How Credit Analysis Is Done : The Bank Credit Analysis Handbook
Banks like commercial, merchant banks, and community banks are all financial institutions that engage in financial intermediation.
By financial intermediation, it refers to the mobilization of deposit from the surplus unit, this surplus unit refers to those individuals with savings (cash) they are not in immediate need of, both in the rural and urban centres for the deficit unit, the deficit unit refers to those people who need cash for their immediate use, most times the deficit unit needs these fund for their business development in return for a higher interest, these are simple basics on how credit analysis is done on a nutshell.
The deposit could be in form of regular savings account, time deposit or even account.
When these excess fund from the surplus unit is extended to the deficit unit that is when credit analysis techniques comes to play, the financial institution that facilitate intermediation commence the credit analysis process with hope of getting back what was given out as well as making profit.
Now the aim of these depositors is to make investment returns in the form of interest received on these various accounts. The banks play another important role by facilitating payment of such deposit upon demand by the depositors depending on the type of account being operated.
A credit analysis example in regular saving payment, occurs when upon completion of withdrawal form without any prior notice, but for a time deposit the agreed time must be observed otherwise, it will attract a penalty of none payment of interest.
And in current deposit, the withdrawal is by use of cheque which does not require prior notice. The bank plays another important role by creating credit on its own through the process of multiplier.
The bank has an obligation of paying interest on deposited accounts and also make profit in order to been in business. It is based on this premise that the banks must critical analysis of credits been granted to ensure safety, growth and profitability in order to satisfy its desired goals.
How Credit Analysis Is Done : Purpose And Objectives of Credits
Although a credit analysis template has already been established, however, the objective of financial institutions is to make profit, even though there are other responsibilities that they must perform within their environment. These responsibilities include social and economic functions. The degree of the execution of these responsibilities depends on the state and towns. Take for instance, the degree of performing social responsibilities by banks in Washington DC will be different from that of New York City, while one is the administrative hub, the other is a business hub.
However, the main objective of credit and lending purposes of any bank is to provide growth, profitability and sustainability which we will look at further below. Another important objective of credit and lending analysis we will consider is gearing.
Gearing means the ratio of debt to the percentage of capital being represented by borrowings; this is where credit analysis ratios come into play. The question now is why do credit analysis? The purpose of considering gearing of borrowers business is to ensure that the lender (the Bank) does not put more money at risk that the owner of the business it is financing and also to ensure that the borrowed fund is not greater than the capital employed by the owners.
What Is Credit Analysis And How Is It Done?
Most times when the question of credit analysis comes our way, what comes to mind is getting free fund from finance institution, without considering the pay back, in credit analysis, there are factors you considered when you want to look at how credit analysis is done, let’s consider a few factors;
Growth – The purpose of banking business is to make profit and to maximise shareholders wealth. In order to achieve this known objective, the bank has to look outward by granting loans in order to make high returns in order to also increase the growth rate of the company. But if the bank continues to lend without proper assessment, there would be likelihood that loan could turn bad in the future date and therefore fails to contribute to the financial institutions loans resources quality. Through the growth of any company depends upon the quality of its management staff, hence the policies are made to sustain the growth and development of the organisation.
Liquidity – when you want to consider how credit analysis is done, you must notice that organisations including banks, must be liquid enough so as to pay off its daily liabilities. Banks are regulated by the central Bank which stipulates the liquidity ratio and cash reserves ratio each bank must maintain so as to pay its customers. It is after making provisions for such ratios that the surplus would be regarded as loanable funds.
Since it has been established that commercial banks sources of fund is short, it will be more prudent to provide short term credits to individuals, organisations and limited liability companies by means of drafts and short-term loans within a period of one year.
Since banks know that their fund is short, it would be unwise and imprudent to invest in long term projects as it could result to illiquidity. The case of distress bank is a good point of call, because most of these distressed banks became illiquid that they could not meet up with their daily obligation. The resultant effect was liquidation and closure of widows to customers.
Profitability – How credit analysis is done in order to achieve profitability? Now profitability is the bench mark of any organization to survive in the long run of its existence, it is also the parameter that is used in measuring management ability, therefore, a company should have a clear cut objective to maximise returns on the investment so as remain in business.
Why credit analysis? It is important that commercial banks (Deposit Money Banks) remember that their stock in trade is depositors funds, therefore in the lending decision, safety and high rate of returns should be considered as priority. Returns is important because no lending is attractive, if the expected return is less than the average cost of borrowed funds. In situations where there are a lot of competition amongst banks for deposit, this could lead to sharp practices which will eventually become common in the process of making profit when overdraft and loans are advanced to customers. But at the same time, bank makes good profit today because of diversification of portfolio as most of the bank now get involved in both local and international business as well as the arrival of universal banking system.