Credit analysis is the practice of calculating the creditworthiness of a business before granting a loan or other forms of credit. Banks usually conduct the calculation method before approving or denying a commercial application for credit.
The central purpose of credit analysis is to evaluate both the potential borrower and lending institution and assign a risk rating from there. There are several ways that banks carry out this practice of evaluation, which is not limited to classic credit analysis tactics and more modern-day methods that involve a univariate scoring system. Business owners looking to get financing should know the following about credit analysis.
1. The Five Cs Matter
The five Cs of classic credit analysis include character, capital, capacity, condition, and collateral. Character concerns the reputation of the borrowing company as it pertains to fulfilling financial obligations. A company that often misses billing due dates may find that the character of the business if quite minimal. Perhaps reputation is influenced by capital, which is the second factor in the scheme. A company’s leverage deals with sales and cash flow. Unstable capital is a major red flag in the credit analysis process.
A lender may be willing to take a chance on a borrower if the capacity, which is the potential for earnings, is high. The company in a financial hole today could be the next greatest hit tomorrow if it is headed in the right direction. Of course, the condition, which is the purpose of the loan, and overall collateral are also significant factors in the credit analysis process and the whole decision of lenders.
2. The Credit Scoring System Is Also Used
A credit scoring system is a modern approach to analysis that quantifies the five Cs of a company. An analyst using credit scoring approaches the situation with the sole purpose of deriving a ratio from an applicant’s reputation capital and overall collateral.
The purpose of a loan as well as the probability of a business reaching success or ruin cannot be easily broken down into numbers. Such is the reason why many banks do not solely rely on the modern approach to credit analysis to help determine the creditworthiness of a company. The ratio alone could easily deem a business suitable for a large loan, but the likelihood of further success of said company could be questionable at best. Many financial institutions, then, take both classic and modern approaches when evaluating an organization’s ability to handle new credit.
3. Having All Things In Order Is Best
With more banks checking twice during the credit analysis process, it is essential that companies hoping to obtain a loan for renovation or business expansion make sure that all financial matters are in order. Presenting the best portfolio to lenders makes them feel more at ease to grant an advance.
Financial institutions consider credit analysis as the gate that keeps all of the wrong applicants away from funding. Business owners hoping to get through the doors must pass the financial test.