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Canons of good lending

Canons of good lending

The success of a loan application is predicated on the customer’s background and provision of valid and reliable information. Information required for a credit decision can be obtained from customer’s bank records, credit reporting agencies, and directly from the customer. Information provided by the applicant is very vital to the success of the loan application.

Assessment of loan application involves the use of different methods with varying degrees of effectiveness. Canons of lending are one of the effective principles of lending. Canons of lending are called a balanced lending process because they provide full risk appraisal; and a structured and professional approach to the completion of customer loan application.
Generally, the canons cover the following lending principles: purpose, amount, repayment, terms, and security; summarised in the acronym, PARTS. These canons constitute one of the complex methods used in assessing loan applications.

Purpose
This addresses the question of why the applicant needs the loan. Specifically, the bank requires the applicant to state the benefits, viability, legality, necessity, morality or ethics, price and estimated useful life of the purchasing asset (item), and compatibility of the loan with existing activities, among others. Statement of the foregoing varies from one loan application to the other.

Amount
It is important for the bank to determine whether the amount requested is sufficient for the intended purpose. Banks are usually not interested in providing funds for a particular project only to be approached for additional funds for the same project within a short period of time. The bank must find out the cost of the item and the customer’s contribution to the cost; the source of his or her contribution; whether the loan amount covers the entire cost of the item or project, and a true reflection of the intended purpose. Thus, due diligence is required in the determination and award of the loan amount.

Repayment
It behooves the bank to assess the customer’s ability to pay back the loan. This assessment may be carried out through checks on the customer’s credit history. For an organisation, the bank considers the credit worthiness of its owners; the firm’s profitability in the past, present, and future as well as its cash flows prior to loan approvals. The bank requires the firm to conduct the following sensibility analysis: the firm understands the impact of its repayment measures on profitability and liquidity; it understands the effect of increased or decreased sales on expectations; the firm is certain on the payment of personal financial commitments from business income; and it is able to measure approximate levels of turnover at which profits would be recorded.

Term
This refers to the estimated life of the loan, which is based on factors related to the business and its owners. Term of the loan may not extend beyond the life of the purchased item. The loan term must be carefully considered by the lender and borrower prior to agreement. An extended payment period gives the borrower peace of mind, but ends up overpaying on the loan.

Security
This refers to any asset the borrower provides as a guarantee for the loan. In many advanced economies, the security does not substitute for proper background check on the borrower. The bank may be interested in estimating the write down value of the asset presented as security.

Write Down Value
This relates to a bank’s internal assessment of a security’s value. An example is a bank writing down a given security or property value to say, 70 per cent of open market value with all borrowings deducted from the calculated figure. It is the bank’s responsibility to determine whether the security is measurable or valuable, easily realisable, stable in value, or likely to increase in value in the long-run.

Analysis, Interpretation of Financial Statement and Decision Making for Lending Proposition

As part of decision making in the lending process, banks examine the financial statements of borrowers to assess their financial strength and ability to repay the contracted loans. These financial statements include balance sheet, profit and loss statement, cash flow statement, budget and cash flow forecast.

Financial Statements

Balance Sheet

This is also called statement of financial position or statement of financial condition. It shows the position of the assets, liabilities, and owners’ equity of a business at a specific date. The balance sheet is representative of the accounting equation which states assets (A) equal liabilities (L) plus owners’ equity (OE),that is, A=L+OE. Information on the balance sheet can be used to calculate liquidity and solvency ratios such as the current ratio, quick or acid-test ratio, and debt ratio.

Profit and Loss Statements

This is also called income statement, earnings statement, or operating statement. It presents detail information on the revenues and expenses of an organisation over a given period of time. It can be used to compute performance and profitability ratios such as return on assets, asset turnover ratio, and return on equity ratio, among others.

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