The Credit Decision
The term debt when used by corporations is commonly referred to as leverage. According to the Oxford dictionary, leverage is the use of debt(borrowed capital) to undertake an investment or project. When one refers to a company, property, or investment as ‘’highly leveraged’’, it means that the item has more debt than equity. The term is hardly used when reference is made to retail or consumer lending. When an individual borrower is accessing credit, reference is only made to the level of indebtedness and not leverage since equity or capital does not apply. Taking on good debt should not be a source of concern as long as the decision was well-thought-out. It is bad debt that every client should strive to avoid as there is every likelihood of ending up in default and the consequences thereof. It has to be acknowledged that all human beings both educated and illiterate have got some level of credit skills because they at one time or another will make a lending or borrowing decision. This can be well illustrated by a practice that has been held for a long in some local African villages. Before the advent of cash, people would use batter trade in the exchange business. Credit was similarly commodity-based. In a village in the western parts of Kenya, credit was even extended in the area of foodstuffs. A popular meal locally referred to as Ugali is made from boiling flour from either maize, cassava, or millet in hot water then together served with vegetables or meat. This is consumed in every homestead almost daily. When it is almost mealtime and a family for one reason or another does not have enough flour then the need to borrow from a neighbour or a fellow villager arises. The flour will be delivered to the borrower in a specified container which the borrower will keep till the date to pay back. To ensure the same quantity of flour is returned, the borrower uses the same container filled to the same capacity with the same flour type borrowed as payback to the lender within the specified time earlier agreed on. It can be observed that there are some basic credit skills required in this simple transaction:
1. The quantity of flour needed i.e. sufficient for the need only.2. How soon they will be able to refund the flour
3. From whom i.e. character, reputation, etc.
4. When the flour will be refunded i.e. time scale
5. Reputation. This touches on the character of the family since there is food involved etc.
The credit decision is a key one that requires great skill for both the lender and borrower who should be level-headed, sober, and emotionally stable. In bigger businesses, the finance department provides advice on how much, why, and when to borrow. Their presentation incorporates facts such as the nature of borrowing, cost of funds, return on investment, and purpose of the borrowing which will help inform the board on whether to go for credit or not. Most times this need occurs when the cash flows are not supportive enough for business activities yet the opportunity for growth exists or when there is a need to acquire capital goods for efficiency or better output and many more. Unless there is proper justification, it is not advised to borrow to settle debts unless an entity is expecting payments that are held up elsewhere. The best solution for this latter case is to dispose of an asset. In credit access, the bigger entities usually have more options since they portend bigger business opportunities for banks. Their advantage lies in their ability to borrow larger ticket sums, thus higher interest and commission income accruing from their business. It is even better for the larger corporates since theirs is a going concern that may not be affected by the entry or exit of individual staff. They thus stand a better chance to qualify for long-term facilities which are not subjected to factors prerequisite for those in the personal sector such as age etc. Personal borrowers by their nature have fewer options on the local finance market with very narrow negotiation margins.
Individual future income informs the cash flows that are relied on for facility servicing. Heavy reliance is placed on projected cash flows after facility disbursement usually to help demonstrate the ability to repay the loan. Traditionally, assessors look at the historical performance of the business and other account information such as monthly account turnovers, balances, and business trends. A client who regularly borrows is therefore advised against registering bounced items on their bank account and diversion of business proceeds to other non-business-related activities. Credible financial institutions will only lend to duly registered entities engaged in legal activity and fulfilling their statutory obligations. It is for this reason that besides management accounts and suitable collateral, one will be required to furnish the lender with information such as the business certificate of registration, evidence of tax compliance, rate payment receipts, etc. Many credit facility applicants who do not have this information readily at hand end up having their facilities declined or experience delays. Lenders will hold them in the queue awaiting the fulfilment of these requirements. A regular bank customer is advised to continuously prepare this information as and when they fall due to avoid being inconvenienced especially when the facility is urgently required. Where collateral is required, valid deeds recognized by law and free of any encumbrances should be ready at hand for submission when called for. Bank securities have their detail and process (a matter to be addressed later on under a separate topic). Remember, preparation makes the process less cumbersome for both parties.
A borrowing decision should be arrived at only after establishing the need for funding and how the funds will be applied. In personal lending, commonly referred to as consumer borrowing, so long as the reason is legal the individual can borrow to spend on projects that may not necessarily be for business investment or registering any return. This means one can borrow for home renovations, payment of school fees, personal car purchases, and other similar items and expenditures. Besides lending to character, the banker will establish the ability to service the loan which is demonstrated by the client's ascertained steady and regular income for the duration of the facility. These could include salary, interest from fixed securities, dividend earnings etc. This type of lending has a set maximum as detailed in the article "Accessing The Non-Secured Credit Facility".
For business borrowers who meet the requirements, the flexibility offered to the client is more than that of the personal borrower. Before acceding to the credit request, every lender will be keen to determine for what purpose the business is seeking funding, and whether there will be returns on the same. The business seeking support should let the material facts be open to the lender since confidentiality is strictly adhered to. For this reason, a client will therefore need to make full disclosures to the bank. Failure to do so easily becomes another reason for facility decline. The expectation by any lender is that funds will only be strictly used for the intended purpose as it behoves the borrower to, by all means, always avoid the temptation to apply the loan funds received from the bank to needs other than what was stated at the onset. The bank analyst does not incorporate this into the factors determining approval and subsequent facility disbursement. Contravening this condition is a major cause of many defaults and subsequent collapse of many a business. Some lenders depending on the nature and value of the investment being funded will establish a monitoring system to ensure adherence to this condition.
The cost of credit is majorly determined by the prevailing cost of money in the economy usually guided by the regulator. In Kenya, there is the Monetary Policy Committee which regularly meets to issue this rate. This is what informs the base lending rate. The interest cost will be a specified point above this base and may vary from one lender to another and is sometimes uniform for those cases where the regulator exerts tight controls on market prices. The latter is common in countries where lending prices are under the direct control of the government. Further variations that may be noticed could be dictated by the internal fundamentals and the risk appetite of the bank in question. The lending rate is also partly sometimes an indicator of the risk inherent in the credit facility being sought. Non-secured loans will thus attract a higher rate than say for example one that is secured by collateral that can be easily liquidated. Other secondary factors determining the rate include ticket size, repayment period, industry the client is involved in, suitability of collateral provided, the prevailing economic conditions, customer loan repayment track record and client negotiation power with the institution just to name a few. Credit assessment rules are not cast in stone and as such, they are subject to change at short notice when market factors shift. For example, at the onset of the Covid-19 restrictions, many business sectors were negatively affected. To avoid piling up bad debts banks will either stop lending to poorly performing sectors, tighten their lending policy in that area and only focus on the performing ones or tighten the conditions to qualify for credit in that sector. In the worst-case scenario banks, in an effort to ensure their assets are well-protected, resort to government securities where certainty is guaranteed.
From the clients’ perspective saving every penny on interest and other charges is key. In the current local market two models of charging interest are in place. First, there is the flat rate (simple interest) and secondly the reducing balance type. It is common for smaller tickets to be issued on a short-term basis. A client is therefore advised to be cautious as it is this type of lending hinged on the small tickets with simple interest that is the most expensive. Lenders in this area make a kill as such a client should carry out their homework well and if not sure engage the services of a financial consultant. The reducing balance method is the most popular on the market as it offers both the client and the lender many conveniences. On the lender’s part, it earns them maximum returns spread over the whole credit life of the facility as the client continues to make repayments in the form of interest even when the full capital investment has been recovered. When market conditions change it is easier to adjust the rates for a loan running on a reducing balance interest charge format as opposed to the flat rate which does not give much room for flexibility. Any client who would seek to pay off their facility earlier than the scheduled time for facilities on the reducing balance format, saves on interest payment, though some lenders seeking to avoid income loss will levy a penalty on this in the name of contract breach. With good investment plans, loans on reducing balance may not appear to burden the client as they make the regular repayments. One key disadvantage of the flat-rate model to the client is that the lender pre-earns interest therefore earlier payment of the loan balance does not offer the borrower any savings on interest unless specifically stated by the lender in the contract. When it comes to borrowing the saying, ’the devil is in the details’ holds. Some terms vary from one lender to another. The advice is to consult a financial expert as well as a lawyer first before committing. Clients who overlook this aspect usually get a rude shock when certain clauses are invoked during the credit lifetime especially when in default.
Once again this is only but a high-level scheming of the various aspects that lead to making a credit decision.
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