How to Evaluate Commercial Loan Requests

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There are two main types of loans: personal and business. Business loans are processed as either corporate or commercial depending on the amount, however, they both call for a rigorous approval process in order to pass the risk manager's assessment--and every good bank has a good risk management department. While every bank has its own evaluation process, there are some common aspects to every commercial loan request. Ultimately as the portfolio manager or reviewer it is your job to 1.) make sure the bank accepts the customer who will repay the debt, and 2.) make sure the bank rejects making a loan to a customer who will default on the loan.

  • Determine the purpose for the loan and what the proceeds will be used for. The best loans are for equipment or working capital. That is, items which can be easily sold. You want the proceeds of the cash to be used for operations and not to finance investments (projects that do not have to do with the company's stated mission).

  • Determine the primary source of repayment. Conduct a cash flow analysis. The goal is for cash flow to come from cash flow from operations and not cash flow financing or investing activities. Look at the Statement of Cash Flows for the past three years to see where cash originates from. Cash flows should align with the purpose for the loan. Determine the payback period. That is, how many years it will take to pay back the loan based on projected cash flows. A shorter payback period presents lower risk to the bank.

  • Identify and review the collateral for the loan. In commercial loans, collateral is commonly referred to as "cushions of protection". These are assets the bank can sell that have been pledged against the amount of the loan. The best cushions of protection are capital assets such as equipment. While company stock is often used as collateral, securities have a tendency to decrease in value if the company is performing poorly. The securities may be worthless should the company default on the loan.

  • Review the past credit history of the customer. While this is less important for commercial loans than it is for personal loans, it is important to look at the risk profile of the borrower. The most commonly used risk metric are credit risk grades. These credit ratings are provided by Standard and Poors, Fitch and Moody's Financial. Another commonly used rating is KMV which is a metric published by Moody's. Most commercial banks subscribe to at least one of these rating agencies.

  • Determine how much to give the borrower. This is a function of both the loan request, collateral, and cash flows produced as a result of the loan. The better the risk profile for the borrower (obligor) the more you can lend.

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