Qualitative Credit Analysis

Credit analysis. It’s a term we frequently hear in banking (especially if you’re involved in credit or loan origination), but what does it really mean these days? At Baker Hill, we have the opportunity to see all the various ways that institutions analyze their business and commercial borrowers in their loan origination processes. While I would concede that there may be some differing situations that make institutions look one way or the other at what is important, there are still some fundamentals that do not vary. In my next few posts, I’m going to go over those fundamental elements of credit analysis and how you can gain insights to feed your loan origination and decision workflow.  

When analyzing a company’s performance, think of it as telling a story many sides. First there is the side of the owners. Business owners love to tell the story of how they started, how they got to where they are and how their banker can help them go even further. There also is the side of the management, full of excitement and hope, which is another good story. Then there is the side we read in the financial statements, the balance sheet, the income statement, and the statement of cash flows. This is where we try to match up what we hear to what we see and read. Ultimately, it’s where the analysis in credit analysis comes into play in your loan origination process. What do we do with the narrative and figures and what does all of this information tell us?

Financial statements outline the activity of the company for the previous periods. Whether they are year ends or interim periods, they tell us how the company performs. They give us a basis for how well a company does. Analyzing that activity is how we determine the credit worthiness of the company and inform our credit decisions within our loan origination workflows.

What are some of the things that we should be looking at when analyzing that activity? Initially, we must understand what the company does beyond the NAICS code. Understanding the type of business and their operational details will help us set our expectations for evaluating any company’s performance. The financial statements of a manufacturer, for example, will be vastly different than that of a service provider like an accounting firm or law office. The activity ratios we would expect to see will be different and our expectations of performance should be different as well for any type of business you investigate lending to.

For manufacturing entities, we would expect the balance sheet to be larger. Higher levels of inventory, accounts receivable, and fixed assets, equipment, and buildings. Additionally, we should expect to see short term debt used to support those working capital assets as well as long term debt that was used to acquire the assets used in the manufacturing process.

For businesses that provide services, we expect different characteristics in the statements. While accounts receivable and cash may still be high, it is quite possible that levels of and types of fixed assets will be considerably different.

The initial phase of your credit analysis should be to gain a high-level overview of what that company does and how it does it. Try to determine the general concept of how they move products or services through the company. By understanding these basic concepts, you can help set the expectations for how long it takes cash to move through a company. Find out about how the company operates. Ask question about the company’s business development. How do they acquire customers? How do the sell to those customers? How do they get paid? Do they give terms? How do they fulfill those orders? What is involved in producing their product or service? Ultimately, you’re looking to understand why they need the financing that they are requesting. Once some of the basic functions of the company are understood, we can begin the process of evaluating if their request is one that can be honored by the institution through the rest of your loan origination workflow.

Baker Hill has been providing innovative loan origination solutions and expert guidance to banks and credit unions for over 35 years. Built by bankers for bankers, we know the importance of automating manual processes like credit analysis. If you’re interested in more ways to implement digital processes into your institution, you can download our whitepaper on how banks and credit unions are leveraging technology.

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Author Bio

As a Senior Business Process Architect, Kevin Dooley guides implementations for new and existing clients. Dooley relies on his 20 years of Commercial Banking and Special Asset experience to support client success. He provides both strategic and tactical recommendations regarding current credit philosophy and assists financial institutions with implementing and executing credit evaluation and portfolio management strategies.

Dooley earned his bachelor’s degree from Purdue University in Political Science and his master’s degree in Finance from Indiana University’s Kelly School of Business.