Credit Analysis Basics
Analyzes corporations or other debt-issuing organizations by an investor or bond portfolio management to assure the company's eligibility to meet its financial obligations
What Is Credit Analysis?
Credit analysis involves the evaluation of a company or entity's ability to pay off its debt. This assessment is sometimes conducted by investors or bond portfolio managers to ensure that the borrower can fulfill its financial obligations.
In simpler terms, the goal of credit analysis is to gauge the likelihood of a company defaulting on its financial commitments. It involves looking at various financial aspects, including operating margins, fixed expenses, overhead loads, and cash flows. It's worth noting that while equity and credit analysis share some common factors, the emphasis on each factor can differ.
Importantly, having a good credit rating doesn't necessarily guarantee a positive stock performance. Understanding how credit ratings function is crucial for analyzing a company's potential in the stock market.
Credit analysis concludes by including an assessment of the available quantitative and qualitative data regarding a client's creditworthiness and recommendations on whether or not to approve the loan request.
Credit analysis aims to determine a client's risk of default and assign a risk rating to each client. The risk rating will decide whether the company will endorse (or reject) the loan application and the amount of credit that will be granted if it is approved.
Key Takeaways
- Credit analysis is conducted to assess the default risk associated with investing in a specific corporation or debt-issuing organization, ensuring its eligibility to meet financial obligations.
- While both equity and credit analysis consider factors like operating margins and cash flows, the emphasis on each varies. Credit analysis is particularly concerned with default risk.
- A good credit rating doesn't guarantee good stock performance. Understanding the workings of credit ratings is crucial for evaluating a company's stock performance potential.
- Traditional methods involve subjective judgment, while credit scoring methods rely on credit history and scoring models. Credit scores, ranging from 300 to 850, influence credit terms.
- The "Five C's of Credit" - Character, Capacity, Capital, Conditions, and Collateral - form the basis for loan decisions. These criteria assess a borrower's dependability, ability to repay, financial strength, economic conditions, and collateral.
Methods of Credit Analysis
The following are the methods of credit analysis:
1. The classic method of CAB
Traditionally, most banks relied on subjective judgment to assess a corporate borrower's credit risk. Bankers essentially used information on various borrower characteristics (5 C's of Credit) – such as character, capital, capacity, and collateral – to determine whether or not to make a given loan.
Creating this type of expert system takes time and money. As a result, banks have attempted to replicate their decision-making process occasionally.
Even so, many banks continue to rely primarily on their traditional expert system for evaluating potential borrowers when granting credit to corporate customers.
2. Credit Scoring Method
One of the most critical aspects of credit risk assessment is determining customer dependability in terms of timely loan repayment. This is done based on a credit history analysis and scoring based on the characteristics of the customer.
Credit bureaus frequently provide information on how customers have paid back and continue to repay their debts. In contrast, credit scoring models are used in customer assessment.
What is the credit score about? A credit score is a three-digit number between 300 and 850, representing your credit risk. Credit risk means the possibility of paying your bills on time.
There are numerous credit scores and scoring models. In general, higher credit scores result in better credit terms.
What factors influence credit score calculation? Credit scores are calculated using information from your credit reports, such as payment history, debt amount, and length of credit history.
Higher scores indicate that you have previously demonstrated responsible credit behavior, which may give potential lenders and creditors more confidence when evaluating a credit request.
Credit score ranges differ depending on the credit scoring model used but are generally similar to:
- 300-579: Bad
- 580-669: Fair
- 670-739: Good
- 740-799: Very good
- 800-850: Excellent
Credit Analysis Framework – The 5 Cs
The first things all lenders learn and use to make loan decisions are the "Five C's of Credit": Character, Conditions, Capital, Capacity, and Collateral. These are the criteria your prospective lender uses to determine whether to make you a loan.
The 5 C's are:
1. Character
As a borrower, this assesses your dependability and trustworthiness. Lenders will typically check your credit score, credit history, and how you've handled your debt obligations in the past.
2. Capacity
This needs to consider your cash flow and indicate your ability to repay your debt. Banks and lenders want to know if potential borrowers have enough cash to repay what they borrow.
3. Capital
Lenders assess your debt level, net worth, and equity to determine your access to capital. The more equity you have and the less total debt you have, the better to assure that your loan application gets approved.
4. Conditions
Lending institutions analyze the new economic state of the business's industry, as well as the borrower's intended use of the funds. They also want to know how the borrower intends to use the loan proceeds.
5. Collateral
This refers to the business and personal assets you can use to secure the loan. The other four characteristics will be more critical for loans that do not require collateral, such as an unsecured loan.
The three critical steps for any credit analysis
We will take a look at the three critical steps for any CAB. These are:
1. Information gathering
Banking information, such as credit extensions, payment history, and sources of recovery, is required at this early stage.
For example, in the case of a corporation seeking a loan, a credit analysis would look into future investments and how the borrowed funds will be used.
Similarly, lenders will look into whether the person, either physical or legal, has guarantees ensuring the full repayment of the debt.
2. Information analysis
This process in traditional credit scoring begins with verifying documents such as identification, passports, and business licenses, among others. It then examines previous financial data such as balance sheets, financial statements, cash flow, etc.
In the case of a company, the project's scope is also investigated, that is, whether the project is scalable, as well as its business performance, competition levels, and company growth.
Analysts use this information to determine potential risks and whether the individual or institution will have enough liquidity to repay the loan. However, because this is a manual process, it can take a long time.
3. Decision making
After the analyst collects and verifies the information in a traditional credit analysis model, he identifies the risk. Then, he sends his positive or negative recommendation to a credit committee, which makes the final decision. As a result, there are more time delays.
What are the Keystones of Credit Analysis Basics?
Some of the keystones are:
1. Financial circumstances
A borrower's financial assessment examines its revenue and cost structures independently (using a cross-section of meaningful ratios and metrics) compared to peer-group and industry benchmarks.
A company is considered creditworthy if it has a cost structure that allows it to generate generally higher-than-average profits throughout all stages of its business cycle.
A strong company should demonstrate pricing power or the ability to pass on increases in raw material and component costs to customers at higher prices. It should also demonstrate management flexibility in responding to changing market conditions by adjusting production and labor costs.
A company is considered weak for credit purposes if it can only generate above-average performance during the peak of its business cycle when demand is high.
A company is also considered weak if it is regularly hampered by burdensome fixed costs and has a limited track record of successful cost reduction, especially if its prices are already higher than its peers.
2. Competitive position
A company's competitive position in its market can significantly impact its ability to sustain its financial position so that detailed credit analysis may consider competitive factors and situations.
- A business strategy that appears to be consistent with industry trends and adaptable to market changes indicates a solid competitive position.
- A poorly articulated business strategy that is clearly at odds with market trends, products that show little or no price premium over competitive products, high rates of customer defection or dissatisfaction, and a low rate of reinvestment relative to peers are all indicators of a weak company.
3. Business environment
Country risk is an analysis of how changes in the political, legal, regulatory, social, and tax climates can impact countries where the company does significant business and may hurt the company's business activities.
- Isolation from these risk factors is an indication of a company's strength.
- On the other hand, indicators of weakness could include costs that fluctuate significantly due to frequent currency translation gains and losses and earnings that fluctuate considerably as the company moves through the peaks and valleys of an industry cycle.
What are the credit analysis techniques?
Some of the techniques are:
1. Ratio analysis
Your debt-to-credit ratio, also known as your credit utilization rate or debt-to-credit rate, is the amount of available credit you use divided by the total amount of credit available to you or your credit limits.
Companies use ratios to compare themselves. For example, they assess stocks within a specific industry. Similarly, they reach a company's current numbers to its historical numbers.
In most cases, understanding the variables driving ratios is also essential because Management has the flexibility to change its strategy to make its in-stock and company ratios more appealing.
Ratios are generally used in conjunction with other ratios rather than alone. However, knowing the proportions in each of the four previously mentioned categories will provide you with a comprehensive view of the company from various perspectives and assist you in spotting potential red flags.
2. Trend analysis
A trend analysis evaluates an organization's financial data over time. Depending on the circumstances, periods can be measured in months, quarters, or years.
The objective would be to compute and analyze the amount and percentage change from one period to the next. When adding numerical data to a chart, you can identify three types of trends.
- Upward trend: An uptrend, also known as an upward trend, indicates that your data points are increasing. Depending on the variable you're looking at and your goal, this could mean different things.
- Downward trend: A downward trend, on the other hand, indicates that the value of your variable is decreasing. For example, investors may need to proceed with caution if a company's profit falls sharply because the stock is risky. After all, its price is falling.
- Horizontal trend: The horizontal line represents stagnation. In other words, prices and other metrics are not rising or falling; instead, they are stagnant. Therefore, investing based on horizontal trends is risky because you never know what will happen.
3. Cash flow analysis
Cash flow analysis determines a company's working capital, which helps you understand whether your company can pay its bills and generate enough cash to continue operating indefinitely.
Long-term negative cash flow situations can indicate impending bankruptcy, whereas consistent positive cash flow often shows good things to come.
4. Projections
Project analysis evaluates every expense or problem associated with a project before the start of work on it. The selection process begins after determining the profitability of a project.
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