Fundamentals of Credit Analysis
It is a process that provides information about the borrower’s creditworthiness, which helps the lender decide whether to provide a loan by keeping in mind the borrower’s past, present and future situations. Private, non-bank lenders come in many shapes and sizes, including residential and commercial real estate lending, equipment finance, and asset-based lending, among others. There are also many opportunities for people with lending experience to look at private loan and mortgage broker firms. This is defined as the risk that a creditor will advance resources to a debtor, but that payment (or repayment) will not be made. Credit analysis is conducted in order to understand the level of credit risk presented by a borrower, given the parameters of a specific credit request. The borrower, also known as the debtor, could be an individual or a business entity; the former is referred to as retail (or personal) lending, and the latter is what’s known as commercial lending.
The outcome of the analysis is a determination of whether to extend credit or loan money to the subject and if so, the amount to be committed. This analysis can also be used to estimate whether the credit rating of a bond issuer is about to change, which could present an opportunity to profit from speculating in ownership of the bonds. Rating agencies like Fitch and Moody’s employ teams of credit analysts to assess the credit risk of publicly traded companies.
How Does Credit Analysis Work?
We first introduce the key components of credit risk—default probability and loss severity— along with such credit-related risks as spread risk, credit migration risk, and liquidity risk. We then discuss the relationship between credit risk and the capital structure of the firm before turning attention to the role of credit rating agencies. We also explore the process of analyzing the credit risk of corporations and examine the impact of credit spreads on risk and return. Finally, we look at special considerations applicable to the analysis of (i) high-yield (low-quality) corporate bonds and (ii) government bonds.
- The univariate approach enables an analyst starting an inquiry to determine whether a particular ratio for a potential borrower differs markedly from the norm for its industry.
- For instance, a company like Apple tends to have a high credit rating and thus, relatively low yields.
- The risk rating, in turn, determines whether to extend credit or loan money to the borrowing entity and, if so, the amount to lend.
- For investments, understanding credit analysis can help you determine whether you’re comfortable with certain fixed-income investments.
To judge a company’s ability to pay its debt, banks, bond investors, and analysts conduct credit analysis on the company. Using financial ratios, cash flow analysis, trend analysis, and financial projections, an analyst can evaluate a firm’s ability to pay its obligations. A review of credit scores and any collateral is also used to calculate the creditworthiness of a business. Credit analysis is a review conducted by an outside party on a business or individual to judge the subject’s ability to repay debt. This analysis typically involves a review of credit scores, cash flows, income, and the presence of sufficient collateral to pay back debt.
What Is Credit Analysis?
Personal lending (often referred to as “retail credit”) tends to be much more formulaic than its commercial counterpart.
Many businesses that sell B2B extend credit terms to their customers; this is what’s called trade credit. Many large corporations employ entire teams of credit analysts to assess the creditworthiness of prospective customers and to set reasonable limits on their accounts. There are countless relationship management, analyst, and risk management-type roles at financial institutions where someone with strong credit acumen can build a very rewarding career for themselves.
This fixed income credit analysis supports debt ratings that are used to price fixed income securities, which trade publicly (like corporate bonds). Before approving a commercial loan, a bank will look at all of these factors with the primary emphasis being the cash flow of the borrower. A credit analyst at a bank will measure the cash generated by a business (before interest expense and excluding depreciation and any other non-cash or extraordinary expenses). The DSCR divides this cash flow amount by the debt service (both principal and interest payments on all loans) that will be required to be met.
In recent decades, a number of objective, quantitative systems for scoring credits have been developed. In univariate (one variable) accounting-based credit-scoring systems, the credit analyst compares various key accounting ratios of potential borrowers with industry or group norms and trends in these variables. A company can be considered strong for credit purposes when it has a cost structure that allows it to produce generally higher-than-average profits during all phases of its business cycle.
One objective of credit analysis is to look at both the borrower and the lending facility being proposed and to assign a risk rating. The risk rating is derived by estimating the probability of default by the borrower at a given confidence level over the life of the facility, and by estimating the amount of loss that the lender would suffer in the event of default. The outcome of the credit analysis will determine what risk rating to assign the debt issuer or borrower. The risk rating, in turn, determines whether to extend credit or loan money to the borrowing entity and, if so, the amount to lend. Some businesses choose not to spend any time on credit analysis when a customer order is quite small, on the grounds that the cost to conduct the analysis is greater than the potential loss from a bad debt. These firms also hire credit analysts to manage risk in their investment portfolios, or even to manage the balance sheets of individual private companies that the firm has invested in and which employ debt in their capital structures.
Classic credit analysis
Credit analysis is a process in which an investor or bond portfolio manager calculates a company’s creditworthiness or other debt issuing entities. It helps the investor and bond portfolio manager measure the risk of investing in companies or other debt issuing entities. We also discussed risk versus return when investing in credit and how spread changes affect holding period returns. In addition, we addressed the special considerations to take into account when doing credit analysis of high-yield companies, sovereign borrowers, and non-sovereign government bonds. Our coverage focuses primarily on analysis of corporate debt; however, credit analysis of sovereign and nonsovereign, particularly municipal, government bonds will also be addressed.
For example, if a company issues bonds to raise capital for its business, credit analysis might be used to assess that company’s ability to fulfill its bond obligations. Credit analysis is the method by which one calculates the creditworthiness of a business or organization. In other words, It is the evaluation of the ability of a company to honor its financial obligations. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan.
From the lender’s point of view, it is essential to have some sort of safety and surety against the loan being granted. For this, the credit analysis helps both the corporation and the lender as it will provide surety to the lender by providing the corporation’s creditworthiness, and the lender can invest the money depending upon the level of risk. Today, Standard & Poor’s, Moody’s, and Risk Management Association can all provide banks with industry ratios. The univariate approach enables an analyst starting an inquiry to determine whether a particular ratio for a potential borrower differs markedly from the norm for its industry.
A DSCR of 0.78 shows the company has enough cash flow to cover 78% of the annual debt payment. Besides fundamental factors used in credit analysis, environmental factors like competition, taxation, regulatory climate, and globalization can also reflect the borrower’s ability to repay the debt. The credit analysis process can be understood better by taking an example of a financial ratio’s debt service coverage ratio used in the credit analysis process. The debt service coverage ratio measures the cash flow available to the borrower to pay the debt. The DSCR below 1 indicates negative cash flow, and the DSCR above 1 shows positive cash flow.
Definition of Credit Analysis
Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability. As mentioned, analysts attempt to predict the probability that a borrower will default on its debts, and also the severity of losses in the event of default. The credit spread is the difference in interest rates between theoretically “risk-free” investments such as U.S. treasuries or LIBOR and investments that carry some risk of default—reflect credit analysis by financial market participants. For example, a debt service coverage ratio of 0.89 indicates that the company’s net operating income is enough to cover only 89% of its annual debt payments.
Underwriting commercial credit requires a larger number of quantitative and qualitative data points, which go into a risk model to calculate a corporate credit rating. Typical education credentials often require a business related bachelor’s degree majoring in finance, business, statistics, or accounting (to include an emphasis in finance or economics). An MBA is not required, however is increasingly being held or pursued by analysts, often to become more competitive for advancement opportunities.
How is Credit Analysis Conducted?
In the investment world, credit analysis also often revolves around ratings from a company such as Fitch, Moody’s, or Standard & Poor’s. Generally, the higher the rating, the more likely the borrower is able to fulfill its obligations. This can apply to anything from rating a country’s creditworthiness as it relates to government debt securities to rating a specific company’s bonds.
Structured finance, a segment of the debt markets that includes securities backed by such pools of assets as residential and commercial mortgages as well as other consumer loans, will not be covered here. A low rating, for example, typically means there’s a higher risk the borrower will default on the loan, which means the investor could lose their principal. So it’s possible that earning such interest from several bond investments more than compensates for a few defaults. A credit analysis usually involves a scoring system that is unique to the reviewing party, and which is designed to maximize its returns while minimizing bad debt losses. The analysis may involve various ratios for the analysis of debt loads, earnings volatility, and the adequacy of cash flows.