What is Commercial Credit Analysis?
Commercial credit analysis is the evaluation of a company’s ability to meet its financial obligations. The objective of the analysis is to determine the level of risk associated with an entity. For example, when a company issues bonds, an investor may analyze the audited financial statements of the issuer to determine its default risk. Banks also review the financial statements of potential borrowers to determine their ability to make timely principal and interest payments.
After the conclusion of the evaluation, a risk rating is obtained. It is done by estimating the borrower’s risk of default at a given confidence level and the amount of loss that the lender will suffer in the event of a default. The risk rating determines if the lender will provide credit to the borrower, and if so, the amount of credit to be provided.
- Commercial credit analysis refers to the evaluation of a company’s ability to honor its debt obligations.
- Credit analysis assigns a risk rating to an entity, based on the entity’s level of default risk and the estimated amount of losses that the lender will suffer in the event of default.
- The lender evaluates the business to determine if it generates adequate cash flows to meet the debt service, i.e., principal and interest payments.
How Commercial Credit Analysis Works
When conducting credit analysis, investors, banks, and analysts may use a variety of tools such as ratio analysis, cash flow analysis, and trend analysis to determine the default risk of a company. Sometimes, credit analysts may conduct a review of the collateral provided, credit history, and the management’s ability. The analysts aim to predict the probability that the borrower will default on their financial obligations and the level of losses that the lender will suffer in the event of default.
When a bank is reviewing a loan application, the main emphasis will be the cash flows generated by the borrower. The main ratio used to measure the repayment ability of the borrower is the debt service coverage ratio (DSCR). The DSCR is obtained by dividing the entity’s total cash flows by the debt service (annual interest and principal payments). The debt service coverage ratio may be expressed as a minimum ratio, below which the lender will not accept to extend credit.
A DSCR of less than one indicates an entity’s cash flow is negative and the cash flow generated is not enough to cover the debt payments. A DSCR of one means that the entity generates enough revenue to cover the debt payments. A DSCR of 1.5 is preferred, and it means that the entity generates enough cash flows to pay all the debt payments and an additional 50% cash flow above what is required to service its debt.
The 5 C’s of Commercial Credit Analysis
The 5 C’s of credit analysis is a basic framework that guides the lender in assessing the creditworthiness of a borrower. The 5 C’s are as follows:
Character is an important element of credit analysis, and it looks at the borrower’s reputation for paying debts. The lender is interested in lending to people who are responsible and needs to be confident that they have the right experience, education background, and industry knowledge to operate the business.
In addition, the lender assesses the borrower’s character by looking at their credentials, reputation, interaction with other people, as well as credit history. It will review the borrower’s credit report to know how much they have borrowed in the past, and whether they paid the credit on time. Most lenders have a base credit score that loan applicants must meet in order to qualify for a specific type of credit.
Capacity evaluates the borrower’s ability to service the loan using the cash flows generated by the business. The lender wants the assurance that the business generates enough cash flows to able able to make principal and interest payments in full.
The lender will assess the capacity of the borrower by looking at their cash flows statements, credit scores, as well as the payment history of current loans and expenses. It will calculate how repayments are supposed to take place, the timing of repayments, current cashflows, and the probability that the borrower will make successful repayments.
Capital is the amount of money that the business owner or executive team has invested in the business. Lenders are willing to extend credit to borrowers who have invested their own money into the business, which serves as proof of the borrower’s commitment to the business.
Borrowers with a large capital contribution in the business find it easier to get loan approval because they present a lower risk of default. For example, when buying a home, a borrower who has placed a down payment of about 20% of the value of the house can get better rates and terms for the mortgage.
Collateral is the security that the borrower provides as a guarantee for the loan, and it acts as a backup in the event that the borrower defaults on the loan. Most often, the collateral provided for the loan is the asset that the borrower is borrowing money to finance. For example, a home acts collateral for mortgages, and auto loans are secured by vehicles. The collateral can also be inventory for the business, real estate property, factory equipment, and working capital.
The condition of the loan refers to the purpose of the loan, as well as the conditions of the business. The loan’s purpose can be to purchase factory equipment, finance real estate development, or serve as working capital. Loans with a specific purpose are easier to approve than signature loans that can be used for any purpose.
The lender also considers the condition of the environment in which the business operates. The conditions can be the state of the economy, industry trends, competition, etc., and how these factors may affect the borrower’s ability to repay the loan.
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