Effective Credit Risk Assessment – Strengthening the Financial Spreading with Technology Enablers

White Paper

Business Process Services

Vijay Muppavarapu

Vijay is a subject matter expert and a member of the Commercial Banking - Offerings and Business Development team at Tata Consultancy Services (TCS). He has over 10 years of experience in corporate and commercial lending. He has been involved in origination and servicing of corporate clients in various capacities across multiple industry segments such as infrastructure, pharmaceuticals, IT and ITES, and retail. Vijay is a graduate in Statistics and Computer Science from Osmania University and holds an MBA from the ICFAI Business School, Hyderabad.

About the Author

Various stakeholders in the credit process (including investors, analysts, company officials, institutional and trade creditors, customers, and government regulatory agencies) require financial information in a structured manner.

Financial statements, though structured, are not adequate to support the decision making process that determines the credit worthiness of a lending institution's customers. This gap can be offset by the process of 'spreading', which enables the comparison of primary financial statements across industry and historical data.

Conventional processes for spreading financial statements typically entail the use of spreadsheets. However, spreadsheets are prone to data loss, human error, and other inaccuracies.

In this paper, we suggest a method for improving the decision-making process for extending credit by leveraging synergies between the conventional knowledge and technology enablers. This method can be used by financial institutions (FIs) and banks, which require structured financial information for decision-making and monitoring.

Contents

Introduction 5

Conventional spreading: limitations and opportunities for improvement 5

An overview of the conventional process of spreading 6

Limitations of the conventional spreading process 7

Effective financial spreading through standardization and use of technology 8

Standardization of the financial spreading process 8

Four steps to identify technology enablers that improve process efficiency 8

Impact of effective financial spreading on FIs and customers 9

Conclusion 10

IntroductionLoan account officers at banks and financial institutions (FIs) require the financial information pertaining to an individual or organization in order to take effective credit decisions. Financial statements of an organization – the balance sheet, profit and loss statement, cash flow statement, and statement of retained earnings – are the most relevant financial information available in a structured format that can be used to evaluate the credit-worthiness of an organization. The amount of information in a financial statement depends on the format and the constitution of the entity (as shown in Figure 1).

However, a financial statement typically does not contain sufficient information for a bank or other lenders to assess the credit worthiness of an organization. Primary financial statements typically need to be restated or classified account-wise on a percentage basis to support better decision-making. This process is called spreading. Spreading enables comparison of information such as the market worth or the credit worthiness of a firm with historical performance, across industry segments.

The conventional spreading process involves the use of spreadsheets, which are subject to manual errors. Technology based solutions can make financial spreading more accurate, and therefore, effective in determining the credit worthiness of a customer.

Conventional spreading: limitations and opportunities for improvementAs shown in Figure 1, financial statements can vary based on the nature and constitution of a business. The information captured in the statements may originate from multiple industries or business lines. Moreover, such information may vary from country to country, and follow different accounting policies (such as US GAAP, IFRS, and IAS).

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Figure 1: Variations in financial statements limit comparison and consistency in evaluation

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The factors depicted in Figure 1 are not exhaustive, but typify some of the reasons for variations in the statements. Since it is challenging to make meaningful comparisons between the information available in different statements, it is essential to consider parity of numbers in the statements across all factors. The easiest way to do this is to represent the information as percentages, rather than absolute numbers.

An overview of the conventional process of spreading

The first step in financial spreading requires restating and capturing the line items (account head and amounts) from financial statements (P&L and balance sheet) into spreadsheets. For a balance sheet, the common denominator for conversion to percentages is the value of total assets; whereas, for an income statement (P&L), it is the value of sales. The resulting accounting entries can be used for common sizing and comparison with historical data and peer firms within the same industry or business segment. The cash flow statement is not spread since it is derived from the income statement and the balance sheet.

A key task at this stage is to recheck the entries for classification errors, such as items of income or expense being considered as operating instead of non-operating entries or vice versa for a P&L statement, or an asset or liability being considered as current (due within 12 months) instead of non-current (due after 12 months) in the case of a balance sheet. To reverse any misclassification, account entries need to be restated or reclassified.

Conventional financial spreading identifies historical trends (through trend analysis) and percentage values (through ratio analysis), and enables analysis of financial characteristics such as the liquidity position, management of firm assets, debt repayment ability, profitability, and market valuation.

The typical process followed in most banks and FIs is depicted in Figure 2.

Figure 2: Financial spreading as followed currently results in multiple spreadsheets for a variety of financial statements, and defeats the purpose of the process

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Limitations of the conventional spreading process

Conventional spreading is cost effective and easily accessible, and used widely by credit analysts and lending institutions. However, it also has some major limitations.

Typically, conventional spreading produces multiple spreadsheets with a different template for each type of financial statement. This defeats the purpose of making the comparison easier. The process is also highly prone to classification errors.

Apart from this, conventional spreading lacks the flexibility to capture account heads specific to an industry or segment. This limits the ability to benchmark with peers within and across industries. It is also not easy to capture the volatility of financial ratios over a period of time. Additionally, in conventional spreading, there is no repository available for data validation, integrity checks and audit trails.

Finally, the use of spreadsheets makes it difficult to conform to relevant accounting standards, making it a purely manual exercise as well as a cumbersome and error-prone process.

These limitations impact banks and FIs in a number of ways:

a) Slower turnaround time in execution and delivery of credit

b) Inability to store critical information and retrieve it whenever required

c) Higher probability of credit loss due to inaccurate assessment of credit quality

d) Delayed audit compliance and conformance with federal bank guidelines

e) Decline in customer and investor confidence due to all of the above

Customers, on the other hand, are impacted by opportunity costs due to the delay in obtaining credit. There is also a possibility of incorrect estimation of credit worthiness. This may damage their relationship with the lending institution.

A study of the benefits and limitations in conventional spreading indicates a significant opportunity for improvement in the process. The use of sophisticated and relevant technology can mitigate the challenges involved.

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Effective financial spreading through standardization and use of technologyPrior to implementation of technological solutions, we need to study existing systems and procedures that will yield the desired results. A clear understanding of the manual and discrete processes followed currently within most banks and financial institutions is also imperative. And finally, it is essential to standardize the application of conventional knowledge on financial spreading and implement technology enablers to improve process efficiency.

Standardization of the financial spreading process

A transformational approach can overcome the deficiencies in conventional financial spreading and optimize the process. Standardizing the organization-wide application of financial spreading involves:

Analyzing existing systems and procedures and identifying deficiencies

Rectifying process deficiencies and adopting benchmarks and best practices

Standardizing formats utilized organization-wide, including customized industry formats

Optimizing existing resources by eliminating redundancies and the need for rework

Demarcating and segregating functions for entry and scrutiny (following the 'maker-checker' concept) to ensure data integrity

Documenting spreading conventions and guidelines for consistent application across the organization

Four steps to identify technology enablers that improve process efficiency

Technology enablers help in harvesting enterprise-wide knowledge on improving financial spreading, and driving process performance. Identification of appropriate technology enablers should involve the following steps:

1. Conduct a detailed study of on-the-ground processes and the capability of the proposed solution to replicate the requisite results.

2. Evaluate the ability of the system to perform required functions such as creation of a repository, integration of data from multiple sources, record retention for historical trends and audits, and easy information retrieval.

3. Mitigate inefficiencies in existing processes and ensure scalability to meet future growth requirements.

4. Identify independent requirements for each function, but consider integrated platforms that meet overall requirements.

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Ensure that the system has the flexibility to adapt to changing business conditions, such as regulatory changes and growing geographical spread. The suggested flow for effective spreading is depicted in Figure 3.

Impact of effective financial spreading on FIs and customersLending institutions as well as their customers can enjoy a number of benefits by adopting a transformational approach to financial spreading. Financial institutions should see an improvement in the quality of the financial spread and a reduction in errors, which will facilitate improved credit and risk assessment. An automated solution reduces the overall turnaround time for credit delivery and offtake, which results in greater customer satisfaction and reduced opportunity costs.

The integration of information from multiple sources helps improve the accuracy in predicting the probability of default. Institutions should consider adopting an integrated platform for financial spreading and risk calculation (by assigning credit scores to customers) that interacts with industry databases for generating peer financial ratios. Easy access to historical customer data ensures easier and faster due diligence.

An automated system also enables easy calculation of the volatility in the customer organization's financial ratios over a given time period. All of these in turn help lending institutions acquire credit worthy customers.

Figure 3 : Suggested approach for effective spreading and easier decision making

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ConclusionWith most economies yet to recover from the recession, raising equity from capital markets is currently not an attractive option for most firms. Hence, institutional credit has become the obvious choice for corporate and business firms.

On the other hand, capital available with banks is limited and does not match the huge credit demand. It is important for banks to invest in prudent and profitable assets. This makes improving the decision making process for extending credit an important objective for most banks and financial institutions.

Two things are key to this process. Lending institutions must employ the right tools for acquiring a customer by diligently mapping the organization-wide risk policy and framework to a customer's credit profile. Secondly, they must implement standards for consistent application of credit guidelines for effective financial spreading.

Adopting technology enablers early on and integrating them with continuously updated risk metrics can help financial institutions effectively profile customers and accurately determine their credit worthiness. By embracing these processes, lending institutions can weather the new economic scenario marked by stringent regulations, tighter capital norms, and high volatility.

Further reading1. Financial Statement Analysis, Pearson Education, Inc., 'The demand for financial statement information', 2007

2. Fact, About Spreading and Financial Analysis, 2012, 2014, http://factcreditrisk.com/What-FACT-Does/Spreading-and-Financial-Analysis/About-Spreading-and-Financial-Analysis

3. Moody's Analytics, Risk Analyst, 2013, 2014, https://www.moodys.com/sites/products/ProductAttachments/RiskAnalyst%20Fact%20Sheet%20English.pdf

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