evaluation of commercial loans



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.
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.

*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