Should the bank give the requested loan?
If the loan is given, will it be repaid together with interest?
What is the financial institution's remedy if the assumptions about the loan turn out to be wrong?
Sound Business Characteristics
Adequate liquidity so it can honour short term obligations easily
The proprietor's stake in the business is high (business is not burdened with too much debt)
Credit analysis factors
Trend (time series) analysis
Trend (time series) Analysis
If the business was run profitably for some years, then it may not be unreasonable to assume the trend will continue.
If the business has a large margin of safety (between actual sales and break even sales), then some fluctuations in business conditions in the future may not be a cause for concern.
The business can be subjected to sensitivity testing.
If the business continues to remain profitable, then the lender can be reasonably certain that the business can withstand future shocks.
What are trends and prospects for the firm's industry? If the industry is growing, then the lender can expect that the firm will also grow.
The lender can analyse trends in the domestic and international economics to gauge the possible impact on the business.
Remedy's for bad loans
Charge on assets
Cross-sectional techniques (ratio analysis)
Time series techniques (trend statements, trend of financial ratios, variability measures)
Combination of financial statement information and non-financial statement information
Inventory turnover ratio
Average collection period
Gross profit-sales ratio
Net profit-sales ratio
Interest coverage ratio
Fixed charges coverage ratio
Expressing the items in a financial statement in an indexed form.
- - Choose one year as the base.
- - Express the values of an item for subsequent years relative to their value in the base year.
(2000 = 56.7, 100; 2001 = 58.4, 103; 2002 = 60.2, 106.17)
Trend of financial ratios
Computing financial ratios for a series of years for the same firm, and studying their trend.
What is not discerned by observing a trend can be known by computing a measure of variability of the ratio
(Max value - Min value)/Mean financial ratio