itt ‘means that the inventory mangement of the business «wry efficent. Caution seeds tobe exerised, however, interpretation of the rate. higher 0 may result in frequent stock-ous and a consequent loss of sale and customers While calculating inventory turnover rai, note the felling points + The atio cam easily be manipulated bya change to the Basi ofthe inventory vation, + Sales should always be gros sales minus sles neta — tt 6 mses, Instead of net sles bog wed asthe wominator, the cost of goods sold is sometimes taken 4 the nominator. This seems reasonable because both the romoator and denominator ae then at cos.The yearend inventory figure may be misleading, so the average inventory figure needs to he trken ge the denominator. The average inventory can be aeulted by taking the average of month-end. inventory gues; for ‘example, ad the figures of inventory a the end of each month amar December) and divice the sum by twelve to amie atthe average vestry ‘The zavo should be compared with the rao of competitor fms or the average rai forthe dusty. “The average collection period “This ratio shoves the elcieney in collection of recsvables.& busines cit is Aicent in deb ellecuon wal fice fewer bquidy problems, The averge cel lection period i the rio of receivables average sles per day Formula ‘The average collection psi i calcu by the following formula Recetas ‘Breage sles per dy or City Fist Saddlery Lite, the average collection period was 2003 110 976. 71365 “8h ae BEST 58 dass (The figme of 9.76 for 2002 has been assumed) Siena The average collection period shouldbe equal coor less than the Rss eet terns forts customers. IF itis the policy of City First Saddlery Limited to allow wp t one month edt only, then the rato as above is unsatisfactory. The frm’ crit policy is usually determined according to the general market pracice. New firms generally allow a longer credit period wo penetrate the market, Similarly, firms may allow a longer credit period wet Inieducing ew products Imerreation 1 the average collection peviod ealenlated by the above fonmol fs less than the credit tem generally allowed by the frm, then the debt collection of the firm ean be regarded as eleent. On the other hand, if It exceeds the credit term, then the collcdon cannot be regaded as elicent. Note the fllowing points +The nominator should be average receivable instead of yearend ecetvables, AAs in the cae of inventnry, the averge receivables cam be ealelsted by verging the month-end receivables + Simi. average sales can be enlculted by averaging the month-end sales Sues,+ The average collection period rao bides the age-wise dstbution of rectal, so should Always be readin conjunclon va the sumaty ‘st agece (days eollesion In acars)reevables. Fortis purpose de Testvbles canbe cased into thre tgp ‘ receables pening collection for more than three months = tecsables pening coletion between ane and thee months = reevbls pending collection forks than one wont Uist ofthe esas ae he st category, then thee no case fr worry fost ofthe estas cen he isa entepoiesowevey, then ‘ecsvablesmimagement slack. Thseestin ayes gut robes, Profiabaty ration _Afnancially sod basins is iets profitable bunicess. The wo popular rota aos ae the ros robe sles ratio andthe net profes “he gress profiad rato Tig the vato of gos roi 0 ners, whore goss pois defined ae the Ailerence berwecn et abs and the oxo goods sald Formula ‘The gross profit-sales mato is caleulsted by the following: (Gres rote Retsles For Ciy Fist Sadlery Limite, the ratio ws 2003, 2002, 49 a $49 ~o21, or 21% #8 ~023, 0%, Benclarl There is no benchmark for this ratio, but the ratio is expected tobe atleast equal to the industry average oF more Iheerprecation ‘The higher the rato, the beter ¢ i The rato measores the pricing a pro evon cost contol aspect. The fem may have ess convol over Pricing, becatoe the maeket decides price, buc can control de cost. The alo shoul be compared with the ratio of other fms in the industry. The net prof-sates ratio ‘This ratio captures the profitability ofthe rm when all the costs (including the sdainstrative cost) ate considered. Formula Te net profit-stes ratio i alla by the following forma: Net profit NetsFor City First Sadery Limite, he ratio was: 2003 2002 33. 0047, 047% 22 <0007, or 33 <0007, orar% B= 0001, or 7. “The ratio can be caleusted by taking either net profit afer tx (as tm the above case) oF net profit before tas the nominator Benchmare Again, there ig no benchmark for ths ratio. The ratio should be equal © oF amore than the industry verge Imurpreution ‘The higher the rato, the beter it i The ratio provides 4 valuable under sanding of the costand profit structure of the fro. Leverage ratios iraneal leverage means the use of debt nance, Leverage rasioe helps assess the isearisng Irom the use of debt east fas been own that fa pte financial leverage could be estblshe, then debt captal isa refened source of finance. Analysis of financial leverage generally uses two types of ratio: sve: ‘ural atos and coverage ratios. The strucrral ratios ate the debt-equity rato, {he proprietary ratio ad the debinasets rai, we the coverage ati re the fnterest coverage ratio and the Fed charges coverage rato, The debt-equiy ratio ‘This ratio shows the proportion of amount borrowed by the Sem comparsi ‘wth the proprietors own investment in the busines. Ft is eto of debt to the "qi af te rm. The debe consists of ll abies of the firm, whether short ‘erm oF Tong ter, ani he equity consist of expt and reserves, Formals “The debt-equity ratios calculated by the following form Deb Eau For City Fits Sadleny Lite, he rato was: 2003 202 wuz 220 _, 3527174 Bo ~ °° Benchmark Generally the ratio should not excerd 2. This means that last 33 cents in & foliar shold come frm the fms en fens In some firms, the deht-eaity rato could be much higher asa result ofthe nature of the business. Mining, Fenlise, shipping and cement companies, for example, may have a mac lrgerInuerrettion “The lower the ratio, the bee it. A lower ratio, asin the case of Cty Fist Saddlery Limited, indicates that creditors enjoy a higher degree of protection because the proprietor stake inthe business sage. Nove the folowing pls The bool value of equlty may be understated, where equity Is shown at Iscoreal (hook) value in the stement of fiancial positon yer the ue ‘wor ofthe company is much higher. + Some long-terin debts, such a debentures, ‘Surgeon aes ofthe fra. + Alower dehe-oqulty rai not necessarily a good sgn. may mean ha he fra snot making use of the leverage to advantage + Tho ater rats that give information str to che debt-oquity rato ae the propery rato and the debt assets rae. The former Is the ato of the Dropuetrs funds to tral assets, while the later 6 the vaio of debt tot ‘set. The debr-equity moi the rai ofthese tv ratios: hat i, the ato ofthe proprietary ratio to the debe asects ratio is exeal to the debt fini. The proprietary ro indicates the stake of the proprietor in the business The higher the sake, the beer iis. Austllan bunks generally require» proprietary rao of 40 perce. The interest coverage vat. “The interest coverage mois the rato of extmings before interest and axes on debe interest. howe whether the frm has suicentresoures to cover the Interest potion ofthe dct In he case a fim having nancial dficalies, the Danley postpone the repayment instalment but would init on, at lest, py ment of the ineest on the eb. Is Sem is unable to pay even the intrest, then itn serious nancial ifcoty. ready be seamed by 2 Formal “The interest coverage ratio i calculsted by dhe folowing for soning befor interest and taxes SHE pyabe oo eas For Cty Fist Saddlery Limited, the ratio was 2003 2002 8 = ws, aan 103 Benconark “There ino benchmark for this ratio, bt the ratio shoul be at est 2 9 give th inn sufcent baler to pay oteest on the deb. Interpretation The higher the ratio, the emer i, Earnings before snenest nd tase are considered as the nominator because interest is uevally paid belore exes,‘orb; interestom the debt ie «tax-deductible expene, Lenders commonly tse this ratio, Note, however, that payment of interes comes fom eashiow tnd not from earings, 9 the lender must carefully examine the exshllow ftatement in addition to tis eato. This rato fe sometimes calulated by 2lding depreciation to the nominator ‘The ised charges coverage ratio ‘histo the ratio of earning before intrest and taxes plas deprecation to tmteest on de Ioan an the loam repayment instalment. Its Yeed to meas the debt serving capaiy of the rz, Formals “he Fine charges covernge ratio is calelated bythe following frm Esmnings before interest and taxes + Depreciation inereston fom + [Repayment of loan = (1~ Tax a3)} For City Fire Saery Li, the ratio ws: 2003 002 ne eee Tivo «oss ~ > Tarrio ross “> (Depreciation has been assumed a 3.0 for 2002, an the rpsymaeat instalment tas been assumed at 10 for both Yeas. The we rate has been assumed at 35 per cen) Please note that only the eepayment of the Toan is adjusted wpa for the tax facor, because the Joan Yepayment amount (zie Interest) 1s not x deductible Bexconark ‘Thais no benchnatk for this ato. The higher the rato, the beste iis Ierpretation ‘The ratio measmes the debe servicing ailty because, besides interest on the Joan, it ao includes the repayment instalment, This tails patcualy impor tant in proect nancing, ere ends our dscussion of ratio analysis. We will now tum t0 the other cose sectional technique! cominon-ize statements Common size statements Common ize analysis enme into vogue beewuse interfim comparisons were needed. When frm are of diferent sles it x hard to compte them unless their financial stements ae expressed ina common form. This commen form i created by expressing the components of the statement of fnancal position and statement of rancial performance a «percentage ool ase loa) revenue respectively Table 21 (page 60) iasuates a common size statement of Financial postion eee :Credit scoring techniques Learning objectives ‘tos renin hs capa, you shouldbe ai: 1. the delpont of eet Song esque 2, acs the bhava apes Feo soring pan he inperabe free scrng zis he aptalon of ev soning 6. sais te ops en impenentaD a eat scoring pracaIntroduction in chapter tas odie hat cei coving teciques te nergy being toed ending nattions or creditmesnent. nis chapter we wl ok a he ‘rolton and apliaon of various state! eet ering ehnque, Stats Sec cog allows for sigros and dpe deesiow-nalang. Other capt, ise he ecimiqus ane! pecs real to aoe nc nein, ‘hater ecw smaljt win a cenralied model ht an be oven sos the ‘whale onanistonw reac he poeta or ero in credit scring Statistical rit scoring bas ben a poplar analy tool of nancil isti- tons sine Ch a 198, feed by he esplsion of technology and the Abily to aply conputer soluions to human problems. Wt important to techs, were, hat the conesp of ere scoring hasbeen aroun ora ong, 45 crit has ben extended. There have always been criteria on which ere fewons have been made a lon have ben extended oF ete, Thee en ten eae bite on compari and ending to bebe isk What separate soting techniques of tay fom those of yesterday ate the reliance on tele ‘ogy and tats naj, andthe dewgading of the oon fee? nthe Consumer marks) to a sales repeat. Overview ‘Sine the ently 1950s, per perso outstanding credit in developed counties has "aeen exponentially md hs comtnned to nerease in wlocty The old systems of ‘nanl scoring ae no loge alfortable. The inerease fn rei applications coi ‘cided with the evolusion of compiler technology, This charge not ony ofsed ‘ay fo speed up the process of ced scoring bar ako provided organisations ‘witha toe tha could be used to expand busines. As demand eomtinaes 10 Incase and the ned for tmly credit decisions creates pressures for pers. nance within a highly competitive sytem, statistical credit coring wil become Increasingly important because it allows a lower coststractre tobe overlaid on the pricing of the Toun. This pricing aspect can ulately mean the dierence ‘tween serial or failure within the ancl nsutstions defined markets Credit sconng as used toda isa stata] method of ranking the probabty ofan unlenosm outcome (tht i, 2 loan paid ora loan defaulted by allocating 4 pnts system to known variables. The credit information of an applicant steed and graded numerically to gain # wll score, which is then cane Secorcing tothe expectations of the fancal station. ees! aspect of ‘oring tate chowld no: dsciminate oa the grounds of Se, rae Pegi, od credit should not be relised on the soe basis of loetion. Umut. waid ‘aia red coring sjstem exhibits the following tree basic charactors, 1 Teagust not rely oa prohibited infomation, andthe informstion used must ‘he statistally justified 2. Thesnformaion seed shoul contribute positively toactientserivorthines 13. The cet extended shoold entrbate to the rede helt ad quay of the lending institution. weenThe ultimate aim of any credit scoring technique sto improve the quali of ‘he loan book that «financial inahiuton maintains Staite credit scoring i widely-used fn the consumer and small Iusiness areas, ane is progressively ‘ning implemented across the lange business nd corporate sectors. Change credit scoring methods are being progressively ineodced se Gnancial nat Tons contiually re-engineer processes nd practices forthe ulate ans of effiency and productivity Credit scoring tchniqes, as statistical measures, can forecast » probable result, depending om the accuracy ofthe dat on which the system i based, Thee is sill areal need for active management and imelyinereention if the ‘uae state ofthe Joan diverges fom the tastel prediction. The development of statistical credit scoring Cedi soring a a measure of loan succes ints modern form began abont they yeas ago, an tt has evolved and matured alongide the evoluson of ‘computer technology. The development of scoring systems continues to pale] the inerease in per person outstanding credit, the expansion of the credit fndustry and the deve for cost redueton and productivity The evoluion of credit seorng elects not only the growth of cet, bt ako reaction tothe need to diferente and vecogast poplaion sabes where ‘nly relate chatacters ate medial apparent (ip oer word, whee the chatacters that separate the population aze noc obvious). Durand (1941) ‘was the fist peso tO recognise thatthe ida of discriminating artong pop Jaton groups {fast ntoduced by Fisher in 1936) as a pur statsteal tol could ‘be used to dently ood leans and bad loans (Thomas 2000). Consuner credit fexpanded rapidly im the 1960 with the modustion of ciedt cards andthe aby to use faire money or earings for small consumer porchises.Financlal Instiatons else the advantage ofan effective scoring ster, initly based ‘on mama completion snd certification. Technology supplied the meng Kk in the 1980s a5 the volume of applications outstripped both economic and siafing roses within insttions. The scene wae set for even move rapid ‘expansion of credit ana, in tar, the fecther development and sophistiaton of the ret soring techniques ‘The implementation and acceptance of scoring was not an easy ansition| Decause many tdionlists opposed the ides of a stastal measure applied arbitrary across the whole population. Capon (1982) argusd hac "he brute force empiricism of credit scoring offends aginst the traditions of our society. We felt tar there should be more dependence on credit history and that It should be possible to explain why 2 scoring system needs cerain character ‘ster and not others, This view mas more than eset by ondence that the efslt rae would drop by move Shan 90 percent. Reporte from Myers an Fongy (1963) and Churchill, Nevin nist Watson (1977) leaced the wy fos ‘wholesale implementation of the process within a lige range of Fra Instatons, They were able 19 demonstente that gaiséal credit searingmodels would not only add value'o the credit analyst process, bu uo add figoar hough the application of probable an measoable outcomes. Most fol the developed wor has introduced legislation that mais it legs wo dis- inate ithe granting of creat ules the reson for erat refusal ca, be tatieally proved or supported. “The svccess of the applieation of sail credit saving techies in te coeds cet market rade i inevitable nthe 1980s that Saneil snctisions Srould expand she ace nto othe ates, inclumg personal loa, honing Toons and small busines uns: The clagues are now used forthe ful ange fending prodacts, fons individual o lager corporat loans “There ane many reasons forthe auccess of stata eed scoring. Once the system has been tested and put in ples, It ensues more aceurate risk Ment Cation and signfcmnt cos reductions, Therese ako 9 substantial reduction in the terection between the lender an the applicant, allowing fr more me to ‘be spent on developing the relationship and less me on sumbercrenching ot regs acts, Succes appliaton af a stasbeal edt score press tis allows 2 financal inttuuon to sesuuetre its stall prof, with more ‘phasis on sales. Ths leads to an increase n the availabilty of eet becaase ‘reourees are relezad to deal withthe inereaces in application vole. The Towering ofthe sll experience level and profile can lead co the potential fer loan pring tobe dseounted, wih «proportion ofthe savings pasted ont the Not all borrowers face a price reduction. Some will cea price rise bectose credit scoring models are able to disurguish good loans from bad lost in # ‘on-eaotional way. This ality to make non-emodonal deisone wil iuprove inthe fnancarena. Historically banks n articular have pened poory in their pricing decisions Because they have hd a ‘one size fits al! mental Advances in the Geld of credit scoring have allowed accurate freeating of porfolo values and, consequently, a ictease inthe Securitisation of lower eve ancl prodacs, ‘With the sucess inthe consumer market, it was inesitable hat the same o- cesses and procedures would be reenginesred for th small business market [Now dhe same degiee of savings and ellcieney guins ae being reaped im hie ‘mponant ae of ending ‘The behavioural aspects of credit scoring ‘The financial environment has been in constant change forthe past rwenty yess, as old methods ae replaced with new ones, The new methods ae ustaly technology sed ensure an adeqte return of shareholders fonds can be achieved economically judgemental decsion making vers ret scoring has ‘een x source of tension within banking cteles since the laters all nro tion. Traditionally banking has born about judgement and eontact, with the relationship berween the banker and the customer 2 paramount business con= cept The bank manager used to be the human face ofthe hank and also the decision maker inthe majority of conta.‘Tames change. The ol-ashiouc way of banking has cesed inthe lace ofthe techniques that evolved com the 1980s. The concept of «folly ged bark manager woiting to service the mcd ofthe client mee too expensive in the brave new world of finance. Technology was used to replace expensive finance manages with new saee-focused stall. These sles sal use analyse techs fo score a proposition that can be passed up the line for approve. The lnk betwen the manager a thee male, andthe cient hes bacome ted dant as acw methods evolve to ensure nancial Sstttions remain profile, snd as technology and process replace jacgement and relationships. Today fale force ca enter inio many mote wansictions thm were posable ude the ld regime, ply a elt of the application of ered scoring tenis ‘Credit analysis is about risk management. The judgemental approach bul very sophisticated techniques for analysis, with maay checks and balances but Jno the stem. The succesful functioning of that system depended ou the {nividal lender being a highly trained individual who supported the network, (Grd scoring bas supplanted thie nv, Is ek mangement by design, alloring costs ta be reduced and businesses to expand ata previously imp ‘sbe rate, Other betvioutal reasons forthe implementation of credit scoring Incinded the breakdven of the judgemental este during the 1980s due to the Irantic dive for marketshare aul the workwide fleregulation ofthe financial stem. The 19606 were # wtershed in the development of the modem fnan- ful system, Banking and the envionment of banking had changed Ul in the revs fly years; processes and procedure had remained constant, Derr Tntlon was alo an lressuble fore, as eoumes across the globe removed ristrleions on capil movements and exchange ates, ‘Ansalia was one of the leading proponents of deregulation. We were faced swith o choice: deveguate and’ modemlse or place higher barers to market fenay. Ausualia chose to dereglate and modernise, which was the right Section heraose our ecomomy has grown apd i the intervening yeas to be hour tweny times larger today than i as In 1981, This envionment f Change and the envy of new competion im financial markets forced the ‘exiting players in Aussi to respond, fst im the dive fr marketshare and second i the maintenance and growth of value for shareholders The imperative for credit scoring ‘Amajor problem in Australis athe search for the petlce cede soring sytem {isthe smile oft populston for snags, Implemeataton of eet eeorng ‘within financial instations inthe 1990s nevertheles led to sigan weduce tion in the volume of ad debts within the consumer marke. Ranks vealsed that credit scoring enabled them, forthe fist cme, to ave a eu measure of ‘sein a given loan portfolio. Once a true measure could bese, then the next step ves to implement standardised form of contol and monitoring by senior ‘management. In other word losses withis a given lazn prdelio can now be ‘redired witha cenain degite of acsracy Compeitiv aantage, bey just (Stance TAT]te invidual safety ofthe loan, is derived frm the cost savings and eclency _a that ret scoring techniques ean generate a & Bradstreet developed set of criteria that justify the mpertive for statsscal vet scoring (Thomas, Crook & Edelman 1992). The aplicon (Sf strong siscaltonls helps reduce the cost of cxedit analysis and, ‘andardisng the process, apply more vigour to the oweal Joan porto, The proce extends allow for marker segmentation uf the total loan book, such That crosssubsidisadon ean be identied and eliminated. Fist, atest score ‘reolts compared with actual operator analysis, to dently and vey statist tally the securacy of che system. Once sis verieation has been conducted snd validated, the system becomes an operational tool with Isle human Input. The process updated on a needs basis. The cost of eredit analyse ie thus reduce ‘Comect application of stati cedit scoring techniques alo allows for a Increase in revenue through the increased volume of credit applications. Faster ‘edit docsions allow for ieeased volume within scare o existing resources, ‘whlch means the pordolio cretion proces ls more productive and wltately mote profitable. The consequent change 10 the staffing profile allows forthe Joan book to gro! wout subsequent growth inthe cost of maintenance. Stats cedtsauring models ths help lending institions to ene cost and inzese thee volume of ew customers. portal, they cat also be sed to check existing clems, The sale of products to existing customers can be Detter momiored and expanded, and new client segments canbe targeted Wath applicable products. By appying beter methods of credit analyse to uew cl ents, statisti credit sco techies allow for gck and acearae segiten- Taton of eastomer groups and quick reaeuon to campeon action, Tey alo provide the potent w prlonise future collections or idented cashows, siling Jor improved collection methods ar casiflow management. Once this Potente lessed, a neal ntti can gow is poroo by more eee tively sing ecurent cashflow Clients nominaly share tthe protes abe fits where a financial institution’ continaal improvement and cost reduction lead to pricing discounts, ‘Given tht the above priniples represen he functions ofa satis! crit scoring sysiem fora faancal Inston, 2 tong stds scoring system has the following advantages foram nstitatto: ‘Credit scoring cam increase returns by identlying. good versus bad propositions based oa the preferences and inputs ofthe nancial nstieton. «An accurte eed scoring astm reduces eed tsk to sigifiant degre, ‘or at east to a statstaly accurate percentage of 2 outtaiing Ina bole + Credit seoing saves ime in considering new creiiteppliations, which allows for volume increases witout necessitating persoonel incre + Credit seoring allows inereaed fleiy and expansion dn the are of stall and medium enterprises (SME). Agtn, sis based on the vlime verses resowrees argument !+ Where a poor eri score is calculated, the lender can ake conectve action inthe case of existing customers or refise new busines fom a potential hen {4 stronger lenderiostomer reladonship can develop fom the ability of the financial Institution to predict pesformance This feae can allow # modera SEnancial nstittion to service customer needs, not their wants, nil (2001) noe They sy pis performance ds not gurantee esl, but i he wor of frei decors Mr often proves to be eee tual Cedi soci, ‘el tht mace the lkstinned of nat seeming acl payment "tory slog ith cr nen and demographic asus are ara mest edit managers 0 seal tols for preshiig sles prospects and Ming Infonmed ert deasons, These days howevet, eet rage ate sawing Hist the dicplined me of roped stil edi scan mele cas) ‘estes sigur boos lite impact by npoving ste td olla Statistical credit scoring techniques versus traditional judgemental methods te implementing and monitoring exe scoring techies, ¢ & kmportant «0 measure and ensure the validity and application of the assessment. When spplying a credit scoring system, the franca intitation must clearly deine ‘nd Urdersand the outcome. Stasbeal measines to be used rust be weed 9 Uo their applicability and alignment with trdonal judgemental mescors Tis vse to compare a saistica system to judgemental system to ensre the ‘red scoring syst als valu tothe ganization. Auy comparison between the two systems wil he in the eye of the bcholder.Stasial systems score highly whem dealing wih inexperienced staff and orgamistions. Experienced lenders plae a high vale om jodgemental methods, hut the sles foes of the ‘modem finan stitution mitigates aginst the development of experience, “Tae 3.1 surananses the ferences berween stati and judgemental credit scoring tehnigues TABLE 8 Sta ors sone s 1. Folate Inpmstay parend © Gdns a eresel perineal ona sovsnpid 3 Ueeatondinaks ———Ceelestemoded Cefn af ocd ects il sada that eon3. deabbefeccoont, Aree tive. Rae nape eect tier michereprs Mays ptned pe 6p ochceree The gat and way af_— Desi ne mde witout Iicrlsionspe edit bvolnomaion kaowing ie wae ae! pwc Sites nd kc i Opeutoting Ten aeemittned igh, Tent cee eon Scorer, comlagen eo Stop ollaions —Gcticenbesmefor iim ‘Mocha’ decimon god er wliefsmallewemae 1a bangeencone. ingens side Wi aaa rnsyorecmirecn Seca e coco Fores origaewids Merson mnie Teledyne 7 epee, tencniinieepe ‘sty popontnape ua: epeg tem © owas, J. CsA B ra 62, Cot Sag an Dos ‘ee Ged eae, ou Soveal cenools of thought exist im the development of techniques and sethods. Based on table 3.1, however, evo brood etegeries of scoring ean be lentes 1 In accountng-based systems, credit analysis forms the basis for the model and ranos are used as the bse for analysis of data Information can begat fred independently or by acces o prepared data from organisations sch 5 Dun & tadsrect, Standard & Poor's, Moody’ and Austrakan Ratings. The Dice of the analy ito seek deviations from the sverage (or mean) that generates questions or comparisons Oat the toerower mest answer before the lender commits to giving an sdrance. Theve model are variate (oe variable) and have ynersted mck dete about dhe eoninung relevance of nasi Bsed on single factor analysis,Although untarate models are til use today, many practitioners Seem to disapprove of simple rato analysis aa. means of asesing the peor tance of busines enity. Many respected theorints downgrade the ari tray roles of tum (such as company ato analysis comparisons) that are ‘widely wsed by practioner; stead, they favour the the aplication of more rigorous statisti echniques (Couette, Altman & Narayanan £998), Some ‘amples ae Altman's Z score mel and is variats, the emerging market foe (EMS), the ZETA credit risk move) (an evetion of the original Z Score) andthe seven-variable model 2. Inquantative credit srening, two broad streams have emerged (@) ereit approval models, which use desson-reaching analy (@) behavioural scoring models, which ste used to improve the profiablity of account and products Both categories ey of the use cf statistical menses, The major eiference is the predictive nature of the accounting based modele a opposed 10 the ear-view analysis ofthe quanlstve modes. n both cases, however, the alms to predic an outcome bssed on avaible information, We wll ow discus ths second set of tatseal credit scoring, Statistical decision-making methods used in credit scoring models Scoring models se designed to ease rik so the expose of he lender can ‘be managed he fst stage of tial analy the erthering of dt. Con sider how mach personal sel Sana information te average Snail ie toton gates from ts estomers. More often tan no, he dats ae elected for sn adnate requiem; agin f that infrmation cold be ved au sed fr dhe safety of the nstuton. The rea sil nay ode sto Sdn the Information that Is ceded ad to sou data in timely and poductve Iaer Management information systems have ben bulk progressively ovr the past to decades to ensure the data ae avalble and accesible. This for ‘nso era aspect one of he esos hat edit scoring bas mushroomed from reall o corporate we i sophisteated credit sk analysts. "The development of cede scoring hastened when the Gmancsl community accepted the conept of wncerainty inthe ealy 1980s, The sector previously {sored thot rick was prediabe gren the reputed environment tt exited {nthe developed world In he context of «deregulated environs, he Hck ‘la ow isthe probability af the borrower making the repayment and the “ncerainy is the actual predictability of the borrowers fete casos Credit meling proves & satel face to the preicve model In other ‘word, rs and eerangy mre modells to give pctre of fine prbe stulincs,Dillent methods were developed to meet the various demands ofthe ‘ud uses (ending ston), meloding the following thrsea main methods dsc by Hoyland (197). maar‘There isa body of berate, beyond the scope of Ths text, that defines the characteristics of “good! lending contact. Is summary the contact shosld protect the interests ofthe lender without Ascourging the peformance of the Dormer Our main inert i in whether the borrower takes payment sccordance with the cotect. There tether stages to his: 1. the ret isk analysis applied tothe borrowers aplication oe loan (topic ofthis chaps) 2 he asrssent of the credit risk profile daring the erm ofthe loun (a opie stated in ths chapter bt expanded in chapter 11) 3. the ered sk profile when a loan becomes a problem (a topic discussed in chapter 13) Point 2 reminds as of «very important issue. Tas long been assorned dat creat sk s state, but both academic and procial experince has shown that ‘edit risk can vary daring the Life of 2 loa, This phenomenon fs known as ‘edit migetion and can be best explained by # sip llsteton Tks banc extends + ten year la to 2 compa, then A 3s wmeaconable to eect th company to remain te erie aver Oe ter of the loa. kis a good Company, then die credit risk profle wil smprove, Af vhe company performs Tray, then is creat risk profile wil deteriorate. It important that these hangs are encapsulated over the term of the Loa, How do we analyse credit risk? ‘This chapter will survey cdi vik analysis over the recent period, Keepin sind tat some ofthe tole discussed in this chapter ate compllx and some Gracia nations sll use the moet basic of tools. In ater words every ane ofthese tools ae stl used in one form ox another The tools can be grouped ‘under che folowing four broad categories: 1. Expert systems ae defined as esenllyLabour aed systems that depend ‘on homie judgement. The main technique used is Ove Cs analysi (ee hapter 1) ora Yarn of thls method (ast dis chapter, 2, Some methods called isk premiam alysis, ede credit ik from Fnac market-based premiums 4, Eomometice ate eystem that use more and more exteusive and comple statcal methods, These methods inclade vegression analysts and nuke discriminant analysis. tn particular, we wil examine risk premium-based snd wledecriminane models, 44 Hybrid systems build on Nnandal dheory and use these understandings to predict eit risk, The best example ithe method that is used by KM Corporation (ee chapter 11, page 380). Expert systems. ‘xpet sytem ae a isnome, given that we shoul not infer hat the methods ‘sed under ths heading are superior to other catagories. Inthe overall contextree: oe cof lending, they are probaly the worst performers. These systems ae chara tersed by the lending officer using predetermined credit extena to make @ ‘ees on s loan application “The preblem with this medhod, other than the cbvions issues of times that she perfonnance such ystems is very uneven. The pesformance peblem elles the experience ofthe lending officer ail the application of dhe adi enter “The success and fale of exper systems relies onthe experience and per sane of the lending ofcer. Many lending efices have the nstincts 0 ake good lending decisions and elfecsively snlyne lending applicntions, macy, Fhowever, vnforomately donot have those insiinete Im many instances decision making procesces are clouded by the lenders relationship withthe bor tower, This is a reason lor dhe eof unsmbiguous statistical tals “heise ofthe lending ete = xrmewht hound wp wath the previoos point Unless crf itn, credit cater can be arbguowelywnepreted the lending offer dees Arn, the lenders relationship with the dient ean pollute the interpretation of the ete, kis abo words mentioning Gat dhse methods were developed before he development of sophisticated computers and sadistic tools. Many simple lending oganisaons, such as smal eed unions, neverthcess would all base ‘heir detsions on soch modee, wit lmted support fom other mechs, summary, these sytens tendo be manually based, with some computer sistance for the eaeuation of simple financial ratios. In essence, the whole ‘rocedure is based on paper, from credit application to approval snd funding, ‘The following tages ae an example of this proce + On receiving application ffom the prospective bortower, the lending insitution attaches checklist to le and fll the step + The lender smlyses and assests ach elemento the checks. + The loan i granted or dectined. ‘tn dhe event of foan approval, documentation Is completa and the Loan is funded. “The tost common procedure ofthis type five Ce analysts. The five Cs {As mentions, finance instions wee « number of exper systems, of which five Cs anni or dervations) isthe most common. In essence, these systems seek to over the nog baste of rs sues for the lender, including questions Sich 2 whether the borrower allowed to enter tothe contract and whether the have the means to pay bac the logn uader most crcumstanees. Expert stems sek wo set a framework that helps lenders ask the right questions. This {isthe aim of ive Cs analysts, which will mow he examined in turn character capacity coh collateral condisions ~ Tage[Note that this discussion i lflrent fom that i aie chapters Its based on Roses (1993) driaton of the five Ceandie designed to highligh tha there re diflereat approaches ‘Character aost equates to the moral bye ofthe bore: s the parpose of te Tosn well defined? Does the potential borrower appese eo be truthful fn ‘awering the qursons? This owe can be vexing f the borrower sew to the Financial instittion snd has no etashed tack reord ‘Capacity i a Tegal question, Does the borrower have dhe legal capacity to borrow? Court proceedings troxghout the wold have Judged the postion of persons signing loan documentation, The following issues nesd te cos Sdezed here, depending on the loan. + Forreaal leas, «ator cannot exeut: loan documentation. ‘the stuation for business loans is a hele more dificult A company represmtive who hes a ule that appess te confer auhorty does not” ecessanly have that auhonity. The postion of Yoamager. for example, has fawsed probleme in the past ss ma care relating to AWA Limited For busines ams, ts suggested that the Tening sittin sec bo mites fon the delegation of fiancial management, fo ensutershagement can sign the binding documentation Tels no surprise that the most important C i cash, because that is what repay dhe om. Much f the Stl statements anaiysiin this chapter fe can- luce to ensure she borrower can generate suficien! casilow (as opposed 19 sccommting exmings) *0 repay the loam. The following ratios are wed most oer * Current sects Garren bes Netsaes ventory Nat profit Nat proficsles rao « NOH Debt Equiy ‘The importance of cashflow should ot be subordinated wo collate whieh ‘an he considered only secondary souee ol assurance of repayment Whether fora business requesting project funds or an individual needing a home loan, the pelmary source af vepayment shoul! eome fom the projects earnings (a ‘opposed 10 the liquidation valve of the project) er the individuals income respectively ‘This brings up the problematic mater of cones Coltri the securing ofa loan with en underiying asset. The vost common example of collateral is the home from a home loan Twenty years agp, ans olen would rely on cole luteal rather tan casllow a comfort thatthe loan would be repald. Tight financial condutions often produce dilfcltes in accessing collateral, howeves, Comrent rn =| Inventory tarmover ro Debe-equty rato ea RTI]a Carnes Consumer lending Learning objectives ‘Mer reing tis fuer, you shuld be able 2 cute the maar yes of consume oan exh now ares ypes of carmen Seles ae eahales ‘pi, te Hoot specimen corsa oan ‘ables, wth ances ing a led i pact pune te pcan eke ‘eens corte oan apexions ius naw cots of coneuma lo Sotto = Se Dey ea ees ana regulon acting caries fn conser er ‘pl te pring aoe f consume lasInsintions pay to one anosber are called interchange fees (Reserve Bank of ‘Ausra and Austalian Competition and Consumer Commission 2000). The cardecuing bane also charges the customer (4) an annoal fe for sung @ ‘edit card and (h) interest on the outstanding balance Having discussed the diferent rypes of consumer Toan, we will now explain how consumer loan appliations are evaluated Evaluating consumer loan applications ere, we wil present the general principles of credit assessment of consumer loan, followed by a stp-by step approach wed by one ofthe Banca nt ston in Asta, General principles Like all cher evaluations of ans, the assesment ofa consume loan appl cation follows the thee fundamental Cs of lending’ characte, capt a Collate} Bork 199, Sore authors CWezver && Kingsley 200, for example fd cpl and condos, and thus have che five Cs of lending According to Couette, Altman and Neayanen (1958), the three Cs of lending ave cae acter, capacity and capita. “Capit, however, ts wally Included under “Capnky to Repay and condone’ ace urllyinuded ander “olen According to Rose (1995), there are only two Cet charater and aby Cor ‘apaciy) to repay In this chapter for convenience we wil fellow the three Ge of character, capa and colltera, incorporating the other two. Cs {capil an condtions) therein, Character The character of the prospective borower is te single ost important ctor that influences a lenders decsion whether to appuove oF reject a loan. Char aster i the most important and, atthe same tine, the mest dente Factor [siers As quoted by Weersoorya (1998, p. 99), the famous Armeican banker Perpoiat Morgan Tol a Senate ingary that ‘the fs ting that t Tooke fore che borrowers character, (We include the Fall oote om page 6.) Nothing ca be ‘more powerful thin this statement to adequately emphasise the importance of tchamcter im bone Tending, although assesment of chraccr ta eupeceve ‘seve the following factors can ais: 2 nak recon ofthe Indidul IF the intending borrower alendy a castomer ofthe hank, hen its easy for the banker to assess the wack record because the borrowers complete Gnancit history Je avalable The longer the relationship, the better if If the borrower Is x eUstomer of another lnk, then bane wera opinion) ate vaquested fom that Ban Banks sometimes len tele wo ere erence ajencies and make enguises with the borrowers Friends and relatives, Before making such enquire, the bank mrt obtain siten consent ftom the borer t9 this elec. ag required der the Provcy et 1988, (Tees erate+ Abily The abity ofthe borrower ean be jadged ftom the formal edeation that esse possesses in dhe aea of aity that hetshe wishes to undertake. In addition to formal ade o other guslifcation, the borrower's experience tn the pantcolar area of activity i also an important consideration. These aspects become particalary important in the eae of business loans. + Purpose of loon, The third txportant factor co he studied I the purpose for ‘which the borower warts finance. The lending banker must ensure that the purpose i lavful and is consistent with the lon policy ofthe bank + The segrty of the borer The cheat must have both the aby and sellngres to repay the Toan’ The abit to repay eam be judged fom the ‘apacty 10 repay. but ellingness to cepay is @ question of characr. The ‘ororwer may have suffiient surplus 10 repay the Tour but nay sil ry t0 void repayment of the loan In time. Horowers often do not resize the Amporanceof timely repayment and are loin making payments to the bank In the case of existing bortowes, thet wack record proves seal fr forming ‘an opinion ofthis aspect af characte, ln case new borroters, the bane has to be more circumspect. + Spending habs. The borowels spending habits are important. Some borrowers are "ig Spender — that i, they spend Lar beyond thie capacity to repay fom shes earings. The likely eeslt of such habits will Be the borrower defaulting on a lea sooner or Iter. The bark must tke adequate precaution at de ine of granting the lan. Lage outstanding balances on 2 rei card multiple debts and Mest inconsisent with earings ae soe Of the symptoms that give ree to smpicon. Borrowers who have # known history of gambling need tbe handled with more cruson, Capacity toe esas tat the purpose of the loa s genuine and if he eharactr checks om ‘he prospective borroter are ll enenaraging, then he lender wil sat aking serious inerest im the loon applistion. The Jender ean judge the repayment apcly of the borrower in several ways {Net nce The stad Freon consideration is the level of net exaings ofthe borower, Net income i the income remaining afer payment of al fxpensex. The spphestion form for constime loans normally seks dete of the souess of income and expeniicue. Income iacudes income fom ‘employment, reeips by way of dividends and so on. the spouse of che borrower is eaming, then the spouse income needs tobe taken ano account. ‘Expendinne iciuds items sueh a5 ren, the ling expences of the aval, and repayment of any other debs, Deposit balances wih the bank. Another way to check the creditworthiness of the borrower i 1 check the averge blance maintamed in hisber accounts ‘sh he bank Staiiy of ab Job stabi and continuity ae other indicators af expacty to ep. Borrowers that have contact] jos need tobe assessed with are rem nese?«+ suailiy of residence. This is mother factor taken into eccount in personal Tone, I generally hekeved that «borrower who hs a stable reideac has Amore sable personal siteatin, Home ownership i often viewed se solid fidence of s stable financial situation, Having ones own telephone, hone tnd household furnitute san indistor of stable fnanclal posidon. + Borrowers margin. The Inger the bormwerS contibuion relative 19 the ‘banks contrition, the better ws. The honowers margin i dhe barnes ‘plain the otal inestmers Collateral Collateral erally means ‘along side’. Something that gos along sie’ the loan 1s called collate. In banking ales, the tam ‘collateral Is used as synony. ‘mous to ‘Security ts often sid that a prudent banker never gies 2 lean ‘gsinct security alone, which mean tht satunty should not be the pra con Sideration in giving # Ioan, The main consideration shoold always be the vie Diity ofthe venture. This is especially trae inthe cae of busines leans. Loans hou he given f the borrower has capacity to repay Colter i something to fal back om Hf the creumstances of the borrower change and helshe finde i Jed to repay the lon out of normal sourees of income Invoking ellaterl i the last resort when all ther means to secure epeyment ofthe loan have fied Tt is Tegal process that is both te consiming and expensive forthe banks ay also eeste bad feling between the borrower and the bun Io aver are left so recover the lan, however, + banker should we the right t dispose of {he collateral and use the proceeds in repayment of the loan, Final, genet cconomie conditions should als be taken into account. In recessions, financial Institutions may be less confident about lending ‘he above priveiples guide al lending decisions, We will now present 2 step-by-step approtch tha is generally followed wile assessing a pessoval lean (for example vehicle loan). This wll help you grasp the esteatals of eral stung consumer loans. Many steps are common tall types of loan, altoogh some of the detail may vary. Step-by-step assessment of personal loans ‘The steps used in evaluating peesonal loan are discussed below. ‘Step 1: oblaining a prescribed application form Applications ean be received by telephone or mail or atthe branch. Applians rust be residents of Astral and preferably are esident ofthe servic area of the branch. The lender should ensure the application is fally complete. In pa cola, He fell mime and addvess of all the borowers, Information about croployment ofthe borrowers (such a5 designation, conbact term, sary, fd other deductions) and lving expenses should be abuated. The lender ao Should ensute to take authorisation forthe disclosire of the applicant’ Infor ration to Baycorp Advantage/Crdit Advantage (former the Creat Reference ‘Assocition of Australi), The authorisation shoul be signed by all applicansmuaantors, Dependents noted om the application must include children fom [revo rlauonship for whom the applicant pays cd suppor. the spi= ‘ant snot an existing cestomer ofthe bank, then it may be approplite to open ‘sovings account frst, after folowing the usual precasins. tis important to ‘biain documentary evidence to support all the information given in the app ‘ation, In Australia, financial instsions mostly ase the eet scoring model (Giseussed i subsequent sections) where certain points Gores) are loted or ach pee of taformation dat the borower provides. The sum of all these points is compared with enbalf score, Step 2: conducting a preliminary assessment Codie. Advantage show conduc: a check om all applicants, nclading guaran tors. All information obtained and it source shouldbe ecorded in weting, The bank ofc doing the credit ches should sgn and date the record. Cheek the applcantscapacltyto repay by ealeuliting hivher net income, Ta calelate net Income, mins all deductions Irom gross come. The total commitments ofthe applicant should not exceed SO per cent ofthe applicants net income. Total commitments are equal 10 the repayment instalment of the lan applied plas bother commitments (such ar payment of ether lon). Inthe ace of oie spp ais, the income of both applicants should be added, Allowances aud overtime payments shouldbe aided to income. Allowances on which tax levied sho beaded wo gross income, while oters shouldbe added 10 net terme. Income from other sources conld be alded to gross income if received om a regular hiss. In the case of self employed applicant, the lender should rele tothe tax etuns fr the previous two or tee yeas or audited statement of financial performance Maintenance payments received by divoreed perso ae not o be treated ae income. roof of income —~ pay sips, group certificates, verification fom employes and so on — used in elculating the bonowers repayment capacity should be Ieid om fi. nspplicantseurent employment, together with the tem of eur rent emplaymient, mst be verified. the coment employment i for les han two years, then the lender shold make checke abowt the applicants previous tmploymest. An employment check invalves contacting employers of in the face of sellemployed applicants, eatacting eeountant, “The addres of the applicant canbe verlied by telepoonng the landlord or sighting rene vecips, morgage documents, counell ates nates, house tnmurance pobey o enfimation from employes. Step 3: accepting and loading applications ‘Applications that ae accepted and loaded on the banks computer ser word ‘be given to customers for signing. An applkation can be cancelled anytime Defoe disbursement, ta Teter to this effect must be obaied from the cus tower and held on recond. Customers also mst he inforzned in waiting. Even ‘where application ae not sanetioned the reasons for rejection shovld he noted {in detail on the application. This fs wsefl if there are subsequent complains, deputes or enquns,Step 4 taking securities Seousties dhat wll be taken for personal Joans consist of one or more of the following documens' a egstered bil of sale over a moter vehi, boat, caravan snd ona charge aver bankbuilding society deposits (that, erm and savings ccounts); and a charge over the sunteder value of ie insurance policy. All vehicles secure by teistzed bil of sae should have comprehensive insoranee repstered inthe aie of the banking society as mortgagee. In the cae of vellles purchased froma licensed deter, details such asthe fall pice ofthe whic, the egstation number, che engine number, he chassis number, ‘the male and model, the year of manufacture the dealers registration mb, the deposit pid and dhe amount of loon shouldbe recorded om the nace Where vehi are putchased privately various searches should be conte to esta Ish tle, nonencumbrance and, im some cases, bankrupty. The vehicle shoul Ibeteiseved in the State where the bank/bnlding society located, The present ‘owners of the yebiele are required to sgn certificate tha they are no bankrypt fd thatthe vehicle isnot subject to any encumbrance AI vehicles aed #5 ecuity should be register with the Sate Motor Vehele Securities Regt ostzare regione wth the Department of Consumer Alas Bl Sle Regist “The fl cost of the wehile x ever Snanced. The borrower i required 19 com trbte a margin (tht is, hither cw hate) tothe costa the vee. Ia the ease ‘of new vehicles, gnerlly 80 percent of the invoice pice aud, inthe case of ‘sed vehicles, 70 percent he iwoiee price or he pce as per the dealer gue (rbichever i lower) is anced. Foanealstintions generally insist that the ‘alu ofthe bile shouldbe at leis $10 000. The nor of valuation in espect Uf lleent types of vehicle ae generally indieated inthe losn manal of the ban, The dishursemenr ofthe loan s generally meds dec tothe seller ofthe ‘veil, 4 bill of sale repstaion fei also charged o the Borrowers account, ‘Funds held in the account of the borrowers or guarantors maybe zen £010 satay at dhe tae of approval hiss know as ce cretion ofa chayge over epost All the parties in whose name the depos account stands ae eequied torsign such a charge Banke somes aba «charge over the sender vale ofthe fe ssuranes policy of the brtower. The surrender value shouldbe ascer- ‘ained fom the insurance company and 75 pe eentof the value maybe reckoned se secatgy An essignment form and memormdom of transfer are completed and ‘egltered sith the ingurance company. “A guarantee usually cannot be wed for «personal lan, excep pthaps where seouiy i ling short. The relationship betwen the borer snd guarantor ‘Should be stated. the guarantor shouldbe given fll pauls ofthe lean con tract, which should not be altered yathout the knowledge of the gvarentor An slteative to guarantee coshorowing. Here, che co-borsemers namie appears ‘mall he Ioan documents and helshe geal the docoment, Stop 5: determining interest, fees and charges ‘To calculate the interest o be charged on the loam, the lender deducts some per centage (forced scone concession an security) from the sandard ate. Thefees and chars thot ate generally ese ined: am appietion fe, loan cone reset samp dg a bill of ele zegietration lee, an encumbrance eatch fee, » Tankrpley search fee and »veistered owner sae fe Step 6: approving/rejecting applications Applications are approved per sanctioning powers given to. managers working at various levels ofthe bank Where an applicaion is rejected 38 4 result ofthe Credit Adeansage report, the Bonower may be adsed acconingly In all ocber casts, dhe borrower may be advised thatthe application did not meet he guidelines ofthe bank there is no need to give any specifi reason It toan s approved, then st the tine of disbursement, «senior ees should be present to weffy al the document, ensure the borrower andl guaraor sigh fp hisher pcsence and certify thx this has been done. Step 7: supervising the loan and following up Person loan accounts donot require mich supervision just regelr follow-up tm enna the epeyrent of lnm instalments ae made im time. Reminder letters ‘may be sent the bonowere whore instante arin areats. The fist reminder is genealy sent within one week of the instalitent fling in areas. and a seni Seat a werk later if tbe pyrnent tl has not been reeked. Every eft Should be made to asst borower who aren areas. This could involve tem poral extending the epuyment period ot accepting avaiable payment now ‘md the remsinders theme ofthe next instalment. The eedivegsl department fhe contolinglhesdoffce generally takes egal action when the borrower fis to pay despite fallow up, Where secu toe repossessed de wo nowpeyment of dues, banks generally appome a mescanile agent. Borrowers should be ‘formed in advance aboot the action and piven sulcent te to bing the good tothe bank themselves, If this warning fi, then the mercanle agent tay be asks to posses the gos and bring them tothe ya ofthe bank. The loans deparanent reports loan deals to Credit Advantage Step-by-step assessment of credit card loans ‘The asessment of credit card lans sll otha of personal loans. Its even single, vain ever tp ten those ned ar pes! ou ‘sep Te obuin the daly filedin prescabed credit ear application form and ensure all deals have been completed. Applications can be recelvel by {elepone or mall over the Internet oat branches ‘+ Sep 2: condvet credit checks via Credit Advantage, employers sad fom other banks where the custome holds accounts 1+ Step 3: f the checks are satisfctory, then Toe the detail of the appliation fon the computer system, The Computer system wil aucomaaly work out the points and give 2 decision against @ st cutoff as to whether the pplication can be accepted oF teete. + Sep 4: where che applleaon is approve, request that a credit cand be made ready, indicating dhe name of the cardholder andthe date to which the card ‘stalin approval leuer ins detaed book of instructions about using thecredit ard willbe sent othe applicant, The cand ned not be sent dey ty the appliant, who instead may be advised that the crit card ere fo collection at local branch, The branch wil hand over the credit card when the applicant produces cis letter and signs the card issue register. Where te pplication isnot approved, dhe apliant may be stably sdse, Example of a consumer loan application Aefering to the Commonveslt Banks personal Tosn apphestion fort sind creditcard loan application form as examples, me will explnin how the if mation sought on the forms ultimately Helps the lending banker wo asses de ‘quality ofthe loan propasil. We have tied to relate the questions on the spi= ‘Sion for to the thre Cs of lending explained exer Personal loans [An application form fora personal lan ts downloadable from tke Common ‘wealth Banks website (womsrcoman co 3) 1c wl help to have the for andy while rendng the felling disssion, Character + On the loan eppliaton, the bak obuins the auhonty of dhe prospective borrower to collect information rma x cet eporting agency ad to exchange that information with other credit povidess. Sach an authority helps the bank fo eary out credit checks. The tnforration tat the bank willreceve wi hr Highton the daracter ofthe borrower The bank may ask wheter the applicant has anyother debts, Some applicants may not disclose this information. which ray ot serve them well beste debunk wil come to kno rom oker sources Uhedher heeare prior debi. Ham applicant hides information, he hake does not form good opinion about the applicant In short, the applicant becomes fan at ig’ prey andthe bank may not view hiner favourably: + Some questions onthe application form relate to the patculrs and contact dete of the applicant. The hank il verify these details. Evlnce that will be used by the bank inches «driver ence, proo of age cad, etizenship cectliate and an overseas ot Austalian passport. The back ean veeify the fspplcantsvesidentialatess by telephoning or visting the residence, The bank wil also sen leer o the veideniladdess and request the cent 12 come to the bunk widh those leues. This eonfims thatthe applicant is scaly resting at dhe addres indicated. The bank also secks the applica’ length of residence atthe address provided. Changing ressence frequent} ray not he viewed Invoutably bythe bank. It shows that the applicant isnot stable atone place, As indiated in che dacussion of credit scoring models (Gee pages 153-8) «longer period of say ata residence ears more pots + One question on the loan application seeke dete sbout the applicants previous employment, The banker may contact the previous employer to check the applicants chaaces, aaa]+The los application contains a father question abot character assessment From the sus of an applica frends, «banker ean obmain a sca of the Socal sts lo which the applicant belong. llluatal fiends are postive inthis asessment process. Capacity + Some questions on the Loan application ee about employment. The bankers trying to asses the stability othe gpplicants employment If the employment is stable, en there will hes sable source of income from which the bark ‘cn expect repayment, The banker want to ensure the prospective borsower ieableto service the debe (oth she tastalment and interes) on tne. The bank sel the tenure ofthe applicants employment Casual or part-time employees ‘may no find favour ths banker. Again, the banks wil aso make inquies ‘vith exployers shout the stas of the applicants employment + Some questions onthe loan application seek to assess the epayment capacity ‘of the applicant in one way or the other The banker slo secs to low ‘whether the purpose for which the loa is souyht is an approved purpose tinder the banks loan policy. Details such asthe items wo be purchased ard ‘hak prices ae sought by de bank to knowhow he loans going w be used, ‘The bank may also requ a quotation + Some questions onthe lean application seek information about dhe amoant {he applicant wants to borrow and the approximate month payment that the applicant proposes to make The amount tht the appliant wants 19 Dono revels the applicants ow margin or conutbusion (recall the C of capital) The bank wil compare these ceils with the net income of the applicant judge whether the applicant em service the Jom togethr wih interest The bank asks whether the applicant is anew customer ofthe bank for an existing ewsmer Mf the applicant & an exsting stom, then the Tank probably aleady knows hiser nancial dealings and has «good idea shout hishner character the applicant is new, then the bik wil be more ‘Gneamepect. Some question cock details sbovt the income and expenditare ofthe applicant, soa to ative a the net surplus avaiable to service the loan. Coltaterat Te purpose of some questons on the lan application fs 10 know the financial standing ar creditworthiness ofthe applicant Ifthe spplicast has property and Investments, then the skin giving lean is much le. A further purpose to ‘now what collateral (eco) the appliart can offer. One-quesion has a similar parpose, requesting deals of the applicants irkendeatve. The bank ‘an suggest that the endlave stand 368 guarantee for the Tout if needed. Credit card loans 4m sppleation foi fora credit cand is downlosdable fom the Commnonelth hank website (wwcommbank om.ay) The information requested bythe bank fe mach the same se tat requested on s personal let application. This esas the ponpos af geking the formation the ame i bot eases. Somesulitions) questions Rave been included, however, and here we wil explain ‘why this nloration require, The slevanc of some of the additional questions is obvious The bark wan ‘erknow the applicants equtements af the ered card thats, he type of ard, the interest-free purchase period required and whether the appllat is a member of the bunk ‘rewacds program. The interest rate at the back wall change on oustanding balances an the cai fe wil vary, depending om the (ye of ead option chosen by he applicant ‘One question on the credit cant application seeks information about the spplcants residency sts Ifthe applicant 6 not a pemzanent resident, then ‘he tank may be cucumspect in issuing the ear. Iemay be had for the bank o hse up credit cand holders residing oversee eere ate any outstandg dcs Precautions to be taken in granting consumer loans Consumer loons ae far simpler to asses and monitor than a, coxpoat lan or lar loans, but ts sill important to take adequate cae to aold problens down the wack A banker may lace some ofthe flowing challenges: 1 Inve may withhold tnformation that cuca to decisionmaking. There could be Sues eating to health or continuity of employes 2, The aplicant may provide incenssent information. The inconsistencies may be intentional or due to lack knowledge of bank procadures 2. Ventying some ofthe information provided could bea problem. On many occasions, employers may not be willing to disclose detsile about th faplojecs to the hark The asker also need tg be more estou in die. {oting information about a prospeeive or existing borrower In the case of ‘owner v. National Provincial and Union Bank of England (1923), he bunker, in the absence of Mr Tourie, tld Mr Touriers employer of is gambling habit and the sat: of his bank account Mr Tourmer’s contact, thes not sensed he lose his jad secessfly soe the hank for stand snd breach of confident 44. The applicane may lave a good character odterwise but not vee the Importance of making rpeyments on the dur date 5, Indondons are saccepible to sickness, injury, les of employment and oiler sur fsues that may alfet ther ability to sepay. Even fam di putes can allect the repeyment perlormance ofa borrower 6, Individuals tend vo overcoumat deo ugh nondisclosure of oer deb. 1. The individual mast havea capacity o enter into lean contract, A oan connac, ike any other const, regues thatthe person should not be & ‘nor (less than 18 years of age), someone of unsound mind o an inslvent |8 The personal loan borrower should be encourged to roan « ovigs acco with the bank 9. Borrowers must sign an documents in the presence of an atorised bank officer and pueerably at te branch of the bal.