Credit Risk Grade? The Banks internal audit on your business

What the bank won’t tell you: 13 factors in credit risk grading

This is the last instalment of a four-part interview series with Mick Hall, Partner at debt advisory and banking advisory business Velvet Pig. In this article, Mick reveals exactly what banks look at when conducting a credit risk grade for business funding. 

As previously discussed in our last article, banks use what’s called a credit risk grade to assess if your business can meet its financial commitments and also determine the level of ongoing financial support it will provide. Risk grades are important because they influence pricing, terms, and conditions. Additionally, banks don’t usually communicate the results of a risk assessment. Therefore, you might have little or no awareness of what your risk rating is–until it’s time to talk about existing terms or new funding requirements with your bank.

All banks will undertake a credit risk grade process internally before issuing an outcome, and this will only increase in regularity and complexity in the post-COVID economy. Therefore, it pays for business owners to be mindful of what’s considered when banks start to analyse their financial position. You may be surprised to learn that it’s not as straightforward as simply reviewing the P&Ls of the business. 

Qualitative and Quantitative insights impacting Bank decision making 

Despite being a financial institution that deals in numbers, banks use a range of qualitative and quantitative insights to create your risk grade. Some of the frequently asked questions that credit assessors may ask include:

1. What does the business’s non-financial and behavioural information reflect ( i.e, account and loan conduct, availability to contact management in need, breaches of non-financial covenants, etc)?
2. How has the revenue and earnings trend been over the past couple of years and have forecasts historically been met? 
3. What are managements forecasts over the next 12 months with respect to revenue and earnings, what are the strategies in place to achieve these forecasts and do they include any material shifts from current operations? 
4. What is the working capital position of the business? While the Current Ratio (Current Assets./Current Liabilities) is a key metric, attention is also given to the level of cash reserves, access to unutilised facilities and ability of the business to meet current commitments when they fall due.
5. Looking at trade receivables, are there any concentration issues, is there an aging profile of the receivables ledger, are provisions considered adequate to cover doubtful debts, and how do the credit terms offered meet with industry averages. What is the bargaining power of the businesses customers?  
6. How is the level of inventory held relative to sales, is there any seasonality affecting holdings, how is the inventory valued in terms of the accounts and how does this compare to the realisable value, and how is inventory turn relative to industry?
7. How are creditor days relative to trade terms and industry average, are creditor ratios deteriorating and are there any creditors applying strong pressure for payment? What is the bargaining power of the business’s suppliers? 
8.  What is the equity position of the business adjusting for directors/shareholders loans, are asset values accurately reflected in the balance sheet, what is the level of intangibles relative to the total balance sheet and is the dividend policy stable? 

Additional insights for credit risk grading

In some circumstances, bank managers may also look at additional information, including:

1. Asset Quality: How is the plant and equipment of the business in terms of working order and age, etc. Is there a need for significant CAPEX spend to refresh to support trading and growth. 
2. Future Repayment Capacity:  in combination with past trading results, what is the ability of the business to service principal and interest on all borrowings from projected cash flow from operations.
3. Management:  how long has management been in the business, what is their track record in terms of managing the business (see profit record, hitting forecasts, meeting/adapting to change in market conditions, etc. What is the management succession plan?
4. Industry Risk: What are the short, medium and longer-term market or industry prospects and its impact on the business and influence of any adverse economic or market events.  
5. Competition: Does the business enjoy a dominant or significant market in the market in which they operate, what are the barriers to entry and how easily can they be met, what is the substitutability for product or business.     

While this may seem like an exhaustive list, gaining the funding support your business needs is possible with the right preparation and planning. If you’d like to discuss your financial business plan, please call 1300 656 141 or leave your details on our contact page. We’d love to support you. 

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About Velvet Pig

Velvet Pig is a debt advisory and banking advisory business. Its team has spent more than 50 years in banking, primarily working in institutional and corporate finance. Contact Mick on +61 481 034 939 or mick.hall@velvetpig.com.au 

About BridgePoint Group

BridgePoint Group, led by managing director Neil Parker, is a chartered accountancy firm that provides expert advice to SMEs across the areas of accounting, taxation, legal, strategy, growth, superannuation and corporate advisory. 

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