Credit Analysis
Credit analysis is considered the back bone of the banking industry. It actually helps investors, lenders, and other financial institutions, in determining how credit worthy any particular individual or a particular firm or a particular government is.
The process determines the ability to pay back debt obligations of a borrower for the decision-maker.
Credit analysis is one of those tools that can help a person understand the concept and importance of credit in the evaluation process and enable them to understand how their lending, investment, or portfolio management will be affected.
The article deals with the concept of credit analysis, methodology in measuring risk, and gives examples on how such research is necessary.
What is Credit Analysis?
The credit analysis refers to the determination of the financial strength of the borrower, hence creditworthiness.
In short words, it involves taking into account all that can have a bearing on the chance that the lender might recover his or her debt by the borrower returning the same to him or her.
Basically, credit analysis has been used to determine the possibility of default through which judgments can be passed on lending or investing in the instruments of debts from the borrower.
Major parties involved in credit analyses include financial analysts, rating agencies, banks, and investors;
who make these analyses either qualitatively or via a combination of quantitative approaches which draw an opinion regarding the financial standing of the borrower, management, the business atmosphere among other determinants critical in judgment of their plausibility of paying off the debt.
In most cases, the output appears as a credit score or rating depicting how plausible he/she can be in repaying his/her debt.
Role of Credit Analysis in Risk Evaluation
Credit analysis essentially evaluates the likelihood that a borrower will not honor his or her debt obligations to pay. That risk, of course, is credit risk, and there are many varieties:
Default risk
the likelihood that the borrower will fail to pay interest or principal based on the scheduled payment.
Credit rating risk
The risk in case the lender downgrades his credit rating of the borrower to raise the price of borrowing.
Liquidity risk
A situation where a borrower may be facing liquidity such that he does not have liquidity for short term obligations.
Risk interest rate
Changes in the interest rates risk where the debtor will be forced to repay a loan.
In the proposal, the analyst comes forth with a lot of key elements that would point toward the level of financial health by the borrower,
and consequently his potential to repay the same while carrying out the assessment of credit risk.
Such key factors would consist of credit history, financial statements, industry outlook, and even macroeconomic conditions.
Key Features of Credit Analysis
Credit History and Scorecard
To start with, the analyst is going to dig into the borrower’s credit history. This covers past borrowing activities, repayments, and whether such a borrower ever defaulted or got bankrupted at any one given time.
Comparatively, less risk is put on a borrower who has records of always making his debtful obligations than him who has experienced missed payments or defaults and issues related to bad credit.
Example: One will be more believable as a borrower who, for instance, had a clean record for repaying the loans and had credits.
Accordingly, a good credit rating should be acquired. A person with different sorts of missed payments or even one with a bankruptcy history may look riskier.
Actually, perhaps the most primitive tool in companies’ credit analysis is a financial statement. Probably, the majority of the issues related to an issuer’s key financial position were disclosed through the issuer’s three important financial documents: a balance sheet, an income statement, and cash flow statement
Income Statement
It reports the income or loss of a borrower in terms of revenue, cost, and then profit or loss earned.
Balance Sheet
This balance sheet shows the assets, liabilities, and equities of the borrower.
Cash Flow Statement
It quantifies the flow of cash to and from a company; thereby it explains and gives the statement of liquidity together with being liquidable.
Example: An infinitely lesser-risk borrower, therefore, would be a more profitable and higher cash-flow generating firm than the most highly indebted firm which, being relatively lesser in terms of profitability.
Debt Levels and Leverage
A credit analysis has to incorporate one essential element which is associated with the leverage ratio of the borrower; it comes out to be a ratio of the debt that finances the business.
A huge leverage ratio can imply that loads of debts used in financing business operations are undertaken, and in case of an economic downturn prevailing, the likelihood of chances for defaulting stand bigger.
For example, if an enterprise has an asset level of $10 million with the debt level of $7 million, its leverage ratio would be 0.7. That is, it is at 70%.
That in itself is not something bad, but if the ratio is that level, say 90%, then it means the enterprise is highly dependent on debt financing instead of the equity financing.
Therefore, it can catch any recession and its impact.
Industry and Economic Environment
The overall industry and economic environment in which the borrower conducts business is another aspect of credit analysis.
For example, such aspects include industry conditions that would speak to the extent of competition, the regulatory environment, and overall market trends.
All these impact the risk appraisal for a borrower.
Other macro factors that influence the ability of a borrower to generate income and pay back his loan are interest rates, inflation rates, and economic growth.
A borrower who has other business activities in industries under recession bears more risk than those seen in booming industries.
For example, this may make an innovative firm with a reputation to grow fast seem a safer debtor than any retailer firm fighting stresses from the impact of e-commerce and changed consumer behavior.
Management Quality
The other qualitative factor of credit analysis is the quality of management. A well-managed company with good past decisions and strategic visions is a credit positive.
A less effective or inexperience management usually ends up creating problems in operations, thus increasing the chance of default.
An example would be that an entity with an experienced top management, especially one that took a company through a recession, will be considered as less risky compared to the borrowing entity whose top management is considered relatively inexperienced or new.
Collateral and Guarantees
In other instances, the lenders may demand that there is collateral or guarantees to hedge against the risks of lending.
Such collateral may be either physical, for instance, real estate or equipment, or it may also be a financial one, like stocks or bonds.
Hence, the existence of collateral would reduce the risk in lending since, in the eventuality of default, it would take the collateral and recover at least part or all the amount due.
Example: It is more probable for a company to be issued loans if there is a mortgage of real estate available as security.
In case there is a failure to pay off, the one borrowing can use the property to sell, hence recovering their amount lent.
Credit Rating and Score
A rating agency such as Moody’s, S&P Global, and Fitch assign ratings to the borrowers.
Such ratings might be easily referred in an attempt to identify the amount of risk involved with the borrower.
Ratings tend to fall between AAA that represents the highest grade with an implication of nearly no risk to D implying a default rating.
Other than formal credit ratings, most financial institutions use credit scores that measure the creditworthiness of a borrower.
Credit scores like FICO scores for personal borrowing are widely used by banks and other lenders to assess consumer borrowers.
Example: A borrower who has been rated AAA is highly creditworthy; whereas, a borrower with BB rating is speculative and has a higher default risk.
Risk Mitigation Strategies in Credit Analysis
Different risk-mitigation techniques applied by the credit analyst in an attempt to mitigate the risks associated with lending or investment.
Diversification: It can be argued that diversifying the loans into numerous different borrowers and sectors is in a position to spread the possible blow of a default from a single borrower
Covenants and Terms
The loan contracts given out by the lenders generally comprise of covenants that some obligations are also bound to the borrowers.
This pertains to limitations over future borrowings or having some particular financial ratios in place or soliciting periodical statements of finances
Credit insurance is something, whereby lenders acquire cover in respect to their obligation upon being defaulted by the borrower so that he may carry out debt servicing.
Securitization: Sometimes the lenders package up the loans and sell them to investors. Therefore, the credit risk is passed on to others.
Credit Analysis in Practical Life
ABC Corp is a manufacturing company for which a bank wants to know whether it would be able to give a loan of $5 million.
Credit analyst at the bank would prepare detailed credit analysis about ABC Corp. It would appear like as follows:
Credit History
The analyst evaluates the credit history of ABC Corp. The corporation has an excellent credit record as no default and delay has occurred in its previous loan cases.
Financial Statements
The analyst reviews the balance sheet and income statement of ABC Corp. The growth rate is stable for revenues; debt-to-equity ratio stands at 40%; cash flows are positive.
Industry and Economic Conditions
Ever-widening gaps in demand in the emerging economies are propelling a spurt in manufacturing. Thus, this augurs well for the near-term prospects of ABC Corp
Quality of Management
The top executive has over 15 years with the organization and has guided the corporation through previous cycles of economic stagnation. To the analyst at any rate, he looks an outstandingly prescient.
Debt Level
ABC Corp debt level is $3 million. Adding the loan in application, it will rise to $8 million.
As cash flow is strong and the debt-to-equity ratio is at a very low level, the bank feels that this risk is well within its comfort zone.
Collateral
The collateral under the loan would be the manufacturing plant owned by ABC Corp. More security for the bank lies outside this point.
Conclusively, by the end of this analysis, the credit analyst of the bank will have reached a conclusion that ABC Corp is a low risk borrower, and therefore the bank will grant the loan. In the extreme case, even the interest rates will decrease as it means low risk.
Conclusion
Credit analysis is fundamentally the most sensitive step in reviewing the risk behind lending or an investment.
That is to say, it analyses many parameters of the borrower-be it financial health and management quality and industry conditions that could pose serious threats to default for a minimum potential.
Credit analysis is important to all lenders, investors, and indeed any financial professional who makes judgments regarding financial dealings accurately.
Summary
Credit analysis is the study of a borrower’s financial status, analyzing his or her ability to pay in order to determine the likelihood of default.
The review involves the study of financial statements, debt burden, industry trends, quality management, and history of credit use.
This measures the possibility that a borrower will repay obligations. This therefore helps inform lenders and investors on diminished-risk decisions.
FAQs
1. What is credit analysis?
Credit analysis assesses the borrower’s ability to pay back debt, based on the financial health, credit history, and industry conditions.
2. Why is credit analysis important?
It helps lenders and investors to determine the risk of default before lending or investing.
3. What factors are considered in credit analysis?
Financial statements, debt levels, industry trends, management quality, and credit history.
4. How do credit ratings affect lending decisions?
Higher credit ratings means lower risk that makes borrowing less difficult, easier, and the interest rate lowers.
5. What is the debt-to-equity ratio?
It refers to the relationship of the debt between the firm to its equity indicating leverage and also financial stability.