featured image: How Banks Assess Credit Risk

How Banks Assess Credit Risk


“It costs money to start a business. Funding your business is one of the first and most important financial choices most business owners make. How you choose to fund your business could affect how you structure and run your business.”

And, if you are looking for ways to fund your business but you are strapped out of cash, then loan might be all you need to get back on your feet. Before processing any loan, the lender looks for following things in a borrower:

  1. Credit Report

Financial institutions will closely scrutinize your credit report (Business as well as Individual) when reviewing your application for a loan as it gives them insight into how you manage borrowed money. A credit score is a three-digit number that reflects your credit behaviour. A poor credit history indicates an increased risk of default. The higher your score, the better. In India, all credit bureaus offer a credit score between 300-900, 900 being the highest. A credit score of 700 and above is considered as ideal. While they look at your credit score, they also dive much deeper. Here are some of the thing’s lenders will consider:

  • Recent applications and existing loans (if any): Lenders take a look to see if you’ve recently applied for any other forms of credit or debt. Too many of application can look risky and indicate financial trouble. They also check on the existing loan status and outstanding balances and how the repayment has been served.
  • Payment history: Lenders also will review your payment history on credit cards, loans, lines of credit and anything else that shows up on your credit report. They want to make sure you have a track record of on-time payments that could indicate you’ll be a responsible borrower. If you have any old payments that were late or missed, the lender may ask you for an explanation.

Credit utilization: Your credit utilization ratio is a factor a lender considers. This ratio indicates how much of your available credit you’re using at a given time. If you’re using too much of your credit, it can make you appear overleveraged, and thus riskier to lenders. Most lenders prefer your credit utilization be under 30%, so make sure you’re not exceeding this to see a positive impact on your credit scores and approval chances. In other words, if you have a credit card with a Rs. 10,000 limit, aim to keep your balance under Rs. 3,000.

  • Major derogatories (such as bankruptcies): This includes any negative mark that makes you look riskier as a borrower. This could be a bankruptcy, judgment, delinquent account, account in collections, charge-off or an account settled for less than what was owed.
  • A dispute statement: Lenders will also check to see if there are any dispute statements or pending disputes on your credit report, and may look upon them negatively. If you have a pending dispute on your credit report, it’s advisable to wait for the dispute process to resolve before you apply for loan. Lenders prefer to see a true view of your credit, without a pending dispute clouding the picture.

2. Lenders Assess Your Business performance

Lenders assess the business performance in terms of its revenue generation and profitability. It is a major factor when it comes to being approved for a loan. Lenders want to know that you will be able to pay back what you borrow. They prefer borrowers who have a stable, sufficient and consistent income to those who don’t. The income requirements vary based on the amount you borrow, but typically, if you’re borrowing more money, lenders will need to see a higher income to feel confident that you can keep up with the payments. Usually lenders collect at least last three years financials to assess the business performance.

3. Lenders Consider Your Assets

While not as critical as your credit or income, lenders will usually want to see your bank statements. They will ask for at least last 6 months to one-year bank statement. On your application, you can also list assets such as cash (things like checking accounts, savings accounts and CDs) and investments (retirement accounts, stocks, bonds or anything else).

Having high-value assets makes you look less risky to lenders. This is because they may mean you’re better equipped to make a larger down payment and pay your payments on time every month. Lenders also like to see that you have some cash in a savings or money market account, or assets that you can easily turn into cash above and beyond the money you’re using for your down payment. This reassures them that even if you experience a temporary setback (like the loss) you’ll still be able to keep up with your payments until you get back on your feet.

4. Lender assess Industry Performance and Market forecasts

The lender wants to know the economic condition in which the business is operating. They want to know how the business will be performing in industry in comparison to its competitors and sustain in the industry. They also want to check will the business have a market in future. One of the reasons behind this is that the industry could be at the risk of a sudden downturn, putting the lender at risk. In order to make sure loan is approved, you must overcome tough economic conditions as well as demonstrate an ability to withstand high expertise in running a volatile business.

5. Lender considers the growth forecasts

The lender wants to know how much revenue and profits will make and their growth percent the business is expecting to meet atleast in the next 3 – 5 years. They will be willing to know if there will is any further expansion plans in business in near future.

6. Lender looks for Minimum Level of Owner’s equity in the business and Collateral (for additional security, if required)

Lender will review and evaluate your business’s capital, which is the amount of money the business has to work with. In case, the lender finds that the business is not well capitalized, then it might decline the application as it may consider the same to be risky and it shows them how vested you’re in your business.

For additional security, bank may require collateral as a cover to risk. Loans that involve collateral are called secured loans while those without collateral are considered unsecured loans. If you fail to repay the loan, then lender has the right to recover what they’re owed through collateral.

7. Cash Flows Generation Capacity review

A lender’s primary concern is whether your daily operations will generate enough cash to repay the loan. Cash flow shows how your major cash expenditures relate to your major cash sources. This information may give a lender insight into your business’s market demand, management competence, business cycles, and any significant changes in the business over time.

8. Debt Servicing Capacity Analysis

The debt service coverage ratio is a good way to monitor your business’s health and financial success. It is used by lenders to determine if your business generates enough income to afford a business loan. DSCR, measures the ability of a company to use its operating income to repay all its debt obligations. Lenders also use this number to determine how risky your business is and how likely you are to successfully make your monthly payments for the length of the loan. A high DSCR indicates that your business generates enough income to manage payments on a new loan and still make a profit. A low DSCR indicates that you may have trouble making payments on a loan, or may even have a negative cash flow. If this is the case, you may need to increase your DSCR before taking on more debt. If the DSCR is less than 1, it suggests the company is unable to service its debt obligations with operating income alone. If the DSCR is more than 2, it indicates a good sign generally across the industries.


Understanding the “Five C’s of Credit”

No matter where you apply, the lender or bank receiving your application generally follows the same review process. This review includes the “5 C’s of credit.” These characteristics of credit are used to evaluate your potential as a borrower. And all the above points are consolidated to this 5 C’s.

  • Capacity: Likely the most important of the five, capacity is your business’ ability to repay loans. Lenders make sure your business plan demonstrates steps to repay any loans borrowed. Specifically, lenders look at current income, the stability of income over a period of time, proposed or projected income, expenses, cash flow and repayment timing. They also look at your business and personal credit scores.
  • Capital:  The cash you put toward starting your business is called capital, and it’s a good way to show a lender how serious you are about success. Capital represents the overall pool of assets under the name of borrower and is an additional security in case of unforeseen circumstances or setbacks (like a loss).
  • Collateral: Collateral is something that you agree to give to the bank if you are not able to keep up with your loan payments. When evaluating a loan application, a lender will generally look at collateral as a secondary source of repayment for the loan. They’ll want to make sure that if the loan payments stop for some reason, they can recover what they’re owed through collateral. This could be equipment, vehicles or inventory. The loan amount will be based on a percentage of the collateral’s value, which is called the loan-to-value ratio (LTV). Different types of collateral have different LTVs.
  • Condition: Conditions takes into consideration the environment of the loan (what’s going on industry and competitors, What’s the intended use for the loan, etc). Conditions take a look at the outside forces impacting the repayment ability. Borrower needs to be prepared to demonstrate that there’s a market for the business and a clear purpose for the loan. He/she should be able to base arguments on the local, regional and national economy, the competitiveness of the business, the type of industry and their experience in it, and the experience they have in managing a business.
  • Character: The final C includes a look into who you are as a borrower, including your educational background, business experience and personal credit history. Your personal credit history is important because you may be required to personally guarantee the loan. Statistics show that the way a person handles personal credit generally indicates how he or she will manage business credit. Any references or other background information you can provide will be considered.

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