Credit Analysis Process

It is the process that desires to calculate a corporation's creditworthiness or any debt issuing entity to calculate the corporation's debt and previous default rate.

Credit analysis is the process conducted by funders, bond managers, banks, and financial institutions that desire to calculate a corporation's creditworthiness or any debt issuing entity to calculate the corporation's debt and previous default rate. In addition, it helps them to calculate the risk associated with investing in corporations. 

It is a procedure in which the lender analyzes the corporation or individual that requested the loan or debt instrument. This activity is conducted to provide the lender with an insight into the company's financial performance requesting the loan. 

This activity consists of many techniques, like cash flow, trend, risk, ratio, etc. 

Each of these techniques is conducted to determine the level of risk the lender will be exposed to in case they provide the requested loan or debt tool to the requesting corporate or individual. 

We have to understand that a corporation with debt does not mean a negative indication. On the contrary, it can mean the opposite, which is growth. But too much debt and weak cash flows can translate to many issues, which can mean unhealthy financial performance by the corporate.  

Such analysis is not only done for corporations or individuals wanting to run a business. Still, banks can also conduct it on individuals who wish to borrow money for personal matters. 

The bank will need to know the default rate and the creditworthiness of the individual requesting the loan. 

How does it work & examples?

This analysis is not an easy task. It needs a long period ranging from weeks to a full month. It also consists of many stages. The following are the critical stages taken to conduct full credit analysis of different institutions. 

1. Gathering of information

This stage is the first and most crucial stage in this analysis. The history of loan applicants is put under a microscope, and information regarding repayment records, financial solvency, and bank transactions is analyzed thoroughly. 

In addition, lenders will also gather information about the purpose of the requested sum or loan and the available collaterals that can be presented by the loan applicant, whether an individual or a corporate. 

This information is up to date, and the lender will take the best approach to gather accurate information. 

2. Information analysis

The second most important stage is information analysis. At this stage, the lender or the loan provider will analyze the gathered information about the applicant. This analysis will emphasize the accuracy of the information collected. 

This is done in variable ways. For example, it can be done through the applicant's bank, company, and any other entity the applicant had financial transactions. 

This stage must ensure the accuracy of the gathered information as the following stages will rely on this collected information. 

3. Approval or rejection

For the typical credit analysis process, this is the last stage conducted. At this level, the lender will formulate a decision regarding the applicant's request for the loan. This is done solely by the credit provider or the lender. 

At this stage, the lender would have reviewed the applicant's information and analyzed the information gathered. 

The lender will measure or compare the risk associated with the applicant and the level of risk they are willing to take, or they usually consider it at a reasonable rate. 

Let's take an example to help us better understand this analysis process. Our model will take the elements of a financial ratio's debt service coverage ratio utilized in the analysis process. 

The debt service coverage ratio calculates the level of cash flow ready with the loan applicant to pay back the debt. 

The DSCR under 1 translates to negative cash flow, and the DSCR above 1 translates to positive cash flow.

A DSCR of 0.78 demonstrates that the corporation's cash flow covers 78% of the annual debt payment.

Alongside fundamental elements utilized in credit analysis, natural or environmental elements like competition, taxation, regulatory climate, and globalization can also display the applicant's readiness or capability to repay the loan.

Credit analysis ratios

Multiple ratios are utilized in the process of credit analysis. This is to assist in the decision-making stage. 

These ratios will be an eye factor to look for by lenders and investors as they indicate different things related to the corporation's performance. 

Here is a list of the ratios: 

  • Liquid Ratios: These ratios involve a corporation's ability to pay back its expenses, creditors, and other short-period obligations.
  • Solvability Ratios: These ratios engage with a company's balance sheet elements.
  • Solvency Ratios: This ratio concerns the corporation's capability to pay back its long-term debt. If it is not good enough, then there are possibilities that the business solvency is negatively impacted in the long run.
  • Profitability Ratios: These ratios demonstrate the corporate's possibilities to make profits.
  • Efficiency Ratios: These ratios display the corporation's ability to make and manage its expenses.

Analysis: 

  • Cash Flow Analysis: This analysis displays a fair picture of the cash flow in the business.
  • Collateral Analysis: The collateral or asset provided as a security against the loan should consist of the qualities of stability, transferability, and marketability.
  • SWOT Analysis: This analysis is conducted to manage the expectation and reality of the situation in the market

5c's of credit analysis 

These five C's represent the major elements any credit analysis personnel looks upon to analyze accounts or loan applicants. They vary in nature, but the end goal is to identify a bad account or account that would likely default in loan repayment vs. an account with a high chance of repaying the debt. 

1. Character 

This section analyzes the overall impression of the borrower. The lender formulated a very subjective belief or opinion regarding the trustworthiness of the individual or corporate to repay the loan. 

Separate requests, background, experience, market view, and other information streams can be an approach to gathering qualitative information. Then an opinion can be articulated whereby the lender can decide about the applicant's character. 

2. Capacity 

It means the borrower's capability to repay the loan from his profits which were generated by his business endeavors. Perhaps, this is one of the most crucial elements of the five elements.

The lender can calculate the amount of repayment that should be paid through statements like cash flow from operations. 

Factors like the probability of successful repayments, payment history, and timing of repayments can all be estimated at the probable capacity of the applicant to repay the loan.

3. Capital 

It represents the applicant's capital invested in the business. It is considered proof of the applicant's commitment to the business. It also shows how much the loan applicant is at risk in case of business failure.

It is expected that loan applicants will contribute to their businesses with their assets to a certain level as a financial guarantee. Good capital contribution by loan applicants will strengthen the trust bond between them and lenders. 

4. Collateral & guarantees 

It is a form of security the borrower will provide to the lender as financial security in case the debt is not repaid. 

On the other hand, guarantees are documents that bind the applicant to conduct loan repayment through other individuals like family members or friends. 

Receiving sufficient collateral or guarantees may deem it suitable to cover part, or the whole amount loan bears great significance. This is an approach to lower default risk. 

Collateral security can be used multiple times to kick off distasteful elements that may have come to the forefront during the screening process.

5. Conditions 

This describes the purpose of the loan request, along with the terms under which the entity is sanctioned. For example, purposes could be working capital, purchasing additional equipment or inventory, or a long-term investment

Before labeling the entity, the loan provider will consider many elements, such as macroeconomic conditions, currency status-quo, and the industry's overall performance. 

Use, and it's important

The use of credit analysis depends on the purposes of the conducting party; usually, this is a financial institution that wants to establish a financial connection with the account or the individual who represents the account. The values are many, but for a financial institution, it's direct. 

  • It is beneficial for the loan providers as it assists them in specifying the borrower's capability to repay the loan.
  • It is beneficial for investors as it assists them in specifying a corporation's financial situation.
  • It assists corporations in satisfying their need for capital by which they can scale their business.

It is beneficial for banks, corporations, investors, etc. As for the expansion of the business, corporations need capital that can be fulfilled by issuing bonds, shares, or by taking a loan. 

From the lender's point of view, it is essential to have safety and surety against the loan being granted.

For this, the credit analysis helps both the corporation and the lender as it will provide surety to the lender by providing the corporation's creditworthiness. As a result, the lender can invest the money depending upon the level of risk.

conclusion 

Credit analysis is an approach for analyzing risk. Studying risk and analyzing risk is a crucial task for an individual or a corporation that provides credit services or loaning services, as it will determine whether they will have profits from their services or carry many bad debts and defaults. 

If understood, this analysis can be conducted even by individuals, but it will require experience as it is neither an easy nor a short task. Yet, despite the complexity and duration needed, this analysis is needed to ensure the mitigation of risk. 

Conducting this analysis relies on information; the more accurate this information is, the more precise the results are. 

In the end, it does not guarantee absolute, but it tries to bring decision makers to the right decision that can be taken regarding a loan request as much as possible. 

As a corporate or an individual, you should be aware that any institution you will request a loan or a loan tool from will run your company through a background check to see the overall financial performance of the company or your financial performance as an individual. 

Today, credit analysis is looked upon differently as the source of the needed information is changing. 

For instance, your mortgage payments would play a major role in your creditworthiness score, while today, your credit card repayments might carry a much heavier value for lenders than a mortgage. Nonetheless, both are still used for credit analysis. 

More and more elements are being included to provide lenders with an accurate risk ratio or cash flow analysis, which translates to a more accurate decision regarding which loan or loan tools the lenders should provide or grant their requests.

This analysis will always exist even if the form and elements change, as it's crucial to understanding the probabilities of pay-back vs. defaults. 

Defaults can occur due to many factors, but knowing the probabilities can save you cash and provide you with good investment probabilities. 

Different types of analysis can be conducted to mitigate the risk associated with borrowers. 

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Researched & Authored by Ahmed Fagiry | LinkedIn

Reviewed and Edited by Sakshi Uradi | LinkedIn

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