What is the Credit Analysis Process?
The credit analysis process refers to evaluating a borrower’s loan application to determine the financial health of an entity and its ability to generate sufficient cash flows to service the debt. In simple terms, a lender conducts credit analysis on potential borrowers to determine their creditworthiness and the level of credit risk associated with extending credit to them.
During the credit analysis process, a credit analyst may use a variety of techniques, such as cash flow analysis, risk analysis, trend analysis, ratio analysis, and financial projections. The techniques are used to analyze a borrower’s financial performance data to determine the level of risk associated with the entity and the amount of losses that the lender will suffer in the event of default.
- Credit analysis is the evaluation of a borrower’s loan application to determine if the entity generates enough cash flows to settle its debt obligations.
- The credit analysis process involves collecting information from the borrower, analyzing the information provided, and making a decision on whether or not to approve the loan.
- A credit analyst uses various techniques, such as ratio analysis, trend analysis, cash flow analysis, and projections to determine the creditworthiness of the borrower.
Stages in the Credit Analysis Process
The credit analysis process is a lengthy one, lasting from a few weeks to months. It starts from the information-collection stage up to the decision-making stage when the lender decides whether to approve the loan application and, if approved, how much credit to extend to the borrower.
The following are the key stages in the credit analysis process:
1. Information collection
The first stage in the credit analysis process is to collect information about the applicant’s credit history. Specifically, the lender is interested in the past repayment record of the customer, organizational reputation, financial solvency, as well as their transaction records with the bank and other financial institutions. The lender may also assess the ability of the borrower to generate additional cash flows for the entity by looking at how effectively they utilized past credit to grow its core business activities.
The lender also collects information about the purpose of the loan and its feasibility. The lender is interested in knowing if the project to be funded is viable and its potential to generate sufficient cash flows. The credit analyst assigned to the borrower is required to determine the adequacy of the loan amount to implement the project to completion and the existence of a good plan to undertake the project successfully.
The bank also collects information about the collateral of the loan, which acts as security for the loan in the event that the borrower defaults on its debt obligations. Usually, lenders prefer getting the loan repaid from the proceeds of the project that is being funded, and only use the security as a fall back in the event that the borrower defaults.
2. Information analysis
The information collected in the first stage is analyzed to determine if the information is accurate and truthful. Personal and corporate documents, such as the passport, corporate charter, trade licenses, corporate resolutions, agreements with customers and suppliers, and other legal documents are scrutinized to determine if they are accurate and genuine.
The credit analyst also evaluates the financial statements, such as the income statement, balance sheet, cash flow statement, and other related documents to assess the financial ability of the borrower. The bank also considers the experience and qualifications of the borrower in the project to determine their competence in implementing the project successfully.
Another aspect that the lender considers is the effectiveness of the project. The lender analyzes the purpose and future prospects of the project being funded. The lender is interested in knowing if the project is viable enough to produce adequate cash flows to service the debt and pay operating expenses of the business. A profitable project will easily secure credit facilities from the lender.
On the downside, if a project is facing stiff competition from other entities or is on a decline, the bank may be reluctant to extend credit due to the high probability of incurring losses in the event of default. However, if the bank is satisfied that the borrower’s level of risk is acceptable, it can extend credit at a high interest rate to compensate for the high risk of default.
3. Approval (or rejection) of the loan application
The final stage in the credit analysis process is the decision-making stage. After obtaining and analyzing the appropriate financial data from the borrower, the lender makes a decision on whether the assessed level of risk is acceptable or not.
If the credit analyst assigned to the specific borrower is convinced that the assessed level of risk is acceptable and that the lender will not face any challenge servicing the credit, they will submit a recommendation report to the credit committee on the findings of the review and the final decision.
However, if the credit analyst finds that the borrower’s level of risk is too high for the lender to accommodate, they are required to write a report to the credit committee detailing the findings on the borrower’s creditworthiness. The committee or other appropriate approval body reserves the final decision on whether to approve or reject the loan.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: