Five C&I credit analysis tips from a Main Street banker

August 12, 2018 9:20 PM

It’s tough to find a good credit analyst these days. That’s why David Nicholson has made it his mission to train as many of them as he can.

He got his start in Fleet Bank’s credit training program in Boston, but as those types of programs have dwindled over the years, he began helping new credit analysts, including at his current job as senior vice president of commercial lending at the $998 million-asset Main Street Bank in Marlborough, Mass. That experience (and the curriculum that evolved) eventually led him to start a side business of his own, Credit Training Inc.

Nicholson told American Banker that he applies the concept of “thin slicing,” which he learned from Malcolm Gladwell’s "Blink: The Power of Thinking Without Thinking," to credit analysis. The basic idea is to look for patterns in “thin slices” of information, rather than trying to digest large amounts of information, to reach a decision.

Here, Nicholson shares five of his best tips for C&I credit analysis.

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Scrutinize the debt load

Borrowers can never have too much equity in a credit agreement, but they can certainly have too much debt, Nicholson said. So how much debt is too much?

The answer to that question may be more art than science, and that’s much of what Nicholson tries to teach in his course. It’s hard to say definitively just how much debt is too much without other financial information.

“Every deal is different,” he said. “I would need to see the financials and how much debt the company is requesting.”

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Look for recurring revenue and cash flow

Are revenue and cash flow recurring? Nicholson said he teaches his students to look at historical revenues and cash flow to figure out how likely those numbers are to happen again in the future.

There’s no one right answer to determine that, but he offered a few ideas. Analysts might look for multiple prior years of recurring revenues or cash flows, or they might take into consideration what a client’s contracts specify about future business. If there are no contracts, an analyst might look for strong business relationships a client has.

Balance cash flow, collateral and guarantees

The primary sources of repayment are cash flow, collateral and personal guarantees. Any shortage of one means you need an excess of the others.

According to Nicholson, if the collateral and personal guarantee are sufficient, then in a C&I deal, the company's earnings before interest, taxes, depreciation and amortization (EBITDA) should be at least 1.25 times the debt service coverage (that is, principal and interest). That’s the basic idea, anyway.

An analyst who encounters a shortage of collateral in a deal, for instance, should look for a higher debt service coverage multiple, as the bank will be more reliant on cash flow in that deal.

Ask hard questions about those one-time items and the like

“If you are not asking good questions, you are not doing your job,” Nicholson said.

Of course, there are hundreds of potential questions an analyst can ask when evaluating a deal, and missing a crucial one can result in a costly mistake.

Here is one of the most important questions for analysts to keep in mind: “What was the increase in revenue or other income due to?”

If it was a one-time event, then an analyst shouldn’t count that item toward the debt service coverage ratio. Doing so could mean the company is unable to pay on its loan the next year.

Watch those accounts receivable and other judgment matters

Analysts need to deliver an opinion-based analysis about a potential deal, rather than an elevator analysis, Nicholson said.

For example, stating that accounts receivable increased is by itself meaningless. If revenues also increased, that could reasonably be interpreted to mean that the company is growing (and therefore, a good credit risk).

On the other hand, if accounts receivable increased while revenues decreased, that should send up a flag for an analyst.