What is the Credit Process?
The credit process is undertaken to review credit applications and determine whether a loan will be granted to the applicant. The process seeks to determine the borrower’s ability and willingness to honor payment obligations (including interest and principal) on time and in full. The process also investigates the source(s) of funds from which the borrower will make to make an informed decision. The institution must also understand the borrower’s industry and may undertake a detailed analysis of how the business generates cash from its operating activities.
The lending institution applies credit analysis, which includes an analysis of both business risk and financial risk to assess the probability of default. The process also allows the lender to make informed decisions about structuring and pricing a loan.
Key Learning Points
- An integral part of the credit process is an analysis of the borrower’s cash flows and financial statements.
- Credit analysis covers two key risks – business risk and financial risk.
- Adequate cash flow is key as the bank is primarily concerned with a borrower’s ability to generate enough cash to service the debt.
- Banks set aside a portion of loan repayments to meet anticipated credit losses. This is called loan loss provisioning.
Credit Process – Steps Involved
A bank’s loan department manages the process of granting loans to corporates, ensures regulatory compliance, and undertakes all other related functions. This is an important corporate banking function, as any type of lending is accompanied by the risk that a borrower will default.
The credit process evaluates the ability and willingness of a borrower to repay the debt, underwrites the risk, prices the loan, and determines whether the loan fits the bank’s portfolio. An integral part of the credit process is analysis of the borrower’s cash flows and financial statements.
What Type of Debt – Short-Term or Long-Term?
Borrowers may seek short-term debt (to fund short-term needs such as working capital) or long-term debt (to support longer-term assets). The most common loans are term loans. Given their longer duration, they carry higher risk and consequently charge a higher interest rate.
The credit process involves several steps that can be broken down into initial and later stages.
1. Generating a Loan Opportunity
In the initial stage, the product team generates the loan opportunity. Thereafter, the credit team undertakes a risk assessment that involves an initial analysis of the potential borrower’s business. Credit analysis covers business risk and financial risk as part of the initial risk assessment.
2. Reviewing the Five Cs of Credit
It might be noted that in credit analysis, financial institutions attempt to mitigate risk by reviewing the five Cs of credit – capacity, capital, conditions, character, and collateral. These five Cs provide lenders a framework for identifying and mitigating risk.
3. Structuring the Loan
If the credit analysis yields a positive initial risk assessment, the bank must structure the loan. The point of structuring a loan is to mitigate risk and includes details such as the identity of the borrower, any complexities in the borrower’s corporate structure, and a payment schedule that matches the borrower’s future cash flows.
4. Preparing a Credit Memo
Once the loan is structured, a credit memo is prepared. The memo includes details such as the borrower’s debt capacity, clarification of risks involved, and how those risks will be mitigated. The memo is presented to the bank’s credit committee, which decides whether to put the bank’s capital at risk. At this stage, an application can be rejected even if it passed the initial risk assessment.
5. Loan Syndication
Should the credit committee approve the loan application, the loan will be disbursed, or in the case of a larger loan, a syndicate team will price the loan and distribute exposure to a group of banks called a syndicate. The final terms between the banks are negotiated and then the funds are disbursed. Thereafter, the loan will be monitored to ensure terms are met.
In loan syndication, a group of lenders collaborate to provide credit to a single large borrower, which could be a conglomerate, multinational corporation, or government. The collaboration usually takes place through an intermediary, the lead bank, that organizes and administers the syndicated loan. In loan syndication, the risk is shared by the group of lenders and each lender contributes a portion of the principal. Syndication typically occurs when the requested loan amount is beyond the capacity of a single lender.
To develop an even more comprehensive understanding of the process undertaken by lenders, enroll in the Credit Analyst online course. The course is designed to develop knowledge and skills that can be applied directly to any credit analyst role.
Credit Analysis – Business Risk and Financial Risk
Credit analysis assesses the ability and willingness of a borrower to make payments on time and in full. Such analysis includes:
Business risk: this includes macroeconomic, industry, and company risks that impact a business’s earning prospects and their ability to generate operating cash flows. This in turn determines their capacity to meet debt obligations. These obligations include periodic or scheduled interest payments and repayment of principal. Business risk is one of the drivers of default risk in corporate lending, along with financial risk, and an increase due to rising economic, industry, and/or company-related risks is likely to increase default risk. As part of the lending process, credit analysts undertake comprehensive business risk assessments to mitigate the risk of default.
Financial risk: the underlying intention of analysis is to gauge whether the borrower will be able to generate sufficient cash flow to meet debt obligations. This part of credit analysis involves the analysis of cash flows, ratio analysis, financial forecasts, and trend analysis to determine creditworthiness. Such analysis enables the lender to determine the level of risk associated with the loan and the potential loss in the event of a default.
The analysis of business operations, the quality of the borrower’s financial statements, current financial position, past financial performance, capital adequacy, and financial flexibility, or the ability of the borrower to raise capital, are all part of the credit risk evaluation.
Finally, note that most banks lend based on cash flows. The ability of the borrower to generate cash to meet interest and principal payments is the strongest determinant of the lending decision.
Cash Flow Adequacy
The cash flow statement measures the change in cash from one year to the next. The key components of a cash flow statement include cash flows from operating, investing, and financing activities as well as the reconciliation of net cash flow.
The concept of cash flow adequacy is important, as a bank is primarily concerned with whether a company will generate enough cash to service its debt and repay the principal. Lending to borrowers with strong operating cash flows (OCF) decreases risk.
The three key metrics in assessing cash flow adequacy include:
- Funds from Operations (FFO)
- Operating Cash Flow (OCF)
- Discretionary Cash Flow (DCF)
Funds from Operations (FFO): Funds from operations demonstrate a company’s ability to generate recurring cash flows independent of fluctuations in working capital. It leaves out changes in working capital, capital spending, and discretionary items (for example, dividends and acquisitions).
Operating Cash Flow (OCF): OCF is cash generated from the business operations of a company, which includes working capital. It ignores the requirement for a company to pay for fixed assets for growth or maintenance.
Discretionary Cash Flow (DCF): DCF refers to the cash generated by operations less CAPEX. It ignores the debt maturity but includes dividends to shareholders, even though these payments rank below interest payments.
Cash Flow Adequacy– A Key Liquidity Ratio
The Cash Flow Adequacy Ratio, a liquidity ratio, is calculated using the following formula:
Cash Flow Adequacy Ratio = Operating cash flows (cash flow from operations)/(Long Term Debt + Fixed Assets Purchased + Dividends Paid)
OCF is compared to the payments made for reducing long-term debt, purchasing fixed assets, and dividend payments to shareholders.
This ratio shows whether a company is generating enough cash from its operations to support these expenses. If the ratio is under 1, the company is not generating enough cash.
Example: A company’s OCF is US$ 250 million and during the period being analyzed, it paid down the long-term debt of US$ 85 million, purchased fixed assets worth US$ 80 million, and paid out dividends of US$ 30 million, then:
Cash Flow Adequacy Ratio = 250/ (85 + 80 + 30) = 1.28
Loan Loss Provisions
To balance income with default losses and survive any economic downturn, banks set aside a portion of loan repayments called loan loss provisions to meet anticipated losses. Several factors impact how loan loss provisions are calculated. These include historical data on defaults and repayments, collections expenses, and losses incurred from late payments. Also considered are prevailing interest rates and the state of the economy.
Below please see an example of a loan loss provision by Bank A. Here past-due loans are categorized by length of delinquency. The percentages (%) of loan provisions are 10%, 15%, and 20%. Based on this information, we can calculate the loan loss provision rate – which in this case is 16.7%. This rate reflects the bank’s capacity to bear the loan losses. A higher loan loss provision rate (%) indicates that the bank has a greater ability to withstand loan losses.
In the second example below, we use the following formula to calculate the loan loss provision coverage ratio.
Loan Loss Provision Coverage Ratio = bank’s pre-tax income + loan loss provision/net charge-offs.
Assume that a bank extends a $20 million loan to a company that manufactures smartphones. After a year, the economy takes a downturn. As a result, the company cannot fully repay the loan. Due to the economic downturn, the bank expects that the company will be able to make only 60% of the repayment. Consequently, it makes a loan loss provision of US$ 8 million.
But the bank collects not 60% of the repayment (US$ 12 million), but only US$10 million, and the net charge-off is US$10 million. Further, the bank records pre-tax income of US$ 3 million. From this data, we calculate the loan loss provision coverage ratio (3.8%).
Access the free download to practice these loan loss provisions calculations.
The credit process involves a thorough assessment of a borrower’s creditworthiness, and their ability and willingness to repay a loan. A bank’s credit policy should clearly define acceptable loan purposes, the various types of loans and structures, and the sectors/industries that it will lend to, along with all information to be provided by the loan applicant. Such a policy plays a pivotal role in creating the framework for lending, the requirements, and acceptable limits, and helps the bank manage credit risk.