UDC: 336.774.

3
005.334:336.77
COBISS.SR-ID 252606476

SCIENTIFIC REVIEW

Methodology of Credit Analysis Development

Slađana Neogradi1*
1 Addiko bank, Belgrade, Serbia

ABSTRACT
The subject of research presented in this paper refers to the definition of methodology for the
development of credit analysis in companies and its application in lending operations in the Republic
of Serbia. With the developing credit market, there is a growing need for a well-developed risk and
loss prevention system. In the introduction the process of bank analysis of the loan applicant is
presented in order to minimize and manage the credit risk. By examining the subject matter, the
process of processing the credit application is described, the procedure of analyzing the financial
statements in order to get an insight into the borrower's creditworthiness. In the second part of the
paper, the theoretical and methodological framework is presented applied in the concrete company.
In the third part, models are presented which banks should use to protect against exposure to risks,
i.e. their goal is to reduce losses on loan operations in our country, as well as to adjust to market
conditions in an optimal way.

Key words: loan, credit analysis, credit risk, credit process, assessment of creditworthiness

JEL Classification: J21, E0

INTRODUCTION

Credit policy is the one that directs credit placements into priority economic branches and
sectors, ensuring the stability of an individual bank as a lender. A good credit policy implies a
well-designed credit analysis and a selection of credit placements. (Hanić A., Žunić E.,
Dželinhondžić, 2017). Adequately defined credit policy means respecting strict principles and
standards for formulating loan applications, financial analysis, credit analysis, credit
classification and structure, implementation of internal control of approved loans, and
determination of methods and ways of credit obligations (Domazet, Marjanović, 2017).
Approving loans to clients is the core business of banks. Loans are the basic component of assets
of most banks. They are the main source of income, but also the main source of risk exposure.
Banks must constantly monitor their overall loan coefficient in relation to total assets, being
aware that the increase in the loan-to-asset ratio is promising higher revenues, but also a higher
risk (Ćirović, 2002).
The coefficient method is most common in banks. Its basic function is to closely monitor the
ability of the borrower to repay the credit obligations, the degree of efficiency of the business
and the use of resources as well as the levels of potential risk (Vuković, Domazet, 2014). One of
these criteria is the company's liquidity, its profitability, its indebtedness, equity, interest rate
coverage, operational efficiency of assets and its business integrity (Ranković, 2005).

* E-mail: s.neogradi@gmail.com
76 Economic Analysis (2017, Vol. 50, No. 3-4, 75-85)

Loan granting is also a risky activity, as apart from the internal factors, there are external
factors which also influence the quality of the loans, such as changes in the economy, natural
disasters, as well as the regulations adopted by the state. The estimation of the probability of the
debtor's default is the main component of any rating category (Anderson, 2007). Among the
existing approaches to measuring credit risk, the key input for each of them is the existence and
use of the borrower's credit rating (Carey & Hrycay, 2001).
Despite innovations in the field of financial services, credit risk is still the most significant
single cause of bank bankruptcy (Vuković, Domazet, 2015). In its broader sense, credit risk also
signifies the risk from a decrease in the credit rating of the debtor or the issuer of securities,
thereby increasing the probability of default and/or loss of money invested (Domazet, Stošić,
2013). The exposure to credit risk in modern banking business is measured by estimating the
expected loss on a certain investment based on quantitative analysis, whereby the expected loss
for this type of risk depends on three components (BCBS, 2004).
Credit and interest rate risk are the two most important risks which commercial banks may
encounter. This article provides a comprehensive framework for measuring the integrated
impact of both types of risk. Taking into account the changes in the prices of characteristics of
assets, liabilities and off-balance sheet items, the integrated impact of loans and interest rates on
banks' economic value and capital adequacy is estimated. The stress test, which is applied on
banks, is fundamental to measuring credit and interest rates (Drehmann M., Sorensen S, and
Stringa M., 2010). Altmant's Z-score model was a logical upgrade of the current development of
credit analysis. The financial indicators that measure profitability, liquidity and solvency of the
company were considered irreplaceable and priceless performance indicators of the company. It
is only recently that, with the development of new credit risk models, the potential of using
financial indicators in assessing the creditworthiness in anticipating bankruptcy of the company
is put to question (Altman, Edward I., G. Haldeman, and P. Nurajanan, 2001).
Loans are granted on the basis of a direct request by the client, who contacts the credit
institution. When discussing with a client, the loan officer assesses his character and the real
purpose of the necessity for additional monetary funds. A loan officer also contacts other
creditors who have previously approved loans to this client to assess their experience in dealing
with this client. Records of an earlier loan can be seen in the credit bureau. When all the
necessary documentation is collected, the loan officer undertakes preparation of the financial
analysis of the loan applicant in order to determine the client's creditworthiness. The Credit
analysis department then makes a proposal and gives their recommendation, i.e. their opinion,
which is further forwarded to the Credit Committee for approval. If the Credit Committee
approves the request, contracts are drafted, signed by both parties.
The evaluation of the borrower's creditworthiness is defined as a financial analysis in which
the information collected is systematically examined and interpreted in order to evaluate the
past and present performance of the borrower, as well as its future prospects. The analytical
techniques used in the financial analysis are numerous. The financial analysis is based on a
critical examination of the balance sheet, the profit and loss account, the cash flow statement
and the ratio of numbers. Balance sheets and profit and loss accounts provide a static picture of
the borrower's creditworthiness, while the cash flow statement brings about the required
dynamism into the analysis (Ranković, 2005).
The most complex method of determining the creditworthiness of a loan applicant is the
degree of business efficiency and utilization of resources, the level of operating funds used, the
efficient use of credit resources and the level of potential credit risk. The analysis becomes a
very suitable approach to continuous monitoring and checking the borrower's creditworthiness,
early detection of deformations in the rating of financial strength of companies and signaling the
process of correcting the business strategy. The determination of creditworthiness through the
coefficient method is applied widely. The method consists of the analytical transformation of
raw balance data and company reports and the comparison of the obtained credit rates with
 Slađana Neogradi 77

standard, theoretical, empirical and sectoral rates. By analyzing all indicators, the
creditworthiness of the company is evaluated, which represents its ability to repay the debt.
The aim of the research is the analysis of the credit analysis methodology and application of
the model to reduce the credit risk in banks in the Republic of Serbia. Risk management becomes
very important under the conditions of constant changes in the banking environment today and
in the organization of banking operations which bear a very high risk. The basic hypothesis is
the application of more rational components for making the improvement in credit
analysis. Banks can use empirical models that can help to determine the financial difficulties of
the borrower. Our banks cannot remain immune to this trend of development, and the need to
control the risks that this development brings about. It emphasizes the process of deregulation
of the economy and the banking system, but also points out the instability of the conditions in
which this process is implemented. In the banking sector this need is best illustrated by the data
on the growing number of non-performing loans in many countries, which further motivated the
National Bank to develop a set of procedures and to introduce regulations governing the control
and protection against credit, interest, currency and other risks, and also encouraged many
banks to seriously direct the actions forecasting and managing risk, and develop functions of risk
management.
The oldest and most popular empirical model is called the Z-score model. The origin of all
empirical models is the Z-score model, designed by Edvard Altmant. The model was a logical
upgrade in the evolution of the development of credit analysis. Financial indicators which are
measured are the following: profitability, liquidity and solvency of companies were considered
indispensable and invaluable indicators of company performance. Yet recently, with the
development of new credit risk models, the potential use of financial indicators to assess the
creditworthiness of companies and bankruptcy forecasts are put on question. The essence of the
method is to bridge the gap between traditional credit analysis and exact parameters obtained
based on statistical multivariate methods of analysis of the creditworthiness of the loan
applicant. Zeta method is considered a second generation of Z indicators and consists in using
current data, a larger number of variables (a total of seven) and the inclusion of a very wide
range of companies from industry, trade, services etc. It is considered to be particularly reliable
for long-term predictions. It is based on the methodology of discrimination analysis and
formulation of synthetic indicators of financial and credit quality of the borrower. This method is
very important in taking decisions on the (non) approval of the loan to a company. Based on the
results of the bank will determine the level of interest rates, compensatory share of borrower,
collateral structure and coverage of credit. Zeta method determines the solvency of the
borrower and the level of potential risk in case of placing the loan. Companies that do not meet
the established framework of the financial profiles cannot get a loan. Methods for early detection
of financial difficulties of enterprises by banks have a wider application in relation to the
allocation of bank resources.

CREDIT ANALYSIS IN THE COMPANY Z-GROUP BASED ON THE PARAMETERS USED IN

BANKS IN THE REPUBLIC OF SERBIA

Credit analysis of the company Z-Group is presented in the paper.

78 Economic Analysis (2017, Vol. 50, No. 3-4, 75-85)

Table 1. Balance sheet Z-Group (in 000 EUR)

ASSETS 31/12/2016 31/12/2015 31/12/2014
Cash and cash equivalents 3,258 2,499 1,435
Receivables from sales 8,929 7,035 5,994
Other receivables 4,994 4,167 2,455
Inventories 35,950 32,111 19,203
Current assets 53,080 45,811 29,078
Land and premises 31,044 21,385 18,856
Plant and equipment 14,144 13,268 9,789
Current payments and construction 1,838 118 9
Tangible fixed assets 47,025 34,771 28,655
Shares, related parties 0 0 0
Receivables from sales (mid-term/long-term) 0 0 0
Other assets (mid-term/long-term) 590 566 100
Various assets (mid-term/long-term) 590 566 100
Accrued taxes 1.470 347 185
Other receivables 626 3,161 65
Goodwill 3,131 0 0
Total goodwill, Z-Group receivables 5,228 3,508 250
Total assets 105,923 84,658 58,083
LIABILITIES AND CAPITAL 31/12/2011 31/12/2010 31/12/2009
Liabilities to banks 34,762 15,461 13,758
Liabilities from sales (short-term) 25,759 23,323 16,369
Other liabilities, deferred income (short-term) 3,757 3,192 2,477
Current mid-term/long-term liabilities 7,360 7,330 4,145
Provisions – without pensions (short-term) 122 266 750
Total short-term liabilities 71,760 49,572 37,499
Liabilities to banks 13,451 7,216 7,880
Liabilities from sales (mid-term/long-term) 472 0 0
Liabilities for pensions 0 0 0
Other mid-term/long-term provisions 0 0 0
Other liabilities, deferred income (mid-term/long-
1.395 151 127
term)
Liabilities (mid-term/long-term) 15,318 7,367 8,007
Minority interest and fixed assets 6,653 6,653 5,892
Extra assets, capital surplus 16,461 16,187 287
Retained earnings/ accrued loss -11,142 3,033 3,638
Own shares -734 -387 -736
Other changes on equity 7,607 2,233 3,496
Equity 18,845 27,719 12,577
Total liabilities and equity 105,923 84,658 58,083
Source: Serbian Business Registers Agency
 Slađana Neogradi 79

Table 2. Profit and loss account of Z-Group (in 000 EUR)

Revenues, expenses and result 31/12/2016 31/12/2015 31/12/2014
Net sales 135,285 110,761 90,671
Costs for goods sold -74,417 -59,548 -47,161
Gross profit (loss) from business operation 60,868 51,214 43,510
Sales, general and administrative costs -29,492 -21,739 -17,116
Other business expenses -39,076 -27,829 -17,116
Writing-off/appreciation of receivables -241 -41 -7
Currency difference -14 358 463
Earnings before interest and tax (EBIT) -7,305 4,061 7,189
Interest and other expenses -6,024 2,190 5,419
Interest receivable and other financial revenues 90 205 42
Earnings before tax/Group/extraordinary -13,239 2,190 5,419
Revenues from participation of related parties 0 0 0
Earnings before tax and extraordinary revenue -13,239 2,190 5,419
Other/Writing-off/Appreciations/Provisions 0 0 0
Extraordinary writing-off of tangible and intangible
0 0 0
fixed assets
Extraordinary expenses 0 0 0
Profit/loss from sales of assets 0 0 0
Addition/Ascribing/with provisions before tax 0 0 0
Extraordinary revenues 0 0 0
Other ascribing and revalorization 0 0 0
Profit (loss) before tax on income -13,239 2,190 5,419
Deferred tax income/loss 1,122 -113 -18
Income tax -144 -1,149 -1,311
Net income -12,261 927 4,089
Source: Serbian Business Registers Agency

Negative and available cash flows in 2015 and in the first half of 2016 are the result of
negative flows from business and investment activities. The Group has an increase in
inventories, a reduction in liabilities to related companies, and a significant investment in
equipment.
Cash flow statement of Z-Group is shown in Table 3.

Table 3. Cash flow statement of Z-Group (in 000 EUR)

Position 31/12/2011 31/12/2010 31/12/2009
Earnings before tax (Profit/loss before income tax) -13,239 2,190 5,419
Depreciation of intangible fixed assets 6,253 4,192 3,047
Writing-off/appreciation of receivables 241 41 7
Loss/profit from sales of fixed assets 0 0 0
Other extraordinary expenses/revenues 0 0 0
Loss/profit from capital investments/related
0 0 0
parties
Interest and financial expenses/revenues 5,934 1,871 1,770
Earnings before interest, taxes, depreciation and
-811 8,294 10,243
amortization/EBITDA
Income tax -144 -1,149 -1,311
Changes in tax/provisions -1,055 -581 0
Earnings before interest, depreciation and
-2,010 6,563 0
amortization/EBIDA
Interest and financial expenses/revenues -5,934 -1,871 0
Current long-term liabilities from the previous year -7,330 -4,145 0
80 Economic Analysis (2017, Vol. 50, No. 3-4, 75-85)

Position 31/12/2011 31/12/2010 31/12/2009

Increase/decrease of provisions for pensions 0 0 0
Increase/decrease of other non-cash items 0 0 0
Cash flow for capital expenses, working capital -15,273 547 0
Working capital -2,597 -7,907 0
Cash flow for capital expenses -17,871 -7,357 0
Inflow of tangible fixed assets -14,668 -12,680 0
Revenues from sales of fixed assets 640 2,229 0
Capital investments/related parties/ financial
-6 0 0
assets
Goodwill (non-tangible fixed assets) -3,131 0 0
Other assets/liabilities 455 -465 0
Adjusting conversion/revaluation/other writing-off 501 -1,357 0
Cash flow of the Group -34,080 -19,633 0
Assets/liabilities of the group 2,535 -3,097
Cash flow before dividend -31,545 -22,730 0
Dividends -1,310 -745 0
Own shares -347 0 0
Stake in loss/profit in minority interest 0 0 0
Financial needs/surplus -33,203 -23,484 0
Cash, cash equivalents, marketable securities -758 -1,064 0
Liabilities to banks (short-term) 19,300 1,704 0
New liabilities to banks (mid-term/long-term) 13,595 6,666 0
Adjusting non-realized changes (realized general
1,066 -476 0
revenues)
Cash after debt financing 0 -16,655 0
Absorption of increase/decrease of share capital 0 0 0
Cash after financing 0 0 0
Source: Authors calculation based on Serbian Business Registers Agency data

After analyzing the balance sheet, the profit and loss account and the cash flow statement all
financial indicators which are applied in the development of credit analysis by domestic banks
with foreign capital are shown in the Appendix part (Table A).
Based on the data used in the proposed model, the financial analysis of Z-Group was made
and the following conclusions were drawn:
1. Return on equity (ROA) is negative in 2016, telling investors that the Group does not
earn any money, despite making investments.
2. Return on assets (ROE) in 2016 is negative. The fall in this indicator shows the
competitive weaknesses of the company.
3. The net margin is the ratio of profit after taxation and net sales. It shows how much net
profit the Group has generated from the total realized business at the market. In the
presented examples it is negative.
4. Return on investment was negative in 2016 and amounted to -12.5%, while in the
previous year it amounted to
5. 2,6%. The company's revenues began to decline, according to which the loan officer
concludes that the Group will hardly repay the existing loan.
6. The return on the engaged capital represents the ratio of the net profit with total assets.
It amounted to -11.1% in 2016.
7. The Group's equity ratio in 2016 was 17.79%. The share of borrowed sources of
financing is significant and is above their own capital: also, business assets are
predominantly (82.3%) financed with borrowed capital.
 Slađana Neogradi 81

8. The ratio of distribution of dividends was negative in 2016 and indicates a weak
development perspective of the company.
9. EBIT/interest expense in 2016 was negative and indicates the possibility of bankruptcy.
It also shows the company's inability to fulfill its obligations to creditors.
10. Debt / EBITDA is negative and poses a problem for the Group to settle its debts to banks
because there is no cash available.
11. Tangible fixed assets/sales - fixed assets in 2016 were provided by sale in the amount of
64.7%.
12. The total liabilities ratio shows that the level of indebtedness increases from year to
year.
13. The gross profit margin amounted to 45% in 2016 and shows how much the Group has
on its disposal to cover current expenses on financial and other expenditures. Gross
profit margin is a measure of market demand for Group's products or services and
market competitiveness.
14. The Z-Group sales ratio in 2016 was decreasing and indicates that the company does not
have the capacity to grow in the local economy and does not use its capacity sufficiently.
15. The debt-to-sales ratio increased from year to year, as equity and net assets declined
faster than the company's liabilities. Most of the financial liabilities represent short-term
liabilities. It is necessary to make the conversion of short-term liabilities to long-term in
agreement with the bank.
16. Business loss in 2016 and negative net result are caused by the large costs of moving the
warehouse and administrative buildings of the company into a new distribution center,
as well as due to the increase in the price of energy products, which resulted in increased
production and distribution costs.

CREDIT RISK MITIGATION

At international level actions are taken and methods of risk assessment are standardized. The
leading financial institutions were involved in the development of internal models for measuring
market and credit risk. The agreement on international capital, now known as Basel II, has been
adopted. The foundations of the Second Basel Accord are the following (Sinhal, 2012):
1. The minimum capital requirements of each bank are based on their own assessments of
risk exposure.
2. Supervisory review for determining the risk assessment procedure of each bank and
adequate level of capital.
3. Increased public informing on the actual financial position of the bank so that market
discipline can become a decisive factor that would force too risky banks to reduce risk
exposure.
One of the key novelties proposed in the Second Basel Accord is the requirement that banks
hold capital to the level they can endure business risk in addition to already existing credit and
market risks. For the assessment of credit risk, two main approaches have been proposed as
follows:
1. Standardized approach
2. Approach based on internal ratings –IRB
A standardized approach includes credit risk weights which are multiplied by credit exposure
in order to obtain weighted risk assets. Ratings assigned to creditors by rating agencies are used
as risk weights. Rating agencies are independent institutions that perform an external credit
assessment of the client. The advantage of this approach is the improvement of refined
approaches in determining risk weights. The standardized approach does not recognize the time
dimension of credit risk, i.e. the different placement maturities when determining risk ponders.
82 Economic Analysis (2017, Vol. 50, No. 3-4, 75-85)

It also does not recognize the maturity structure of interest rates that reflects the rise in credit
risk with the flow of time.
The IRB refers to the fact that ratings internally assigned to borrowers play a major role in the
determination of risk weightings. The practice has shown that most banks base their credit risk
assessment methodology on one component of credit risk - bankruptcy probability. An
important feature of the IRB approach is that it measures both unexpected and expected losses.
The expected losses should be covered by reserves for losses on credit placements, which is why
they are separated from the second level of regulatory capital. The level of expected losses is
obtained as a multiplication of the probability of bankruptcy and bankruptcy loss. The
conditional expected loss, which is the multiplication of the two previous explanations of the
parameter, indicates the total capital that the bank must possess to cover the expected and
unexpected loss.
The risk weight function promoted in Basel II has the following form
(http://www.addiko.com): Figure 1.

N –standard normal probability

G –inverse standard normal distribution
R –correlation coefficient
B (PD) - adjustment for maturity date which depends on the bankruptcy probability
Conditional probability of bankruptcy in the function of risk weight is presented by the
following:

  R 
N (1 − R )−05 xG(PD ) +  xG(0,999) (1)
 (1 − R )
05
 

In this expression, G (0.999) is interpreted as the inverse standard deviation from which the
conservative value of the system factor for the confidence level of 99.9% is derived. Another
important element of the expression is G (PD), which denotes the inverse standard normal
distribution from which the bankruptcy threshold is derived under normal business conditions,
based on a certain probability of bankruptcy. Similar to the conditional probability of
bankruptcy is the average probability of bankruptcy PD. It is weighted by the loss caused by
bankruptcy in conditions of an unfavorable environment in order to obtain the unexpected loss
measure. It is the economic interpretation of the term (http://www.addiko.com):

  R 
LGDxN (1 − R )−05 xG( PD) +  xG(0.999) − PDxLGD (2)
 (1 − R )
05
 

An important parameter in the above expression is the correlation coefficient R. The

correlation coefficient R is characteristic for each class of credit exposure. Changes in the value
displayed by various classes of credit exposure are dependent to a various degree on the state of
 Slađana Neogradi 83

the general economic environment. The new agreement recognizes the basic and higher IRB
approach. (Alexander, C. and E. Sheedz, 2004).
If the bank applies a higher IRB approach, it independently determines the probability of
bankruptcy, but it also has the ability to independently determine the value of some other risk
factors, and potentially of all of them together. When estimating the probability of bankruptcy,
banks have a lower limit of its value to 0.03%. Also, it should be determined on the basis of the
long-term average rate of bankruptcy of borrowers from a given class or subclass for the time
period of one year. The quality of the IRB approach derives from the following (Alexander, C.
And E. Sheedz, 2004):
• It is obligatory to evaluate the credit rating of each loan applicant.
• Obligatory risk assessment of any business transaction that should be subject to loan
making.
• A diversified scale of risk weight
• The ability of banks to use their own internal risk models, as more sophisticated and more
precise models in determining a risky portfolio of a particular bank.
The Basel Committee decided to introduce the latest standards - Basel III. The new set of rules
implies an increase in operating capital in case of market instability. Banks are required to keep
ratio of capital and their total assets to 7%. For these reasons, banks will have to retain their
profits, which they will not give to the shareholders or spend on bonuses. The reform package
that Basel III brings about envisages that the minimum ratio of regular capital is increased from
2% to 4.5%. Banks will be obliged to have stabilization reserve that will be used to protect
capital in times of crisis. The stabilization reserve is allocated on the basis of a set of rules that
limit the payment of dividends and rewards when the limit of stabilization reserve is exceeded.
(BCBS, 2010).
Although banks in the region have mainly introduced a risk management framework which
is in accordance with regulations, the issue of optimizing business processes remains unsolved.

CONCLUSION

In this paper, the development of credit analysis is presented as well as the implementation of
all ratio indicators. In the development of credit analysis, return on equity (ROE) is a very
important indicator, as its decline points to competitive weaknesses of the company. Return on
assets (ROA) represents the ability of the company management to maximize profit in relation to
invested capital. Based on a net margin, a credit analyst concludes to what extent the
management is able to maintain revenue growth by investing in relation to the increase in costs
due to interest payments on the company's loans.
In the analysis of debt ratios, banks apply another three coefficients as follows: EBIT / interest
expenses, EBITDA / interest expenses and interest debt / EBITDA. The indicator between
interest debt and EBITDA represents the ability of the company to settle its loan obligation
which is required to be less than five where a credit officer can conclude that a company can
settle its obligations in five years from its own funds. Based on the value of net working capital,
the credit analyst concludes that the company is funded by external sources of financing or by its
own sources. If the company has a negative cash flow, the company relies more on external
sources of financing, being a high-risk enterprise with low profitability.
The European Union has adopted a key directive introducing a mandatory requirement for all
banks in the EU. As Basel II focuses on the conscious management of risks by the bank
management, banks will have to archive data, primarily by shifting ratings and failing to fulfill
obligations as well as by determining the distribution of these phenomena by rating classes.
84 Economic Analysis (2017, Vol. 50, No. 3-4, 75-85)

In this paper, models for the assessment and management of credit risk are defined. Some of
their basic characteristics have been examined. The conclusion can be drawn that all models can
be applied in banks in Serbia in order to reduce uncollectibles.

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Article history: Received: October 31, 2017

Accepted: November 21, 2017