Credit Analysis Framework - Business Risk: Credit Analysis Framework

Introduction

Understanding a business’s financial risk is essential to the analysis of its overall credit risk. While analysis of the past financial
performance of a company gives us some insights into the quality of historical decisions taken by the management, and the past
business and industry environment, this analysis has a limited value when we are trying to get a fix on the future financial
performance of the company.

Remember, the facility that your bank will extend today, will be repaid by FUTURE cash flows. Hence, to arrive at a reasonably
informed credit decision, we must take into account significant factors that are likely to influence the future cash flows of the
company.

There are three significant factors that exert a strong influence on the future financial performance and future cash flows of a
company. These factors are:

1. Developments in the industry, commonly referred to as Industry Risk.

2. Developments in the business, commonly referred to as Business Risk.
3. Management decisions, commonly referred to as Management Risk.

In this course, we will learn to:

1. Gauge the impact of Industry and Business Risk on the future financial performance and future cash flows of the
company.
2. Use our views from the above analysis to determine the robustness of the assumptions provided by the customer, whilst
preparing financial projections.

Credit analysts often refer to Industry, Business and Management Risk as “qualitative” analysis, while historical financial
statement analysis is referred to as “quantitative analysis”. Many also believe that these two analyses are in no way
interconnected! Quite the opposite.

To arrive at a reasonably well-informed credit decision, you need to have a good grasp of the “qualitative” factors that will
significantly influence the future cash flows of the company.

Learn more about the influence of Business & Industry Risk on Financial Performance

By the end of this lesson, you should be able to:

Discuss the basic purpose for performing a credit analysis.

Describe the linkage between the quantitative and qualitative analyses.
Explain the difference between the liquidity and solvency tests.
Explain how the four quadrants of the liquidity/solvency matrix impact the credit decision.
Describe the five assessments of credit risk analysis.
Identify the four primary areas involved in a complete market risk assessment.
Describe the 11 steps of the loan decision process.

Industry and Business Risk Influences

Throughout the lesson’s content and glossary, you will find links to additional information.

What You Need to Know

There are two types of analytical tests that assess a borrower's credit risk: the liquidity test and the solvency test.

The liquidity test determines if the business is generating enough cash from normal day-to-day operations to cover all
normally occurring expenses, including interest and debt repayment.
The solvency test determines if there is enough cash from other sources (primarily liquidation of assets in distressed
circumstances) to pay all debt principal and any accrued interest.

Show the Liquidity/Solvency Matrix

The liquidity and solvency tests can be viewed together to measure a business's creditworthiness:

The results represented in quadrants II and IV lead to easy decisions. If a business passes both tests, the credit risk
assessment process continues. If it fails both tests, no further assessment is necessary because the loan is easily
declined.

An organisation falling into quadrants I or III makes for a more difficult decision. Passing the liquidity test but failing
the solvency test often suggests a need to continue the risk assessment process, especially in cases where a
strong, cash-heavy guarantor can be added to the ultimate loan structure. On the other hand, passing the solvency
test while failing the liquidity test suggests not continuing, simply because few lenders wish to extend credit where
borrowers are clearly unable to make loan payments on time from internally generated cash flow.

Credit Risk Assessment Outcomes Results

Pass Liquidity Test/Pass Solvency Test Pass

Pass Liquidity Test/Fail Solvency Test Bias to Pass

Fail Liquidity Test/Pass Solvency Test Bias to Fail

 Fail Liquidity Test/Fail Solvency Test Fail

The complete credit risk analysis covers the following five crucial areas.

Credit policy
Financial risk
Management risk
Industry and business risk
Facility structure risk

Show the Components of Credit Risk Analysis

Credit policy: This text forms the institutional guidelines on how to assess credit risk; which types of customers to
lend money to; and how to carry out all other aspects of the credit decision, including granting and ongoing
management of the loan.

Financial risk: This refers to the risk that a borrower will fail the liquidity or solvency test, or both, which may
indicate a failure to repay the loan.

Management risk: This is the risk that the borrower's managers lack capacity, integrity, depth, or staying power to
run the business in a way to generate enough cash to repay the loan as initially agreed.

Industry and business risk: This is the risk that the competitive marketplace in which the borrower operates may
create impacts that cannot be readily managed or mitigated, increasing the likelihood of a failure to repay the loan.

Facility structure risk: This is the risk that a loan has been structured inadequately, adding unnecessary stress to
the credit relationship, and/or failing to protect the lender if the borrower is unable to repay the loan.

A complete industry and business risk assessment consists of the thorough analysis of the following:

The general business environment

Industry status
Competition
Individual business vulnerability

This process includes determining the historical, current, and potential impact on a business from these influences, which
management cannot directly control. The process also considers how management anticipates and guides the business in the
context of its external, competitive environment.

A traditional loan decision process, one that does not include automated risk rating inputs, may involve several steps. These
range from gathering data to determine policy compliance to structuring and pricing the loan request.

Show the Steps of Loan Decision Process

The loan decision process may involve the following steps:

Screen against loan policy: Collect enough data to determine that the credit request and purpose fall within
the bank's policy guidelines.
Gather data: Collect all remaining financial and non-financial data needed to reach a credit decision.

Enter financial data: Input the financial data into the spreading and reporting software used by your
organisation (e.g. CMA forms).
Analyse financial data: Conduct general research, then review and analyse ratios and cash flow to arrive at a
preliminary financial risk assessment. If the risk level is acceptable, proceed to the next step.
 Conduct management interviews: Prepare a list of questions for the borrower’s management team based on
the analysis results. Conduct interviews with the management team.
Build analysis assumptions: Based on both the analysis and management interviews, prepare assumptions
for the borrower's risk (cash) drivers.
Make projections: Make projections of future performance and compare the results of projected ratio and
cash flow reports with the most recent actual results. Determine and evaluate projected risk, and assess
whether projected results change the preliminary financial risk assessment: the risk may be reduced via
credit enhancements (risk mitigation measures), if desirable or required.
Identify credit enhancements: Provide necessary or desirable credit enhancements in the form of security
and/or guarantees to mitigate the impact of any losses.
Structure covenants: Provide for early detection of conditions indicating that business performance is lower
than assumed in projections.
Determine pricing: Price the credit, taking into account established guidelines, perceived credit quality, and
expected competitive issues, while also considering the credit enhancements.
Grade the risk: Assign a risk grade according to the institutional guidelines and rating scale.

You can mitigate credit risk by structuring the loan and documenting it effectively and according to the bank's credit policy.

What You Need to Do

Assessing industry and business risk is a key activity in the overall credit risk assessment process. You should keep in mind:

Correctly calculate… Evaluate… Determine…

sales growth figures. the management’s
i. If the historical
Then, fully understand strategic response to
the causes behind financial these business & industry
changes in historical and performance developments and the
reflects the key
projected sales levels. impact of the actions
changes in the taken by the
business and management on key
industry dynamics.
components of the
ii. Assumptions used financial statements
to project the (Sales, Costs, Capital
financial Expenditure, Capital
performance Structure, etc.).
reflect the
business &
industry dynamics
and management’s
strategic response.

How This is Useful

You are assisting a more experienced credit officer with a loan request. Even though you are still new in the credit approval field
you understand that whenever a request for credit is received, the lender initiates a decision process that considers many
aspects of the potential transaction. This process includes analytical steps that ultimately evaluate the likelihood that a business
will meet prescribed benchmarks for liquidity and solvency in order to qualify for credit in accordance with policies at your
institution. You understand that an important aspect of the overall process, which should not be overlooked or neglected, is to go
beyond the business's financial statements and review industry and business and management-related risks.

In the end, once the risks have been identified and creditworthiness established, you work together with your colleague to
examine how to structure the loan so that the risks you identified are minimised. You look forward to learning more of the
intricacies of commercial lending. You also appreciate what you've learned by participating in a process that leads to sound
judgments about the probability that both principal and interest will be repaid as agreed.

Questions You Should Ask

Asking the right questions is a key part of successfully analysing the industry and business risk of a business. The following
questions may be very helpful:

What are the credit policy issues present in the proposal? Do they permit continuing with the assessment of the
request for credit?

Using the liquidity and solvency tests as the overall focus for assessing credit risk, should you proceed with a full
analysis?

What does the assessment of industry and business risk suggest about the assessment of financial, management,
and facility risks?

What has been done, and what still needs to be done, to complete the entire credit decision process?

Knowledge Check

Question 1

When we assess credit risk, what are we really evaluating?

How much money will be lost in the event the borrower defaults on a loan.

The likelihood that the principal and interest payments associated with the loan will be made as agreed.

Whether or not a loan can be repaid in a distressed circumstance through the liquidation of borrower assets.

Whether or not the borrower intends to repay a loan.

The main purpose of assessing credit risk is to evaluate the likelihood that both principal and interest will be repaid in cash as
scheduled.

Question 2

What does the solvency test measure?

A borrower's ability to generate enough cash from ongoing operations to pay all normal expenses, including interest and
scheduled principal payments.

The adequacy of cash from the liquidation of business assets in distressed circumstances to pay off all debt and accrued
interest.

The ability of a business to continue its operations without taking on more debt.

A business's ability to meet all debt repayment obligations from normal operations, similar to the liquidity test.
 The solvency test establishes if there is adequate cash from non-operating sources (primarily liquidation of assets in
distressed circumstances) to pay off a business's debt and accrued interest. The liquidity test determines if a business is
generating sufficient cash from normal day-to-day operations to cover typical expenses, including scheduled payment of
interest and debt.

Question 3

Which one of the following risk assessment categories is NOT among those normally addressed in the credit risk assessment
process?

Industry and business risk

Financial risk

Global risk

Management risk

Credit risk analysis evaluates a potential loan in five crucial areas:

credit policy
financial risk
management risk
industry and business risk
facility risk

Question 4

What areas of analysis are typically covered when assessing industry and business risk?

Financial risk assessment, management risk assessment, general business environment and competition.

Management integrity, management skill, competition and general business environment.

Financial ratio analysis, industry status, cash flow analysis and general business environment.

General business environment, industry status, competition and business vulnerability.

Industry and business risk assessment encompasses the analysis of:

the general business environment;

industry status;
competition; and
business vulnerability

This process includes determining the historical, current and potential impact on a business from these influences that
management cannot directly control and considering how management anticipates and navigates the business through those
forces.

Question 5

Industry and business risk is the risk that the competitive marketplace in which a business operates creates forces that the
managers of the company can manage or mitigate by moving to another market.

True

False
 Industry and business risk is the risk that the competitive marketplace in which a borrower operates creates pressures that
cannot be readily managed or mitigated, and which therefore can inhibit timely repayment of principal and interest.

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