3 Steps of Credit Analysis

3 Steps of Credit AnalysisCredit analysis is the process of evaluating an applicant’s loan request or a corporation’s debt issue to determine the likelihood that the borrower will live up to his/her obligations.

In other words, credit analysis is the method by which one calculates the creditworthiness of an individual or organization.

Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as a credit history and management ability.

Analysts attempt to predict the probability that a borrower will default on its debts, and also the severity of losses in the event of default.

1. Steps During the Information Collection Stage

Collecting information about the applicant

The first step in credit analysis is to collect information of the applicant regarding his/her record of loan repayment, character, individual and organizational reputation, financial solvency, ability to utilize the load(if granted), etc.

The bank may inquire into the transaction record of the applicant with the bank and other banks. The repayment history of loans previously granted may also reveal useful information in this regard.

Collecting information about the business for which loan is required

The loan officer should know the purpose of the loan, the amount of the loan and if it is possible to implement the project by that amount.

The banker should make sure the project is feasible. The project must have good potential and the applicant has a good plan to execute the project.

Collecting information about the recovery process

The loan officer should collect information about the sources from which the borrower would repay the loan.

Information for this purpose may include the profitability of the project, the payback period, the sensitivity of the project cash flow to different economic factors, etc.

Collecting information about the security

Banks, most often than not, lend money against personal and non-personal securities. A bank would always prefer getting the loan repaid by the borrower to realizing the loan from the sale proceeds of the security.

However, should the borrower default in repaying the loan the lender will have to fall back on the security. Hence, it is always advisable to know information like price stability, etc. about the security before advancing the loan.

Collecting additional information if necessary

When the loan under consideration is for a large amount a bank may find it necessary to gather additional information like the overall business activities in the economy, the probably political and economic condition of the country, efficiency, and candidness of the management team, likely effect of local and international competition on the project, etc.

2. Steps During the Information Analysis Stage

Analyzing the accuracy of information

The information given in and along with the application is analyzed to judge their accuracy.

In this regard, the analyst would scrutinize the national identity card, driver’s license, trade license, partnership deed, corporate charters, resolutions, and other legal documents attached to the application.

Analyzing the financial ability of the applicant

In this stage, the financial ability of the applicant is taken into consideration. The financial solvency of the applicant and his skill and capability are important factors in this regard.

The analyst works out different financial ratios from the past and proforma income statements, balance sheets, cash flow statements, and other financial statements of the applicant and analyzes them to reach about a conclusion about the applicant’s financial ability.

Analyzing the effectiveness of the project

One aspect of credit analysis is the analysis of quality, purpose, and prospect of the project for which loan has been applied. The banker will be at ease to grant loans if the project is productive, expandable, and of course profitable.

On the other hand, if the project is in a declining stage, is up against the intense competition, or is confronted by adverse conditions the bank is likely to be reluctant to grant any loan.

Analyzing the possibility of loan repayment

The analyst looks at what effect the proposed loan will have on increasing the liquidity and income of the applicant.

The net cash flow is a good indicator of the ability of the applicant to repay the loan along with interest and other expenses within due time.

An analyst may also interested to see the- interest burden and fixed charge burden of the applicant.

3. Decision-Making Stage

Depending on the analysis the analyst identifies and measures the credit risk associated with a loan application and determines whether the level of risk inherent is acceptable or not.

If the analyst is satisfied that the risk is acceptable and is convinced that the loan will be repaid, he/she prepares and submits a recommendation to the appropriate loan approval authority for sanctioning the loan.

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