MCF 304: Bank Management Lecture 4.2 Credit Analysis

Credit Analysis Credit analysis is the most important activity in the lending process of any commercial bank. This activity involves a network of task which are based on theoretical model to ascertain the credit standing of loan applicants At the end of credit analysis process, a credit decision proposal will be presented to the bank’s management for final decision making

Credit Analysis The credibility of a credit decision is very much dependent on the credibility of the credit analysis. Credit analysis is greatly influenced by ratio analysis because of the availability of financial information

Credit Analysis Determine the credit standing of potential borrower However the issue of asymmetric information often arise because borrowers certainly have more information than banks on their future Credit analysis is practiced to determined the repayment capacity of prospective borrowers & their attitude towards loan repayment

Credit Analysis Banks desire borrowers not only with repayment capacity but also posses the sense of responsibility towards loan repayment The 5C model is used in credit analysis to determine credit risk related to non-repayment of loans

5 C’s Character Evaluation on the applicant willingness to make payment Historical credit records & character reference from third party Image, good standing, reputation, business prospects, etc.

5 C’a Capacity Evaluate the applicants both from the legal & finance point of view Is the borrower have legal capacity to enter into a contract? Main objective is to determine the borrowers capacity to repay the loan

5 C’s Collateral Any asset pledge by borrower to secure a loan Need to know the age, condition & specialization level of the pledged assets Banks however is more interested in loan repayment rather than the collateral

5 C’s Conditions Evaluate the economic conditions that may effect the borrowers capacity to repay the loan Forecast the exposure of borrower’s business to economic and interest rate changes Capital Applicant’s net worth because its symbolize success & commitment Higher net worth indicates higher loan repayment capacity Net worth encompasses accumulated earnings

Scope of credit Analysis Depends on the size & maturity period of the loan, the track records of the company, the collateral involved and the past relationship between the applicant & the bank Does not mean that credit analysis can be forgone even if the collateral value exceeds the loan amount

Source of Credit Information Source of Credit Information Loan applicant interviews – to collect information on the character of applicants Bank records – factual & highly reliable credit information Business premises – to verify the existence of business & understand the structure and operations of the company

Credit Analysis Financial statements – to performed trend analysis on credible (audited) financial statements Credit bureau – CCRIS / CTOS / RAM Inter bank references – cross checks from other banks

Evaluation of Financial Statements Assets Evaluation Review the accounts receivables / debtors for possible bad / doubtful debts disaster Ageing analysis, trade debtors, factoring Determine the age, liquidity & stability of inventories and the efficiency & effectiveness of the company asset management

Evaluation of Financial Statements Liability & Net Worth Evaluation Determine the status of creditor’s on clients balance sheet to protect the interest of the bank in the event of loan default Creditors can be categorized as secured, preferential & general creditors The amount & maturity of short / long term debts must be taken into consideration in determining the financial risk of applicants

Evaluation of Financial Statements Income Statement Evaluation Information on the profitability & stability level of the company Will reveal the effectiveness of the company credit, operations & debt utilization policy The sensitivity of each expenditure level to change in sale

Evaluation of Financial Statements Statement of Changes in Financial Position Reflect the change in liquidity of the company Determine the source & uses of funds to determine the balance between financing & investment policy

Ratio Analysis Trend analysis is used to find out if the financial performance & position have improved / deteriorated / remain unchange over a period of time Four groups of ratio analysis Liquidity ratio Asset management ratio Financial leverage ratio Profitability ratio

Liquidity ratio Current Ratios. Measure the ability of the company to fulfills its long term loans using its current assets. current assets current liabilities

Liquidity ratio Quick Ratios Measures the ability of the company to pay its short terms loans quickly. Current assets – (inventory + prepayments) current liabilities

Assets management ratios Average collection period Measure the average days taken by the company to collect accounts receivables Account Receivables x 365 days Annual Credit Sales

Assets management ratios Inventory turnover Measures the efficiency of inventory management Sales Average Inventory

Assets management ratios Fixed assets turnover Measures the efficiency of the company in using its fixed assets to generate sales. sales fixed assets

Assets management ratios Total assets turnover Measures the efficiency of the company in using its assets to generate sales sales total assets

Financial Leverage ratios Debt ratio Measures the percentage of total assets that are financed by debts total debts total assets

Financial Leverage ratios Fixed Charged Coverage Ratio - Measure a company capacity to pay fixed charges such as interest on loans Net Income Fixed Charges

Profitability ratio Return on assets Measures the effectiveness of the company in using its assets in generating profit after tax earnings total assets

Profitability ratio Return on equity Measures the efficiency of the company in generating profits for its ordinary shareholders after tax earnings shareholder's equity

Profitability ratio Net profit margin Measure the ability of a company to generate net profit from each dollar of sale after deducting all expenditure after tax earnings sales

Izdihar Baharin @ Md Daud Thank You! Izdihar Baharin @ Md Daud Post Graduate Centre HP: 006019-5170817 Email: izdi@oum.edu.my