Loan Evaluation
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Loan Evaluation
As a practitioner-researcher, you will apply knowledge to real-life situations. In the following scenario,
assume you are a loan officer for a bank and the owner of a small business approaches you regarding a
loan. Consider the following questions as you formulate your decision:
� What financial ratios would you examine and why?
� Is there other information, in addition to the ratios, you would want to obtain from the business owner
before making your decision on the loan?
� How would your answer change if it were a larger company seeking the loan?
LOAN EVALUATION 2
Loan Evaluation
When a small business approaches a bank for a loan, its business plan is a very important
component of what will finally influence the loan officer to approve the loan. While it may seem
like the loans officer makes decision based on arbitrary standards, loan application will begin by
interrogating the business plan to determine the different ratios.
Ratios are important since they give a peek into the business operation without having to
visit the business in person (O’Connor, Priem, Coombs, & Gilley, 2006). The loan officer will
want to understand how the business controls its expenses. This will be derived from the cost of
goods sold/net sales; selling, administrative and other expenses/net sales; wages and salaries/net
sales; interest expenses on borrowed funds/net sales; overhead expenses/net sales; depreciation
expenses/net sales and taxes/net sales.
Of importance to the loans officer is the efficiency with which a business operates. This
will be derived from the net sales/total assets, annual cost of goods sold divided by average
inventory levels, net sales/net fixed assets and net sales/accounts and notes receivable (Skogsvik,
2008). Given a business will trade in a product, service or skill, it will be important to determine
its marketability. This will be verified by the gross profit margin, or net sales less cost of goods
sold to net sales, and the net profit margin, or net income after taxes to net sales.
LOAN EVALUATION 3
The loans officer will also be interested in understanding how loan and interest will be
covered by specific business aspects. This will include interest coverage (such as income before
interest and taxes divided by total interest payments), coverage of interest and principal
payments (such as earnings before interest and taxes divided by annual interest payments plus
principal payments adjusted for the tax effect), and the coverage of all fixed payments (such as
income before interest, taxes and lease payments divided by interest payments plus lease
payments) (Graham, Harvey, & Rajgopal, 2006). Every business operates to be profitable.
The loans officer will develop profitability ratios like before-tax net income divided by
total assets, net worth, or sales, and after-tax net income divided by total assets (or ROA), net
worth (or ROE), or total sales (or ROS) or profit margin (Moyer, McGuigan, & Kretlow, 2009).
Of importance to a business is the ability to meet expenses as they are incurred. The loans
officer will determine the liquidity of the business through the current ratio (current assets
divided by current liabilities), and the acid-test ratio (current assets less inventories divided by
current liabilities).
Finally, the loans officer will seek to determine how the business is leveraged. This will
be known through the use of the leverage ratio (total liabilities/total assets or net worth), the
capitalization ratio (of long-term debt divided by total long-term liabilities and net worth), and
the debt-to-sales ratio (of total liabilities divided by net sales).
Ratios will not tell the whole story as they only reflect the symptoms of a possible
predicament as opposed to exposing the root cause and nature of the problem. The loans officer
will, thus, make a more informed decision if they should investigate the reasons behind the trend
exhibited by the ratios (Charantimath, 2006). After all, when a ratio changes, it could be as a
result of a shift in the numerator or the denominator or both. A loans officer will also seek
LOAN EVALUATION 4
additional information that will capture the experience of the owner, the potential value of
prospective customers and other non-balance sheet items (Haskins, 2002).
For a large company seeking a loan, a loans officer will seek the credit history of the
organization. This will be given by the credit reference bureau. The company will also have to
provide collateral and any options available. The choice of collateral used to secure a loan will
affect the bank’s acceptable loan-to-value ratio.
LOAN EVALUATION 5
References
Charantimath, P. M (2006). Entrepreneurship Development and Small Business Enterprise,
Dorling Kindersley, New Delhi
Graham, J., Harvey, C., & Rajgopal, S. (2006). Value destruction and financial reporting
decisions. Financial Analysts Journal, Vol. 62, No. 6, pp, 27–39.
Haskins, M. (2002). Instant insight. Strategic Finance, Vol. 84, No. 3, pp. 42–47.
Moyer, R. C., McGuigan, J & Kretlow, W (2009). Contemporary Financial Management, 11 th
Ed, South-Western Cengage Learning, Mason OH.
O’Connor, J., Priem, R., Coombs, J., & Gilley, K. (2006). Do CEO stock options prevent or
promote fraudulent financial reporting? Academy of Management Journal, Vol. 49, No.
3, pp. 483–500.
Skogsvik, S. (2008). Financial statement information, the prediction of book return on owners-
equity and market efficiency: The Swedish case. Journal of Business Finance &
Accounting, Vol. 35, No. 7and 8, pp. 795–817.
