Loan Request Evaluation
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 loan
outstanding might decline rapidly and even be repaid early. The required loan
amount is thus a function of the initial cash deficiency and the pattern of
future cash flows. *The primary source and timing of repayment: The primary
source of repayment of loans is