Credit Evaluation: 7Cs of Creditworthiness (2024)

The terms loan, advances, and credit are used interchangeably but may have different nuances. In Islamic banking, credit is referred to as investment.

Credit is defined as the lender’s confidence in the borrower’s ability and willingness to repay the debt according to the scheduled payments.

Based on this definition, it is imperative to focus on the borrower’s capability and willingness.

Conducting a thorough analysis and investigation is a prerequisite for establishing confidence in the borrower’s capacity and reliability.

Investigation involves the careful and official examination of facts pertaining to a subject. It entails collecting information and evidence to form an opinion about the matter under scrutiny.

Credit investigation or credit evaluation is the meticulous assessment of credit proposals and other relevant information from various perspectives, aimed at gathering evidence to form an opinion regarding the borrower’s creditworthiness.

What is Credit Evaluation?

Credit evaluation refers to the process borrowers are subjected to for them to be eligible for funding or to pay for products within a specified period. It also refers to the steps lenders undertake while examining the credit request.

How Does The Credit Evaluation Work?

Loan approval primarily depends on the two parties, the lenders and the borrowers. For instance, the lender must be willing to offer credit after assessing the capacity of the borrower to obey the obligation fully.

On the other hand, the borrowers must demonstrate the willingness and the ability to repay the principal amount and the interest within the agreed period. In general, small business is required to seek approval in order to qualify for credit.

When lenders approve a loan application and give funds, they are often convinced and have total confidence in the creditworthiness of the respective borrowers.

We talk of creditworthiness; we refer to the borrowers’ capacity as well as the willingness to repay the borrowed money.

There are several tools used in the evaluation of credit.

In case the borrower is the business, the lenders focus more on the statement of financial position and income statements, the rate of stock turnover, the efficiency of the management, debt structure, and the prevailing marketing conditions.

In general, lenders prefer dealing with borrowers with positive cash flows and net earnings that meet any likely debt obligation.

What is Creditworthiness?

Creditworthiness consists of a record of trustworthiness, including borrowers’ moral character and the possibility of consistent performance. Lenders offer lower rates and better terms to borrowers with excellent credit scores. This is one of the most important eligibility requirements for most lenders.

4 Factors Determining Creditworthiness

Credit assessment helps the banker to ensure selection of right type of loan proposals/projects/ventures/enterprise and right type of borrower.

Once the information is collected, it must be assessed from different dimensions.

Whenever a customer approaches with request for a credit facility, the branch Relationship Management will go through the loan application submitted by the client and collect the required information, papers and documents, review the merit and prepare a fully documented credit proposal for approval of the same from appropriate authority.

S/he must apply maximum prudence to assess the collected information, which will eventually help the management to take the right decision regarding the selection of the borrower.

The debt burden

To be approved for a loan, lenders require your earning power to significantly surpass the payment schedule requirements.

The debt size is primarily restricted by the resources currently available. A secure debt-to-capital ratio makes it easy for lenders to approve loan applications.

Loan size

Lenders often prefer jumbo loans for a simple reason – the administrative costs lessen in proportion to loan size—borrowers are expected to have the potential to ingest a considerable amount of money.

The rate of borrowing

Clients who frequently borrow often establish a good reputation with lenders. This has a bearing on their capacity to obtain credit at better terms.

The period of commitment

Generally, lenders take more risks with the increase in the timeframe. To provide for the additional risks, lenders often increase the interest rate. They usually charge higher rates for loans that take a long time.

These are the basics the borrowers are supposed to keep in mind. These variables play a significant role when it comes to credit evaluation.

7Cs of Creditworthiness

Creditworthiness measures how deserving an applicant is to get a loan sanctioned in his favor. In other words, it assesses the likelihood that a borrower will default on their debt obligations. It is based upon factors such as their repayment history and credit score.

Lending Institutions also consider the availability of assets and the extent of liabilities to determine the probability of default. The 7’Cs of creditworthiness indicate the characteristics or features of creditworthiness.

Character

Responsibility, truthfulness, serious purpose, and serious intention to repay all monies owed make up what is called character.

The loan officer must be convinced that the customer has a well-defined purpose for requesting credit and a serious intention to repay. The loan officer must determine if the purpose is consistent with the bank’s loan policy, even with a good purpose.

However, the loan officer must determine that the borrower is responsible for using borrowed funds, is truthful in answering questions, and will make every effort to repay what is owed.

Capacity

The loan officer must be sure that the customer 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 areas, a minor cannot legally be held responsible for a credit agreement; thus, the lender would have difficulty collecting on such a loan.

Similarly, the loan officer must be sure that the representative from a corporation asking for credit has proper authority from the company’s board of directors to negotiate a loan and sign a credit agreement binding the company.

Cash

This feature of any loan application centers on the question.

Does the borrower have the ability to generate enough cash to repay the loan in the form of flow? In an accounting sense, cash flow is defined as:

• Cash flow = Net profits + Noncash expenses.
• This is often called traditional cash flow and can be further broken down intoCash flow = Sales revenues – Cost of goods sold – Selling, general, and administrative expenses- Taxes paid in cash + Non-cash expenses.

The lender must determine if this volume of the annual cash flow will be sufficient to comfortably cover the repayment of the loan and deal with any unexpected expenses.

Loan officers should carefully examine five areas when lending money to business firms or other institutions. These are:

1. The level of and recent trends in sales revenue.
2. The level of and recent changes in the cost of goods sold.
3. The level of and recent trends in selling, general, and administrative expenses.
4. Any tax payments made in cash.
5. The level of and recent trends in noncash expenses.

Capital

Capital represents the potential borrower’s general financial position, emphasizing tangible net worth and profitability, which indicates the ability to generate funds continuously over time.

The net worth figure in the business enterprise is the key factor that governs the amount of credit made available to the borrower.

Collateral

In assessing the collateral aspect of a loan request, the loan officer must ask, Does the borrower possess adequate net worth or owns enough quality assets to provide adequate support for the loan?

The loan officer is particularly sensitive to such features as the borrower’s assets’ age, condition, and degree of specialization.

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 work or industry and how changing economic conditions might affect the loan.

A loan looks very good on paper, only to have its value eroded by declining sales or income in a recession or by high-interest rates occasioned by inflation.

Control

The last factor in assessing a borrower’s creditworthiness status is control.

This factor centers on such questions as whether changes in law and regulation could adversely affect the borrower and whether the loan request meets the lender’s and the regulatory authorities’ standards for loan quality.

Creditworthiness Examples: Acceptable and Unacceptable Loan Requests of Commercial Banks Examples

After assessing the borrower’s creditworthiness for the loan, banks make the final decision of accepting or discarding loan requests.

The regulatory agencies restrict some types of loans while others are logically unacceptable from a recovery point of view.

In the following section, we will see some acceptable and unacceptable loan requests:

This list is far from complete, including only some types more or less generally regarded as desirable/ undesirable for commercial banks.

Depending on the type, location, and size of the bank, others that might be included are;

• Term loans to more than a certain maturity: nonresidential,
• The long-term real estate loans: revolving credits, floor plan lines;
• Loans to second mortgage companies;
• Construction loans, unsecured loans to individuals, etc.

This list could be further broadened, but it should be understood that some or all of these types may be highly acceptable to some banks, although inappropriate for others.

Now that we have covered credit evaluation; read our materials on banking and banking fundamentals.

Muntasir Minhaz Muntasir runs his own businesses and has a business degree. Founded iEduNote.com and writes on various business subjects.