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11C Fundamental Credit Analysis

11C Fundamental Credit Analysis. Topics covered: Five C’s of credit analysis Home loan underwriting Credit scoring C&I loan underwriting Cash flow analysis Other considerations Ratio analysis. Five C’s of Credit Analysis. Capacity Capital Collateral Conditions Character.

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11C Fundamental Credit Analysis

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  1. 11C Fundamental Credit Analysis • Topics covered: • Five C’s of credit analysis • Home loan underwriting • Credit scoring • C&I loan underwriting • Cash flow analysis • Other considerations • Ratio analysis

  2. Five C’s of Credit Analysis • Capacity • Capital • Collateral • Conditions • Character

  3. Home Loan Underwriting • Relies heavily on collateral • But ability/tendency to pay also important • Recourse loan • Two key measures • LTV (loan to value) • Debt service ratios • GDS (gross debt service) • Housing cost/gross income • Typically (interest + principal + taxes + insurance)/gross income 28% for FNMA • TDS (total debt service) • (all debts & commitments/gross income) 36% for FNMA

  4. Credit Scoring • Actually began in C&I, but primarily used in consumer lending • Quick & low cost • Typical Factors: • Income • Mortgage/rent cost • Credit card debts • Payment history • Age • Own/rent & length of time • Job stability • Relationship with institution

  5. Credit Scoring (cont.) • FICO Score is the most common consumer credit score • Ranges from 300 to 850 • 760+ Excellent credit, may get better terms • 723 median US score • 680 typically qualify for prime flat on HELOC • 620 typically qualify for FNMA mortgage

  6. C&I Loan Underwriting • Larger loan balances • Customized Terms • Priced to credit risk rather than just accept/reject decision • Significant post-issuance monitoring • Bread and butter for local commercial banks

  7. C & I Loan Underwriting (cont.) • Focus on ability to repay • Hence, extensive cash flow analysis • Financial statements are verified • Tax returns a common source • Check with related parties • Customers • Prospects • Suppliers • Capability and character of management key • Key facets of business investigated • Production • Marketing • Capital Requirements

  8. Cash Flow Analysis • There should be enough cash flow from business operations to service debt • Should not have to sell assets • Should not have to borrow • Most measures are “coverage” ratios of the general form: Cash from operations/debt payments • See Handout • Tables 11-A-1 and 11-A-2

  9. Ratio Analysis • Common-sizing statements is standard • Liquidity Ratios: current ratio = current assets/current liabilities Quick ratio = current assets-Inv./current liabilities • Asset management ratios: Number days receivables (DSO) = A/R x 365/sales or credit sales Number of days inventory = Inv x 365/COGS Sales to WC = Sales/WC Sales to assets = Sales/Fixed Assets Sales to total assets = sales/total assets

  10. Ratio Analysis (cont.) • Debt and Solvency ratios debt to assets = ST Liab +LT Liab/total assets note that 1:1 debt to equity = .5 debt to assets Times interest earned (interest coverage ratio) = earnings available to meet interest charges/interest charges Cash flow to debt ratio = EBIT + Depreciation/Debt this ratio should easily exceed debt interest rate

  11. Ratio Analysis (cont.) • Profitability ratios: Gross margin = gross profit/sales Operating profit margin = Operating Profit/Sales ROA = EAT/ Total Assets ROE = EAT/Total Equity Dividend payout = Dividends/EAT • Always need to be careful about comparability in ratio analysis • Same items can be accounted for in different ways

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