Credit evaluation and approval is the process a business or an individual must go through to become eligible for a loan or to pay for goods and services over an extended period. It also refers to the process businesses or lenders undertake when evaluating a request for credit. Granting credit approval depends on the willingness of the creditor to lend money in the current economy and that same lender’s assessment of the ability and willingness of the borrower to return the money or pay for the goods obtained—plus interest—in a timely fashion. Typically, small businesses must seek credit approval to obtain funds from lenders, investors, and vendors, and also grant credit approval to their customers.
Evaluating Borrower’s ability/willingness to pay
In general, the granting of credit depends on the confidence the lender has in the borrower’s credit worthiness. Credit worthiness—which encompasses the borrower’s ability and willingness to pay—is one of many factors defining a lender’s credit policies. Creditors and lenders utilize a number of financial tools to evaluate the credit worthiness of a potential borrower. When both lender and borrower are businesses, much of the evaluation relies on analyzing the borrower’s balance sheet, cash flow statements, inventory turnover rates, debt structure, management performance, and market conditions. Creditors favor borrowers who generate net earnings in excess of debt obligations and any contingencies that may arise. Following are some of the factors lenders consider when evaluating an individual or business that is seeking credit:
Credit worthiness. A history of trustworthiness, a moral character, and expectations of continued performance demonstrate a debtor’s ability to pay. Creditors give more favorable terms to those with high credit ratings via lower point structures and interest costs.
Size of debt burden. Creditors seek borrowers whose earning power exceeds the demands of the payment schedule. The size of the debt is necessarily limited by the available resources. Creditors prefer to maintain a safe ratio of debt to capital.
Loan size. Creditors prefer large loans because the administrative costs decrease proportionately to the size of the loan. However, legal and practical limitations recognize the need to spread the risk either by making a larger number of loans, or by having other lenders participate. Participating lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to ingest a large sum of money.
Frequency of borrowing. Customers who are frequent borrowers establish a reputation which directly impacts on their ability to secure debt at advantageous terms.
Length of commitment. Lenders accept additional risk as the time horizon increases. To cover some of the risk, lenders charge higher interest rates for longer term loans.
Social and community considerations. Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. Examples might include banks participating in low-income housing projects or business incubator programs.