What is Corporate Credit Analysis?
Corporate credit analysis is the process of evaluating the creditworthiness of a corporate borrower by assessing its financial ability to generate enough cash flows to meet its debt obligations. When evaluating the financial ability of a borrower, the credit analyst uses various qualitative and quantitative tools to analyze the financial data provided by the borrower.
The financial data may be obtained from the balance sheet, income statement, cash flow statement, or other financial reports that are specific to the borrower’s business. The outcome of the credit analysis determines whether or not the bank will provide the loan that the borrower applied for, and if so, the amount of loan that the bank can extend to the borrower.
The credit analysis of a corporate entity shows the financial performance of an entity and determines if the loan applied for is enough to meet the financial needs of the entity. If the loan amount that the borrower’s applied for falls below the amount required to carry out the purpose to completion, there is a high risk of the project failing midway and the lender incurring losses.
The amount applied for should be sufficient to finance the purpose or project, pay a salary to the owner and its directors, and meet the operating expenses of the business. An analysis of the current and expected cash flows can determine the entity’s ability to service the debt, and it can demonstrate the extent to which the company can withstand debt.
- The objective of corporate credit analysis is to evaluate the creditworthiness of corporate borrowers.
- The credit analysis provides information on the level of risk associated with extending credit to specific corporate borrowers.
- Credit analysis of corporate borrowers is a complex and lengthy process due to the vast amount of records and documents that a credit analyst is required to evaluate.
What is the Assets to Liabilities Ratio?
The asset to liabilities ratio is a key indicator of the creditworthiness of a company. The ratio compares all the assets owned by a company against every debt it owes to other companies and individuals. The ratio is obtained by taking the value of all assets and dividing it by the value of all liabilities of the company, as shown below:
Assets to Liabilities Ratio = Total Assets / Total Liabilities
The ratio can be interpreted to provide different perspectives. A figure of 2 or greater means that the creditworthiness of the company is high. The higher the figure, the better placed and rated a company becomes in terms of creditworthiness.
If the quotient is 1, it means that the value of a company’s assets and the value of its liabilities are equal, inferring that there is some risk associated with lending to that entity. A figure that is less than 1 means that the company is overburdened with debt and will not sustain any more debt. In such a case, the value of its liabilities exceeds the value of its assets, and there is a high probability that the company will default on its obligations.
Extending credit to such an entity means taking too much risk since the company will likely utilize the funds to pay its liabilities rather than investing in assets that can generate cash flows to settle its debt. Calculating the assets to liabilities ratio can help the credit analyst gain insights into the stability of an entity’s business activities and the level of credit risk exposure.
Components of Corporate Credit Analysis
1. Unpaid receivables
The rate at which receivables are defaulted and becoming bad debt provides insights into how stable an entity is. Bad debts are an expense to the company, and the higher their value, the greater the amount of losses that the business incurs.
The value of unpaid receivables can be obtained by dividing the value of account receivables by the average sales in a month and multiplying the value obtained by 30 days. It gives you the average number of days in a month that the account receivables remain unpaid.
Accounts receivables require payment within a short period of time, usually a few days or weeks. If they go unpaid for a longer duration than is allowed, it means that there is a risk associated with lending to that entity.
2. Capital stability
The capital stability of a company demonstrates the commitment of its shareholders. How much capital can the shareholders add to the business when it is performing dismally? If the owners are willing and ready to provide additional capital for the company, it means that they are committed to seeing the success of the company.
The owners’ support and commitment can give a bank the confidence to lend to the company. The business can, therefore, take up additional debts to stabilize its operations, invest in expansion, and purchase additional assets.
3. Credit guarantee
An entity should be able to provide collateral against the commercial loan they intend to take. The collateral acts as security in case the company is unable to honor its debt obligations. Although no financial lender intends to seize a debtor’s property as repayment for a loan, the collateral serves as insurance if there are no other options of recovering the amount extended to the business as loan.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: