Credit analysis is the process of analyzing a borrowing request and determining under what conditions, if any, money should be lent. To do this effectively, it is important to know what analytical tools to use and when.
For newcomers, this can seem overwhelming. First of all, it is intimidating to think about the large volume of money about to change hands. Second, the number of adverse situations that can arise seems endless and impossible to fully understand. Both are good reasons for concern, but proven methods have helped us conquer these problems effectively.
Our first method for dealing with a world full of infinite risk is trying to categorize all risk into 5 buckets we call the “5 Cs of Credit.” All risk can be categorized as follows:
1. Character, which includes reputation and payment history
2. Capacity, which includes whether the enterprise provides enough cash to repay the debt.
3. Collateral, which is generally an asset that could be sold to offset the debt in default.
4. Capital, which is an assessment of how much the borrower has at stake in the transaction.
5. Conditions, which is an assessment of economics, industry, and operating environment of the borrower.
Ideally, if each category looks strong, we should have little to worry about. Most of the time, you will find some of the categories are weak therefore exposing more risk, and the question arises whether the stronger categories can carry the weaker ones.
How these 5 Cs of Credit should be investigated is where most analysts unknowingly run into problems. There are several analytical tools which can be used in credit analysis and it is confusing to know which one applies to each specific situation.
Not understanding what is in your tool box will lead you to making mistakes. Often I have seen an attempt to use every analytical tool simply to assure no stone is left unturned, but doing so can be foolish. It is like watching someone use a screw driver to hammer a nail or like watching someone trying to eat soup with a fork.
Using the right tool means first identifying what type of problem you are trying to solve. There are actually different areas of lending that will require you to look at different metrics. For the types of loans we typically encounter, there are three broad lending types:
* Commercial Real Estate (CRE)
* Commercial and Industrial operations (C&I) and
* Agriculture
The 5 Cs still apply to each lending area, but the how they will be investigated will differ. Each lending type will require its own unique tools, and it doesn’t always make sense to use the same tools in each situation.
For example, take Capital. For a loan to acquire an existing commercial property (CRE lending type), capital will be measured using a loan-to-value (LTV) ratio. But for C&I and Ag, capital will be measured by a debt-to-net worth ratio. Even though you will use a debt-to-net worth ratio for both C&I and Ag, a ratio of 2.00 may be considered acceptable for C&I but will be considered unacceptably high for Ag.
Another area that often causes confusion in using the right tool is the term of the request. Short term credit will have different metrics than long term credit. For example, debt service coverage ratio (DSCR) is an adequate measure of Capacity to repay long-term debt, but it is a poor way of measuring the capacity to repay short-term debt. Why? Short term debt service is often interest only payments and does not account for the need to curtail principal. Therefore, when a DSCR is used for a short-term interest only line of credit, the capacity to repay the debt is not being reflected.
Often the real challenge with analysis is not failing to account for some hidden risk, but using the proper tool. Using the right tool will help report the 5 Cs adequately so an informed decision can be made. But, if you use every tool at your disposal regardless of lending type, the result is often white noise that nobody can understand. That is why it is important to identify the proper lending type and then only use the tools that are relevant.
In my coming articles, I will explain each of the 5 Cs in the context of different lending types and suggest the proper tools you may use for analysis.--Trevor Plett