* Safety of Loan: Borrower should be of good character, financially sound with the ability and willingness to repay the loan. * Suitability of Loan Purpose: Loan applications may be accepted or rejected subject to bank policy, legality and ethical principles.
* Profitability: The risks and returns from lending activities must be carefully considered to improve viability of loan portfolio. * Following the Lending Principles: Regardless of loan size, lending principles of varying levels of sophistication must be rigorously adhered to.Traditional Methods of Credit Analysis — the “Five Cs”: * Character : Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered.
The quality of your references and the background and experience levels of your employees will also be reviewed. Capacity : Capacity to repay is the most critical of the five factors, it is the primary source of repayment - cash. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal or commercial- is considered an indicator of future payment performance.
Potential lenders also will want to know about other possible sources of repayment. * Capital : Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding. * Collateral : Collateral, or guarantees, are additional forms of security you can provide the lender.Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan.
A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan. * Conditions : Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory?The lender will also consider local economic conditions and the overall climate, both within your industry and in other industries that could affect your business. TO GET INFORMATION ON 5’C A FIRM MAY RELY ON THE FOLLOWING : 1. Financial Statements – Financial statements contain a wealth of information.
Asearching analysis of the customer’s financial statements can provide usefulinsights into the creditworthiness of the customer. The following ratios seemparticularly helpful in this context: current ratio, acid-test ratio, debt-equity ratio,EBIT to total assets ratio, and return on equity. 2.Bank References – The banker of the prospective customer may be another sourceof information. To ensure a higher degree of candour, the customer’s banker maybe approached indirectly through the bank of the firm granting credit.
3. Experience of the Firm – Consulting one’s own experience is very important. If the firm has previous dealings with the customer, then it is worth asking: Howprompt has the customer been in making payments? How well has the customer honoured his word in the past? Where the customer is being approached for thefirst time, the impression of the company’s sales personnel is useful. .
Prices and Yeilds on Securities – For listed companies, valuable inferences can bederived from stock market data. Higher the price-earnings multiple and lower theyield on bonds, other things being equal, lower will be the credit risk Modern Approaches to Credit Risk Measurement: * Econometric techniques : involve the modelling of the probability of default. This probability is used as a dependent variable (effect) whose variance is explained by a set of independent variable (cause). Financial ratio and other external variable are generally used as independent variables.
Econometric techniques include linear and multiple discriminant analysis, multiple regression, logit analysis and probit analysis. * Optimisation models : use mathematical programming techniques to minimise lender error and thus maximise profit. * Neural networks : try to emulate the human decision-making process using data asa used in econometric techniques. * Hybrid systems : involve establishing causal relationship by estimating the parameters of such relationship. The KMV Corporation’s KMV model is an example of hybrid system.
