11-1

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

11-2

Five C’s of Credit Analysis

Capacity Capital Collateral Conditions Character

11-3

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

11-4

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

11-5

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

11-6

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

11-7

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

11-8

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

11-9

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

11-10

Ratio Analysis (cont.)

Debt and Solvency ratios

debt to assets = ST Liab +LT Liab/total assetsnote 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/Debtthis ratio should easily exceed debt interest rate

11-11

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