Credit Basics

Factors Affecting Credit Eligibility for Small Businesses

A bank will review a number of important factors about your business when assessing whether to provide access to credit. These factors include financial performance, management characteristics, business environment and the effect the requested loan could have on future financial performance. After assessing your performance in these broad categories, a bank will have enough information to decide whether or not they are comfortable extending you credit. This article provides insight into how lenders view small businesses and show how small businesses borrowers are currently performing.

Revenues, Ratios & Returns
Financial Risk

The financial performance of your business is one of the most heavily weighted factors considered by the bank. Banks review both historical and projected future results. These assessments help them determine whether you will be able to make future principal and interest payments in the scheduled timeframes based on the operating activities of your business.

The quickest way for a bank to assess business performance is to review ratios created using the financial statement values and review how a business compares to its peers. The chart below shows some important ratios and how small businesses performed in specific industries.

Small Borrower Ratios by Industry

For each of the broad industries above, this shows the median ratio value for small business found in Moody’s Analytics Credit Research Database. You can compute each of these ratios based on your own financials and then see how you compare to peers in your industry. Below is a brief explanation of what each of the ratios represent:

A quick ratio tutorial:

  • ROE: A profitability measure showing how much profit a company creates relative to the amount contributed by shareholders. Calculated as: Net Income / Shareholder Equity, the higher the value, the greater return to the owners.
  • Profit Margin: A profitability measure showing how many dollars of sales are kept as earnings. Calculated as Net Income / Revenues, the higher the value, the more profitable the firm.
  • Quick Ratio: An indication of short-term liquidity. Calculated as: Current Assets – Inventory / Current Liabilities, the higher the quick ratio, the better a company make short term payments.
  • Interest Coverage: Determines how easily you can make interest payments on outstanding debt. Calculated as: Earnings Before Interest & Taxes / Interest Expense, a value of 1.5 or lower indicates interest payments may be questionable and a value of 1 shows an inability to make interest payments.

The most common way banks assess financial risk is through a probability of default (PD) value. A PD is the percentage chance a firm will default within a specific timeframe, usually 1 year. You can calculate your PD on using Moody’s Analytics RiskCalc tool. RiskCalc is a PD model that uses ratios calculated using your financial statement and includes an industry and adjustment reflecting the credit environment to calculate a PD measure called an EDF. Once you calculate your EDF, which will range from .1% (very low risk) to 35% (very high risk) you can use the tables and charts below to see how your risk compares to others in your industry peer.

EDF Risk Measures by Industry

If your EDF falls below the value for your industry in the 25th percentile (%) column, your risk is very low compare to your peers. Values around the 50th percentile mean your risk is similar to your peers. Risk above the 50th percentile shows your risk is higher than your peers.

Cyclicality & Competition
Market Risk

Two main components of market risk are competition and the economic factors impacting your specific industry. Other components we won’t touch upon are impact of government regulation, your natural environment and ability to find alternative sources of funding.

When reviewing market risk, banks look at the overall market and the specific market in which you operate. The overall market can be assessed by reviewing an applicable default rate and analyzing how borrower payment ability changed over time. The table below shows the private firm default rate for small and larger companies.

Private Firm Default Rate
Small companies, < $500,000 in total assets

Banks can also see how the borrower risk is changing by reviewing how EDFs change over time. Because the EDF contains an cycle adjustment factor (meant to reflect the market’s current assessment of the credit cycle), EDF trends can show credit cyclicality.

Median RiskCalc EDF Since 2000

To view the specific market in which you operate, banks review benchmark data specific to your asset size and industry. They may review how ratio values and EDFs changed over time and how borrower performance within a bank’s portfolio changed over time.

Ratios & EDF credit measures over time
Banks may review ratios and EDF credit measures over time to gauge whether overall ratios improved or deteriorated. Banks may use this information in deciding whether to include certain covenant terms, such as minimum ratio levels, financial value levels or EDF credit measure levels in your loan contract. The ratio chart below shows an example of small business ROA in the retail sector over time. If in this sector, the bank could assign covenant terms based on the historical values. The Median EDF values chart below provides insight into how risk changed in each industry over the last month and the last year. This shows how your overall industry performed in the different time frames.

Median Yearly ROA for Small Businesses in Retail Sector

Median EDF Values and Industry Change
April 2009 & March, April 2010

Existing borrower performance by industry
Banks may also review the payment history of borrowers in their existing portfolio to gauge how an industry is performing. The table below shows the percentage of credits in the US portfolio that banks classify as high risk for not repaying the principal and interest of their loan.

Percentage of Bank portfolio at risk for default
At December 2009

As the chart shows, banks might be more reluctant to lend to companies operating in the Construction, Agriculture or Information if the borrower is weak is their other credit risk assessment categories.

Integrity, Skill & Depth
Management Risk

Company leadership plays an important role in deciding whether or not to lend to a small business. Banks will decide whether management is skilled at making and executing the company strategy and whether they can drive growth and profitability as necessary for solvency in the future. Outlining management integrity, skill and experience provides insight into the continued success of any business.

Try, Test & Try Again
Facility Risk

If other areas of the credit assessment are lacking, the bank will analyze facility risk in order to mitigate the weaknesses. For example, if the borrowers financial risk assessment does not qualify them for a loan, but the borrower can provide collateral equal to 100% of the loan value, the bank will likely use the collateral to mitigate the weak financials. Lenders will also assess the impact of the loan on the borrower’s financial position.

You can assess the impact of a loan on your financial position by running test scenarios through the RiskCalc model. Use your most recent financial as a starting point. Then try different loan terms, balances and interest rates by adjusting your financial statement to reflect the different situations. Depending on the loan terms you’re anticipating, you might adjust cash flow, interest expense, short-term debt and long-term debt.