——<¢ = ee ee ) Is the Borrower Creditworthy? - The question that must be dealt with before any other is whether or not the customer can service the loan—that is, pay out the credit when due, with a comfortable margin for error. This usually involves a detailed study of six aspects of the loan application: character, capacity, cash, collateral, conditions, and control. All must be satisfactory for the loan to be a good one from the lender's point of view. (See Table 17-3.) Ja Character. The loan officer must be convinced that the customer has a well-defined am purpose for requesting bank credit and a serious intention to repay. If the officer is not sure “exactly why the customer is requesting a loan, this purpose must be clarified to the bank's “satisfaction. Once the purpose is known, the loan officer must determine if it is consistent with the bank's current loan policy. Even with a good purpose, however, the loan officer must determine that the borrower has a responsible attitude toward using borrowed funds, is truthful in answering the bank's questions, and will make every effort to repay what is owed. Responsibility, truthfulness, serious purpose, and serious intention to repay_all monies owed make up what a loan officer calls character. If the bank’s loan officer feels the cusfomer is insincere in promising to use borrowed funds as planned and in repaying as agreed, the loan should nor be made, for it will almost certainly become a problem credit for the bank, :530 Part V_— Providing Loans 10 Businesses and Consumers | bb Capacity. The loan officer must be sure that the customer fequesting credit has the authority to request a loan and the legal standing to sign a binding loan agreement. This customer characteristic is known as the capacity to borrow money. For example, in most states a minor (e.g., under age 18 or 21) cannot legally be held responsible for a credit agreement; thus, the Lank would have great difficulty collecting on such a loan. Simi- larly, the Ipan officer must be sure that the representative from a corporation asking for credit has proper authority from the company’s board of dirgctors to negotiate a loan and sign a credit agreement binding the corporation. Usually this can be determined by obtaining a copy of the resolution passed by 4 corporate customer's board of directors, authorizing the company to borrow money. Where a business partnership is involved, the loan officer must ask to see the firm’s partnership agreement to determine which individuals are authorized to borrow for the firm. A loan agreement signed by unautho- rized persons could prove to be uncollectible’and, therefore, result in substantial losses + for the bank. ‘ | C - Cash.” This key feature of any loan application centers on the question: Does the bor- Cash rower have the ability to genetate enough cash, in the form of cash flow, to repay the loan? ‘The flow of liquid In general, borrowing customers have only three sources to draw upon to repay their loans: ene normally (a) cash flows generated from sales or income, (b) the sale or liquidation of assets, or berinien! a repay (6) funds raised by issuing debt or equity securities. Any of these sources may provide suf- his or her loan. ficient cash to repay a bank loan. However, bankers have a strong preference for cash flow as the principal source of loan repayment because asset sales can weaken a borrowing cus- tomer and make the bank’s position as creditor less secure. Moreover, shortfalls in cash flow are common indicators of failing businesses and troubled loan relationships. Cash flow What is eash flow? In an accounting sense, itis usually defined as: . Usually defined as net aia profits plus noncash f et profits Noncash expenses : expenses for a =: (ortotal expes business or personal Cash flow = reyenmes eas * (SSP81Y income for a all expenses) depreciation’ household. f Another definition used by some accountants and financial analysts is: _Net profits + Noncash expenses + Additions to accounts payable Cash flow = +" "Additions to inventories and accounts receivable One of the benefits of this latter definition of cash flow is that it helps to focus a bank loan officer’s attention on those facets of a customer's business that reflect the quality and experience of its management and the strength of the market the customer serves. A bor- rowing customer that stays afloat through heavy use of trade credit (accounts payable), is piling up large inventories of unsold goods, or is having difficulty collecting from its own credit customers (accounts receivable) is likely to be a problem credit for a bank. Most banks would hesitate to commit their scarce reserves to such a customer without the good prospect of a turnaround in the customer's circumstances. a © ‘The loan officer's evaluation of a borrower's cash flow involves asking and answer- ing such questions as these: s there a histofy of steady growtvin earnings or sales? Is there . a high probability that sueh growth v Treaiesene support the foan? Current borrower1a re Ug Chapter 17 Bank Lending: Policies and Procedures 531 income and the borrower's income history are important pieces of evidence in answering such questions. - Collateral. In assessing the collateral aspect of a loan request, the loan officer must ask, Does the borrower possess ad ‘net worth or own enough quality assets to provide adequate support for the Ioan? The loan officer is particularly sensitive to such features as the age, condition, and degree of specialization of the borrower's assets. Technology plays an important role here as well. If the borrower's assets are technologically obsolete, they will have limited value as collateral because of the difficulty of finding a buyer for those assets should the borrower's income falter. Conditions. The loan officer and credit analyst must be aware of recent trends in the. ~ borrower's line of work or industry and how changing economic conditions might affect the loan. A loan can look very good on paper, only to have its value eroded by declining ” sales or income in a recession or by the high interest rates occasioned by inflation. To assess industry and economic conditions, most banks maintain files of information— newspaper clippings, magazine articles, and research reports—on the industries repre- sented by their major borrowing customers. Control. The last factor in assessing a borrower’s creditworthy status is control, which centers on such questions as whether changes in law and regulation could adversely affect. the borrower and whether the loan request meets the bank’s and the regulatory authorities’ standards for loan quality. For example, a few years ago passage of the windfall profits tax in the United States made a number of energy companies somewhat less desirable as bor- rowing customers because that tax absorbed a substantial proportion of their current éash flow.