Credit Analysis of a Company
A process that involves evaluating the financial statements of a company, an organization, or an entity, which is the borrower.
Credit Analysis is a process that involves evaluating the financial statements of a company, an organization, or an entity, which is the borrower. It is a kind of Financial analysis that an analyst performs to assign a credit rating to the organization.
"If you think nobody cares if you're alive, try missing a couple of car payments." ~Earl Wilson
The ratings assigned by the credit agencies (For example, CRISIL, S&P Global Ratings (S&P), Moody's, etc.) in the form of alphabets like 'A+' or 'AAA' express their opinions about the ability of the company to attain its financial obligations without defaulting.
Thus, this process ensures that the borrower can repay the debt, the principal amount, and the interest payments and does not run out of cash before the established due date.
The main motive of Credit Analysis is to keep the lender informed about the dangers that they might be exposed to after lending funds to the other party in the picture.
Credit Analysis also includes identifying, evaluating, and mitigating risk factors to provide better insights to the user.
For instance, a Credit Analyst discovers that the credit rating of the borrower firm is less than the lenders' benchmark and that there has been a history of defaults.
They then will warn the lenders that this firm has a high default rate and is most certainly not in a position to realize the loan amount till the due date.
The firm can then arrive at a conclusion based on the results, whether to reject the loan or lend at a high-interest rate to compensate for the risk factor.
However, analysts need to muster quantitative and qualitative data to draw conclusions before the final rating. We have an article for you to read about the Credit Analysis Process.
How does Credit Analysis of a company Work?
To get a fair judgment on whether a company or an organization can repay its debt, banks, big retail investors, and analysts conduct credit analysis on that company. It is a part of the due diligence process conducted by a party of interest in a particular firm.
This is done using various analysis tools and techniques like trend analysis, financial ratios, cash flow analysis, and projections.
By these methods, an analyst can conclude the future standing of the company. Thus, lenders look at the credit scores and any collateral the company may have to evaluate its creditworthiness.
As discussed earlier, credit ratings are performed to assess the borrower's traits by evaluating the data available to us, including the borrower's equity and collateral.
The bank may even check the credit scores either by inspecting along with the internal credit score system of the entity or may approach a third party, like CRISIL, CARE, ICRA, etc., to reach an unbiased outcome.
The borrower is then allocated an appropriate risk rating based on the results obtained.
A high credit rating shows that the lender can take the deal forward as the borrower seems to have enough capacity to repay the principal loan amount with the interest payments when the due date arrives.
Contrariwise, if the credit rating is lower than the prerequisite, the lender can either call the deal off or raise the rates depending upon the credit rating.
It also predicts whether an entity's credit rating is about to shift in the future, transposing the positions of both parties involved in the arrangement.
Numerous financial ratios are used to analyze the results. For instance, DSCR or Debt Service Coverage Ratio is a measurement that detects the firm's cash flow availability and, thus, its capacity to meet its financial obligations.
It indicates if the company has enough cash inflows, or income, to pay for the debt within the due period. The formula for calculating DSCR is as given below:
The 5 C's of Credit Analysis (Qualitative Analysis)
Lenders will always examine your creditworthiness with all the tools and information available. To simplify the task even more, there are five parameters or metrics through which this could be achieved.
The weightage that each category may hold depends totally on the lender's preference.
- Character
- Capital
- Capacity
- Collateral
- Conditions
Now let's take a glance at each one of the parameters.
1. Character
The character of an entity tells about its creditworthiness, personality, and reliability. This factor is essential for the Banks to consider as this ensures that the company is responsible and can keep commitments.
It can be measured by past work experience, credit history records and behavior, references, and public eminence. Remember that these qualitative characteristics help us come to a conclusion.
As Brad Farris, one of the famous Business and Growth Advisors, quoted, "Character is something you can control and promote, but only if you have a bank that cares about relationships."
One should always maintain a good and consistent credit score to qualify for credit easily in the future.
2. Capital
Capital is the amount of total investment made in the business. It may include savings, assets, owner's equity, and borrowings from external sources, either public or private.
Lenders are interested to know the exact mix of capital components in the business investments as they would want to be savvy if the borrower has some "skin in the game," as Warren Buffet would say.
The statement above means that the credit decision would largely depend on the proportion of equity or personal interest of the borrower in the business. This way, the lender is guaranteed financial security up to a certain point.
3. Capacity
Understanding the capacity of a firm to generate cash flows ascertains the ability of the business to repay its debt.
Exact calculations (in a projected manner) are made to know how the repayment will take place in the future.
The capacity could be calculated by a simple metric known as Debt-to-Income or DTI ratio.
To calculate the DTI ratio, we add up all the debt payments for the period and divide it by the pre-taxed income to obtain the ratio. Then, we can multiply it by 100 to convert the figure as a percentage.
Since the DTI is relatively low, it depicts that the student can pay the debts quickly and still has some money to save.
Moreover, one can lower their ratio by either finding a way to decrease debt obligations or increase their income.
4. Collateral
A collateral is a guarantee that secures the loan. That is, it is a backup source for the borrower's failure to repay the loan, and the issuer would take the Collateral.
Moreover, Collateral is a pivotal factor in deciding whether to proceed with a loan issue. If the entity's creditworthiness appears not up to the mark, the Collateral comes to the rescue of that firm.
Consequently, Collateral plays a significant role in determining a loan agreement. Secured loans keep the lenders in the clear.
5. Conditions
Conditions include other miscellaneous information that might assist in reaching the final decision.
It may include reasons like:
- How do you plan on using the borrowings
- Other factors that may be out of our control
Interestingly, people sometimes add a "6th C' to the 5 C's of credit analysis which is the 'credit score' or the 'credit report.'
Qualitative Data
Now, let's look into the quantitative characteristics affecting credit decision-making.
Undoubtedly, a qualitative aspect is critical in the process of Credit Analysis.
As a result, the risk involved needs to be quantified; that is, the risk factor has to be represented using figures to conclude based on quantifiable proof.
a. Credit History
It is one of the main elements to project the future behavior of the entity concerning loan holdings.
It is influenced by many factors, such as owners and/or founder members' qualifications, the growth timeline of the company, the capital structure of the company, etc. All this information is as essential as any other for reaching a stand in the agreement.
b. Financial Statements
Crunching numbers is the fundamental part of any analysis. Therefore, financial statements play a significant role in the quantitative analysis of credit assessment.
The borrower must provide the lender with Financial Reports such as Income Statement, Cash Flow Statement, Balance Sheet, or any other as per the lender's need.
The lenders may even ask the borrowing party for the financial statements for the last few years to gain an insight into how the company has been performing lately.
c. Market Information
The market information like industry size and its current situation, market share, public relation, market standing or competitive advantage, and even the current market listing if the company has gone public already, all these come under mustering marketing information.
You can read more about the Credit Analysis Process here.
Case Study: An illustration
Let's take an example to understand the significance of the process in real life.
Suppose Mr. Stinson, a man from a well-off family, wants to start a business in the food industry. He wants to start a big cafe in the city's most fancy place. He plans on using his life savings and some debt as a capital component.
The estimated capital needed to kick-start his cafe came out to be $2 million, out of which he seeks a loan for a mere $1 million of funds.
He approaches the Bank for a loan, and the following information appears after a thorough background check. He has a lot of family wealth in terms of assets like bungalows and cars and a lot of money (too rich, he seems ;)), thus, securing the loan collaterally covering it partly or wholly.
He owns two more family businesses he has his share in but is headed by his two sisters. These existing businesses are profitable and are known for their adherence to corporate responsibility by donating a part of their profits to children's NGOs.
Thus, ensuring his reputation in the market.
Further, the Bank asks for the plans and decisions undertaken for the new business and analyzes the projections of revenues and costs of business for the future period. It shows a positive trend in revenues generated with a slight increase in the percentage of costs involved.
On that account, Mr. Stinson will get a loan of $1 million, quickly approved by his Bank, to start his cafe shop. However, one should never forget that the forecasts are made over the foundations of simulation tests and not the prevailing reality.
Thus, what happens in the future is still not unveiled, so the loan sanctioned will always have an intrinsic risk factor associated with it.
Conclusion
The example we just saw was the perfect scenario which does not quite happen in the real world.
The real-life cases are much more complicated. Therefore, even though this article provides you with the most basic and standardized credit analysis framework, it is practically impossible to maintain uniformity in the assessment processes of different businesses in distinct industries.
This article focuses on imparting that Credit Analysis aids us in making important decisions regarding loan agreements, keeping in mind the borrower's complete historical, present, and projected records and performance.
Sometimes, you will face a problem with which element to provide more leverage. But this issue could be solved easily by applying analytical tools and techniques to reach a fair conclusion.
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Researched and authored by Anushka Raj Sonkar | Linkedin.
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