Credit analysis serves an important function in the debt capital markets, distributing capital efficiently by appropriately assessing credit risk, pricing it accordingly, and repricing it when risks change. How do fixed-income investors assess the riskiness of debt, and how do they evaluate how much they need to earn to compensate for that risk?
This article discusses the fundamental ideas of credit analysis, the credit analysis process, and the ratios.
What Is Credit Analysis?
Credit analysis is a type of financial research performed on firms, governments, municipalities, or any other debt-issuing entity by an investor or bond portfolio manager to assess the issuer’s capacity to satisfy its debt commitments. Hence, credit analysis aims to determine the acceptable amount of default risk associated with investing in the debt instruments of a specific firm.
Examples of Credit Analysis
The debt service coverage ratio is an example of a financial measure that one can use in credit analysis (DSCR). The DSCR measures the amount of cash available to satisfy current debt obligations such as interest, principal, and lease payments. A debt service coverage ratio that is less than one shows a negative cash flow.
A debt service coverage ratio of 0.89, for example, shows that the company’s net operating revenue is only able to cover 89 percent of its yearly debt payments. Environmental factors such as regulatory climate, competition, taxes, and globalization can be utilized in conjunction with fundamental elements in credit analysis to reflect a borrower’s ability to repay its obligations relative to other borrowers in its industry.
What is the Credit Analysis Process?
The credit analysis process entails reviewing a borrower’s loan application to determine an entity’s financial health and ability to generate sufficient cash flows to service the debt. A lender performs credit research on potential borrowers to establish their creditworthiness and the level of credit risk involved with granting loans to them.
A credit analyst may employ a range of methodologies during the credit analysis process, including cash flow analysis, risk analysis, trend analysis, ratio analysis, and financial predictions. The methodologies examine a borrower’s financial performance data to determine the entity’s level of risk and the number of losses that the lender will suffer in the case of default.
Read Also: 5 Cs of Credit: Why Are They Important? (+ Detailed Guide for Beginners)
Credit Analysis Process Stages
The credit analysis process is a time-consuming, spanning anything from a few weeks to months. The essential stages in the credit analysis process are as follows:
#1. Information gathering
The first step in the credit analysis procedure is gathering information about the applicant’s credit history. The lender is specifically has interest in the customer’s past repayment record, organizational reputation, financial solvency, and transaction records with the bank and other financial institutions. Also, the lender may also evaluate the borrower’s ability to produce additional cash flows for the organization. They do so by examining how well the borrower used the previous borrowing to expand its primary business activities.
The lender also gathers information on the loan’s purpose and feasibility. Also, the lender wants to know if the project being funded is viable and has the ability to create significant cash flows. The credit analyst assigned to the borrower is responsible for determining the loan amount’s sufficiency to complete the project and the availability of a good plan to complete the project effectively.
The bank also collects information regarding the loan’s collateral. So, this serves as security for the loan if the borrower defaults on its debt commitments. Typically, lenders prefer that the loan be returned from the proceeds of the project being funded, and the security is simply used as a backup in the case that the borrower defaults.
#2. Information evaluation
The information gathered in the first stage is evaluated to determine its accuracy and veracity. Personal and corporate documents, such as passports, corporate charters, trade licenses, corporate resolutions, agreements with customers and suppliers, and other legal documents, are inspected to ensure their accuracy and authenticity.
The credit analyst also assesses the borrower’s financial ability by analyzing financial statements such as the income statement, balance sheet, cash flow statement, and other related papers. The bank also evaluates the borrower’s expertise and credentials in the project to determine their competency in completing the project.
On the negative side, if a project is experiencing severe competition from other organizations or is declining, the bank may be hesitant to grant loans due to the high likelihood of suffering losses in the event of default. However, if the bank believes the borrower’s level of risk is acceptable, it can offer credit at a high-interest rate to compensate for the high risk of default.
#3. Loan application approval (or rejection)
The decision-making step is the final stage of the credit analysis process. The lender decides whether the evaluated degree of risk is acceptable or not after acquiring and assessing the required financial facts from the borrower.
If the credit analyst assigned to the individual borrower believes that the assessed level of risk is appropriate. Also, that the lender will have no difficulty servicing the loan, they will submit a recommendation report to the credit committee on the review’s findings and the final decision.
However, if the credit analyst determines that the borrower’s level of risk is too high for the lender to accept, they must make a report to the credit committee outlining their views on the borrower’s creditworthiness. The final decision on whether to approve or reject the loan is reserved by the committee or other suitable approving authority.
What do Credit Analysis Ratios mean?
Credit analysis ratios are tools that aid in the process of credit analysis. These ratios assist analysts and investors in determining whether individuals or organizations are financially capable of meeting their obligations. Credit analysis entails both qualitative and quantitative considerations. Ratios deal with the quantitative aspect of the analysis. So, the key ratios can be divided into four categories: (1) profitability; (2) leverage; (3) coverage; and (4) liquidity.
#1. Profitability Ratios
Profitability ratios, as the name implies, assess a company’s ability to create profit with sales, balance sheet assets, and shareholders’ equity. This is significant for investors because it may be used to forecast whether stock prices are likely to rise. They also assist lenders in determining a company’s growth rate and ability to repay debts.
Profitability ratios are divided into two categories: margin ratios and return ratios.
Margin ratios include the following:
- The margin of gross profit
- The EBITDA margin
- Margin of operating profit
Return Ratios includes the following;
- The return on investment
- Return on risk-adjusted investment
- Return on investment
So, higher margin and return ratios indicate that a corporation is better able to repay its loans.
#2. Leverage Ratios
Leverage ratios relate the amount of debt on a balance sheet, income statement, or cash flow statement to other accounts. They assist credit analysts in determining a company’s ability to repay its loans.
The following are examples of common leverage ratios:
- Debt-to-asset ratios
- Asset-to-equity ratios
- Debt-to-equity ratio
- Debt-to-capital ratio
In terms of leverage ratios, a smaller leverage ratio denotes less leverage. For example, if the debt-to-asset ratio is 0.1, it signifies that debt funds 10% of assets while equity funds the remaining 90%. A lower leverage ratio also indicates that debt is used to fund fewer assets or capital. This is appealing to banks and creditors because it represents less existing risk.
#3. Coverage and Credit Analysis Ratios
Coverage ratios assess the amount of coverage provided by revenue, cash, or assets for debt or interest expenditures. So, the bigger the coverage ratio, the greater a company’s capacity to satisfy its financial obligations.
Coverage ratios include the following:
- The ratio of interest coverage
- Debt-service-to-income ratio
- The ratio of cash coverage
- The ratio of asset coverage
#4. Liquidity Ratio
Liquidity ratios demonstrate a company’s ability to transform assets into cash. In credit analysis, the ratios demonstrate a borrower’s ability to repay current debt. Higher liquidity ratios indicate that a corporation is more liquid and, as a result, can pay off outstanding obligations more readily.
Among the liquidity ratios are:
- Current ratio
- Quick ratio
- Cash ratio
- Working capital
Read Also: Liquidity Ratio: Types, Formulas and Calculations
Summary
Credit analysis is the examination of a borrower’s loan application to evaluate whether the firm generates sufficient cash flows to meet its debt commitments. So, the credit analysis process entails gathering information from the borrower, assessing the data, and deciding whether or not to authorize the loan.
A credit analyst determines a borrower’s creditworthiness using numerous approaches such as ratio analysis, trend analysis, cash flow analysis, and predictions.
Credit Analysis Frequently Asked Questions
What are the tools of credit analysis?
A credit analyst uses numerous credit analysis tools such as ratio analysis, trend analysis, cash flow analysis, and predictions.
What are 5 C's of credit analysis?
The five Cs of credit analysis are character, capacity, capital, collateral, and conditions.
Is it hard to be a credit analyst?
Working as a credit analyst can be a demanding profession. It implies you select whether or not an individual or a business can make a transaction and at what interest rate. It is a significant duty that should not be treated lightly.
