How credit evaluation is done

ABCAdda | Updated Jan 11, 2023

How credit evaluation is done? The question gets in the mind of borrowers applying for a loan. We now explain in detail what factors determine the creditworthiness of a person for granting a loan. So, without further delay, let's dive into the topic together.

Define Credit.

Credit is the process where borrowers ask for money from a financial institution with the understanding that the amount is repaid later with interest.

Define credit evaluation.

  • Credit evaluation is a process a business entity or a person must undergo to get a loan from an organization. Credit evaluation weighs the pros and cons for the lender when granting credit to an organization.
  • Credit bureau staff prepare the credit evaluation report, which tells how the borrower pays the debts, his income sources, his assets, the amount of unpaid debt, and the borrower's credit history and credit rating.

Before knowing in detail about "How credit evaluation is done", let us discuss the importance of credit evaluation.

What is the importance of credit evaluation?

Credit shows a person's financial status. Credit lets individuals and organizations meet their aims. The pros and cons of credit depend on the person's ability to use it properly.
Credit evaluation gives a clear idea to the lender by analyzing what type of loans a bank can approve and to whom a bank can sanction the loan. Did the borrower meet the bank policy guidelines? Whether the borrower has a history of bankruptcy? How is he going to utilize the credit?

How is credit evaluation done?

The credit evaluation starts by analyzing a borrower's creditworthiness and willingness to repay the debt. The credit officer must check the steps below before sanctioning a customer loan. The stages in credit analysis include:

  1. The company's/customer's financial status.
  2. Credit analysis evaluates the company's ability to withstand an unexpected drop in sales.
  3. The company's credit history and alternate ways a company repays the loan.
  4. The optimal loan structure includes loan reimbursement, covenants, and reporting requirements- the underwriting elements.

Once the credit officer analyzes all the information regarding the borrower's financial condition, he should look at the bank's credit policy guidelines and approve the loan to the customer.

What best describes how credit evaluation is done?

Each lender has their procedure for doing credit evaluation. Most financial organizations use the 5Cs (character, collateral, capacity, capital and conditions) before approving a loan.

Capacity:

The capacity talks about the borrower's ability to repay the loan by considering various factors like a person's income, expenses, cash flow, debt-to-income ratio, debt-to-equity ratio and repayment timing.
When a person's debt-to-income ratio and debt-to-equity ratio are less, there are more chances for approval of a large sum as a person has a relatively low amount of debt.

Capital:

When you apply for a bank loan, the bank officer looks at whether the person invested his savings in the startup business, as this shows how serious a person is about his business.

Collateral:

Collateral involves an alternate/backup source to repay the loan, like a home, gold or land. Bank officers must approve a loan to the individual only when the borrowers put in assets to secure the loan.

Conditions:

The lender wants to know whether your business has enough reputation in the market, so while applying for a loan, mention your business plan that can withstand competition from other companies.

Conclusion:

We hope our article on "How credit evaluation is done" has given the answer you are searching for. This article provides insights to borrowers and lenders to look at the 5Cs while applying for a loan. So, here is the end of our writing.