Question

You are appointed as a credit manager in the local branch of ZAA Bank that is situated in an industrial area. Most customers are businesses. Provide a brief summary of important credit risk factors relating to the following forms of business that you as a banker should keep in mind:

a. Sole proprietor

b. Partnership

c. Private company

Answer 1

CREDIT RISK FACTORS

A. Sole Proprietor

• Single person Obligation - The interest & principal obligation undertaken by the sole proprietor falls entirely on a single person and his/her assets with no backing from any other party. Moreover, the success of the proprietor business is also prerogative of a single person.
• Capacity to repay - Since in case of sole proprietor, the liability of the business is unlimited. Hence, if the business fails, even personal assets will be directed towards recovering business losses. Hence, the capacity of the person to pay bank's loan(s) comes down severely.
• Lack of financial expertise - Since the entire operation and management of the business is in the hands of a single person, who might not be efficient in financial management, there is a higher possibility of financial mismatch of capability versus withdrawal. This increases the credit risk.

B. Partnership

• Financial Flexibility - Partnerships rely on capital contribution from partners only. There is limited scope in arrangement of funds for payment of pending loan obligations.
• Liquidity - Partnerships are not absolute winners in terms of liquidity as compared to companies who have better access to capital arrangements. This might lead to delay in payments of bank loans.

C. Private Company

• Limited Scope - The scope of capital generation is limited compared to a public company. Hence, in case of loan repayment requirement, the company relies on limited shareholders since they do not have much access to capital markets and cannot generate capital through open public.
• Extensive Borrowing - A private company that is in line of expansion may borrow more than its capacity to repay since borrowing is the cheapest source of finance. More debt on the balance sheet creates credit risk for the bank.
• Disclosures - In case of private companies especially when they are not listed, there is no obligation to disclose financials. These companies are informationally opaque. Hence, there is no concrete way of knowing the financial health of the business. This increases the credit risk.