The Five P's of Credit Analysis
by George L. Evans, Jr., Vice President, Hampden Bank
In the 1980’s, as management trainees at The Manufacturers Hanover Trust Company (now JP Morgan Chase) in New York City, we learned the 5 P’s of Credit Analysis: People, Purpose, Payment, Protection, and Perspective. This was Manny Hanny’s (as the Bank was affectionately called) own refinement of the traditional 5 C’s: Capacity, Capital, Collateral, Conditions, and Character.
Commercial lending is more art than science, particularly in this rapidly changing and complex credit environment. Thus, a review of a proven systematic approach such as the 5 P’s from a banker’s outlook seems appropriate and useful at this time.
1) PEOPLE, the first of the 5 P’s, is also the foundation of this approach. An investigation of the principals' backgrounds through the normal sources such as credit bureau reports will be one indication of their integrity and professional competence. An evaluation of operating results and trends can also be a good index of a successful and responsible business. And from a banker’s perspective, does it treat its bankers equitably? The company's treatment of its bankers is demonstrated by the principals' willingness and ability to repay debt as agreed, by a reasonable attitude toward disclosing appropriate financial and credit information, and by the realization that a reasonable profit for the bank is a requisite for a continuing relationship.
2) PURPOSE of every bank loan can be assigned to one of three categories:
(1) acquire assets; (2) replace other creditors; and (3) replace equity. Assets may be further broken down into three types: (1) current assets of a seasonal nature;(2) current assets of a non-seasonal nature; and (3) non-current assets, normally productive capacity. Replacing other creditors can take the form of either assistance in taking trade discounts, making tax payments, or the riskier category of "taking out" other banks or financial institutions. Replacing equity is the most risky purpose since the effect of substituting debt for equity may substantially increase leverage.
3) PAYMENT is normally related to Purpose. It is the borrower's ability to repay a specific dollar obligation when it is due. The source and timing of the repayment must be appropriate for the type of loan and the probability of fulfillment must be high. The difficulty in analyzing repayment is that the loan officer is dealing with uncertainty (the future), armed only with information from the past. The past will suggest the probabilities of future events unless, of course, the company is involved in frequent major mergers, is changing the nature of its operation (diversifying, expanding), has a high degree of technological change built into its industry, or has had an extremely volatile history.
A.) Asset conversion loans (LINES OF CREDIT - Short-term lending), whether seasonal or a "one-shot" contract, should be analyzed using the "accordion" balance sheet concept: when and how much do total assets expand, and when and how will they contract? The source of repayment lies in the increase in trading assets purchased with bank money. Their timely reconversion into cash should retire the bank debt and provide profit to the firm.
B.) Cash flow loans (TERM LOANS - Longer term lending) are not repaid by asset conversion but from future profit or external funds (debt or equity) which the firm can attract because of its profit record or potential.
4) PROTECTION involves a "second way out" in case the primary repayment source fails.
A.) Internal protection, where the lender looks exclusively to the borrower, can be either specific collateral or general corporate credit responsibility. Collateral should be analyzed as to who controls it physically (the bank or the borrower), its marketability, and therefore the appropriate lending margin. General corporate credit responsibility can be overall leverage and liquidity for a cash flow borrower, or profitability for an asset-conversion borrower. Balance sheet protection can be enhanced by loan agreement covenants alerting the lender to liquidity problems, precluding dangerous leverage, prohibiting the borrower from giving collateral to third parties through a negative pledge clause, and a variety of other restrictions.
B.) External protection, where a third party adds its credit responsibility to that of the borrower, most commonly takes the form of guarantees, endorsements, or repurchase agreements. A loan based solely on the credit responsibility of the guarantor is normally a high risk loan at the outset because there is only one source of repayment.
5) PERSPECTIVE is the overview: does the credit make sense within the basic risk and reward framework? Here the risks of principal loss or the opportunity costs of being "locked in" must be weighed against the rewards of a banking relationship: the interest income plus any fees, free demand deposit balances, and related products and services, both actual and potential.
In summary, a systematic approach such as the Five P's touches on the basic issues in almost any loan request in a logical and timesaving manner.
George L. Evans, Jr., Vice President and commercial lender at Hampden Bank, has a BA from Wesleyan University and an MA and PhD from U Mass-Amherst. He can be reached at 413.452.5146 or at gevans@hampdenbank.com.
