Evaluating Commercial Loan Request
This report introduces a procedure that can be used to analyze the quantifiable aspects of commercial credit requests. The procedure incorporates a systematic interpretation of basic financial data and focuses on issues that typically arise when determining creditworthiness. Cash flow information is equally important when evaluating a firm’s prospects. Reported earnings and EPS can be manipulated by management debts, are repaid out of cash flow not earnings. The basic objective of credit analysis is to assess the risk involved in credit extension to bank’s customers. Risk refers to the volatility in earnings. Lenders are concerned with net income or the cash flow that hinders a borrower ability to service a loan. Credit analysis assigns some probability to default. Some risks can be measured with historical and projected financial data.
The key issues include the following:
1. For what are the loan proceeds going to be used?
2. How much does the customer need to borrow?
3. What is the primary source of repayment, and when will the loan be repaid?
4. What collateral is available?
Fundamental credit issues:
Virtually every business has a credit relationship with a financial institution. But regardless of the type of loan, all credit request mandate a systematic analysis of the borrower’s ability to repay.
When evaluating a loan a bank can make two types of errors:
1. Extending credit to a consumer who ultimately would repay the debt.
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2. Denying a loan request to a customer who ultimately would repay the debt.
In both cases the bank loses a customer and its profit decreases. For this reason, the purpose of credit analysis is to identify the meaningful and probable circumstances under which the bank might lose. So a credit analyst should analyze the following items:
*Character: The foremost issue in assessing credit risk is determining a borrower’s commitment and ability to repay debts in accordance with the terms of a loan agreement. An individual’s honesty, integrity, and work ethic typically evidence commitment. Whenever there is deception or a lack of credibility, a bank should not do business with the borrower. It is often difficult to identify dishonest borrowers. The best indicators are the borrower’s financial history and personal references. When a borrower has missed past debt service payments or has been involved in default or bankruptcy a lender should carefully document why to see if the causes were reasonable. Similarly, borrower’s with good credit history will have established personal and banking relationship that indicate whether they fully disclose meaningful information and deal with subordinates and suppliers honestly. Lenders look at negative signals of a borrower condition beyond balance sheet and income statement. For example:
A borrower’s name consistently appears on the list of bank customers who have overdrawn their account.
A borrower makes a significant change in the structure of business.
A borrower appears to be consistently short of cash.
A borrower’s personal habits have changed for the worse.
A firm’s goals are incompatible with those of stockholders, employees, and customers.
*Use of loan proceeds:
The range of business loan needs is unlimited. The first issue facing the credit analyst is what the loan proceeds are going to be used for. Loan proceeds should be used for legitimate business operations purposes, including seasonal and permanent working capital needs, the purchase of depreciable asset, physical plant expansion, acquisition of other firms. Speculative asset purchases and debt substitutions should be avoided. The true need and use determines the loan maturity, the anticipated source and timing of repayment and the appropriate collateral. A careful review of a firm financial data typically reveals why a company deeds financing.
The Dissertation on Related Literature to the Cash Flow Management
The role of cash flow information in discriminating between bankrupt and non-bankrupt companies remains a contentious issue. In a number of literature reviews on bankruptcy prediction (e. g. Zavgren, 1983; Jones, 1987; Neill et al. 1991; Watson, 1996) the common view is that cash flow information does not contain significant incremental information content over accrual information in ...
*Loan amount:
Borrowers request a loan before they clearly understand how much external financing is actually needed and how much is available internally. The amount of credit required depends on the use of proceeds and the availability of internal sources of funds. The lender job is to determine the correct amount such that a borrower has enough cash to operate effectively but not too much to spend wastefully. Once a loan is approved the amount of credit actually extended depends on the borrower future performance. If the borrower cash flow is insufficient to meet operating expenses and the debt service on the loan it will be called upon to lend more and possibly to lengthen the loan maturity. If cash flows are substantial, the initial loan outstanding might decline rapidly and even be repaid early. The required loan amount is thus a function of the initial cash deficiency and the pattern of future cash flows.
*The primary source and timing of repayment:
The primary source of repayment of loans is the cash flows. The four basic sources of cash flow are the liquidation of assets, cash flow from normal operations, new debt issues, and new equity issues. Credit analysis evaluates the risk that a borrower future cash flow will not be sufficient to meet expenditures for operations and interest and principal payments on the loan. Specific sources of cash are typically associated with certain types of loans. Short-term, seasonal working capital loans are normally repaid from the liquidation of receivables or reduction in inventory. Term loans are normally repaid out of cash flows from operations. A comparison of projected cash flows with interest and principal payments on prospective loans indicates how much debt can be serviced and the appropriate maturity.
*Collateral:
Banks can lower the risk of loss on a loan by requiring back up support beyond normal cash flow. Collateral is the security a bank has in assets owned and pledged by the borrower against a debt in the event of default. Banks look to collateral as a secondary source of repayment when primary cash flows are insufficient to meet debt service requirements.
The Review on Determinants of Dividend Payout Ratio
Determinants of Dividend Payout-Ratio: A Study of Philippine Stock Exchange-Listed Banks, 2007-2011 Introduction Dividend policy is one of the most controversial subjects in finance literature and still `management always ponders about the dividend payment and also why investors need to pay attention on dividend. It is also a corporate profit that is paid out or considered as an income by the ...
Having an asset that the bank seize and liquidate when a borrower defaults reduce loss, but it does not justify lending proceeds when the credit decision is originally made. From a lender perspective, collateral must exhibit three features:
-First, its value should always exceed the outstanding principle on a loan.
-Second, a lender should be able to easily take possession of collateral and have a ready market for sale. Highly illiquid assets are worth far less because they are not portable and often are of real value only to the original borrower.
-Third, a lender must be able to clearly mark collateral as its own.
When physical collateral is not readily available, banks often ask for personal guarantees. On the other hand, liquidating collateral is a second-best source of repayment for three reasons: 1- there are significant transaction costs associated with foreclosure. 2- bankruptcy laws allow borrowers to retain possession of the collateral long after they have defaulted. 3- when the bank takes possession of the collateral, it deprives the borrower of the opportunity to salvage the company.
At last, a loan should not be approved on the basis of collateral alone. Unless the loan is secured by collateral held by the bank, such as bank CDs, there is risk involved in collection.
A PROCEDURE FOR FINANCIAL ANALYSIS
The purpose of credit analysis is to identify and define the lender’s risk in making a loan. There is four stages process for evaluating the financial aspects of commercial loans:
1. Overview of management and operations.
2. Financial ratio analysis.
3. Cash flow analysis.
4. Financial projections.
During all phases the analysts should examine facts that are relevant to the credit decision and recognize information that is important but unavailable.
1. Overview of management and operations:
Before analyzing financial data, an analyst should gather background information on the firm’s operations. This evaluation usually begins with an analysis of the organizational and business structure of the borrower. The evaluation should also identify the products or services provided and the firm’s competitive position in the marketplace. This inquiry leads to a brief analysis of industry trends. Moreover, particular attention should be focused on management quality. This helps identify motivating factors underlying their decisions. Finally the overview should recognize the nature of the borrower loan request and the quality of the financial data provided.
The Essay on Comparative Ratio Analysis
Comparative and ratio analysis are two of the most common types of analyses used in examining a company’s fiscal records, and both used the same information contained in a firm’s financial statements. This paper is written better understand the role of each type of analysis in evaluating a company this paper expounds on such involvement. Definition Ratio analysis assesses the association among the ...
2. Financial ratio analysis:
Most banks initiate the data analysis with statement spread forms, which array the firm’s balance sheet and income statement items in a consistent format for comparison over time and against industry standards.
The next step is to calculate a series of ratios that indicate performance variances. This analysis should differentiate among at least four categories of ratios:
A-Liquidity ratio: indicates the firm’s ability to meet its short-term obligations and continue operations. Measures of net working capital, current and quick ratios, inventory turnover, the average receivables collection period, the days payable outstanding, and the days cash-to-cash cycle help indicate whether current assets will support current liabilities.
B-Activity ratios: signal how effectively a firm is using assets to generate sales. (Sales-to-asset ratios).
The key ratios include accounts receivable turnover, inventory turnover and fixed asset turnover.
C-Leverage ratio: indicate the mix of the firm’s financing between debt and equity, hence potential earnings volatility. The greater a firm’s leverage, the more volatile its net profit (or losses).
Ratios that should be examined include debt to total assets, times interest earned, fixed charge coverage, net fixed asset to tangible net worth, and the dividend payout %.
D-Profitability ratios: provide evidence of the firm’s sales and earnings performance. Basic ratios include the firm’s ROE, ROA, profit margin, and asset utilization.
Finally, an analyst should evaluate these ratios with a critical eye, trying to identify firm strengths and weaknesses.
3.Cash flow analysis:
Most analysts focus on cash flow when evaluating a non-financial firm’s performance. Cash flow estimates are subsequently compared to principal and interest payments and discretionary expenditures to assess a firm’s borrowing capacity and financial strength.
The Business plan on Bankruptcy Among Young People Because of Credit Card
Consumer credit can be defined as a debt that someone incurs for the purpose of purchasing a good or service. Common forms of consumer credit include credit cards, store cards, motor (auto) finance, personal loans (installment loans), consumer lines of credit, retail loans (retail installment loans) and mortgages. The spread of credit card ownership and usage across developing Asia Pacific ...
The importance of cash flow has recently been emphasized by the introduction of the statement of financial accounting standards (SFAS).
The cash-based income statement is a modified form of statement of cash flows. It is essentially a statement of changes reconciled to cash that combine elements of the income statement and balance sheet. It records changes in balance sheet accounts over a specific time period. Its purpose is to indicate how new assets are financed or how liabilities are repaid. The statement of changes is summarized here:
Sources of cash Uses of cash
-Increase in liability -Decrease in Liability
-Decrease in non-cash asset -Increase in non- cash asset
-New issue of stock -Cash expenses/cash dividend
-Additions to surplus -Taxes
-Revenues -Deduction from surplus
-Repayment/refund of stock
Additional two ratios are useful for evaluating a firm cash flow:
1- Cash flow from operations divided by the sum of dividends paid and last periods current maturities of long term debt.
2- Cash flow from operations divided by the same two terms plus short-term debt outstanding at the beginning of the year.
If these ratios exceed one, then the firm cash flow can pay off existing debt and support new borrowing.
4. Financial projections:
The three-stage process described previously enables a credit analyst to evaluate the historical performance of a potential borrower. Projections of the borrower financial condition reveal how much financing is required and how much cash can be generated from operations to service new debt, and can be used to determine when a loan may be repaid.
The proforma analysis is a form of sensitivity analysis. Three alternatives scenarios to analyze the relationship between the balance sheet and the income statement: -Best case scenario: improvement in planned performance. Worst case scenario: represents the greatest potential negative impact on sales and earnings. Most-likely scenario: indicates the most reasonable sequence of economic events and performance.
The three alternative forecasts of loan needs and cash flow establish a range of likely results that indicates the riskiness of credit.
The Essay on Access to Bank Credit to Small and Medium Enterprises
Finance function is the most important of all business functions. It remains a focus of all business activities. Financing SMEs has acquired enormous importance in contemporary world of finances. This is primarily due to the national focus and priority of various countries – developed and developing ones as well. In the Sri Lankan context , the government has provided impetus to the ...
As a conclusion no matter what are the alternatives or the credit analysis adopted, do you think that we will get to have a 100% correct analysis with no risk?
Evaluating Consumer Loans
Chapter 22
The purpose of this chapter is to analyze the characteristics and profitability of different types of consumer loans and introduces general credit evaluation techniques to assess risk. Commercial loans were available in large volume, net yields were high and the loans were highly visible investments. Consumer loans involved small dollar amounts, a large staff to handle account and a lower prestige associated with lending to individuals. This perception changed with the decline in profitability of commercial loans. Today, many banks target individuals as the primary source of growth in attracting new business. Even with the high relative default rates, consumer loans in the aggregate currently produce greater profits than do commercial loans. This reflects the attraction of consumer deposits as well as consumer loans. Interest rate deregulation forced banks to pay market rates on virtually all their liabilities. Corporate cash managers, who are especially price sensitive, routinely move their balances in search of higher yields. Individual’s balances are more stable. While individuals are price sensitive, a bank can generally retain deposits by varying rates offered on different maturity time deposits to meet the customer’s needs.
From a lender’s perspective, the analysis of consumer loans differs from that of commercial loans. First, the quality of financial data is lower. Personal financing statements are typically unaudited, so it is easy for borrowers to hide other loans. It is similarly easy to inflate asset values. Second, the primary source of repayment is current income, primarily from wages, salaries, dividends, and interest. This may be highly volatile, depending on the nature of individual’s work experience history. The net effect is that character is more difficult to assess, but extremely important.
Types of consumer loans:
Installment loans:
Installment loans require the periodic payment of principal and interest. In most cases, a customer borrows to purchase durable goods or cover extraordinary expenses and agrees to repay the loan in monthly installments. While the average loan is quite small, some may be much larger, depending on the use of the proceeds. Installment loans may be either direct or indirect loans. A direct loan is negotiated between the bank and the ultimate user of the funds. The loan officer analyzes the information and approves or rejects the request. An indirect loan is funded by a bank through a separate retailer that sells merchandise to a customer. The retailer takes the credit application, negotiates terms with the individual, and presents the agreement to the bank. If the bank approves the loan, it buys the loan from the retailer under prearranged terms.
Installment loans can be extremely profitable. Depending on the size of the bank, it cost from $140 to $208 to make each installment loan. Acquisition costs include salaries, occupancy, computer, and marketing expenses associated with soliciting, approving, and processing loan applications.
Even though these costs are high, banks were able to earn excellent spreads on the average loan.
Credit cards and other revolving credit:
Credit cards are utilized to purchase goods and services on credit in contrast to debit cards, which are used to withdraw cash from ATM (Automated Teller Machine).
Revolving credit: an arrangement by which the borrower and repay as needed during a specific time period, subject to maximum borrowing level.
Credit cards and overlines tied to checking accounts are the two most popular forms of revolving credit arrangements. Banks offer a variety of credit cards. While some banks issue cards with there own logo and supported by their own marketing effort, most operate as franchises of Master Card or Visa. All cards display the Master Card and Visa logos along with the issuing bank name. The primary advantage of membership is that an individual bank card is accepted nationally and internationally at most retail stores without the bank negotiating a separate agreement with every retailer.
Some alternatives to the credit cards exist:
-Debit cards: they are widely available but not attractive to customers. As the name suggests when an individual uses this card his or her balance at a bank is immediately debited funds are transferred from the card user account to the account of the retailer. But there is a disadvantage in using it, the loss of float, which explains why debit cards are not popular.
-Smart cards: is an extension of the debit card and contains a computer memory chip that stores and manipulates information. These cards can handle all purchasing that consumer prefers.
-Prepaid cards: are a hybrid debit card in which consumers repay for services to be rendered and receive a card again which purchases are charged. The advantage of this card is that the processing costs are low and there is little risk.
Credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans. Card issuers earn income from three sources: -charging card holders annual fees, charging interest on outstanding loan balances, and discounting the charges that merchants accept on purchases. Consequently as banks have increased their competitive focus they have begun to lower loan rates and annual fees such that many customers can avoid fees entirely and pay interest at rates slightly above NY quoted prime.
Credit card lending involves issuing plastic cards to qualifying customers. The cards have pre-authorized credit limits that restrict the maximum of debt outstanding at any time. Many cards can be used in electronic banking devices, such as automatic teller machines, to make deposits or withdrawals from existing transaction accounts at a bank.
Credit cards are becoming extremely attractive. Many banks view credit cards as a vehicle to generate a nationwide customer base. They offer extraordinary incentives to induce consumers to accept cards in the hope that they can cross-sell mortgages, insurance products, and eventually securities. Credit cards are profitable because many customers are price insensitive. However, credit card losses are among the highest of all loan types.
The returns to credit card lending depend on the specific roles that a bank plays. A bank is called a card bank if it administers its own credit card plan or serves as the primary regional agent of major credit card operations. A non-card bank operates under the auspices of a regional card bank and does not issue its own card. Non-card banks do not generate significant revenues from credit cards.
The credit card transaction process: Once a customer uses a card, the retail outlet submits the sales receipt to its local merchant bank for credit. A retailer may physically deposit the slip electronically transfer the information via a card-reading terminal at the time of sale. The merchant bank discounts the sales receipt by 2 to 5 percent as its fee. Thus a retailer will receive only 97$ credit for each 100$ sales receipt if the discount is 3 percent. If the merchant bank did not issue the card, it sends the receipt to the card-issuing bank then bills the customer for the purchase. Most card revenues come from issuing the card that a customer uses. The bank earns interest at rates ranging from 6 to 22 percent and normally charges each individual an annual fee for use of the card. Interest rates are sticky. Thus, when money market rates decline and lower a bank’s cost of funds, the net return on credit card revenues. The remaining 20 percent is merchant discount.
Overdraft protection and open credit lines:
Revolving credit also takes the form of overdraft protection against checking accounts. The customer must pay interest on the loan from the date of the draft’s receipt and can repay the loan either by making direct deposits or by periodic payments. These loans are functional equivalent of loan commitments to commercial customers. The maximum credit available typically exceeds that for overdraft lines, and the interest rate floats with the bank’s base rate.
Home equity loans and credit cards:
Home equity loans meet the tax deductibility requirements because they are secured by equity in an individual’s home. Many of these loans are structured as open credit lines where a consumer can borrow up to 75 percent of the market value of the property less the principle outstanding on the first mortgage. Individuals borrow simply by writing checks, pay interest only on the amount borrowed and can repay the principal at a rate of the outstanding balance. In most cases, the loans carry adjustable rates tied to the banks base rate. These credit arrangements combine the risk of a second mortgage with the temptation of credit card, a dangerous combination. Home equity loans place a second lien on a borrower’s home. If the individual defaults, the creditor can foreclose so that the borrower loses his or her home.
Non-installment loans:
A limited number of consumer loans require a single principal and interest payment. The individual borrowing needs are temporary. Credit is extended in anticipation of repayment from a well-defined future cash inflow. The quality of the loan depends on the certainty of the timing and the amount anticipated net cash inflow from the sale.
Consumer loans:
Consumer loans are extended for a variety of reasons for example, the purchase of an automobile, mobile homes, home improvements, furniture and appliances, and home equity loans. Before approving any loan, a lending officer request information regarding the borrower’s employment status, periodic income, the value of assets owned, outstanding debt, personal references and specific terms that generates the loan request. The lending officer collects information regarding the borrower’s five C’s then he interprets the information in light of the bank lending guidelines and accepts or rejects the loan. In addition, banks employ judgmental procedures and quantitative credit scoring procedures when evaluating consumer’s loans.
Recent risk and return characteristics of consumer loans:
Historically, banks viewed themselves as being either wholesale or retail institutions, focusing on commercial and individual customers respectively. Recent developments, however, have blurred the distinction, as traditional wholesale banks have aggressively entered the consumer market. The attraction is twofold. First, competition for commercial customers narrowed commercial loan yields so that return fell relative to potential risks. So consumer loans provide some of the highest met yields for banks. Second, developing loan and deposit relationships with individuals presumably represents a strategic response to deregulation. The removal of interest rate ceilings substantially reduced bank’s core deposits by making high-balance customers more price sensitive. On average, individuals hold small balances and move deposit accounts less frequently, providing a more stable deposit base. Thus liquidity risk declines as a bank’s retail deposit base increases.
Revenues from consumer loans:
Banks earn significant revenues from interest on loans and associated fees. Since many usury ceilings have been eliminated or are no longer effective, banks can ration credit via price rather than by alerting non-price credit terms. This permits banks to quickly raise consumer loan rates, as conditions require. When conditions permit, banks also delay lowering rates when their borrowing costs decline.
Consumer loan rates have been among the highest rates quoted at banks in recent years. Most consumer loans are made at fixed rates that banks do not charge frequently. In a declining rate environment, consumer loans thus yield a large a large spread relative to the bank’s borrowing cost. When short-term rates rise, the spread narrows until banks raise loan rate.
Consumer groups still argue that consumer loan rates are too high, especially when the prime rate declines. They claim that lenders must be conspiring to fix prices. However, there are many reasons for large spreads. First, consumer loans are typically smaller in size and thus cost more to administer on a unit basis than do commercial loans. Second, consumer loans are longer and often carry fixed rates. Third, individuals are more likely to default than businesses. The spread should be large to cover greater losses. Finally, many lenders still face state usury ceilings that may not be lifted when rates increase. In response to this criticism, many banks now offer variable-rate credit cards as alternatives to fixed-rate cards.
In addition to interest income, banks generate substantial non-interest revenues from consumer loans. With traditional installment credit, banks often encourage borrowers to purchase credit life insurance on which the bank may earn premium income. Credit card operations also provide different types of fee income. banks often impose other fees for late payments and cash advances.
Consumer Loan Losses
Losses on consumer loans are the highest among all categories of bank credit. Losses are anticipated because of mass marketing efforts pursued by many lenders, particularly with credit cards. Both losses and delinquent accounts rise during recessions and decline during high growth periods. Many lenders simply factor losses into their pricing as a part of doing business.
Interest Rate and Liquidity Risk with Consumer Credit
The majority of consumer loans are priced at fixed rates. In most cases the borrower can repay the loan without any penalty when rates decline. Bankers have responded in two ways: first: they price more consumer loans on a floating-rate basis. Second: commercial and investment banks have created a secondary market in consumer loans that allows loan originators to sell a package of loans to investors with longer- term holding periods. Banks now routinely sell certificates supported by credit cards receivables and other consumer credit as means of moving assets off the balance sheet.
Balance sheet for outer limits
Assets 1993 1994 Changes Type
Cash & MS 30 6 -24 source
Account receivable 102 215 113 use
Merchandise inventory 65 104 39 use
prepaid expense 8 5 -3 source
Gross fixed assets 120 149 29 use
accumlated depreciation 40 57 17 source
net fixed assets 80 92 12 use
intangible assets 4 3 -1 source
Liabilities 1993 1994 Changes Type
notes payable-bank 106 223 117 source
current maturities of LTD 9 11 2 source
accounts payable 33 50 17 source
accruals 2 9 7 source
federal income tax payable 3 4 1 source
long term mortgage 16 15 -1 use
long term debt 43 32 -11 use
common stock 40 40 0
retained earnings 37 41 4 source
net worth 77 81 4 source
Statement of variation
ASSETS Sources Uses
cash & MS 24
account receivables 113
merchandise inventory 39
prepaid expenses 3
gross fixed asset 29
intangible asset 1
LIABILITIES
notes payable 117
account payable 17
current maturities of LTD 2
accruals 7
depreciation 17
federal income tax 1
long term mortgage 1
long term debt 11
retained earnings 4
TOTAL 193 193
Statement of changes reconciled to cash
Net sales $ 861
change in account receivable $ (113) asset increased
Cash receipt from sales $ 748
Cost of goods sold $ (680) expenses
change in inventory $ (39) asset expense
change in accounts pay $ 17 liability increase
Cash purchases $ (702)
Cash margin $ 46 (748-702)
total operating expense $ (150)
depreciation $ 26
change in prepaid expense $ 3
change in accrued expense $ 7
Cash operating expense $ (114)
Cash operating profit $ (68) (46-114)
other income $ 6 revenue
other non interest expense $ –
cash before interest and tax $ (62) (-68+6)
interest expense $ (18) expenses
income tax reported $ (5) tax expense
change in income tax payable $ 1 liability increase
Cash flow from operations $ (84)
payment for last period
current maturities of LTD $ (9)
dividend paid $ (10) dividend
capital expenditure $ (38) asset increased
Discretionary cash expenditure $ (57)
Cash before external financing $ (141) (-57-84)
change in notes payable $ 117 liability increase
change in stock $ –
change in surplus $ –
external financing $ 117
Change in cash $ (24) (-141+117) asset decreased
To begin our analysis, we can say that the company has collected less in credit sales than it billed its customers because outstanding account receivables increased from 1993 and 1994. Thus net sales are offset by the $113 million increase in receivables to obtain actual cash receipts. Had receivables declined, actual cash receipts from sales would have exceeded the reported sales figure. Moving to cash purchases, purchases equals $680 million + $39 million; so because the inventory has increased which reveal that actual purchases are more than cost of good sold. The statement then subtracts the change in outstanding accounts payable from total purchases to get actual cash purchases. The $17 million increase in payables indicates that a portion of purchases is financed by additional trade credit from suppliers. Cash purchases thus equaled $702 million. In general, net cash purchases equal the cost of goods sold adjusted for inventory accumulation not financed by additional trade credit.
The next step is to subtract cash operating expense.
Bibliography
personal research work, from financial ecperts
