Annual Commercial Loan Review

Annual commercial loan reviews have become more important in recent years and financial regulators expect financial institutions to have a process in place staffed by bankers that serves as the annual credit review of commercial loan borrowers and is the critical element in this process. Obtaining and analyzing current financial information is important; however, there are other factors that should be considered for a comprehensive annual review process. 

Along with obtaining and analyzing current financial statements, it is important to spread financial statements and tax returns for all parties and include K-1s for distributions and contributions and then perform a complete cash flow analysis. It is useful to see a financial comparison to the previous year. A review of the borrower’s financial performance and condition with a focus on changes since the last review and their impact on repayment sources should be discussed. Understanding contingent liabilities and changes in a guarantor’s financial condition is important during this process, as these obligations may have to be repaid in the near future and may affect global cash flow.

Trend analysis is important when examining financial statements to see how company assets have grown over time. A discussion should describe significant changes in the borrower including management, industry or the local market.  This review can help to see if the business is investing its money and investing wisely. Ratio analysis can evaluate a company’s net profit margin, return on equity, revenue and expense trends, operating and performance trends, and liquidity patterns.

Covenant testing and compliance should be performed annually and in accordance with the terms of the loan agreement. During this review, the banker should test all financial and reporting covenants and see if they comply with the loan agreement. Should there be non-compliance issues, the results should be communicated to the borrower and bank management.

Liquidity analysis should be considered if guarantors have substantial liquid assets on their financial statements that may be considered a potential repayment source should it be needed. Obtaining and validating brokerage statements on an annual basis should be a part of this review.

Site visits to a borrower’s business should be performed once a year. Inspections help keep the borrower honest. The benefit of inspections is showing the borrower that the bank is interested in the condition of the collateral and the status of the business or project. The site inspection should describe the site as well as the surrounding neighborhood of the business collateral.  Recalculating the collateral is more important for asset-based loans where accounts receivable and inventory levels fluctuate. Advance rates should be recalculated and heavier discounts should be applied for older receivables and raw materials. If the property is commercial real estate and non-owner occupied vacancies should be reviewed as well as a review of rent receipts.

A credit report should be obtained annually and the results addressed in the annual review and compared to prior years. The personal credit report debt as well as all long-term business debt should be analyzed and compared to previous years with a narrative on debt service coverage trends to prior years and reviews.

Risk to repayment should describe any new risks that may be evident to repayment of the loan. The primary source of repayment for most business loans is the cash generated by the company over one or more operating cycles. If that source of repayment is not available due to financial risks, then a secondary source of repayment is needed. Additionally, non-financial risk such as vulnerability to changes in technology could affect repayment.

The annual review process is a good time to validate the loan risk grade.  The banker should summarize in a short narrative the current grade and confirm the grade or consider a grade change if appropriate.