Unit
- Lending foundation: Credit analysis is the systematic evaluation of a borrower's ability and willingness to repay debt, and it forms the basis for every small business lending decision.
- Risk quantification: Lenders rely on credit analysis to quantify risk, set appropriate pricing, and determine loan terms that balance business needs with portfolio safety.
- Business model review: The process begins with understanding the borrower's business model, including revenue streams, cost structure, and competitive position within its market.
- Risk categories: Analysts must differentiate between business risk and financial risk, as each contributes separately to the likelihood of default.
- Continuous process: Credit analysis is not a one-time event; it continues throughout the life of the loan through ongoing monitoring and covenant compliance checks.
- Interdisciplinary skill: The discipline draws on accounting, finance, economics, and law to build a comprehensive view of the borrower's creditworthiness.
- Small business challenges: Small business lending presents unique challenges because financial data may be less structured and owners often intermingle personal and business finances.
- Information asymmetry: Effective credit analysis reduces information asymmetry between lender and borrower, enabling more efficient capital allocation.
- Risk acceptance: The ultimate goal is not to avoid all risk but to make informed decisions that price risk appropriately and structure protections.
- Consistent decisions: Strong analytical frameworks produce consistent, defensible decisions that satisfy both internal policy and external regulatory scrutiny.
Financial Formula
Expected Loss Formula
Expected Loss = Probability of Default x Loss Given Default x Exposure at Default
Expected Loss = Probability of Default x Loss Given Default x Exposure at Default
Where:
- Probability of Default: The likelihood that the borrower will fail to make scheduled payments, often estimated from historical data and credit scores.
- Loss Given Default: The portion of exposure that is not recovered after default, influenced by collateral and guarantees.
- Exposure at Default: The total amount owed at the time of default, including principal, interest, and fees.
Regulatory Requirement
Regulation: Equal Credit Opportunity Act (Regulation B)
Lenders must evaluate credit applications without discriminating based on race, color, religion, national origin, sex, marital status, age, or receipt of public assistance. Credit analysis policies must be consistently applied to all applicants.
Quick Revision
- Credit analysis evaluates repayment ability and willingness for small business loans.
- Expected loss combines probability of default, loss severity, and exposure size.
- Lending decisions require ongoing monitoring, not just initial underwriting.
- Regulation B prohibits discriminatory credit evaluation practices.