Credit Analysis

Decomposition of the lending function

Loan application
Credit analysis
ORIGINATION
Design of loan contract including pricing

Loan extension conditional on outcome of credit

FUNDING analysis

Bookkeeping
SERVICING Collection of loan payments
LENDING

Post-lending monitoring to control default risk

Diversification to control default risk
RISK PROCESSING
Loan workouts to control default risk
Control of interest rate risk

Organizational design
Reporting arrangements
CREDIT CULTURE Communication practices
Incentive schemes for credit officers
Structure of Loan Agreement
• A loan agreement
(1) specifies the obligations of borrower and lender
(2) makes certain warranties
(3) usually places certain controls and restrictions on the borrower

• Details:
– Principal: amount to be borrowed
– Maturity: short- (below 1 year), intermediate- (1 to 5 years), long-
term (more than 5 years)
– Pricing formula (fixed/floating rate, transaction rate, closing fee,
etc.)
– Provisions (conditions precedent, warranties, covenants and events
of default)
Standard provisions
• Conditions precedent
– Requirements the borrower must satisfy before the bank is legally obliged to
fund the loan
– Examples: business transactions that must be completed or events that must
have occurred, certificate of no defaults

• Warranties
– Information and assumptions about the borrower’s legal status and
creditworthiness
– Examples: warranties that all financial statements submitted are genuine and
fairly represent the borrower’s financial position, that borrower has a valid
title of all assets, etc.

• Loan Covenants
– Clauses in loan contracts that are designed to protect the bank and prohibit
borrower from taking actions that could adversely affect the likelihood of
repayment.
– Reduce moral hazard
– Violation of covenants creates an event of default and gives the bank the right
to accelerate the required payment
Types of loans covenants
• Affirmative covenants
– Obligations imposed on the borrower
– Examples: provision of periodic financial statements, maintenance of minimum working
capital, management acceptable to the bank

• Restrictive clauses
– Limits on the borrower’s actions
– Examples: restrictions on dividends, salaries, bonuses, investments

• Negative covenants
– Prohibitions on the borrower
– Examples: prohibitions on mergers, consolidations, and sales of assets

• Default provisions
– Conditions under which the entire loan is made immediately due and payable
– Acceleration clause that specifies events of default
Credit analysis
• To determine the ability and willingness of the borrower to repay the loan.

• How to do credit analysis?

– Examine factors that may lead to default in the repayment of a loan
– Look at the borrower’s past record (reputation), economic prospects
– Look at the present economic condition and forecast future cash flows

• Must remember:
– Getting unwilling borrower to repay the loan is costly
Credit analysis: The five “Cs”
Capacity:
Ensures that borrower has legal and economic capacity to
borrow.

Character:
Refers to borrower’s reputation and desire to settle debt
obligations.

Capital: Likelihood
Resolves private information and moral hazard problems. Repayment

Collateral:
These resolve private information and moral hazard problem.
Also directly reduces bank’s risk. Moreover, collateral can
eliminate underinvestment problem.

Conditions:
These are economic conditions that affect borrower’s ability to
repay the loan.
Capacity
• Legal capacity to borrow:
– In the case of partnerships, whether all the signing partners have the
legal authority to borrow
– In the case of corporation, need to check the corporate charter and
bylaws to determine who has the authority to borrow

• Financial capacity to borrow:

– Evaluating borrowers’ future cash flows available to service the debt
• Financial statements analysis (hard information), qualitative
assessment of managerial capacity (soft information)
– Who else has claims on the borrower, and what’s the seniority of such
claims?
Character
• Borrower’s ability to repay debts and desire to settle all obligations within
the terms of the contract

– In different words: borrower’s reputation for meeting payment

obligations

• Requires a careful examination of the borrower’s past record in debt

repayment and related behaviors

– The better a borrower’s credit reputation, the less incentive she/he

has to default

– Credit history is a key indicator in credit analysis

• External sources (e.g., credit bureaus)
• Internal source (e.g., bank records)
Capital
• Equity capital (as a fraction of total assets) the borrower has invested in
the firm – first line of defense.

• Helps to resolve moral hazard by imposing a greater loss on the borrower

for poor project outcomes.

• Signals the profitability of the borrower’s project and the confidence in the
firm’s future prospects.

• Interest rate inversely related to the borrower’s equity-to-total-assets ratio

Collateral
• Lender has first claim to collateral in the event of default

• Inside collateral: assets owned by the firm to which the loan is extended,
e.g., accounts receivables, equipment, machinery, real estate, and
inventory

• Outside collateral: assets that the bank would never have a claim to
unless they were specifically designated as collateral, e.g., personal assets
of the owner with limited liability

• Costs of using collateral:

– Ongoing monitoring of the collateral
– Liquidation costs, including legal costs of ownership transfer, costs of
carrying and selling
Why is collateral so widely used?
• Risk reduction
– Collateral provides the lender greater protection against loss in the
event of default

• Signaling instrument
– Collateral can convey valuable information to the bank

• Moral hazard
– Using collateral can help resolve a variety of moral hazard problems:
• Asset substitution
• Underinvestment
• Inadequate effort supply
Conditions
• Economic conditions that affect the borrower’s ability to repay the loan:

– Industry outlook
– Company conditions: competition, customer relationships, supply risks
– Debts are repaid from four sources:
• Income (Selling prices of its goods, Costs of inputs, Competition,
Quality of goods and services, Advertising effectiveness, Quality of
management, etc.)
• Sale of assets
• Sale of stocks
• Borrowing from other sources

• Need analysis of borrower’s financial statements as well as its

management
Trends in credit analysis
• Banks are becoming increasingly sophisticated in credit analysis: involves
both a quantitative and qualitative assessment of borrowers ability and
willingness to repay

• Rely more on computer-based statistical analysis of borrower attributes to

determine the level of risk inherent in a particular loan

• Use of credit scoring models

• Use of financial analysis techniques

• Cash flow of the borrower

• Debt service coverage ratio = Cash flow before interest expense excluding
depreciation / debt service required >1.2
Financial variables
• Liquidity
• Current ratio = current assets / current liabilities
• Quick ratio = current assets – inventories / current liabilities

• Profitability
• Return on assets (ROA)
• Return on equity (ROE)

• Leverage
• Total debt / total assets

• Activity
• Inventory turnover = sales / inventory
• Total assets turnover = sales / total assets
Financial Analysis: Altman
• Formula for firm default:

Z = 0.012 X 1 + 0.014 X 2 + 0.033 X 3 + 0.006 X 4 + 0.999 X 5

• X1 = working capital / total assets

• X2 = retained earnings / total assets
• X3 = earnings before interest and taxes (EBIT) / total assets
• X4 = market value of equity / book value of total debt
• X5 = sales / total assets

• Z below 2.68 is a strong sign that the firm will go bankrupt.