FREE ESSAY ON EVALUATION OF COMMERCIAL LOANS

EVALUATION OF COMMERCIAL LOANS

Evaluating Commercial Loan Request
This report introduces a procedure that can be used to analyze the quantifiable aspects
of commercial credit requests. The procedure incorporates a systematic interpretation of
basic financial data and focuses on issues that typically arise when determining
creditworthiness. Cash flow information is equally important when evaluating a firm's
prospects. Reported earnings and EPS can be manipulated by management debts, are repaid
out of cash flow not earnings. The basic objective of credit analysis is to assess the
risk involved in credit extension to bank's customers. Risk refers to the volatility in
earnings. Lenders are concerned with net income or the cash flow that hinders a borrower
ability to service a loan. Credit analysis assigns some probability to default. Some
risks can be measured with historical and projected financial data.
The key issues include the following:
1. For what are the loan proceeds going to be used?
2. How much does the customer need to borrow?
3. What is the primary source of repayment, and when will the loan be repaid?
4. What collateral is available?
Fundamental credit issues:
Virtually every business has a credit relationship with a financial institution. But
regardless of the type of loan, all credit request mandate a systematic analysis of the
borrower's ability to repay.
When evaluating a loan a bank can make two types of errors:
1. Extending credit to a consumer who ultimately would repay the debt.
2. Denying a loan request to a customer who ultimately would repay the debt.
In both cases the bank loses a customer and its profit decreases. For this reason, the
purpose of credit analysis is to identify the meaningful and probable circumstances under
which the bank might lose. So a credit analyst should analyze the following items:
*Character: The foremost issue in assessing credit risk is determining a borrower's
commitment and ability to repay debts in accordance with the terms of a loan agreement.
An individual's honesty, integrity, and work ethic typically evidence commitment.
Whenever there is deception or a lack of credibility, a bank should not do business with
the borrower. It is often difficult to identify dishonest borrowers. The best indicators
are the borrower's financial history and personal references. When a borrower has missed
past debt service payments or has been involved in default or bankruptcy a lender should
carefully document why to see if the causes were reasonable. Similarly, borrower's with
good credit history will have established personal and banking relationship that indicate
whether they fully disclose meaningful information and deal with subordinates and
suppliers honestly. Lenders look at negative signals of a borrower condition beyond
balance sheet and income statement. For example:
-  A borrower's name consistently appears on the list of bank customers who have
overdrawn their account.
-  A borrower makes a significant change in the structure of business.
-  A borrower appears to be consistently short of cash.
-  A borrower's personal habits have changed for the worse.
A firm's goals are incompatible with those of stockholders, employees, and customers.
*Use of loan proceeds:
The range of business loan needs is unlimited. The first issue facing the credit analyst
is what the loan proceeds are going to be used for. Loan proceeds should be used for
legitimate business operations purposes, including seasonal and permanent working capital
needs, the purchase of depreciable asset, physical plant expansion, acquisition of other
firms. Speculative asset purchases and debt substitutions should be avoided. The true
need and use determines the loan maturity, the anticipated source and timing of repayment
and the appropriate collateral. A careful review of a firm financial data typically
reveals why a company deeds financing.
*Loan amount:
Borrowers request a loan before they clearly understand how much external financing is
actually needed and how much is available internally. The amount of credit required
depends on the use of proceeds and the availability of internal sources of funds. The
lender job is to determine the correct amount such that a borrower has enough cash to
operate effectively but not too much to spend wastefully. Once a loan is approved the
amount of credit actually extended depends on the borrower future performance. If the
borrower cash flow is insufficient to meet operating expenses and the debt service on the
loan it will be called upon to lend more and possibly to lengthen the loan maturity. If
cash flows are substantial, the initial loan outstanding might decline rapidly and even
be repaid early. The required loan amount is thus a function of the initial cash
deficiency and the pattern of future cash flows.
*The primary source and timing of repayment:
The primary source of repayment of loans is the cash flows. The four basic sources of
cash flow are the liquidation of assets, cash flow from normal operations, new debt
issues, and new equity issues. Credit analysis evaluates the risk that a borrower future
cash flow will not be sufficient to meet expenditures for operations and interest and
principal payments on the loan. Specific sources of cash are typically associated with
certain types of loans. Short-term, seasonal working capital loans are normally repaid
from the liquidation of receivables or reduction in inventory. Term loans are normally
repaid out of cash flows from operations. A comparison of projected cash flows with
interest and principal payments on prospective loans indicates how much debt can be
serviced and the appropriate maturity.
*Collateral:
Banks can lower the risk of loss on a loan by requiring back up support beyond normal
cash flow. Collateral is the security a bank has in assets owned and pledged by the
borrower against a debt in the event of default. Banks look to collateral as a secondary
source of repayment when primary cash flows are insufficient to meet debt service
requirements.
Having an asset that the bank seize and liquidate when a borrower defaults reduce loss,
but it does not justify lending proceeds when the credit decision is originally made.
From a lender perspective, collateral must exhibit three features:
-First, its value should always exceed the outstanding principle on a loan.
-Second, a lender should be able to easily take possession of collateral and have a ready
market for sale. Highly illiquid assets are worth far less because they are not portable
and often are of real value only to the original borrower.
-Third, a lender must be able to clearly mark collateral as its own.
When physical collateral is not readily available, banks often ask for personal
guarantees. On the other hand, liquidating collateral is a second-best source of
repayment for three reasons: 1- there are significant transaction costs associated with
foreclosure. 2- bankruptcy laws allow borrowers to retain possession of the collateral
long after they have defaulted. 3- when the bank takes possession of the collateral, it
deprives the borrower of the opportunity to salvage the company.
At last, a loan should not be approved on the basis of collateral alone. Unless the loan
is secured by collateral held by the bank, such as bank CDs, there is risk involved in
collection.
A PROCEDURE FOR FINANCIAL ANALYSIS 
The purpose of credit analysis is to identify and define the lender's risk in making a
loan. There is four stages process for evaluating the financial aspects of commercial
loans:
1. Overview of management and operations.
2. Financial ratio analysis.
3. Cash flow analysis.
4. Financial projections.
During all phases the analysts should examine facts that are relevant to the credit
decision and recognize information that is important but unavailable.
1. Overview of management and operations:
Before analyzing financial data, an analyst should gather background information on the
firm's operations. This evaluation usually begins with an analysis of the organizational
and business structure of the borrower. The evaluation should also identify the products
or services provided and the firm's competitive position in the marketplace. This inquiry
leads to a brief analysis of industry trends. Moreover, particular attention should be
focused on management quality. This helps identify motivating factors underlying their
decisions. Finally the overview should recognize the nature of the borrower loan request
and the quality of the financial data provided.
2. Financial ratio analysis: 
Most banks initiate the data analysis with statement spread forms, which array the firm's
balance sheet and income statement items in a consistent format for comparison over time
and against industry standards.
The next step is to calculate a series of ratios that indicate performance variances.
This analysis should differentiate among at least four categories of ratios:
A-Liquidity ratio: indicates the firm's ability to meet its short-term obligations and
continue operations. Measures of net working capital, current and quick ratios, inventory
turnover, the average receivables collection period, the days payable outstanding, and
the days cash-to-cash cycle help indicate whether current assets will support current
liabilities.
B-Activity ratios: signal how effectively a firm is using assets to generate sales.
(Sales-to-asset ratios). The key ratios include accounts receivable turnover, inventory
turnover and fixed asset turnover.
C-Leverage ratio: indicate the mix of the firm's financing between debt and equity, hence
potential earnings volatility. The greater a firm's leverage, the more volatile its net
profit (or losses). Ratios that should be examined include debt to total assets, times
interest earned, fixed charge coverage, net fixed asset to tangible net worth, and the
dividend payout %.
D-Profitability ratios: provide evidence of the firm's sales and earnings performance.
Basic ratios include the firm's ROE, ROA, profit margin, and asset utilization.
Finally, an analyst should evaluate these ratios with a critical eye, trying to identify
firm strengths and weaknesses.
3.Cash flow analysis:
Most analysts focus on cash flow when evaluating a non-financial firm's performance. Cash
flow estimates are subsequently compared to principal and interest payments and
discretionary expenditures to assess a firm's borrowing capacity and financial strength.
The importance of cash flow has recently been emphasized by the introduction of the
statement of financial accounting standards (SFAS). 
The cash-based income statement is a modified form of statement of cash flows. It is
essentially a statement of changes reconciled to cash that combine elements of the income
statement and balance sheet. It records changes in balance sheet accounts over a specific
time period. Its purpose is to indicate how new assets are financed or how liabilities
are repaid. The statement of changes is summarized here:
Sources of cash Uses of cash
-Increase in liability -Decrease in Liability
-Decrease in non-cash asset -Increase in non- cash asset
-New issue of stock -Cash expenses/cash dividend
-Additions to surplus -Taxes
-Revenues -Deduction from surplus
-Repayment/refund of stock 
Additional two ratios are useful for evaluating a firm cash flow:
1- Cash flow from operations divided by the sum of dividends paid and last periods
current maturities of long term debt.
2- Cash flow from operations divided by the same two terms plus short-term debt
outstanding at the beginning of the year.
If these ratios exceed one, then the firm cash flow can pay off existing debt and support
new borrowing.
4. Financial projections:
The three-stage process described previously enables a credit analyst to evaluate the
historical performance of a potential borrower. Projections of the borrower financial
condition reveal how much financing is required and how much cash can be generated from
operations to service new debt, and can be used to determine when a loan may be repaid.
The proforma analysis is a form of sensitivity analysis. Three alternatives scenarios to
analyze the relationship between the balance sheet and the income statement: -Best case
scenario: improvement in planned performance. Worst case scenario: represents the
greatest potential negative impact on sales and earnings. Most-likely scenario: indicates
the most reasonable sequence of economic events and performance.
The three alternative forecasts of loan needs and cash flow establish a range of likely
results that indicates the riskiness of credit.
As a conclusion no matter what are the alternatives or the credit analysis adopted, do
you think that we will get to have a 100% correct analysis with no risk?
Evaluating Consumer Loans
Chapter 22
The purpose of this chapter is to analyze the characteristics and profitability of
different types of consumer loans and introduces general credit evaluation techniques to
assess risk. Commercial loans were available in large volume, net yields were high and
the loans were highly visible investments. Consumer loans involved small dollar amounts,
a large staff to handle account and a lower prestige associated with lending to
individuals. This perception changed with the decline in profitability of commercial
loans. Today, many banks target individuals as the primary source of growth in attracting
new business. Even with the high relative default rates, consumer loans in the aggregate
currently produce greater profits than do commercial loans. This reflects the attraction
of consumer deposits as well as consumer loans. Interest rate deregulation forced banks
to pay market rates on virtually all their liabilities. Corporate cash managers, who are
especially price sensitive, routinely move their balances in search of higher yields.
Individual's balances are more stable. While individuals are price sensitive, a bank can
generally retain deposits by varying rates offered on different maturity time deposits to
meet the customer's needs.
From a lender's perspective, the analysis of consumer loans differs from that of
commercial loans. First, the quality of financial data is lower. Personal financing
statements are typically unaudited, so it is easy for borrowers to hide other loans. It
is similarly easy to inflate asset values. Second, the primary source of repayment is
current income, primarily from wages, salaries, dividends, and interest. This may be
highly volatile, depending on the nature of individual's work experience history. The net
effect is that character is more difficult to assess, but extremely important.
Types of consumer loans:
 Installment loans: 
Installment loans require the periodic payment of principal and interest. In most cases,
a customer borrows to purchase durable goods or cover extraordinary expenses and agrees
to repay the loan in monthly installments. While the average loan is quite small, some
may be much larger, depending on the use of the proceeds. Installment loans may be either
direct or indirect loans. A direct loan is negotiated between the bank and the ultimate
user of the funds. The loan officer analyzes the information and approves or rejects the
request. An indirect loan is funded by a bank through a separate retailer that sells
merchandise to a customer. The retailer takes the credit application, negotiates terms
with the individual, and presents the agreement to the bank. If the bank approves the
loan, it buys the loan from the retailer under prearranged terms.
Installment loans can be extremely profitable. Depending on the size of the bank, it cost
from $140 to $208 to make each installment loan. Acquisition costs include salaries,
occupancy, computer, and marketing expenses associated with soliciting, approving, and
processing loan applications.
Even though these costs are high, banks were able to earn excellent spreads on the
average loan.
 Credit cards and other revolving credit:
Credit cards are utilized to purchase goods and services on credit in contrast to debit
cards, which are used to withdraw cash from ATM (Automated Teller Machine). Revolving
credit: an arrangement by which the borrower and repay as needed during a specific time
period, subject to maximum borrowing level.
Credit cards and overlines tied to checking accounts are the two most popular forms of
revolving credit arrangements. Banks offer a variety of credit cards. While some banks
issue cards with there own logo and supported by their own marketing effort, most operate
as franchises of Master Card or Visa. All cards display the Master Card and Visa logos
along with the issuing bank name. The primary advantage of membership is that an
individual bank card is accepted nationally and internationally at most retail stores
without the bank negotiating a separate agreement with every retailer. 
Some alternatives to the credit cards exist:
-Debit cards: they are widely available but not attractive to customers. As the name
suggests when an individual uses this card his or her balance at a bank is immediately
debited funds are transferred from the card user account to the account of the retailer.
But there is a disadvantage in using it, the loss of float, which explains why debit
cards are not popular.
-Smart cards: is an extension of the debit card and contains a computer memory chip that
stores and manipulates information. These cards can handle all purchasing that consumer
prefers.
-Prepaid cards: are a hybrid debit card in which consumers repay for services to be
rendered and receive a card again which purchases are charged. The advantage of this card
is that the processing costs are low and there is little risk. 
Credit cards are attractive because they provide higher risk-adjusted returns than do
other types of loans. Card issuers earn income from three sources: -charging card holders
annual fees, charging interest on outstanding loan balances, and discounting the charges
that merchants accept on purchases. Consequently as banks have increased their
competitive focus they have begun to lower loan rates and annual fees such that many
customers can avoid fees entirely and pay interest at rates slightly above NY quoted
prime.
Credit card lending involves issuing plastic cards to qualifying customers. The cards
have pre-authorized credit limits that restrict the maximum of debt outstanding at any
time. Many cards can be used in electronic banking devices, such as automatic teller
machines, to make deposits or withdrawals from existing transaction accounts at a bank.
Credit cards are becoming extremely attractive. Many banks view credit cards as a vehicle
to generate a nationwide customer base. They offer extraordinary incentives to induce
consumers to accept cards in the hope that they can cross-sell mortgages, insurance
products, and eventually securities. Credit cards are profitable because many customers
are price insensitive. However, credit card losses are among the highest of all loan
types.
The returns to credit card lending depend on the specific roles that a bank plays. A bank
is called a card bank if it administers its own credit card plan or serves as the primary
regional agent of major credit card operations. A non-card bank operates under the
auspices of a regional card bank and does not issue its own card. Non-card banks do not
generate significant revenues from credit cards.
The credit card transaction process: Once a customer uses a card, the retail outlet
submits the sales receipt to its local merchant bank for credit. A retailer may
physically deposit the slip electronically transfer the information via a card-reading
terminal at the time of sale. The merchant bank discounts the sales receipt by 2 to 5
percent as its fee. Thus a retailer will receive only 97$ credit for each 100$ sales
receipt if the discount is 3 percent. If the merchant bank did not issue the card, it
sends the receipt to the card-issuing bank then bills the customer for the purchase. Most
card revenues come from issuing the card that a customer uses. The bank earns interest at
rates ranging from 6 to 22 percent and normally charges each individual an annual fee for
use of the card. Interest rates are sticky. Thus, when money market rates decline and
lower a bank's cost of funds, the net return on credit card revenues. The remaining 20
percent is merchant discount.
 Overdraft protection and open credit lines:
Revolving credit also takes the form of overdraft protection against checking accounts.
The customer must pay interest on the loan from the date of the draft's receipt and can
repay the loan either by making direct deposits or by periodic payments. These loans are
functional equivalent of loan commitments to commercial customers. The maximum credit
available typically exceeds that for overdraft lines, and the interest rate floats with
the bank's base rate.
 Home equity loans and credit cards:
Home equity loans meet the tax deductibility requirements because they are secured by
equity in an individual's home. Many of these loans are structured as open credit lines
where a consumer can borrow up to 75 percent of the market value of the property less the
principle outstanding on the first mortgage. Individuals borrow simply by writing checks,
pay interest only on the amount borrowed and can repay the principal at a rate of the
outstanding balance. In most cases, the loans carry adjustable rates tied to the banks
base rate. These credit arrangements combine the risk of a second mortgage with the
temptation of credit card, a dangerous combination. Home equity loans place a second lien
on a borrower's home. If the individual defaults, the creditor can foreclose so that the
borrower loses his or her home.
 Non-installment loans:
A limited number of consumer loans require a single principal and interest payment. The
individual borrowing needs are temporary. Credit is extended in anticipation of repayment
from a well-defined future cash inflow. The quality of the loan depends on the certainty
of the timing and the amount anticipated net cash inflow from the sale.
Consumer loans:
Consumer loans are extended for a variety of reasons for example, the purchase of an
automobile, mobile homes, home improvements, furniture and appliances, and home equity
loans. Before approving any loan, a lending officer request information regarding the
borrower's employment status, periodic income, the value of assets owned, outstanding
debt, personal references and specific terms that generates the loan request. The lending
officer collects information regarding the borrower's five C's then he interprets the
information in light of the bank lending guidelines and accepts or rejects the loan. In
addition, banks employ judgmental procedures and quantitative credit scoring procedures
when evaluating consumer's loans.
Recent risk and return characteristics of consumer loans:
Historically, banks viewed themselves as being either wholesale or retail institutions,
focusing on commercial and individual customers respectively. Recent developments,
however, have blurred the distinction, as traditional wholesale banks have aggressively
entered the consumer market. The attraction is twofold. First, competition for commercial
customers narrowed commercial loan yields so that return fell relative to potential
risks. So consumer loans provide some of the highest met yields for banks. Second,
developing loan and deposit relationships with individuals presumably represents a
strategic response to deregulation. The removal of interest rate ceilings substantially
reduced bank's core deposits by making high-balance customers more price sensitive. On
average, individuals hold small balances and move deposit accounts less frequently,
providing a more stable deposit base. Thus liquidity risk declines as a bank's retail
deposit base increases.
Revenues from consumer loans:
Banks earn significant revenues from interest on loans and associated fees. Since many
usury ceilings have been eliminated or are no longer effective, banks can ration credit
via price rather than by alerting non-price credit terms. This permits banks to quickly
raise consumer loan rates, as conditions require. When conditions permit, banks also
delay lowering rates when their borrowing costs decline.
Consumer loan rates have been among the highest rates quoted at banks in recent years.
Most consumer loans are made at fixed rates that banks do not charge frequently. In a
declining rate environment, consumer loans thus yield a large a large spread relative to
the bank's borrowing cost. When short-term rates rise, the spread narrows until banks
raise loan rate.
Consumer groups still argue that consumer loan rates are too high, especially when the
prime rate declines. They claim that lenders must be conspiring to fix prices. However,
there are many reasons for large spreads. First, consumer loans are typically smaller in
size and thus cost more to administer on a unit basis than do commercial loans. Second,
consumer loans are longer and often carry fixed rates. Third, individuals are more likely
to default than businesses. The spread should be large to cover greater losses. Finally,
many lenders still face state usury ceilings that may not be lifted when rates increase.
In response to this criticism, many banks now offer variable-rate credit cards as
alternatives to fixed-rate cards.
In addition to interest income, banks generate substantial non-interest revenues from
consumer loans. With traditional installment credit, banks often encourage borrowers to
purchase credit life insurance on which the bank may earn premium income. Credit card
operations also provide different types of fee income. banks often impose other fees for
late payments and cash advances.
Consumer Loan Losses
Losses on consumer loans are the highest among all categories of bank credit. Losses are
anticipated because of mass marketing efforts pursued by many lenders, particularly with
credit cards. Both losses and delinquent accounts rise during recessions and decline
during high growth periods. Many lenders simply factor losses into their pricing as a
part of doing business. 
Interest Rate and Liquidity Risk with Consumer Credit
The majority of consumer loans are priced at fixed rates. In most cases the borrower can
repay the loan without any penalty when rates decline. Bankers have responded in two
ways: first: they price more consumer loans on a floating-rate basis. Second: commercial
and investment banks have created a secondary market in consumer loans that allows loan
originators to sell a package of loans to investors with longer- term holding periods.
Banks now routinely sell certificates supported by credit cards receivables and other
consumer credit as means of moving assets off the balance sheet. 
Balance sheet for outer limits 
Assets 1993 1994 Changes Type
Cash & MS 30 6 -24 source
Account receivable 102 215 113 use
Merchandise inventory 65 104 39 use
prepaid expense 8 5 -3 source
Gross fixed assets 120 149 29 use
accumlated depreciation 40 57 17 source
net fixed assets 80 92 12 use
intangible assets 4 3 -1 source
Liabilities 1993 1994 Changes Type
notes payable-bank 106 223 117 source
current maturities of LTD 9 11 2 source
accounts payable 33 50 17 source
accruals 2 9 7 source
federal income tax payable 3 4 1 source
long term mortgage 16 15 -1 use
long term debt 43 32 -11 use
common stock 40 40 0 
retained earnings 37 41 4 source
net worth 77 81 4 source
Statement of variation 
ASSETS Sources Uses 
cash & MS 24 
account receivables 113 
merchandise inventory 39 
prepaid expenses 3 
gross fixed asset 29 
intangible asset 1 
LIABILITIES 
notes payable 117 
account payable 17 
current maturities of LTD 2 
accruals 7 
depreciation 17 
federal income tax 1 
long term mortgage 1 
long term debt 11 
retained earnings 4 
TOTAL 193 193 
Statement of changes reconciled to cash 
Net sales $ 861 
change in account receivable $ (113) asset increased
Cash receipt from sales $ 748 
Cost of goods sold $ (680) expenses
change in inventory $ (39) asset expense
change in accounts pay $ 17 liability increase
Cash purchases $ (702) 
Cash margin $ 46 (748-702) 
total operating expense $ (150) 
depreciation $ 26 
change in prepaid expense $ 3 
change in accrued expense $ 7 
Cash operating expense $ (114) 
Cash operating profit $ (68) (46-114) 
other income $ 6 revenue
other non interest expense $ - 
cash before interest and tax $ (62) (-68+6) 
interest expense $ (18) expenses
income tax reported $ (5) tax expense
change in income tax payable $ 1 liability increase
Cash flow from operations $ (84) 
payment for last period 
current maturities of LTD $ (9) 
dividend paid $ (10) dividend
capital expenditure $ (38) asset increased
Discretionary cash expenditure $ (57) 
Cash before external financing $ (141) (-57-84) 
change in notes payable $ 117 liability increase
change in stock $ - 
change in surplus $ - 
external financing $ 117 
Change in cash $ (24) (-141+117) asset decreased
To begin our analysis, we can say that the company has collected less in credit sales
than it billed its customers because outstanding account receivables increased from 1993
and 1994. Thus net sales are offset by the $113 million increase in receivables to obtain
actual cash receipts. Had receivables declined, actual cash receipts from sales would
have exceeded the reported sales figure. Moving to cash purchases, purchases equals $680
million + $39 million; so because the inventory has increased which reveal that actual
purchases are more than cost of good sold. The statement then subtracts the change in
outstanding accounts payable from total purchases to get actual cash purchases. The $17
million increase in payables indicates that a portion of purchases is financed by
additional trade credit from suppliers. Cash purchases thus equaled $702 million. In
general, net cash purchases equal the cost of goods sold adjusted for inventory
accumulation not financed by additional trade credit.
The next step is to subtract cash operating expense.
Bibliography
personal research work, from financial ecperts