Components of Credit Risk Analysis
Hello people, i hope your day is making sense. Today we would be taking at components of a credit analysis. I hope you learn a thing or two from this post. So if you don’t already know, Credit analysis is the method a bank or financial institution uses to calculate the credit worthiness of a loan applicant, business or organization. There are 5 Components of credit analysis, also called 5 C’s, and they are:
- Capacity: The first step for any lender is to assess the borrower’s ability to pay back the prospective loan. Capacity to repay is one of the most critical factors for a loan application. The lender would base his analysis on expected income of the borrower within the proposed repayment period. The lender would consider cash flows that come from income sources such as salary for individuals or profit from businesses. The lender would also consider if the borrower would be able to successfully repay the loan, probability of successful repayment of the loan, other possible sources of repayment such as homes, gold etc.
- Capital: The lender would also need to investigate if the borrower has any capital to invest towards the purchase of the asset or whatever use of the loan. For corporate loan or project finance loans, the capital referred to here is known as equity. Lenders would like to see companies which invest their own money into the business and take up a personal financial risk in order to carry out the business. In project finance transactions for example, lenders might request for additional equity investment into the SPV to give them a greater level of comfort.
- Collateral: Collateral is needed for almost all types of loans, except maybe consumer loans. Collateral is a specific asset the loan taker or borrower pledges towards repayment of the loan in case he defaults in the repayment. Collaterals may include homes, cars, property or commercial building. The usual practice is to drop the original certificate with the bank until the loan is successfully paid off.
- Conditions: Some loans come with various conditions which must be met by the loan applicant before it can be approved. Also, lenders might include some certain requirements which must be met either before approving the loan or during the repayment period. In project finance for example, there is usually a requirement for a minimum amount that must be in the Debt Service Reserve account. If the DSRA falls below the minimum amount, the lenders give borrowers a cure period of which money must be added to meet the minimum amount. If the borrower fails to do so, it is seen as an event of default.
- Character: This component might be subjective as the lender takes his general perception of the applicant into consideration. For a business owner taking a loan, a lender might formulate his opinion based on factors like his educational background, professional qualifications, and experience in the industry where he is carrying out his business, quality of referees and so on.
Blaise Ganguin., John Bilardello., Standard & Poor’s Fundamentals of Corporate Credit Analysis
Ciby Joseph., Advanced Credit Risk Analysis and Management