Content area
Full Text
**A debt-repayment stress test as part of a credit analysis can lead to stronger loan structures that ultimately protect the bank from losses.
Conducting a stress test on line items in financial statements will provide more meaning to a credit analysis, going beyond a simple debt service coverage (DSC) ratio and giving additional information to the decision makers on the credit.
Perhaps the DSC is 1.95, but a minor fluctuation in rents or accounts receivable- or a 200-basis-point increase in interest rates-could push it to 1:1 or worse. A DSC stress test will choose various relevant line items in either the income statement (for EBITDA DSC) or cash flow (for cash-from-operations DSC) and move them to reach a DSC of 1:1. It also stresses the total debt payments to reach 1:1 DSC. Balance sheets are stressed to reach specific ratios that are important to your credit culture. Perhaps it could be the current ratio or debt to tangible rent worth.
While it would be possible to analyze every single line item in a what-if scenario, this would be information overload. If a line item is so small or so stable that it would need to move 1,500% to reach a 1:1 DSC, this is not a meaningful piece of data. But it does contribute to information overload. The stress test should highlight the most important, the most relevant, and the most risky facets of the credit.
A typical stress test will adjust one variable at a time, but why not stress multiple variables at one time? The answer is that the analysis is trying to determine which type of shock to a business will create a 1:1 DSC. However, these shocks do not always come in individual events.
If you know that two or more events are likely to occur together, you should create a stress test that will reflect this. Note: If you know exactly what the changed costs will be, you should create a pro forma. If you know only that these multiple changes will occur but the cost is unknown, you should create a multiple-variable stress test.
For example, you know that 1) new city codes for upgrading fire systems are imminent, which will raise cash operating expenses as the work...