How to Determine a Borrower’s Ability to Repay a Loan
November 28, 2022
How to determine a borrower's ability to repay a loan

The success of every lending operation lies on its ability to identify its ideal customers and know their ability to repay. However, predicting a borrower’s capacity is difficult. This is either due to the absence of required data or limited knowledge of the data needed to determine a borrower’s repayment capacity.

In this article, we’ll cover how lenders can accurately predict borrower’s ability to repay.

  1.  Define your ideal borrower

Every lending institution has sophisticated data that define who its ideal customer is. Regardless of the sector or niche a lender focuses on, an ideal borrower should meet the five Cs of credit. They should have the capacity to repay the loan which is determined through the borrower’s DTI, debt-to-income ratio. An ideal borrower should also have capital, collateral and meet the conditions of the loan.

In addition to these, it is pertinent that they are creditworthy. There should have a repayment history acting as proof that they have taken some loans in the past and have repaid them successfully. Finally, an ideal borrower should possess the character and willingness to repay the loan. 

  1. Determine a borrower’s cash inflow

In addition to the 5Cs of credit, another dimension used to define an idea borrower is cash flow. cashflow is important because capital and capacity most times, don’t translate to cash. A customer can have capital and capacity but no cash flow. This lack of cash flow is an impediment to repayment. 

In consumer lending for instance, If the applicant is not employed, meaning that he does not earn a salary, regardless of character and willingness to repay, the applicant cannot meet the obligation. The same applies to SME lending. Business owners who have little or no stock and no cash inflow will be unable to repay even though they have character and are creditworthy.

Another non-financial criterion to consider when mapping an ideal customer is if the borrower meets the condition of the loan. The condition is so extensive and beyond interest rates. It answers the question “how does the applicant manage the business?” 

When exploring the non-financial criterion, inquire about the time the business opens, its closing time, how it uses cash and the borrower’s experience managing that kind of business.

Another non-financial criterion is collaterals. When it comes to collateral, most lenders limit themselves to physical collateral. In addition to or in the absence of physical collaterals, lenders can hedge on other non-physical collaterals lenders like guarantors and social capital. 

  1. Calculate the borrower’s debt-to-income ratio and obligations. 

In some countries, the law stipulates that a loan should be 33.3% of a borrower’s earnings. To abide by this regulation,  examine the borrower’s obligations including the loans they have with other lenders. It is also important to consider their savings as an obligation. A borrower may have a saving scheme or a standing order that is debited from their account at every particular time. It is important to tie repayment to this savings deduction.

For SME lending, the approach is slightly different. Stock taking and investigation into the borrower’s business and sector help to determine viability. 

How to determine the repayment capacity of SME borrowers

  1. In SME lending, it is imperative that the lender understands the business model of the customer. They need to understand the cash flow; What generates revenue for the business? what are the business’ expenses? For example, the lender needs to understand if the business owner diverts for personal consumption or if all earnings are reinvested into the business.
  1. Every lender has to be cautious when analyzing an SME’s capacity. This is because the continuous inflow and outflow in the income statement account don’t always reveal the true state of the business. They need to be aware that there is bank cash flow and business cash flow. If these two are not separated,  it is difficult to track the money that belongs to the borrower. To track the business cash flow, ask SME owners key questions about receivables and debtors. These questions are important because a business may have cash flow yet 80% is debt that will not be due in 30 days. This will affect their ability to repay.
  1. Another determinant of an SME’s ability to repay is supplier credit. For instance, A business owner’s revenue maybe 10 million. Out of this revenue, what actually belongs to the business is just 5 million but the lender has mistaken the 10 million contained in the bank statement as belonging solely to the business and has appraised the business owner based on that. This wrong appraisal will affect the business owner’s ability to repay.

This is called overfunding. Going back to our previous example, a borrower who is worth 5 million will appear to be worth 20 million contained in their bank statement while in the real sense, they are only making a commission on those sales, not the actual profits. 

  1. The next consideration is payables. Payables provide insight into how often borrower pays for their purchases. If they have an extension of time to pay vendors to supply products It’s proof that they have enough liquidity to sustain repayment. On the other hand, if the borrower has high receivables and early payables, the borrower will be cash-strapped and won’t be able to meet up with their obligations. To lend successfully to SMEs, lenders need to pay attention to these key metrics that show the liquidity of the business and the asset turnover of the business. 

Asset turnover applies to service-based businesses where inventory doesn’t apply. In that case, lenders have to ascertain how the available assets generate income for the company. This is where the asset turnover activity ratio becomes important.- Here, you list what an asset will help the business produce and how that product will generate profit for the business.  These show the financial parameters of that business. 

  1. Character plays a key role in lending. To understand the value of character in lending, consider the repayment quadrant. It shows 3 categories of customers: those who have the capacity and willingness; those who have the capacity but don’t have the willingness, however with the right coercion, they will pay because they have the capacity; those who have the willingness but have no capacity. This group will source money to repay; finally, there is the group who have no willingness and no capacity.  If you lend to them, you are ready to write off that loan. 

When lenders categorize these customers based on their repayment behaviour, they can identify who their ideal customers are, the sectors they play in and the optimal amount to lend to them.

Finally, SME lending is tough. It is difficult to predict a customer’s behaviour. Therefore it is advisable to trust your instincts even while working with data.

Bonus Section: How can new lenders determine customers’ capacity considering that they have no historical data to benchmark?

Macroeconomic indicators provide the information new lenders need to determine creditworthiness. In addition to macroeconomic indications, new lenders should cap the obligor limit they extend to borrowers. This is necessary as the first loan they disburse is used to give borrowers a credit journey with their lending outfit.

They should collect as much information as they can from the borrower, and use this data to build a profile for the borrower which is in turn, measured against generalized industry data. This data include the business sector, the performance of that sector, business location, predominant risk in that sector, the customers age and marital status.

Some lenders also consider the borrower’s ethnicity. This is based on the belief that certain ethnic groups excel in certain businesses. That being the case, it is less risky to lend to people who own this kind of business.

New lenders should pay attention to where the borrower’s business is situated. This helps to estimate the number of sales they can generate to accommodate the loan repayment. Others are where they source their goods from, the risk of logistics from point of purchase to point of sale, and the operational expenses within the movement of the product. These are all important as it influences the margin of the business and may affect the gross profit.  Pay attention to other statutory expenses like savings and bills as these also affect the residual income

Lending is a risky business. While a 100% repayment rate may not be feasible at all times, lenders can greatly increase their repayment rates when they have an accurate model for determining borrowers’ repayment capacity.

November 28, 2022
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