If you are seeking debt for a commercial real estate project, you need to understand the basics of credit analysis. It is a step in the credit approval process that evaluates the financial strength of the borrower. So, if you want to perform credit analysis on your own, here is a guide for you. Keep in mind that you also need to be aware of spreading financial statements. Banks use special tools for spreading financial statements, underwriting financial statements and other steps in the process. However, you can use a financial statement analysis template for financial statement analysis. Now, step into the shoes of the bank.
The following are the 5 Cs of credit analysis:
Does the borrower have the ability to pay back the loan? To analyze capacity, analyze the borrower’s historical and projected cash flows. Review financial statements and tax returns of the past 3-5 years to determine a cash flow figure. It is defined as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Administration).
You need a plan B if the borrower is unable to pay back the loan. Collateral provides you with extra assurance that if the borrower is unable to generate the much-needed cash flow, the loan won’t go bad. Collateral includes the following:
- Real estate
In the underwriting process, a third-party appraisal is required to place a dollar value on collateral. Loan to Value ratio caps the loan amount.
If the borrower’s cash flow turns negative for one or two seasons, sufficient capital provides a “cushion”. The number is calculated using the debt to equity ratio.
The lender makes sure that the company will not be affected by adverse industry trends. It is good for the lender if the borrower has a competitive advantage in the economics of the industry and economic environment.
This is the most important factor as the borrower must be trustworthy. It is important to understand the history of the borrower.
Financial statements spreading
The lender gathers and reviews the borrower’s financial statements and tax returns of the past 3 to 5 years. This is followed by the credit analyst spreading financial statements. You can use Excel for spreading financial statements. Banks use specialized software for this step.
Spreading financial statements allows the analyst to compare financials over different time periods.
Credit Analysis Ratios
The bank speaks to the borrower and performs a full written financial analysis. This return analysis involves the positive and negative trends that affect the borrower’s business. The following are the most common ratios considered in credit analysis:
● Liquidity Ratios
Liquidity is the borrower’s ability to pay short-term obligations as they come due. The ratio is less important for a borrower with stable cash flow and operations. If the borrower’s business goes through ups and downs in revenue, liquidity ratios become important.
● Current Ratio
This ratio shows the assets that can be converted to cash to pay off debts incurred in one year. It roughly indicates if the borrower can cover short term liabilities. The cushion is greater when the ratio is higher.
Current ratio=total current assets/total current liabilities.
● Quick Ratio
The quick ratio is also known as “Acid-test” ratio. It is calculated as:
Quick Ratio=Cash & Equivalents+Trade Receivables (net)/Total Current Liabilities
This ratio measures the number of times the borrower’s trade receivables turn over in a year.
Sales/Receivables=Net Sales/Trade Receivables
● Day’s Receivables
This ratio indicates the average number of days receivables outstanding.
Day’s receivables=365/(sales/receivables ratio)
Other key Ratios and Respective Formulas include:
|Cost of sales to inventory ratio||Cost of sales/inventory ratio|
|Day’s Inventory||365/(cost of sales/inventory ratio)|
|Cost of sales to payables ratio||Cost of sales/payables|
|Day’s payables ratio||365/(cost of sales/payables ratio)|
|EBIT (Earning Before Interest Ratio) to interest ratio||EBIT/Annual Interest Expense|
|Fixed/Worth Ratio||Net Fixed Assets/Tangible Net Worth|
|Debt to Worth Ratio||Total liabilities/tangible net worth|
|Profit before taxes to tangible net worth ratio||(profit before taxes/tangible net worth)×100|
|Profit before taxes to total assets ratio||(profit before taxes/total assets)×100|
|Sales to net fixed assets ratio||Net sales/net fixed assets|