Commercial Credit Analyst

What is a Commercial Credit Analyst?

Commercial credit analysis plays an important role in today’s financial world. It helps in assessing an organization's financial health and creditworthiness, which helps creditors or lenders make a much more informed decision while lending money.

It is one of the highly demanded skills required today in the financial markets. Companies often hire credit analysts with strong credit analytical skills to ensure and double-check that the firm's money lands in a safe place.

In the world of finance, any financial entity experiences three major types of risk: 

• Interest rate risk
• Liquidity risk
• Credit risk

In credit analysis, the last listed risk (Credit risk) is the part that is dealt with by credit analysts. A credit analyst needs to have strong analytical skills to make a much more sound and informed decision by analyzing the parameters before lending money.

To understand the role of credit analysis, let’s take an illustration of banks, as banks are usually the ones that require credit analysts the most.

Banks usually run their business on a credit basis. They need to get back the money lent to maintain a smooth cash flow.

If person A has deposited, let’s say, $100 in a bank. The bank will now lend this money to person B at an interest rate of 5%. So the bank must get $105 from person B.

However, the problem here is that if B defaults on his payments, The bank will be unable to give A his money back.

The bank will now have liquidity issues since it does not have sufficient cash to proceed with this transaction. Hence it is important to consider how long an individual will take to return the money borrowed from the bank.

In simple terms, commercial credit analysis involves assessing the creditworthiness of businesses to determine their capability to repay borrowed funds. Banks and other financial institutions frequently employ this evaluation to make well-informed choices.

Commercial credit analysis aims to evaluate the level of risk involved in lending funds to a business. This process entails assessing multiple factors, such as:

• Company's financial statements 
• Past performance 
• Industry trends 
• Managerial competencies 
• Prevailing economic conditions 

The purpose is to gauge the business's capacity to generate adequate cash flows and fulfill its financial responsibilities. Let’s start with the basics first and then build upon them.

What is Commercial Credit and why commercial credit analysis is important?

Credit is the process of giving funds or resources to one party by another party, anticipating that the recipient will repay the borrowed sum later.

It entails a trusting relationship where a lender or creditor provides goods, services, or money to a borrower or debtor, expecting the borrower to reimburse the borrowed amount and any relevant interest or fees within a mutually agreed-upon timeframe.

Credit can manifest in different forms, such as:

• Loans
• Mortgages
• Lines of credit
• Trade credit. 

In all instances, the lender furnishes a specific amount of money to the borrower, enabling them to acquire goods or access funds that are currently beyond their possession.

The borrower accepts the responsibility of repaying the borrowed sum, usually through regular payments distributed over a predetermined period, as outlined in the terms and conditions of the credit agreement.

Credit plays a vital role in any economy as it helps expand consumption, investment, and business operations in the economy. It empowers individuals and businesses to acquire assets, finance projects, and manage cash flow when immediate funds are not readily accessible.

Most individuals perceive credit as an arrangement to acquire goods or services with the commitment to make payment later. This is commonly known as purchasing credit.

Credit cards currently serve as the prevalent method for engaging in credit-based transactions. This introduces an intermediary into the credit arrangement. The bank providing the credit card to the buyer pays the merchant in full, granting credit to the buyer.

Subsequently, the buyer repays the bank gradually over time and accrues interest. One should not confuse loans and credit.

Loans and credits are distinct methods for obtaining funds. In contrast to a loan, credit involves the bank providing the customer with a specific sum of money that can be utilized as required. The customer has the freedom to use all, some, or none of the funds as necessary.

Further, while analyzing a commercial entity for its creditworthiness, a credit analyst uses the 5’C principle, which is used to define the creditworthiness of a company.

Credit Analysis Framework – The 5 Cs

Before approving a loan application, a lender usually evaluates several factors. These considerations are commonly referred to as the Five C's of Credit.

Let’s discuss each one briefly, as these are necessary concepts required for a well-established credit analyst.

Character 

In the context of borrowing money, a borrower's character is determined by their level of willingness to meet their obligations. To assess an individual's character, lenders often evaluate their credit report, which provides a detailed credit history summary.

This report provides insight into the borrower's credit management behavior in the past and helps predict their likelihood of fulfilling their future financial commitments.

Capacity 

Capacity is evaluated by several factors, such as the type and stability of an individual's income source. This includes if the person is salaried, self-employed, or has a commission-based or seasonal job.

In addition, the lender will consider the time the individual has been at their job and the employer's stability. The total Debt Service Ratio is also taken into account.

Capital 

Lenders prefer borrowers who demonstrate their commitment to an investment by investing their funds, reflecting their seriousness and dedication toward the endeavor. 

Net worth is another effective measure of capital. It is determined by comparing an individual's assets to their liabilities. High net worth signifies stability and indicates sound savings or budgeting practices.

Collateral 

In certain loan applications, there may be an opportunity to provide collateral as a means to bolster the application.

Collateral can take various forms, such as a home, a vehicle, or other negotiated assets. By providing collateral, borrowers can also benefit from a reduced interest rate on the loan since it reduces the risk for the lender.

Conditions 

If the lender is aware that the loan has a specific purpose, they may be more able to approve the request than in a situation where the loan is sought merely to have access to available credit.

These are some of the most trusted and renowned credit rating agencies in the financial world, which help credit analysts assess a company’s creditworthiness.

The Role of Credit Rating Agencies in Commercial Credit Analysis

As discussed earlier, these agencies assist credit analysts in gaining more insight into a company's creditworthiness. The market is dominated by 3 players: Standard and Poor’s, Moody's Investor Service, and Fitch Ratings.

These firms hold nearly 95% of the market share, and their ratings are recognized and most widely accepted in the financial world.

So it's important to understand and dive deeper into the concept and importance of credit rating and credit rating agencies.

A credit rating assesses the credit risk associated with a borrower, whether an individual, business firm or government. Its objective is to assess the borrower's capacity to repay the borrowed amount or debt and involves an implied forecast of the probability of default.

Let’s discuss these credit rating agencies in-depth and their role in the world of finance.

Fitch Ratings

Fitch, which is among the leading credit rating agencies globally, has offices in New York and London. Its primary role involves assessing the creditworthiness of companies by considering factors such as their debt levels and vulnerability to changes like interest rates.

Additionally, countries often approach Fitch and other similar agencies to obtain evaluations of their financial standing, considering the political and economic conditions.

Fitch employs a letter grading system to denote credit ratings, with AAA to BBB representing investment-grade ratings indicating a minimal to a low likelihood of default on debt.

In contrast, ratings below the investment grade category span from BB to D, with the lowest rating (D) indicating that the debtor has already experienced default.

Moody’s Investors Service

Moody's, another credit rating agency, assigns letter grades to both countries and company debt, albeit with a slightly different approach.

For company debt, Moody's uses a scale ranging from AAA, the highest grade possible, to BAA3, indicating the debtor's capability to repay short-term debt. 

These grades span from Ba1 to C, with a decreasing probability of repayment as the letter grade descends.

Standard And Poor’s Ratings

Standard & Poor's, a credit rating agency, utilizes a comprehensive set of 17 ratings to evaluate both corporate and sovereign debt. Within this framework, any debt assigned a rating from AAA to BBB- falls into the investment grade category, indicating a strong ability to repay debts.

On the other hand, debt rated from BB+ to D is classified as speculative, implying an uncertain outlook for repayment. As the rating descends, the likelihood of default increases, with a D rating representing the lowest level of creditworthiness.

Summary

Let’s take a look back and summarize the concepts learned. Commercial credit analysis is a crucial process in the financial world that helps assess organizations' financial health and creditworthiness. It enables creditors to make informed decisions when lending money.

Credit analysts with strong analytical skills are in high demand, especially in the banking sector, where it is essential to ensure that funds are allocated safely.

Credit analysis focuses primarily on evaluating credit risk, which is one of the three main risks encountered by financial institutions, alongside interest rate and liquidity risk.

Credit risk refers to the risk of default on payments by borrowers. In the context of banks, lending money to individuals or businesses is crucial for maintaining smooth cash flow.

However, when a borrower fails to meet their payment obligations, it can create liquidity difficulties for the bank, restricting their capability to fulfill withdrawal requests from depositors.

Commercial credit analysis involves evaluating the creditworthiness of businesses to determine their ability to repay borrowed funds. Banks and other financial institutions typically conduct this evaluation to make well-informed lending decisions.

Also, remember about the 5’c of credit, which includes: 

• Character
• Capacity
• Capital
• Collateral
• Conditions

The analysis considers various factors, including 

• Financial statements 
• Past performance 
• Industry trends 
• Managerial competencies 
• Prevailing economic conditions 

The objective is to assess a business's capacity to generate sufficient cash flows and meet its financial obligations.

Credit rating agencies play a vital role in credit analysis. These agencies provide credit ratings that evaluate the credit risk of prospective debtors, indicating their ability to repay debts and the likelihood of default.

The ratings provided by these agencies are widely recognized and accepted in the financial world, assisting credit analysts in assessing a company's creditworthiness.

Fitch Ratings evaluates the creditworthiness of companies based on factors like debt levels and vulnerability to changes.

It employs a letter grading system to denote credit ratings, with AAA to BBB representing investment-grade ratings and BB to D representing non-investment-grade ratings.

Moody's Investors Service assigns letter grades to both countries and company debt, using a scale ranging from A.

Researched and authored by Snehal Kute | Linkedin

Reviewed and edited by Mohammad Sharjeel Khan | Linkedin

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