Our eBook, A Credit Renaissance: Reduce Underwriting Lending Risk and Revive the Lost Art of Credit Analysis Using Industry Intelligence, is available now! The eBook examines how Industry Intelligence bolsters credit underwriting and analysis and improves the lending process. This blog series highlights concepts within the eBook on a high level, with more in-depth insights found in the eBook itself. This is the second entry in this four-part series.

Commercial lending decisions need to be made with facts, which is why credit analysis is an important part of the lending process. Credit analysts examine quantifiable data from the business’s historical and current financial statements. They then use additional data points — nuances of the company’s industry, working capital cycles, and suppliers — to project how the company will look in the future.

Of course, all of this is designed to ensure the bank’s risk is well-managed if the loan gets approved. It’s a very structured, organized process at most banks.

Sometimes along this credit journey, members of the credit team will develop “analysis paralysis” — there can be so many different datapoints, documents, and reference materials that it can get a bit overwhelming to digest. You might equate it to trying to drink from a firehose.

When that information overload occurs, and lenders or analysts find themselves unable to see the forest for the trees, it is wise to pump the brakes. To escape from that hyper-analysis trap, there are two strategies that can help: thin-slicing and the toolbox approach. When properly employed, these approaches can save analysts time while still protecting the bank through the due diligence process.

Go with your gut by using thin-slicing

In his best-selling book Blink: The Power of Thinking Without Thinking, Malcolm Gladwell delves into the power of the human brain to rapidly make decisions — sometimes in the blink of an eye. The book explains how our unconscious mind analyzes and interprets events or signals, blending them with our past experiences to quickly make informed choices

One of the psychological techniques that Gladwell explores for making these rapid decisions is a concept called thin-slicing in which we draw inferences from limited information in order to make a choice. You might think of it as a more formal name for going with your gut.

Research into the human decision-making process has found that quick judgments based on these thin-slices of information are actually quite similar to decisions made with much more data. In fact, decisions that employ thin-slicing techniques are often as or even more accurate than choices based on more information.

Thin-slicing techniques can be used by commercial credit lenders and analysts to overcome analysis paralysis when looking at a prospective client’s financial statements. By reviewing the following, an experienced analyst can thin-slice a company’s financials in just a few minutes and get a fairly accurate assessment of a prospective credit deal:

Operating performance:

  • Revenue size
  • Revenue trends
  • Profitability
  • Cash flow

Financial condition:

  • Equity
  • Leverage
  • Liquidity
  • Cash position

By taking this handful of data points and comparing them to average benchmarks for other businesses in the same industry, a member of the commercial credit team can get a reasonably good handle on a deal’s viability. If you see red flags about the company or the deal after going through this thin-slicing exercise, it can save everyone involved a lot of time, money, and headaches.

You’ll find benchmark data on hundreds of industries within Vertical IQ’s Industry Profiles. Additionally, our Financial Comparison Toolkit widget allows you to plug in the numbers from a prospect’s financial statements and objectively computes how they stack up to their industry peers.

Back to the basics with the toolbox approach

If a deal clears the thin-slicing hurdle, an important second phase of evaluation is the toolbox approach. Much like thin-slicing, this technique is about minimum input to achieve a maximum output. It also can help commercial lenders overcome analysis paralysis quickly, but effectively.

The toolbox relies on three tried and true credit analysis techniques. The commercial credit team should go through each of these tasks, following this order:

  1. Spreading: Taking a business’s financials or tax returns and putting them into an Excel-style software system. There are different ways of doing this, so an analyst needs to know their bank’s preferred method as it can materially impact leverage, liquidity, and cash flow (the bank’s primary form of repayment).
  2. Financial performance projections: Used to project what is going to happen in the future is essential to the credit underwriting process. Discussing turn days, percentage growth, and margins with the client can help fill in these blanks, but it’s critical for the analyst to determine if the figures provided by the client are reasonable or possibly inflated.
    * The key is to ask good, relevant questions, then look for anomalies in their projection figures that might be cause for concern. Industry Intelligence from Vertical IQ can help you with industry benchmarks as well as with tailored questions to ask based on the industry’s operations, trends, and risks.
  3. Debt service coverage analysis: Lending should be based on historical performance indicators to determine that the company can handle the prospective new debt and will be able to repay it with 1) cash flow, 2) collateral, and/or 3) a personal guarantee. A credit analyst needs to be able to accurately calculate cash flow, as well as the value of collateral items like receivables, eligible inventory, and equipment. Industry Intelligence can provide you with helpful insights about each of these.

Credible credit analysis that’s streamlined, simplified

Thin-slicing and the toolbox approach are simple but effective ways to overcome analysis paralysis during the credit underwriting process. But they are just the start. In our ebook, A Credit Renaissance: Reduce Underwriting Lending Risk and Revive the Lost Art of Credit Analysis Using Industry Intelligence, we share other analysis methods that can be used.

Synthesizing all of these data points can seem daunting, but leaning on Industry Intelligence — including industry benchmark data, ratios, and balance sheets, common risks, trends, outlook, and more — helps simplify this analysis and boosts the credit team’s credibility internally with the credit team … as well as externally with the client/prospect.

The data and information gathered, alongside Industry Intelligence, supports more formal credit discussions and documentation. This includes the credit write-up, which presents a full picture of a company’s ability to take on new or additional debt. It’s all about working smarter, not harder!

>> Want to master the art of credit analysis and alleviate analysis paralysis using Industry Intelligence? Download A Credit Renaissance: Reduce Underwriting Lending Risk and Revive the Lost Art of Credit Analysis Using Industry Intelligence to learn more!

Image credit: Vertical IQ

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