The Credit Analysis is a diagnostic approach adopted by banks at the time of assessment of personal and corporate loans. Banking and financial institutions explore the implications of financial personal as well as corporate credit and the analysis is carried out to ensure that extension of loan should be on appropriate terms to clients who could and who would pay them back (Sathye, Bartle, Vincent, & Boffey).
Learning Objectives:
To define personal and corporate credit analysis.
To recognize the elements of lending process and its underlying principles.
To recognize industry metrics used for analyzing performance and trends.
To describe the areas of financial statements that determines credit analysis perspective (Sathye, Bartle, Vincent, & Boffey).
Credit analysis of Personal Loans
Personal loan are a type of consumer loans which facilitates the customer to fulfill the immediate requirement of money. Credit analysis is the much essential process for the bank or the financial institutions before providing the loan to any person or individual for his personal usage. It is very important for the bank to analyze the credit worthiness of the person as it does not take any security against the loan. Personal loan can be of various types but the evaluation, assessment and processing gone through a systematic step by step process which acts as a standard process for financial institutions and analyzes the credit worthiness of the person. As no security, collateral or Guarantors are required for the personal loan so comparative rate of interest on such loan is high but it does not mean that the personal loans are most easy loan to make them available. It is the responsibility of the bank to analyze the credit worthiness of the person with full precautions (Design and Development of Credit Scoring Model for the Commercial banks of Pakistan: Forecasting Creditworthiness of Individual Borrowers, 2012). Before analyzing the process of credit analysis of personal loans, let us discuss about the types of personal loans:
On the basis of purpose:
On the basis of purpose, personal loans are divided as home loans, Holiday loans, Motor vehicles and car loans, education loans or as per the requirements of the customer this loans are classified.
On the basis of Term:
On the basis of term, Personal loans are divided as:
Short term having term less than 1 year.
Medium term of term period from 1 year to 3 years.
And Long term having the term period more than 3 years.
On the basis of terms of repayment:
On the basis of terms of repayment, personal loans are divided as:
Installments Loans.
Non Installments Loans.
On the basis of security:
On the basis of security, Personal Loans are divided as:
Secured Loans having mortgage as security.
Unsecured loans having no Mortgage (Sathye, Bartle, Vincent, & Boffey).
Evaluating Loan Application:
The loan applications of Personal Loans are evaluated on the basis of 3 C's analysis of person's creditworthiness. This 3 C's are as follows:
Character:
Character represents the personal integrity of the person whom the loan is going to be provided. It is considered as the subjective judgment made by the bank or the financial institution about the prospective customer. The decision of providing loan or not is based on the trustworthiness in relation to repayment of loan and return on investment. The character of the person is evaluated on the following grounds:
Track Record of the individual.
Ability of the person to repay the loan and the installment amount.
Purpose of the person to take such loan.
Integrity of the borrower.
Sending habits of the person or borrower (Golam Kabir, 2010; Sathye, Bartle, Vincent, & Boffey).
Capacity:
Capacity is the most important factor of evaluation which refers the ability of the person to repay the loan. The capacity is evaluated on the following grounds:
Current employment details of the borrower.
Capacity of the borrower to service the prospective loan
Details given by the client for the usage of the amount such the list of items to be purchased from such amount.
Amount that is requested to be borrowed and rearrangements of paying such borrowed amount.
Verifying the customer financial history (Golam Kabir, 2010; Sathye, Bartle, Vincent, & Boffey).
Collateral:
Collateral is the backup source for repayment of loan; it is the form of security that the borrower provides to the bank which provides backup to the lender. For the personal loans, collateral evaluation is based on the analysis of the asset that borrower present as the financial security or the personal guarantor that the borrower presents (Golam Kabir, 2010; Sathye, Bartle, Vincent, & Boffey).
Capital:
Capital with respect to the person relates to the investment and other savings made by the person in various options. The investments and other assets of the person depict about his creditworthiness and ability to pay back the loan and if he is not able to pay the loan, such amount could be recovered through such asset if it is included in the terms and conditions of the lending. The lending institute looks carefully on the amount and quality of capital so invested by the prospective borrower. Analyzing capital also includes the analysis of the financial aspects of the prospective borrower such as analysis of the accounts and its transactions made such person to analyze the creditworthiness of the person (Golam Kabir, 2010; Sathye, Bartle, Vincent, & Boffey).
Conditions:
Conditions criteria analyze on the basis of two prospects; first refers to the overall economic climate and the external environment on which the bank and the economic conditions of the person's family is dependent. During the period of recession or high inflation, the bank contracts the economy to maintain the monetary policy which affects the investments and savings of the individual and thus the conditions of the environment also affect the evaluation process of the lending institution. The second aspect is the purpose of the person to borrow the amount of loan from the lending body. The purpose of the borrower can be anything such as enhancing his property or asset or fulfilling the immediate requirement of the borrower (Golam Kabir, 2010; Sathye, Bartle, Vincent, & Boffey).
Assessment Process:
Assessment process of analyzing the personal loan application requires a step by step process which is the basis for credit analysis of the borrower. It includes following stages:
Step 1: Collecting and analyzing the information about the prospective borrower applying for the loan, and designing the indicators about the financial situation of such prospective borrower.
Step2: Collecting and analyzing the credit event of the borrower through the preliminary assessment and the evaluation criteria for the personal loans.
Step3: Assessing the credit risk associated with the credit provided to the prospective borrower. This step is followed by the acceptance and loading of the application of the borrower.
Step4: Taking securities for evaluating the collateral strength of the borrower. At this step, the reliability of the information provided by the client is also analyzed.
Step5: Preparing the analysis for the credit risk which includes the evaluation of interest, fees, charges and other return on the investment for the bank.
Step6: Under this stage, the acceptance or the rejection of the application on the basis of analysis is made.
Step7: Setting the credit terms through effective supervising of loan and follow up (Sathye, Bartle, Vincent, & Boffey; Feschijan, 2008).
Precautions for Granting Credit:
Following precautions must be kept in the mind before granting the personal loan to the borrower:
Inconsistent or withheld information should not be entertained.
Dangers about the over commitment of borrower.
Assure the proper signing of all the documents.
Adhered to bank's lending policy strictly.
Proper analysis of bankruptcy and other information should be done (Sathye, Bartle, Vincent, & Boffey).
Credit Scoring:
In order to optimize the credit analysis process of personal loans, credit scoring technique is the best solution. It facilitates the bank to process large volume credit application quickly with low cost and time. The approvals for the loans can also be made through mails with the help of such scoring (Gerschick, 2002). The criteria for credit scoring are based on following credit scoring model:
Figure : Credit Scoring Model
Source: (Gerschick, 2002)
Pricing of the personal loan:
Loan pricing relates to pricing the loan on the basis of term period, type of loan, return on investment etc, it is considered as the function of cost of funds, Risk, macroeconomic factors, Inflation and competitor's pricing. It can be either fixed or variable or may be with or without early payment penalties. The fees related to the loan are considerably added to the pricing of loan (Quantitative Methods in Credit Management: A Survey, 1994).
Corporate Credit Analysis:
Overview of Corporate Lending:
In today's free economy, lending has become the prime and major function of banks and to channel financial resources to the viable and most productive uses. And for carrying out this function effectively, loan and credit officers are ought to be capable enough for the assessment of proposed business plan whether it is likely to pay off from the operational cash flows. The function of corporate lending by the banks is taken stringently and in a prudent manner in order to adhere to the position of paying off the money to depositors and rightful owners (Savvides, 2011).
Purpose of Corporate Lending:
Organizations and business companies borrow funds from banks for many purposes. One of the most common reasons for is to fulfill ongoing short term monetary obligations and to meet operating expenses, especially in between the time period of conversion of assets into cash. Other reasons are -
Financing of fixed assets or inventories.
Financing a change in the ownership of the company.
Financing long term survival of the company, unless it undergoes turn around (Al-Khazali, 2007).
Principles of Corporate Lending:
The Lending Principles:
Ensure provision of appropriate information about products and services.
Ensure fair treatment to corporate who are interested in our products and services.
Provision of proactive and clear feedback on rejection of application for finance (Dogarawa, 2012).
Periodically review of business circumstances and working closely to build relationship beyond banking.
Sympathetic and positive consideration of circumstances in the event of business facing difficulties (Al-Khazali, 2007).
Methods of Lending Assessments:
5C's Approach:
Key Factors
Issues
What to Look For
Character
Information about the owner
Honesty and Integrity
Reputation in Market
Capacity
Business's ability to repay the loan
Cash flow of business
Repayment Capacity
Demonstrated capacity from repayment of other loans
Capital
Owners investment in the business and capital structure
Loan use and needs in relation to the type and conditions in the loan
Collateral
Loan guarantees - back up of sources of repayment
Business Assets
Personal Guarantee
Group Guarantees
Conditions
Key economic conditions that can impact the business's ability to repay the loan
Economic conditions for that type of business and region.
Risk of price fluctuations.
Production Risks
Source: (Al-Khazali, 2007)
The Corporate Credit Cycle:
The banking lending standards have a statistically discernable relationship and ascertain economical effect of aggregate fluctuations. The dynamics of changes in the bank lending standards from tightening to laxity are rendered and depicted in aggregate fluctuations, and are outlined below -
Dramatic increase during the period of recession, involuntary separations and lay-offs evolve as a key indicator of business cycles.
Effect of established pro-cyclical relationships among aggregate economic activities and extensive credit aggregates.
Changes arising in the banking standards highly dominate cyclical changes in the financing by corporate and business houses, largely influenced during the peak and downside phases of the cycle.
This pattern suggests that during extractions loans are extended on easier terms, instead during contractions (Patrick K. Asea, 1997).
The Credit Rating Agencies:
Favorable ratings available from the recognized agencies by the U.S Securities and Exchange Commission are certainly crucial for the issue and grant of credit that is based on the mortgages and debt obligations. Here is the list of the Credit Rating Agencies -
MODDY'S
moodys thumb Top 10 Credit Rating Agencies of the world
Standard & Poor's
SP thumb Top 10 Credit Rating Agencies of the world
Fitch
fitch ratings thumb Top 10 Credit Rating Agencies of the world
DBRS
DBRS thumb Top 10 Credit Rating Agencies of the world
A.M. Best
A.M. Best thumb Top 10 Credit Rating Agencies of the world
Japan Credit Rating Agency Limited
Japan Credit Rating Agency thumb Top 10 Credit Rating Agencies of the world
Rating & Investment Information Inc.
RI thumb Top 10 Credit Rating Agencies of the world
LACE Financial
lace financial corp thumb Top 10 Credit Rating Agencies of the world
Realpoint LLC
http://www.wealthson.com/wp-content/uploads/2011/07/Real-point.jpg
Egan Jones
Egan Jones thumb Top 10 Credit Rating Agencies of the world
Source: (White, 2010)
Required Skill Set for Loan Officer:
Credit and Loan officers are ought to be trained in the investment appraisal methodology and risk analysis tools additionally the ability to understand the competitiveness aspects of business with success factors.
The credit officer should posses knowledge not only in finance but should be also well verged with marketing concepts in order to judge and determine the reasonability of market projections, market prices and market shares.
Structured training should be imparted of the Monte Carlo Simulation software and its usage for determining and assessing the impact of uncertainty and evaluation of project risks. This eventually leads to the arrival of appropriate financing structure of for the loan proposal (Savvides, 2011).
The Importance of Financial Statements for Credit Risk Assessment:
The quantitative measures of financial statements and ratio analysis are used to detect the financial and operating capabilities and difficulties, especially to determine the degree of bankruptcy prediction. However, the analytical technique of traditional ratio analysis is no longer implemented to the approach of business bankruptcy prediction. Thereby, the theories of scholars and researchers have suggested that traditional ratio analysis when executed in a multivariate framework results in a high statistical significance and is encouraging in today's scenario (Altman, 1968).
Discriminant - Ratio Model:
The Discriminant ratio model has been proved to be the most accurate in determining and predicting extent of bankruptcy of corporate business houses and business credit evaluation. The sign of deterioration is determined by the Ratio Index which can be further utilized to take profitable action. The Discriminant function is as follows -
Z = V1X1 + V2X2 + V3X3 + …..+ VNXN
Where,
V1, V2 ...VN = Discriminant Coefficients
X1 X2 … XN = Independent Variables
Z = Overall Index
X1 - Working Capital to Total Assets Ratio
X2 - Retained Earnings to Total Assets
X3 - Earnings Before Interest and Taxes to Total Assets
X4 - Market Value of Equity to Book Value of Total Debt
X5 - Sales to Total Assets
Source: (Altman, 1968)
Conclusion:
Credit analysis is considered as very important aspect from the both lender's and borrower's point of view. The credit analysis is the only means of evaluating the borrower or the company on the standardized grounds. The credit analysis of both personal loans and corporate lons are equally important and has various similarities in evaluation and assessment process. Yet there are some differences which make the credit analysis of corporate loans much complex s it involves the credit rating and the analysis of financial statement.
