Corporate Credit Analysis

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Corporate Credit Analysis

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Last Updated:November 9, 2023

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What is Corporate Credit Analysis?

Like any other business entity, corporations have cash flow gaps during their operational years. As a result, they tend to fill in these gaps by borrowing cash and requesting loans from different lenders.

Before lenders can lend these corporations the cash or loan requested, they need to conduct a "corporate credit analysis."

The analysis focuses on evaluating a company's financial performance and ability to fulfill its debt obligations once the loan request or any other debt instrument is granted.

In simple words, the analysis aims to determine the corporation's creditworthiness. Professionals conducting this analysis usually focus on the corporation's cash flows that request the debt instrument.

The cash flow analysis will provide them with the needed knowledge to identify the company's ability to pay back its debt obligations and how likely it is to default.

Quantitative data is needed to conduct this complex analysis. This ensures that the credit score given to the corporation before granting its debt instrument request is accurate. The data used to conduct this analysis can be collected from the balance sheets, cash flow statements, and other financial documents that relate to the company extending the loan request.

The loan provider will know the potential client's risk level based on the results.

Corporate credit analysis not only assesses the corporation's financial health but also if the amount provided by the loan or other debt instrument would be enough for the corporation's particular need.

If the requested amount would satisfy the corporate client's cash flow or project funding needs, the lender sees that as a good sign. In addition, the company has set realistic goals it can achieve with the funds requested.

On the other hand, it is a large warning sign if the loan requested is less than what is needed to fill the cash flow gap from current operations or the project launch.

This indicates to the lender that the corporation might suddenly close operations or be unable to finish its planned objectives, which means losses would incur. In that case, the lender might not be repaid the full loan amount.

The sum requested should be sufficient to support the purpose or the intended project but not so much that it overburdens the company to the point that it cannot repay it. As we have mentioned, a cash flow analysis can demonstrate repayment ability.

elements of the corporate credit analysis process

These elements allow analysts to determine the corporation's financial performance and forecast possible risks and issues arising from the company's behavior.

Unpaid Receivables

This refers to the rate at which accounts receivable go unpaid. Therefore, this is also the rate at which bad debts occur.

As these bad debts increase, this translates to more borrowed credit from the corporation or more sold products and services that will not be paid for.

The result is that the corporation faces extra losses, which lowers its credit score.

Unpaid receivables can be assessed through the average collection period. To find the average collection period, divide the value of the accounts receivable by the average sales in a month and then multiply this value by 30 days.

Average Collection Period = Accounts Receivable / Average Sales in a Month * 30 Days

For instance, your total accounts receivables are $30,000, and your average sales in a month are $5,000; when applying the formula gives you the following:

= ($30,000/ $5,000) * 30

= 6 * 30

= 180 days Average collection period

A short collection period is best. This indicates that account receivables are paid quickly. Note that collection periods vary by industry and business model. If accounts go unpaid for a relatively long time, lending to that entity could be risky.

Assets To Liabilities Ratio

A business's assets-to-liabilities ratio is one element that allows creditors to determine the risk involved in lending cash to a corporation.

This ratio is calculated by dividing the corporation's total assets by liabilities. Scoring two or higher translates to being very creditworthy.

The assets-to-liabilities ratio also gives insight into how the firm is funded. For example, firms can be either funded through debt, which is a liability, or share purchases, which is shareholder's equity.

An assets-to-liabilities ratio above one means that the firm is partially funded through equity and may have fewer obligations to other lenders.

Capital Stability

This element represents the commitment and faith the shareholders have toward the corporation. For instance, how much capital would those shareholders be willing to put into the corporation if it performs poorly due to capital shortage? Do the owners contribute?

If the shareholders and founders are willing to generously provide capital when the corporation needs it throughout its operational years, this shows commitment to the loan providers. They realize a belief in this corporation and a support foundation that wants to see it succeed.

Credit Guarantee

Any loan or loan instrument request would require the same sort of collateral as a guarantee against the amount requested by borrowers. In addition, collateral acts as insurance if the borrower fails to pay the agreed-upon loan return installments.

Naturally, lenders would receive the repayment in full rather than the asset. However, they need something that helps them reclaim the value of the loan in case it is not paid. Otherwise, they face high losses.

This is only done to ensure that both parties are treated fairly in this transaction and that no party will be given more risk than the other. However, collateral requirements can sometimes be a significant limitation for some corporations, like start-ups.

Corporate Credit Rating

This rating specifies an entity’s creditworthiness based on several factors. There are rating agencies that rate and offer rating services to corporations.

To develop a balanced and unbiased assessment for investors, corporations often invite multiple agencies to rate their securities.

Corporate Credit Analysis Importance

This analysis is crucial for many loan providers, including banks, investment funds, angel investors, and private equity providers. Such analysis provides these lenders with the much-needed insight to evaluate corporate clients’ credit requests.

When corporations or start-ups decide to expand, they achieve this through bond issuance, stock offerings, or by taking on debt.

Banks and other financial institutions decide whether to lend based on how safe they think it is to lend to a client.

After all, they make their revenues through interest on the loan. This analysis is also essential, for instance, to bondholders who, in a way, lend to corporations by buying these bonds.

Finally, stockholders who are last in line if the firm fails can use the analysis to determine their chances of being paid.

In addition, corporate credit analysis is also helpful for individuals who wish to invest in corporations by buying stocks or through crowd-funding opportunities.

To recap, corporate credit analysis is helpful in the following ways:

Lenders whose business model relies on knowing a corporation’s capability to return loans.
Holders of corporate securities, whose prices and yields change depending on the firm’s creditworthiness.
Stockholders who have their money tied up in the company.
Individuals who want to invest in a particular corporation need a way to assess a corporation’s financial stability and performance.

So we could say that conducting this analysis will provide value not only to lenders or those looking for investment opportunities but also to corporations trying to understand and improve their financial performance and credit score.

This will help them best adjust their operations and plans to expand in a way that helps them mitigate risk and makes them more attractive to investors and lenders.

In addition, once their credit analysis demonstrates good results, they can confidently display their sound performance.

Corporate Credit Analysis Process for different financial tools

Let's take a look at some of the tools below:

Loans

A classic source of funding for corporations is loans. Loans can be secured or unsecured. There are priority stages for collateral claims if a borrower files for bankruptcy.

Secured lenders have the first or priority claim on assets provided as collateral. The latter type of lender then follows them. This is due to their policies and their terms for borrowing.

For corporate loans, the 5 C’s of Credit are often used to determine credit quality:

Character: The borrower’s reputation
Capacity: Their ability to repay the loan
Capital: How much can the borrower put towards the investment themselves
Conditions: The economic environment and the conditions on the loan itself
Collateral: The asset used as insurance for the lender

Bonds

From the bondholder's point of view, the corporation’s bond ratings specify the issuing company’s risk of default.

Some well-known rating agencies that conduct credit analysis include Moody’s and S&P. On the other hand, non-investment grades are called “high yield” or “junk” bonds.

These bonds rely on favorable business, financial, and economic conditions to satisfy financial obligations. As a result, the yield is higher to compensate for the increased risk. Junk bonds often have C or D ratings, the lowest rating available depending on the rating agency.

Companies with high levels of debt will automatically have a low bond rating and be ranked as high-risk corporations, letting investors and lenders know they can easily slip into default as they already have many debt obligations.

Equity

Equity investors or buyers buy shares in a corporation and make profits by selling them when their prices rise and from dividends paid by the company.

Corporate credit analysis can affect the company’s investors because it affects the value of their stocks.

The second key element for those who purchase equity is the claim on assets. This refers to who will get what and when the firm fails.

Equity holders have the last claim on assets. So if a company goes bankrupt and the assets are sold, it will be the last to receive compensation.

They only receive funds after secured and unsecured lenders are paid. Hence the level of existing debt is crucial for equity holders to determine and plan for the worst-case scenarios.

The value of corporate stocks relies on the level of growth and the stability of the company. Balancing these two elements is crucial, and debt is essential in this equation.

The role of debt

Debt can drive up investment and growth, yet excessive debt will affect the company’s stability and standing. For instance, a company with excessive debt will see the price of its stock fall because the public feels that this excessive debt is an indicator of internal issues.

High debt levels can indicate a high risk associated with the corporation and that this corporation will have a hard time paying the incurred debts. This, in turn, means less growth, expansion, and possibly disaster.

On the contrary, if a corporation manages to keep its debts at a reasonable level and always meet its debt obligations, this positively impacts its stock prices.