C Fundamental Credit Analysis  Topics covered: Five C’s of credit analysis Home loan underwriting Credit scoring C&I loan underwriting  Cash flow analysis  Other considerations  Ratio analysis

11-2 Five C’s of Credit Analysis  Capacity  Capital  Collateral  Conditions  Character

11-3 Home Loan Underwriting  Relies heavily on collateral But ability/tendency to pay also important  Recourse loan  Two key measures LTV (loan to value) Debt service ratios  GDS (gross debt service) Housing cost/gross income  Typically (interest + principal + taxes + insurance)/gross income 28% for FNMA  TDS (total debt service) (all debts & commitments/gross income) 36% for FNMA

11-4 Credit Scoring  Actually began in C&I, but primarily used in consumer lending  Quick & low cost  Typical Factors: Income Mortgage/rent cost Credit card debts Payment history Age Own/rent & length of time Job stability Relationship with institution

11-5 Credit Scoring (cont.)  FICO Score is the most common consumer credit score Ranges from 300 to Excellent credit, may get better terms 723 median US score 680 typically qualify for prime flat on HELOC 620 typically qualify for FNMA mortgage

11-6 C&I Loan Underwriting  Larger loan balances  Customized Terms  Priced to credit risk rather than just accept/reject decision  Significant post-issuance monitoring  Bread and butter for local commercial banks

11-7 C & I Loan Underwriting (cont.)  Focus on ability to repay Hence, extensive cash flow analysis  Financial statements are verified Tax returns a common source  Check with related parties Customers Prospects Suppliers  Capability and character of management key  Key facets of business investigated Production Marketing Capital Requirements

11-8 Cash Flow Analysis  There should be enough cash flow from business operations to service debt Should not have to sell assets Should not have to borrow  Most measures are “coverage” ratios of the general form: Cash from operations/debt payments  See Handout Tables 11-A-1 and 11-A-2

11-9 Ratio Analysis  Common-sizing statements is standard  Liquidity Ratios: current ratio = current assets/current liabilities Quick ratio = current assets-Inv./current liabilities  Asset management ratios: Number days receivables (DSO) = A/R x 365/sales or credit sales Number of days inventory = Inv x 365/COGS Sales to WC = Sales/WC Sales to assets = Sales/Fixed Assets Sales to total assets = sales/total assets

11-10 Ratio Analysis (cont.)  Debt and Solvency ratios debt to assets = ST Liab +LT Liab/total assets note that 1:1 debt to equity =.5 debt to assets Times interest earned (interest coverage ratio) = earnings available to meet interest charges/interest charges Cash flow to debt ratio = EBIT + Depreciation/Debt this ratio should easily exceed debt interest rate

11-11 Ratio Analysis (cont.)  Profitability ratios: Gross margin = gross profit/sales Operating profit margin = Operating Profit/Sales ROA = EAT/ Total Assets ROE = EAT/Total Equity Dividend payout = Dividends/EAT  Always need to be careful about comparability in ratio analysis Same items can be accounted for in different ways