Comprehensive financial analysis and proper documentation have become increasingly important due to rising credit risk profiles.
Commercial credit risk analysis involves more than financial ratio calculations. It requires an integrated assessment of the borrower's ability, willingness, and intention to repay.
Accurate identification and documentation of repayment sources are also essential for underwriting and portfolio management. Comprehensive financial analysis and proper documentation have become increasingly important due to rising credit risk profiles associated with ongoing loan growth, increased delinquencies, and nonperforming loans, which have led to greater regulatory scrutiny of commercial loan portfolios.
Understanding the nature of commercial credit risk
Unlike consumer lending, commercial credit typically involves larger exposures, longer maturities, and more complex structures. This complexity introduces additional layers of risk. A borrower’s financial performance is only part of the equation; external factors such as economic cycles, market competition, and managerial effectiveness significantly shape credit outcomes.
Insufficient evaluation of repayment capacity — or an overdependence on collateral and guarantees — exposes lenders to potential credit losses and regulatory complications. There is an increasing emphasis on payment performance and secondary or tertiary sources of repayment, as primary sources or repayment continue to be affected by prevailing interest rates, inflationary trends, and the influence of government policies related to tariffs.
Key risk considerations in commercial credit risk
Lenders must account for a wide spectrum of risks, including:
- Cash flow volatility — Revenue and expense fluctuations tied to seasonality, economic conditions, or customer concentration.
- Industry and market dynamics — Shifts in competitive positioning, pricing power, supply chain reliability, or regulatory frameworks.
- Management value — Leadership’s strategic vision, adaptability, and operational track record.
- Collateral quality — Uncertainty in asset values, liquidity, condition, and enforceability during stressed conditions.
Each element affects the borrower's risk profile, highlighting the need for institutions to objectively assess borrowers’ underwriting assumptions and regularly reassess underwriting standards. Also, the requirement for thorough ongoing analysis has become increasingly important.
Commercial credit risk repayment sources hierarchy
Regulatory agencies such as the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve System, and National Credit Union Administration have placed more emphasis on identifying and prioritizing sources of loan repayment given the higher interest rate environment and elevated inherent credit risk profiles across the industry. This hierarchy provides clarity for both underwriters and decision makers:
- Primary source – operating cash flow — The ongoing income generated from core business operations or property performance. Considered the most important repayment mechanism.
- Secondary source – guarantees or external support — Personal or corporate guarantees, or other third-party commitments. These may offer added protection but remain contingent and less predictable.
- Tertiary source – collateral — Recovery through liquidation of pledged assets such as real estate, accounts receivable, or inventory. This is generally a fallback option, not a principal repayment method unless the loan is asset based.
Sound underwriting centers on operating cash flow, the most reliable indicator of a borrower’s financial health and repayment ability. Prioritizing this repayment source allows credit analysis to focus on the borrower’s capacity to service debt through regular business activity, rather than relying on external support.
Through this prioritization, lenders can construct realistic stress tests, validate forecasts, and detect risks early. Institutions should evaluate their risk rating systems to align with the inherent risk in their loan portfolios. Additionally, these systems should facilitate effective risk assessment of commercial loans by appropriately weighing primary, secondary, and tertiary sources of repayment.
Ongoing monitoring of commercial loans is important to detect changes in repayment sources, especially when there is increased reliance on guarantees or collateral, and to identify elevated credit risk. We’re noticing more situations where the primary repayment source is not performing to projections, leading to greater dependence on secondary and tertiary sources of repayment. In such situations, financial institutions should use comprehensive analysis so loans are rated according to their risk.
“Telling the story” of the credit
Beyond numbers, a strong credit analysis should present a coherent narrative. The credit memorandum is the primary vehicle for this narrative, transforming financial data into decision-ready insight. An effective memorandum should:
- Clearly outline repayment sources and cash flow priorities,
- Evaluate management’s experience and performance capabilities,
- Identify key risks alongside mitigation strategies,
- Clearly document underlying assumptions for forecasts and analysis, and
- Justify loan structure relative to repayment capacity.
The credit memorandum serves as a comprehensive record, blending financial data, qualitative insights, and strategic context. Done well, the credit memorandum becomes more than a regulatory guidance expectation — it’s a calculated tool. By presenting a transparent, integrated view of the borrower’s history, current performance, and outlook, it equips underwriters, credit committees, directors, and regulators with the information needed for sound decision making.
This narrative approach boosts transparency, aligns with regulatory expectations, and informs all third parties of the credit rationale.
How CLA can help with commercial credit risk analysis
Effective commercial credit risk management requires thorough underwriting and comprehensive documentation. Carefully identifying primary, secondary, and tertiary sources of repayment, combined with a well-articulated credit narrative, provides transparency, resilience, and defensibility.
By centering analysis on operating cash flow and presenting a cohesive borrower story, financial institutions not only meet regulatory expectations but also strengthen the quality of their credit decisions on portfolio monitoring. Our experienced financial services team can help get you identify your repayment sources as well as get your documentation in order.