Financial Analysis and Credit Approval Document

Initial Credit Risk Assessment

An effective underwriting process needs to take place before a loan is submitted for approval, and is a key factor in managing credit risk. Sound underwriting requires that a credit union fully understand a borrower’s operations and financial ability, as well as identify all associated risks. Underwriting ensures the loan is structured appropriately for the purpose of the borrowing need and the borrower has the financial capacity to meet the repayment requirements.

To ensure a thorough credit risk assessment, a credit union should consistently apply its policy and procedures. When competition or other pressures cause a credit union to weaken its underwriting and structural protections, credit risk increases. Credit unions must maintain consistent, disciplined, and sound underwriting practices. A well-underwritten loan is a value added service the credit union provides to the member.

Financial Analysis

The credit risk assessment and rating process begins with a thorough analysis of a borrower’s financial condition and ability to repay. The financial analysis should focus on:

  • A review and explanation of a borrower’s financial performance, based on a reasonable period sufficient to establish a reliable trend
  • Debt service ability
  • Income and expense trends
  • Balance sheet changes (including impact on the ability to service debt)
  • Satisfactory borrower payment history

Specifically, the following components of income statement and balance sheet should be reviewed and analyzed.

  1. Income Statement

    1. Sales/revenue trends and explanation (percentage and dollar figures)
    2. Gross profit trends and explanation (percentage and dollar figures)
    3. Expense trends and explanation, with explanation of significant changes (percentage and dollar figures)
    4. Net profit trends (percentage and dollar figures)

  2. Balance Sheet

    1. Asset composition, changes/trends, and the reason for the changes
    2. Liability composition, changes/trends, and the reason for the changes
    3. Debt-to-worth ratio
    4. Inventory, accounts payable, accounts receivable turnovers
    5. Financial ratios such as leverage, liquidity, and others
    6. Contingent liabilities and off-balance sheet items

A credit union’s analysis should include an evaluation of related entities and principals and the influence they have on a borrower’s ability to repay. The analysis should evaluate other sources of income or losses that affect a guarantor or principal to determine a borrower’s global financial condition and debt service ability.

A credit union’s policy should address the quality of the financial information required to make an accurate evaluation of risk. The quality of the financial information should be commensurate with the size and complexity of the borrowing relationship.

Financial statement quality is determined by the level of assurance provided by the preparer and the required professional standards that support the preparer’s opinion. In many cases, tax returns or financial statements professionally prepared in accordance with GAAP are sufficient for less complex borrowing relationships such as those that are limited to a single operation of the borrower and principal with relatively low debt.

For more complex and larger borrowing relationships, such as those involving borrowers or principals with significant loans outstanding or multiple or interrelated operations, a credit union should require borrowers and principals to provide either an auditor’s review of the financial statements prepared consistent with GAAP to obtain limited assurance (a “review quality” financial statement) or an independent financial statement audit under GAAS for the expression of an opinion on the financial statements prepared in accordance with GAAP.

Financial projections provided and prepared by a borrower are a major component of a credit assessment. They help a credit union determine whether a borrower is planning and managing operations to achieve future goals. A credit union should require financial statement projections when a borrower’s historic performance does not support the proposed debt repayment, or when the credit union anticipates a structural change in the borrower’s future operations and repayment depends on the success of the changes. A borrower needs to prepare the projection, as they will be responsible for executing the projected plan.

A credit union should address the criteria and thresholds for the required financial reporting in its policies. Exceptions in the credit policies should be allowed if a credit union determines the borrowing relationship does not require the same level of assurance and the credit union is satisfied that the lesser quality still provides an accurate reporting of the borrower’s financial performance. Any exception must be documented by staff and approved by the appropriate designated internal authority. Exceptions should be tracked by the commercial lending department and periodically reported to senior management and the board.

As part of the credit analysis, a loan officer or credit officer should determine the level of risk associated with the loan request and assign an initial risk rating.

Credit Approval Document

A credit union should prepare a credit approval document before originating a loan, renewing a loan, conducting an annual review, or performing a loan workout. This internal credit union document provides the analysis and supports the lenders’ approval or decline decision. It is the document submitted to the appropriate approving authority and is the official record of the actions taken by the credit union. It should be a stand-alone document that is organized in a standard, logical format to provide all relevant information which allows the individual(s) authorized to approve loans to make a fully informed credit risk decision.

The use of a standard format helps ensure that a credit union uses a consistent and fair process to evaluate all borrowers. A complete credit approval document should address and verify key information as described below. Specifically, this document should include, but is not limited to:

  • Full description of each borrower and their business background, including:

    • Business entity structure and type
    • Number of employees
    • Description of the nature of the business (products and services offered, customer description)
    • Year business was started
    • A discussion of any concentration of sales to one or a limited number of customers
    • An assessment and analysis of potential of a concentration of or dependence on one or a limited number of suppliers
    • Name of principals involved in the ownership and management of the business
    • An assessment of management’s ability
    • An assessment and analysis of the industry and competition within it
    • Repayment history
    • Relationships between entities, and how one business is impacted by the other(s)
  • A summary and aggregation of all loans and commitments outstanding to the member and associated members to confirm they comply with NCUA regulation §723.4(c)

  • Amount of the financing request, the loan purpose, and source and use of funds

    • Both internal and external refinance loans should clearly state the original purpose and use of funds. When a credit union refinances a loan from another institution, refinancing is the action—not the loan purpose. The purpose of the loan is the use of the funds when the loan was originated at the other institution.
    • Acquisition of fixed assets should state the purchase price and the borrower’s investment.
    • Include the initial interest rate and adjustments, as well as the term of the loan.
    • Coincide the loan term and amortization with the useful life of the asset to be purchased or used to secure the loan.
    • Document environmental issues and due diligence process.
  • The collateral description and value, the valuation method, and the LTV
  • A full financial analysis of the borrower and guarantor, including:
  • Components of the income statement and balance sheet, presented consistently and in an orderly fashion
  • Identification of the preparer, source (tax return, compilation, review, or audit), and quality of the financial information used in the analysis
  • Three years of historical financial data (when available), in most cases
  • Trends to support the borrower’s ability to generate sufficient and reliable cash flow to repay the loan (Discuss the trends and the reason for the trends disclosed in the income statement and balance sheet.)
  • Comparison of financial performance to industry standards, as appropriate
  • Documentation that a credit union understands and has explained the impact of material changes in the balance sheet, key financial data, and trends
  • Results of stress-testing key components that affect cash flow, when applicable, to show how much these can change before either break-even or minimum acceptable cash flow results (Examples for key items may include market rental rate declines, vacancy level increases, revenue declines, expense increases, or loan interest rate increases.)
  • Sources of repayment and a borrower’s ability to service debt (The body of the credit approval document, or an attachment, should include the complete calculation, including all the components of the calculation of DSCR or GDSCR.)
  • A full guarantor analysis to understand the other sources of income or losses impacting the guarantor along with a documented understanding of the composition of the guarantor’s assets and liabilities. (In most cases, especially for guarantors with multiple income producing projects and entities, a global analysis should be completed. The global analysis will identify other stresses on the guarantor that could ultimately impact the borrower. At the very least, any entity guaranteed or that has a documented legal commitment for support—such as cash calls for limited partnership by the guarantor—should be included in the global cash flow.)
  • References to financial information, which is supported and easily identified in the underlying financial statements, tax returns, and financial calculations. (A credit union should clearly label and identify all attachments referenced in the credit approval document and identify the quality of the financial information, the preparer, and the period being analyzed.)
  • Use of projected financial statements, when appropriate.

In addition, a complete credit approval document should:

  • Document the borrower’s strengths and weaknesses (market, industry, borrower, collateral, or financial issues)

  • Explain financial reporting requirements, such as the frequency of the submission of financial information and the required quality of the statements (tax return, compilation, review or audit)

    • Financial information prepared by the borrower for interim financial reporting is acceptable if a credit union is comfortable with a borrower’s ability to generate reliable information.

  • Clearly identify any approval conditions

    • These might include receipt of appraisal noting a value sufficient to comply with the stated LTV requirement, or receipt of other verification documentation.

  • Assign the appropriate risk rating and document the justification and factors that support the risk rating with each credit approval

  • Identify potential or actual risks and mitigations

  • Document and explain any policy exceptions and justifications to waive the policy requirement

  • Outline all material and specific details for the proposed loan commitment letter (if issued) and/or loan agreement, including key financial covenants

  • Include any other reporting requirements necessary to determine changes in risk associated with the borrowing relationship

Last updated November 25, 2016