Properly Identifying Sources of Repayment

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Val Stark

When underwriting a new loan there are several key components that should be a part of the credit presentation. Relevant information that helps not only the loan officer, members of the loan committee and bank personnel, but also third party loan review analysts that may at some point review the file. Credit presentations generally should include the loan’s purpose, narrative comments regarding the borrower’s background, documentation of cash flow analysis, details of collateral analysis, identify loan policy compliance, and recognize credit strengths and weaknesses along with mitigating factors for identified weaknesses. There seems to be a missing piece to the puzzle. How is the Bank going to be repaid? Properly identifying the source(s) of repayment is one of the most important parts of a credit presentation.

Depending on the type of loan which is being underwritten, the sources of repayment may vary. Even when underwriting loans that are the same type, the sources of repayments may be different. Therefore it is important to identify, at origination, what will ultimately repay the loan: from the borrower’s cash flow, to business cash flow or even global cash flow. It could also be cash flow from an income producing property or conversion of assets for asset-based loans. Banks typically will identify three sources of repayment; the main source (i.e. business cash flow) and two additional sources that will come into play if the first one fails (i.e. global cash flow, or sale of collateral).

Periodic reviews (at least annually) have been adopted by most banks as a best practice. After receiving updated current financial information, spreads of financial statements and tax returns are prepared, along with listings of internal and external borrower and guarantor loan commitments and corresponding debt service requirements in order to determine repayment capacity. However, in some cases the source of repayment may change over the years. It is a good opportunity, when performing annual reviews, to revisit and ensure the original source of repayment remains the same or, if it has changed, to properly address it. If the original source of repayment shows deterioration and the bank is now relying on other sources, it should be explained.

It is an important factor to properly identify the main source of repayment when underwriting credits as well as on an ongoing basis, when performing annual reviews, to ensure repayment capacity remains adequate and are in compliance with the Bank’s loan policy.