What is the Credit Analysis Process?

What is the Credit Analysis Process?

The credit analysis process involves a thorough review of a business to determine its perceived ability to pay. To do this, business credit managers must evaluate the information provided in the credit application by analyzing financial statements, applying credit analysis ratios, and reviewing trade references.

Lending money to high credit risk borrowers can result in lower revenue and cash flow for banks or other lending institutions. To mitigate the credit risk from borrowers who might not repay the loans, the banks have a credit analysis process in place to evaluate the financial standing of the borrower and check whether they meet the criteria specified by the banks or other lending institutions.

The credit analysis process is all about evaluating and assessing the loan request of the borrowing party to determine whether they have a good cash flow to service their loan payments promptly. It helps to determine the creditworthiness of the borrower based on their historical financial track record and also identify the level of credit risk associated with loaning the money to the borrowers.

Now to evaluate the creditworthiness, the lending parties have various credit analysis techniques that will help to find out the facts. Some of the most prominent credit analysis techniques include ratio analysis, risk analysis, cash flow analysis, trend analysis, financial projections, etc.

This technique helps to effectively evaluate the amount of loss that will occur in case the borrowers default on their loan payments. Primarily the credit risk analysis process is distributed in three stages.

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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.

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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.

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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.