What is Credit Approval?
Borrowers must complete a process called credit approval in order to qualify for a loan. Through this process, a lender assesses the ability and willingness of a borrower to fully repay (interest and principal) a loan on time. Any loan extended by a financial institution is subject to this process to manage the bank’s level of risk exposure.
In assessing the creditworthiness of a corporate borrower, a lender analyzes the client’s financial statements, including the balance sheet, income statement, and cash flow statement as well as inventory turnover rates, debt structure, management performance, and market conditions. Other factors include the borrower’s outstanding debt, the size of the loan required, the term of the requested loan, and the frequency of borrowing.
Key Learning Points
- The key players in the credit approval process are the sales manager, relationship manager, credit officer, and credit analyst.
- The credit approval process involves the entire credit team, which produces a credit memo.
- The credit approval should take into account four factors: the type of borrower, cash flow source, value and type of collateral, and level of exposure.
- Credit risk can be categorized into three risk components: the probability of default (PD), loss given default (LD), and exposure at default (EAD).
- The debt service coverage ratio (DSCR) allows lenders to assess the ability of a company to meet its financial obligations. It’s calculated by dividing net operating income by total debt service costs.
Key Players in the Credit Approval Process
Within a bank’s loan department, there are many individuals involved in the credit approval process when the bank receives a commercial loan request. The most common type of commercial loan application is for term loans.
Every bank has a team of commercial relationship managers who are supervised by a sales manager. He or she is usually the first person to view the loan request. Typically, the sales manager’s involvement includes an expeditious decision on whether to accept a loan request or reject the same.
Relationship manager: this is the salesperson of the bank/lender who most of the time attempts to get new ‘relationships’ for the bank i.e. loan and deposit accounts, and is actively involved in enticing prospective borrowers and depositors to have a banking relationship with the bank.
Credit officer: he or she is authorized by the bank to approve or deny a credit request by a prospective borrower. This officer is usually authorized to approve a loan request up to a certain amount (for example, US$100,000) – which is the maximum amount they are permitted to approve. If the size of the loan request exceeds the credit officer’s approval authority, it may need to be forwarded to a senior credit officer, or for amounts beyond a certain limit be referred to the credit committee of the bank.
The credit officer assesses a loan application to determine whether it is viable or not and assesses the financial history of the prospective borrower to gauge whether it is a risk worth taking or not. He or she reviews the prospective borrower’s credit history, collateral, and capacity.
Credit analyst: this person analyses the financial information and situation of the borrower, and analyses all the information accumulated by the relationship manager vis-à-vis the borrower i.e. to evaluate the credit risk of the prospective borrowing company. He or she uses ratios – profitability ratios, leverage ratios, coverage credit analysis ratios, and liquidity ratios – to assist in the credit analysis process. Further, the borrower’s relative market position and operating efficiency are also analyzed and so are the quality of management and industry-specific credit risk.
Following the aforesaid analysis, the same is included in a loan approval document. This document includes the various types of risks involved if the loan request is accepted, the benefits of approving the loan, and outlines the probability of repayment/default on the loan.
If the credit is approved, this document is signed by the relationship manager and the credit officer.
Credit Approval Process
Identification of loan prospect: the relationship manager of the bank/lender identifies a prospective borrower (company) and commences preliminary discussions around the amount required term and cost of borrowing, and the purpose for which the loan is required – short-term or long term. Usually, loans made are term loans. Relationship and Sales – in the next step, the relationship manager forwards the loan request to the sales manager. They discuss the profile of the prospective borrower and whether they wish to take the loan request forward or not. If the decision is to go ahead, then the sales manager will get back to the prospective borrower and request the audited financial statements of the company – balance sheet, income statement and cash flow statements, and any other documents that are required for the credit approval process.
Credit analysis: the aforesaid documents are then forwarded to the credit analyst of the bank. Then the relationship manager and the credit analyst discuss the proposed structure of the loan. The point of structuring a loan is to mitigate risk. It includes discussions such as to whom the bank is lending, if there are any complexities in the borrower’s corporate structure, choosing the right kind of loan that matches the future cash flows of the borrower with the repayment schedule, etc.
Following the discussions, the credit team performs a credit analysis of a company that wants to borrow. This involves assessing business risk and financial risk. Upon completion of the analysis, a loan approval document is prepared, which is sometimes referred to as a credit memo.
Loan approval document or credit memo: this document includes details such as the debt capacity of the borrower, clarity on risks involved and mitigating factors to those risks, a summary of the loan request that includes the loan amount, term of the loan, proposed interest rate, use of funds, and guarantors among other details, and information of the prospective borrowing company with reference to what it does, how long has it been in operation and its operating experience.
The loan approval document ie. and credit memo also include information pertaining to industry research, which includes how the prospective borrowing company compares to other companies in the industry, prevailing trends vis-à-vis the industry, and the industry’s growth prospects and outlook.
The analysis of the ability of the company to repay the debt in full and on time is also included in this document. This assessment includes an analysis of past data, growth trends, overall industry trends, proposed loan terms, and making certain assumptions that will help the bank to estimate the debt service coverage ratio (DSCR).
Next, insights pertaining to the financial statements are mentioned in this document and contain key ratios, historical trends, and some data that reflects the financial health of the company. Further, details about the guarantor of the loan, financial analysis of the same, the ability of the guarantor to cover any shortfalls in debt servicing, and liquidity of guarantor-related analysis are also stated in this document. Lastly, the loan approval document contains information regarding whether the prospective borrower is an existing or new client. Further, what other loans do they have outstanding, and do they have deposits?
Having stated the above, once the loan approval document is completed by the credit analyst, it is forwarded to the relationship manager for examining the same. There are usually two or three rounds of edits that take place and included proposed loan covenants too.
After the contents of the loan approval document or credit memo are reviewed by the relationship manager and he or she is satisfied with it, it will be reviewed by the credit officer. This officer reviews and changes/edits this document to ensure that the loan structure or deal is something he or she is comfortable with. Once this is ensured, thereafter, the credit officer will sign this document with the relationship manager.
Upon approval of the credit request by the credit officer, the relationship manager gets in touch with the prospective borrower and outlines the approved structure of the loan. This is sent in a term sheet. The borrower could try to alter some aspects of the deal but usually does not have too much latitude. If the terms of the loan are acceptable, the borrower signs the term sheet. Thereafter, the bank/lender issues a letter of commitment.
Finally, after the aforesaid procedure is completed, the bank’s internal loan operations area or an attorney is involved in the preparation of the loan documents. Once these documents are prepared and the borrower’s attorney has reviewed the same, the borrower will sign these documents resulting in the culmination of the credit approval process.
Segmentation of Credit Approval Process
Three factors should be taken into account vis-à-vis the segmentation of the credit approval process i.e. structuring such a process.
Type of borrower: in general, is used as the highest layer in the process of credit approval. The type of borrowers can be categorized into sovereign borrowers, other public authorities, corporates, and individual borrowers (i.e. the retail segment). Each of them has a different risk profile.
Cash flows source: the credit review has to focus on the asset that has to be financed and the cash flows that are expected from the same.
Value and type of collateral: the value and type of collateral have a major impact on the risk associated with lending. Some types of forms of lending give the lender a substantial degree of control over the asset being financed and consequently lower their risk exposure – when compared to other types of collateralized lending. For example, mortgage finance and leasing finance.
Level of Exposure: what is the level of exposure of a bank/lender, as it has an immediate impact on the Exposure at Default (EAD). Consequently, if there is a rise in the level of exposure to a prospective borrower, it should trigger a more comprehensive credit approval review for the purpose of risk minimization.
Categorization of Credit Risk
From a risk perspective, the quality of the credit approval process is determined by the best possible identification and assessment of the credit risk resulting from a loan request. The credit risk can be categorized or distributed into three risk components.
Probability of default (PD): the probability that a prospective borrower will default is assessed by its current and future ability to honor all debt-related payments – interest and principal. The PD for companies is obtained from credit rating agencies. If the probability of default is lower, then the credit might be approved with a lower cost of borrowing i.e. at a lower interest rate or with no requirement of down payment against the loan. Pledging of collateral against the loan is a measure to partly manage the risk involved.
Loss given default (LGD): is an assessment of the amount of loss that a bank/lender could incur, should the borrower default on the loan. The LGD is affected by the collateralized portion, along with the cost of selling the collateral. Consequently, in the designing of credit approval processes, the computed value, and type of collateral also need to be taken into account.
Exposure at default (EAD): assesses the amount of exposure to loss the bank/lender is exposed to at any particular point in time and reflects the risk appetite of the lending institution.
What is Debt Service Coverage Ratio?
An integral part of the credit approval process is the analysis of the financial standing of the prospective borrower and it involves assessing the ability of the same to honor its debt repayment obligations in full and on time. For this purpose, certain financial ratios are analyzed by the credit analyst. One such ratio is the debt service coverage ratio (DSCR).
Debt service coverage ratio (DSCR) is a financial ratio through which lenders assess the ability of a company to meet its financial obligations i.e. ability to use its operating income to meet all debt (short-term and long-term) related obligations that include periodic or scheduled payment of interest and repayment of principal. A higher (lower) ratio indicates a greater (lower) ability of a company to meet its debt obligations. Simply put, this ratio measures the relationship between a company’s business income and its debt and reflects its current financial condition. Generally, a DSCR of 2 or higher is considered an ideal ratio.
The DSCR is important as it reflects how healthy is the cash flow of a company. If it is generating enough income to qualify for a loan (for lenders, this is a key ratio to assess) i.e. to determine the company’s debt servicing ability.
Other important ratios (leverage ratios) assessed for the purpose of determining a borrower’s debt servicing ability are a debt to assets ratio, asset-to-equity ratio, debt-to-equity ratio, and debt-to-capital ratio. These ratios compare the level of debt of a prospective borrower against other metrics using the balance sheet, income statement, or cash flow statement.
Banks or creditors prefer lower leverage ratios, as it is indicative of less leverage and therefore lower existing risk. Lower leverage ratios are reflective of the fact that less asset or capital is being financed by debt.
Debt Service Coverage Ratio (DSCR) – Formula and Salient Points
A company’s DSCR can be computed by either of these two formulas:
DSCR = EBITDA/ Interest Expense + Principal (i.e. Total Debt Service)
DSCR = EBITDA – CAPEX/ Interest Payment + Principal (i.e. Total Debt Service)
EBITDA = Earnings before Interest, Tax, Depreciation, and Amortization
Principal = Total of Short and Long-Term Debt
Interest Expense = Interest Payable on all Debt
Capex = Capital Expenditure
When CAPEX is excluded from EBITDA, it may provide a more accurate picture of the actual amount of operating income that is available to a company for meeting its debt repayment obligations. Note, that Capex is not expensed to the income account.
A high DSCR indicates that a company is generating adequate income to meet its debt-related obligations and still making a profit. Further, If the DSCR of a company is more than 1, it means that the company’s net operating income is adequate enough to meet all its debt-related obligations. For example, if a company’s DSCR is 1.2, it means that it can meet its annual debt service-related obligations 1.2 times with its net operating income.
If the DSCR is below 1, it suggests that a company is unable to service its debt and there is a higher probability of default or bankruptcy. A low DSCR also indicates that a company may even be having a negative cash flow. More specifically, if the DSCR is less than 1, it means that the company’s net operating income generated by it is not adequate enough to cover all its debt-related obligations. If for example, the DSCR is 0.6, it means that the company’s net operating income can only cover 60% of its annual debt service-related obligations.
Debt Service Coverage Ratio (DSCR) – Formula and Salient Points
Given below is the calculation of DCSR (including CAPEX) and DCSR (minus CAPEX) of Company A, based on the information below (using the aforesaid formulas). The calculations show that the DSCR in both cases is less than 1. This company can repay or cover its debt service 0.62 times over its operating income (when including CAPEX) and only 0.2 times over its operating income (when CAPEX is deducted).
This company has a low DSCR i.e less than 1, which possibly suggests that the probability of default is high. Consequently, it is unlikely to be granted credit approval vis-à-vis its loan request, as this company is unlikely to be able to generate adequate income to meet its debt-related obligation in full and on time.