What Is Credit Analysis?
Credit analysis is a type of financial analysis that an investor or bond portfolio manager performs on companies, governments, municipalities, or any other debt-issuing entities to measure the issuer's ability to meet its debt obligations. Credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity's debt instruments.
Key Takeaways
- Credit analysis evaluates the riskiness of debt instruments issued by companies or entities to measure the entity's ability to meet its obligations.
- The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.
- The outcome of the credit analysis will determine what risk rating to assign the debt issuer or borrower.
How Credit Analysis Works
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.
Not only is the credit analysis used to predict the probability of a borrower defaulting on its debt, but it's also used to assess how severe the losses will be 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.
Credit Analysis Example
An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest, principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow.
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. In addition to fundamental factors used in credit analysis, environmental factors such as regulatory climate, competition, taxation, and globalization can also be used in combination with the fundamentals to reflect a borrower's ability to repay its debts relative to other borrowers in its industry.
Special Considerations
Credit analysis is also used to estimate whether the credit rating of a bond issuer is about to change. By identifying companies that are about to experience a change in debt rating, an investor or manager can speculate on that change and possibly make a profit.
For example, assume a manager is considering buying junk bonds in a company. If the manager believes that the company's debt rating is about to improve, which is a signal of relatively lower default risk, then the manager can purchase the bond before the rating change takes place, and then sell the bond after the change in rating at a higher price. On the other side, an equity investor can buy the stock since the bond rating change might have a positive impact on the stock price.
FAQs
Credit analysis evaluates the riskiness of debt instruments issued by companies or entities to measure the entity's ability to meet its obligations. The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.
How does credit analysis work? ›
Credit Analysis by Industry
Banks are typically evaluated based on their capital strength, liquidity, and asset quality, whereas real estate developers could be assessed on financial strength, experience, and track record. Energy companies might be rated on their reserves, production, and financial strength.
What is credit risk analysis? ›
Credit risk analysis is the means of assessing the probability that a customer will default on a payment before you extend trade credit. To determine the creditworthiness of a customer, you need to understand their reputation for paying on time and their capacity to continue to do so.
What is the work of a credit analyst? ›
A credit analyst gathers and analyzes financial data associated with lending and credit products. This includes reviewing a borrower's payment history, along with liabilities, earnings, and assets they possess. The analyst looks for indicators that the borrower might present a level of risk.
How is credit analysis defined in Quizlet? ›
Credit analysis is the process where a lender determines a borrower's ability and willingness to repay a loan in accordance with the terms of the contract. Methods are used to do the process via information supplied by the borrower or financial institution.
How to evaluate credit risk? ›
Factors that impact a borrower's credit risk level
- Payment history.
- Current outstanding balances and debt.
- Amount of available credit being used, or credit utilization ratio.
- Length of time the accounts have been open.
- Derogatory marks, such as a debt sent to collection, a foreclosure or a bankruptcy.
- Total debt carried.
An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest, principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow.
What is the first step in credit risk analysis? ›
1. Understand the business In the case of B2B lending, in addition to analysing financial data, it's also crucial to understand the borrower's business. This step involves analysing the borrower's industry, market position, competitive landscape, social status, etc.
What are the 5 C's of credit risk analysis? ›
Lenders also use these five Cs—character, capacity, capital, collateral, and conditions—to set your loan rates and loan terms.
What does a credit risk analyst do? ›
Credit Risk Analysts analyze credit data and financial statements of individuals or firms to determine the degree of risk involved in extending credit or lending money.
If there is a difference, a credit analyst would examine individual credits and the risk analyst would be responsible for the entire risk portfolio.
Where can a credit analyst work? ›
Credit analysts are employed by commercial and investment banks, credit card companies, credit rating agencies, and investment companies. They may also work in the credit departments of a wide range of companies.
Is credit analysis a skill? ›
For a credit analyst to perform his/her responsibilities effectively, they are required to be skilled in several areas, such as financial analysis, due diligence, multitasking, and attention to detail. The skills can be obtained through formal training or work experience.
What is the main focus of credit analysis? ›
Credit analysis focuses on an issuer's ability to generate cash flow. The analysis starts with an industry assessment—structure and fundamentals—and continues with an analysis of an issuer's competitive position, management strategy, and track record.
How is credit analysis defined? ›
Credit analysis is a process undertaken by lenders to understand the creditworthiness of a prospective borrower, meaning how capable (and how likely) they are of repaying principal and interest obligations.
What is credit risk What is the main purpose of performing a credit analysis? ›
Credit risk analysis determines a borrower's ability to meet their debt obligations and the lender's aim when advancing credit. Expected losses, risk-adjusted return, and other considerations all serve to inform the outcome of the credit risk analysis process.
What are the 3 C's of credit analysis? ›
The factors that determine your credit score are called The Three C's of Credit – Character, Capital and Capacity.
What are the 5 C's of credit analysis? ›
Each lender has its own method for analyzing a borrower's creditworthiness. Most lenders use the five Cs—character, capacity, capital, collateral, and conditions—when analyzing individual or business credit applications.
What are the 4 C's of credit analysis? ›
The “4 Cs” of credit—capacity, collateral, covenants, and character—provide a useful framework for evaluating credit risk. Credit analysis focuses on an issuer's ability to generate cash flow.
How are banks doing credit analysis while offering credit? ›
In summary, the bank checks credit repayment history, the character of the client, financial solvency, the client's reputation, and the ability to work with the amount granted as a loan.
