Steps of Credit Analysis

Credit analysis covers the area of analyzing the character of the borrowers, capacity to
use the loan amount, condition of capital, objectives of taking a loan, planning for uses,
probable repayment schedule & so on. Credit proposals are needed to be analyzed by
the eight-step analysis process:

1. Collecting loan information of the applicant,

2. Collecting business information for which loan is sought,
3. Collecting the risk related information,
4. Assembling all credit information together,
5. Analyzing sensitive risky credit information,
6. Analyzing refined & very essential risk information,
7. Making a decision on the basis of loan analysis,
8. Design the appropriate loan structure according to a positive decision.

(1) Collecting loan information of the applicant It requires a collection of

information from the past and present financial statements of the business provided by
the applicant. Analysis of the personal characteristics, that is, whether he is involved in
any forbidden activities such as gambling, drinking habit or any other unethical affair’s
is also focused on this step.

(2) Collecting business information for which loan is sought The bank should
know the purpose of the loan, the amount of the loan and whether it is possible to
implement the project by that amount. It is essential to collect the information about
the sources from which repay the loan. The information of past loan of the borrower
should also be collected by the loan officer.

(3) Collecting the primary risk related information

 Assessing the overall political and economic risks.

 Identification and give explanations to the positive and negative factors in
conducting the business.
 Evaluation of the positive sides of cash inflow and its possible stability in the light
of the historical demand of the business.
 Consideration of the future consequences and need for investment in light of the
applied loan proposal and repayment assurance of the loan.
 Evaluation of the impact on the balance sheet of the borrowers after using the
loan.
 Assessing the possibility and the extent to which change is occurred in the risk
level previously measured.

(4) Assembling all credit information together

 Collection of detailed descriptions about the proposed loan

 Collection of detailed information about the loan applicant
  A detailed description of the general financial objectives and plans of the
business.

(5) Analyzing sensitive risky credit information

 Inspection of the proposed business location,

 Collection of detailed information regarding profit earnings from the existing
bank-clients and other parties related to the business,
 Inspection of the internal working environment of the business,

Analysis of the Information regarding trading (selling/purchasing) and the availability

of getting credit opportunity from the suppliers (Trade Credit) and the relationship
with the suppliers.

(6) Analyzing refined and very essential risk information Analysis of the
honesty, integrity sincerity in individual and overall sense towards the proposed
business on the part of the owners, employees, staffs and laborers of the company.

 Analysis of the possible political and economic risk.

 Evaluation of the operational possibility in consideration of the proposed loan.
 Identification of the sources and uses of future cash inflow and outflow of the
proposed loan project.
 Assessment of the secondary safety of the collateral and surety.

(7) Making a decision on the basis of loan analysis

 Determination of the explicit or implicit risk level of the proposed loan.

 If the level of risk is beyond acceptable, then loan proposal should be closed with
a negative comment.

(8) Design the appropriate loan structure according to the positive decision

 Determination of the types of loan, duration of loan and amount of interest in

light of risks associated with the loan.
 Loan analysis process should be here if the terms and conditions for applied loan
are not acceptable.
 Get approvals from the appropriate loan sanctioning authority.
 Sit for discussion with the borrowers about the acceptable conditions of the loan
Preparation & Maintenance of necessary documents of the permitted loan.

Profitability Analysis
Profitability analysis is part of enterprise resource planning (ERP) and helps business
leaders to identify ways to optimize profitability as it relates to various projects, plans,
or products. It is the process of systematically analyzing profits derived from the
various revenue streams of the business.
Sometimes profitability analysis is incorrectly assumed to exclusively rely on
profitability ratios. In fact, profitability analysis relies on both qualitative and
quantitative analytics.

While profitability analysis does answer many quantitative questions, it is unique in

that it can also help business leaders identify which sources of information are most
factual and reliable. This is especially helpful in helping to select new enterprise
resource planning solutions as the need for factual and reliable data is paramount.

Profitability Analysis Important

Understanding the quality of a business’s earnings is important for many reasons. In order
to maximize profits, business leaders first need to understand the drivers behind their
profits. This helps to create efficiencies in the processes and activities that generate
revenue. Consequently, it forces leaders to continually find ways to reduce overhead and
other costs that impact profitability.

The analysis helps to identify ways to enhance product mixes to maximize profits both in
the near and short term. This makes it helpful for budgeting purposes as leaders work to
create reasonable goals and map how they will achieve them. The ability to identify both
short- and long-term product mixes also helps management to determine what
modifications, if any, need to be made to the business.

Finally, profitability analysis examines the various relationships with customers and
vendors. This helps to identify which customers are the most and least profitable and
which vendors have the biggest impact on profitability. This can be especially helpful in
navigating relationships with customers and vendors.

Methods of Performing Profitability Analysis

There are many ways to carry out analysis on profitability. Some industries have
considerations that are specific and unique to the businesses that operate within them.
While each business ultimately goes about it differently, here are three common methods
of profitability analysis.

Profitability Ratios
Profitability ratios are financial metrics that are used to garner information on how well
the business can generate revenue relative to its cost, assets, and equity over time. Some of
the more common profitability ratios are operating profit margin, return on assets (ROA),
and return on equity (ROE) etc.
 Numerator
Profitability Ratios Interpretation and Benchmark
Denominator
Net income
Profitability of all equity investors’ investment
Return on equity (ROE) =
Benchmark: EB (Cost of equity capital), PG, HA
Average total shareholders’ equity
Net Income + Interest expense * (1-tax rate)
Overall profitability of assets. Sometimes called return on investment (ROI).
Return on assets (ROA) =
Benchmark: EB (WACC), PG, HA
Average total assets
NOPAT = EBIT * (1- tax rate) Overall profitability of invested capital. Sometimes called return on capital
Return on invested capital (ROIC) =
employed (ROCE) or return on net operating assets (RNOA).
(See Course Note for details)
Average invested capital Benchmark: EB (WACC), PG, HA
Net sales – COGS = Gross margin Captures the relation between sales generated and manufacturing (or merchandising)
Gross profit margin on sales = costs
Net sales Benchmark: PG, HA
EBIT
Measures profitability independently of an enterprise’s financing and tax positions
Operating Margin =
Benchmark: PG, HA
Net sales
Net income
Net income generated by each sales dollar
Net profit margin on sales =
Benchmark: PG, HA
Net Sales
CFO
Measures return on assets on “cash” basis.
Cash return on assets =
Benchmark: PG, HA
Average total assets
Net income less preferred dividends
Net income earned per common share
Earnings per share (EPS) =
Benchmark: PG, HA
Weighted common shares outstanding
Market price of stock
Ratio of market price to earnings per share
Price earnings ratio (P-E) =
Benchmark: PG, HA
Earnings per share
Market value of equity Ratio of the market’s valuation of the enterprise to the book value of the enterprise
Market to book ratio = on its financial statements.
Book value of equity Benchmark: PG, HA
Cash dividends paid on common equity Percentage of earnings distributed as cash dividends. Note: Some firms/analysts
Dividend Payout = calculate this using cash dividends declared in the numerator instead.
Net income Benchmark: PG, HA
Cash dividends paid per share of common equity
Percentage of share price distributed as cash dividends
Dividend Yield =
Benchmark: PG, HA
Price per share

Abbreviations for benchmarks:

ROT: rule of thumb. EB: economic benchmark. PG: peer group average.HA: firm’s historical average