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Unit 7: Loans and Advances

7.6.2 Evaluating Commercial Loans Notes

When evaluating loan requests, bankers can make two types of errors in judgment. The first is
extending credit to a customer who ultimately defaults. The second is denying a loan to a
customer who ultimately would repay the debt.
It is often difficult to identify dishonest borrowers. The best indicators are the borrower’s
financial history and personal references. Just because a company has audited financial statements,
however, does not mean the reported data are not manipulated. Management has considerable
discretion within the guidelines of generally accepted accounting principles and thus can “window
dress” financial statements to make the results look better.
Loan proceeds should be used for legitimate business operating purposes. Speculative asset
purchases and debt substitutions should be avoided. The amount of credit required depends on
the use of the proceeds and the availability of internal sources of funds. The required loan
amount is a function of the initial cash deficiency and the pattern of future cash flows.
Loans are repaid from cash flows. Credit analysis evaluates the risk that a borrower’s future cash
flows will not be sufficient to meet mandatory expenditures for continued operations and
interest and principal payments on the loan. The four basic sources of cash flow are: the liquidation
of assets, cash flow from normal operations, new debt issues, and new equity issues.
It is not by chance that the question of collateral is the last question to be addressed. In general,
a loan should not be approved on the basis of collateral alone. Collateral improves the bank’s
position by lowering its net exposure. It does not improve the borrower’s ability to generate
cash to repay the loan. Virtually any asset, or the general capacity to generate cash flow, can be
used as collateral.
From a lender’s perspective, however, collateral must exhibit three features. (1) Its value should
always exceed the outstanding principal on a loan. (2) It must have a ready market for sale. (3) A
lender must be able to clearly mark collateral as its own.
There is a four-stage process for evaluating the financial aspects of commercial loans:

1. Overview of Management, Operations, and the Firm’s Industry: Before analyzing financial
data, the analyst should gather background information on the firm’s operations, including
specific characteristics of the business and intensity of industry competition, management
character and quality, the nature of the loan request, and the data quality.
2. Common Size and Financial Ratio Analysis: Common size ratio comparisons are valuable
because they adjust for size and thus enable comparisons across firms in the same industry
or line of business. Most analysts differentiate between at least four categories of ratios:
liquidity, activity, leverage, and profitability. Liquidity ratios indicate a firm’s ability to
meet its short-term obligations and continue operations. Activity ratios signal how
efficiently a firm uses assets to generate sales. Leverage ratios indicate the mix of the
firm’s financing between debt and equity and potential earnings volatility. Finally,
profitability ratios provide evidence of the firm’s sales and earnings performance.
3. Cash Flow Analysis: Accounting standards mandate that the statement of cash flows be
divided into four parts: operating activities, investing activities, financing activities, and
cash. Operations section includes income statement items and the change in current assets
and current liabilities (except bank debt). Investments section includes the change in all
long-term assets. Financing section includes payments for debt and dividends, the change
in all long term liabilities, the change in short term bank debt, and any new stock issues.
Cash section includes the change in cash and marketable securities. The key element in the
analysis is to determine how much cash flow a firm generates from its normal business

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