Credit Appraisal Techniques

Credit Evaluation : Credit evaluation refers to the process borrowers are subjected to for them
to be eligible for funding or to pay for products within a specified period. It also refers to the
steps lenders undertake while examining the credit request.

How Does the Credit Evaluation Work?

Loan approval primarily depends on the two parties, the lenders, and the borrowers. For instance,
the lender must be willing to offer credit after assessing the capacity of the borrower to obey the
obligation fully.

On the other hand, the borrowers must demonstrate the willingness and the ability to repay the
principal amount and the interest within the agreed period. In general, small businesses are
required to seek approval in order to qualify for credit.

When lenders approve a loan application and give funds, they are often convinced and have total
confidence in the creditworthiness of the respective borrowers.

We talk of creditworthiness; we refer to the borrowers’ capacity as well as the willingness to

repay the borrowed money.

There are several tools used in the evaluation of credit.

In case the borrower is the business, the lenders focus more on the statement of financial position
and income statements, the rate of stock turnover, the efficiency of the management, debt
structure, and the prevailing marketing conditions.

In general, lenders prefer dealing with borrowers with positive cash flows and net earnings that
meet any likely debt obligation.

What is Creditworthiness?

Creditworthiness consists of a record of trustworthiness, including borrowers’ moral character

and the possibility of consistent performance. Lenders offer lower rates and better terms to
borrowers with excellent credit scores. This is one of the most important eligibility requirements
for most lenders.

Factors Determining Creditworthiness

4 factors determining creditworthiness are.

1. The debt burden.

2. Loan size
 3. The rate of borrowing

4. The period of commitment

The debt burden.

To be approved for a loan, lenders require your earning power to significantly surpass the
payment schedule requirements.

The debt size is primarily restricted by the resources currently available. A secure debt-to-capital
ratio makes it easy for lenders to approve loan applications.

Loan size

Lenders often prefer jumbo loans for a simple reason – the administrative costs lessen in
proportion to loan size—borrowers are expected to have the potential to ingest a considerable
amount of money.

The rate of borrowing

Clients who frequently borrow often establish a good reputation with lenders. This has a bearing
on their capacity to obtain credit on better terms.

The period of commitment

Generally, lenders take more risks with the increase in the timeframe. To provide for the
additional risks, lenders often increase the interest rate. They usually charge higher rates for
loans that take a long time.
The 7Cs credit appraisal model: character, capacity, collateral, contribution, control, condition,
and common sense has elements that comprehensively cover the entire areas that affect risk
assessment and credit evaluation.

The 7 “C’s” of Credit

1. Capacity : Do I have experience running a business? Have I had this business for more than
one year? Do I know this industry well? Do I have a good team working for me? Is the business
operating well?

2. Cash Flow : Is my business profitable? Do I have a bookkeeping system that will allow me to
demonstrate this to the bank? Can I produce financial statements from this data? Is my cash flow
sufficient to make the loan payments?

3. Capital : Do I have sufficient reserves, or other people who could invest in the business,
should unexpected problems or hard times arise?

4. Collateral : Do I have collateral (business and/or personal) which I can offer? Is the property
I own mine, or do I share it with my husband or family?

5. Character : Can I show the bank that I am honest, and keep my promises? If I have had a
loan or supplier credit before, did I always pay on time? Have I always paid my personal bills on
time? Can I prove this to the bank? Do I have good references?

6. Conditions : Is the industry that I am in a good one? Do I have a unique product or service
which makes me different from my competitors? Is there growing demand for my products?
Does a loan make sense for my business?

7. Commitment : Am I committed to working hard so that my business will succeed? Do I really

want it to grow? Have I put my own money into the business?
These are the basics the borrowers are supposed to keep in mind. These variables play a
significant role when it comes to credit evaluation.

7Cs of Creditworthiness

Creditworthiness measures how deserving an applicant is to get a loan sanctioned in his favor. In
other words, it assesses the likelihood that a borrower will default on their debt obligations. It is
based upon factors such as their repayment history and credit score.

Lending Institutions also consider the availability of assets and the extent of liabilities to
determine the probability of default. The 7’Cs of creditworthiness indicate the characteristics or
features of creditworthiness.

7C of creditworthiness are:

1. Character

2. Capacity

3. Cash

4. Capital

5. Collateral

6. Conditions

7. Control
Character

Responsibility, truthfulness, serious purpose, and serious intention to repay all monies owed
make up what is called character.

The loan officer must be convinced that the customer has a well-defined purpose for requesting
credit and a serious intention to repay. The loan officer must determine if the purpose is
consistent with the bank’s loan policy, even with a good purpose.

However, the loan officer must determine that the borrower is responsible for using borrowed
funds, is truthful in answering questions, and will make every effort to repay what is owed.

Capacity

The loan officer must be sure that the customer has the authority to request a loan and the legal
standing to sign a binding loan agreement; this customer characteristic is known as the capacity
to borrow money.

For example, in most areas, a minor cannot legally be held responsible for a credit agreement;
thus, the lender would have difficulty collecting on such a loan.

Similarly, the loan officer must be sure that the representative from a corporation asking for
credit has proper authority from the company’s board of directors to negotiate a loan and sign a
credit agreement binding the company.

Cash

This feature of any loan application centers on the question.

Does the borrower have the ability to generate enough cash to repay the loan in the form of flow?
In an accounting sense, cash flow is defined as:

Cash flow = Net profits + Noncash expenses.

This is often called traditional cash flow and can be further broken down into Cash flow = Sales
revenues – Cost of goods sold – Selling, general, and administrative expenses- Taxes paid in cash
+ non-cash expenses.

The lender must determine if this volume of the annual cash flow will be sufficient to
comfortably cover the repayment of the loan and deal with any unexpected expenses.

Loan officers should carefully examine five areas when lending money to business firms or other
institutions. These are:

 The level of and recent trends in sales revenue.

  The level of and recent changes in the cost of goods sold.

 The level of and recent trends in selling, general, and administrative expenses.

 Any tax payments made in cash.

 The level of and recent trends in noncash expenses.

Capital

Capital represents the potential borrower’s general financial position, emphasizing tangible net
worth and profitability, which indicates the ability to generate funds continuously over time.

The net worth figure in the business enterprise is the key factor that governs the amount of credit
made available to the borrower.

Collateral

In assessing the collateral aspect of a loan request, the loan officer must ask, Does the borrower
possess adequate net worth or owns enough quality assets to provide adequate support for the
loan?

The loan officer is particularly sensitive to such features as the borrower’s assets’ age, condition,
and degree of specialization.

Technology plays an important role here as well. If the borrower’s assets are technologically
obsolete, they will have limited value as collateral because of the difficulty of finding a buyer for
those assets should the borrower’s income falter.

Conditions

The loan officer and credit analyst must be aware of recent trends in the borrower’s work or
industry and how changing economic conditions might affect the loan.

A loan looks particularly good on paper, only to have its value eroded by declining sales or
income in a recession or by high-interest rates occasioned by inflation.

Control

The last factor in assessing a borrower’s creditworthiness status is control.

This factor centers on such questions as whether changes in law and regulation could adversely
affect the borrower and whether the loan request meets the lenders and the regulatory authorities’
standards for loan quality.

Creditworthiness Examples: Acceptable and Unacceptable Loan Requests of Commercial Banks

Examples
After assessing the borrower’s creditworthiness for the loan, banks make the final decision of
accepting or discarding loan requests.

The regulatory agencies restrict some types of loans while others are logically unacceptable from
a recovery point of view.

In the following section, we will see some acceptable and unacceptable loan requests:

Acceptable Loan Request Unacceptable Loan Request

Short-term working capital loan of the self- Loans to change the ownership structure of the
liquidating feature. firm.

Loans are based on unmarketable securities. Construction loans without making clear the
source and schedule for repayment.

Loans to finance the carrying of commodities Loans secured by the second mortgage on real
where the collateral is the negotiable estate.
warehouse receipts.

Non-spec relative construction loans with Construction loans on condominiums

commitments from reliable long-term lenders. (ownership of more than one person) unless
they are pre-sold.

Immovable property developments/expansion Loans to a new business without a record of

loan with a clear repayment schedule accomplishment unless it is with adequate
collateral.

Various kinds of permissible consumers loan So-called “bullet” loans or non-amortizing

term loans

Exceptionally long-term and revolving nature Loans where the source of payments is solely
of credits to very dependable parties. public or private financing, not passionately
committed.

Construction loans for housing/real estate of Unsecured loans for real estate purposes.
which the ownership is indisputable.

Loan (without collateral) to a successful Loans based on unmarketable securities.

businessman with an extremely high
reputation.
This list is far from complete, including only some types more or less generally regarded as
desirable/ undesirable for commercial banks.

Depending on the type, location, and size of the bank, others that might be included are.

 Term loans to more than a certain maturity: nonresidential,

 The long-term real estate loans: revolving credits, floor plan lines.

 Loans to second mortgage companies.

 Construction loans, unsecured loans to individuals, etc.

This list could be further broadened, but it should be understood that some or all of these types
may be highly acceptable to some banks, although inappropriate for others.
7 Cs of Banking

1. Collateral : Collateral provides some security to the banks when they are giving a high
amount of loans to the borrowers. Banks use collateral as the secondary source of repayment of
the loan if the company fails to repay the loan.

It provides some comfort to the banks as they will be able to recover either some parts or the
entire amount of the loan in future by selling the collateral. Banks accept account receivables,
Inventory, Land, Fixed assets, real estates as collaterals while providing loans.

2. Conditions : Conditions refer to the current business scenarios and the overall credit
environment. Banks normally hesitate to provide loans if the current business situation is not
good, and profitability of the companies is not up to the mark. For companies, banks also analyze
the sector they are operating in and the current condition of the entire sector. Banks check the
below details while analyzing the condition of a company while providing loans.

• Company’s risk management processes

• Its historical financial performance and key financial parameters

• Competition in the industry in which the company operates

• Diversification of the business

• Supply, patent related disputes and other possible risks

• Regulatory or legal issues involved If any

After checking all these parameters, banks provide the loan to the company only if they find it
suitable based on these conditions.

3. Character : Character of the company owners or the individual Is one of the most important
parameters banks checks while providing the loans to companies or individual. Banks refer to the
previous track records of the borrower and his willingness to repay the loan amount. Banks
provide loans only to people with sound character who can also be trusted to honor their
commitment in repaying the loan amount.

These are especially important parameters that the banks use to take decisions about the approval
of the loans. The Individuals and companies should also try to improve these parameters before
going for any fresh loan application.

4. Credit : Credit refers to the credit score of the borrower which reflects their ability and
willingness to repay the loan.

Banks check the credit and repayment history to produce the credit rating for borrowers which
helps the banks to take a decision about the loan.

5. Capacity : Capacity refers to the money generated by the company or business in order to
repay the loan and interest on the same. For companies, banks use different financial ratios like
Debt Service Coverage Ratio” and “Interest Coverage Ratio” to analyze the loan repaying
capability of the company. Banks normally do not provide the loan when there is some
uncertainty in the cash flow.

6. Currency : Currency parameter is used for cross-border lending where the banks analyze the
historical trend in currency movement while taking decisions about a loan. Steep unfavorable
movement (domestic currency depreciation) can make a cross border loan very much costlier and
increase the probability of default. Banks need to check this parameter while providing cross-
border loans to foreign companies.

7. Country : Country Is also an important parameter used by the banks in cross border lending.
Here the country’s political system, legal system, laws, and regulations are closely verified
before providing loans to companies operating in the country. Political stability and the proper
legal system are especially important parameters to boost confidence among the cross-border
lenders. Banks will not be willing to provide loans to the foreign companies if the government is
politically unstable, legal system Is not suitable and the government policies do not support
industrial growth and foreign investment.