What are the Credit Analysis Basics?
Learning the credit analysis basics is key to achieving success in the lending industry. Credit analysis is an evaluation method that lenders use to determine the financial ability of a potential borrower and the probability that they will be able to honor their financial obligations.
Investors can also perform an analysis of a company to determine the financial performance of a bond issuer to determine its ability to repay the financial obligations at a future date.
- Credit analysis is a method that analyzes an entity’s financial data to determine its ability to meet its debt obligations.
- Banks use credit scoring systems to determine the level of credit risk associated with lending to a potential borrower.
- The bank assigns a borrower a credit rating, which determines whether or not the bank will extend the credit.
Understanding Credit Analysis Basics
Credit analysis draws conclusions by evaluating the available quantitative and qualitative data regarding the creditworthiness of a client and making recommendations on whether or not to approve the loan application. The objective of credit analysis is to determine the risk of default that a client presents and assign a risk rating to each client. The risk rating will determine if the company will approve (or reject) the loan application, and if approved, the amount of credit to be granted.
Credit Analysis: Traditional Approach vs. Modern Approach
Traditionally, banks relied on subjective methods to evaluate the creditworthiness of their clients. The methods focus on the character of the borrower, and the credit analyst is required to assess the level of credit risk associated with lending to the borrower. The traditional approach evaluates the main characteristics of the borrower, commonly referred to as the 5 C’s of Credit. An analysis that is based purely on the characteristics of the borrower is subject to human error and misuse. Banks continue to rely on traditional credit analysis approaches when evaluating potential borrowers.
Unlike traditional approaches, modern credit analysis approaches are based on qualitative credit scoring systems. In such an approach, credit analysts use the univariate accounting-based credit scoring systems to compare key accounting ratios of specific clients versus industry ratios to show how a client’s ratio differs from the industry standards or trends.
Credit scoring systems assign scores to several aspects associated with the creditworthiness of a borrower. The scores can range from 300 to 850, with the latter being the highest credit rating that a borrower can get. The key aspects of a borrower that determine their credit score include payment history, current debt, length of debt, type of debt, and the payment interest. A bank can establish its own credit scoring system or use third party services such as FICO.
Key Elements of Credit Analysis
The following are some of the key elements that lenders or investors are interested in when assessing the creditworthiness of a borrower:
1. Financial Assessment
Financial assessment involves assessing the current cash flows that the business generates to determine if the borrower is in a position to service the debt. The lender can evaluate the financial performance of a company either in isolation or in comparison to other companies operating in the same industry as the lender.
Ideally, a company will be considered to possess strong financials for credit purposes if its cost structure allows it to produce consistently higher than average profits throughout the financial period. It means that the company maintains above-average revenues during the peak season, as well as during a downturn. Such a company will find it easier to get loan approval because it demonstrates a low risk of default.
Conversely, a company with irregular revenues across all phases of the business cycle will be considered weak for credit purposes. It may refer to a company that reports above-average results during the peak season but struggles to generate profits when there is a business downturn because of low market demand. The lender may either reject the loan application on the basis of weak cash flows or extend a lower credit than what the borrower needed and at higher costs.
2. Industry Competitiveness
How competitive is the company in the industry? A bank is interested in lending to a company with a strong competitive position in its specific industry. When assessing the competitiveness of a company, the lender looks at the company’s business strategy and how consistent and adaptable it is to the current trends and changes in the market.
Dominant companies with an upper hand in the market have strong barriers that limit new entrants into the market. The barriers may be licensing agreements, strong patents, copyright protection, and franchises, which may be too expensive for new entrants to afford. Weak companies often have poorly structured business strategies that are not in line with market trends and changes. Such companies also tend to see high rates of customer dissatisfaction and low-rates of reinvestment.
3. Business Environment
The lender looks at the business environment in which a business operates to identify any challenges that the business may be facing and that may affect its ability to honor its financial obligations. For example, the lender can consider the industry risk to determine how the industry dynamics and regulatory climate can affect the performance of the business.
Another consideration is country risk, specifically how the political, legal, and tax climates in the country where the company operates affect its business activities. A company may be considered a viable borrower if it can isolate itself from such risks and create strategic alternatives to hedge against them. On the other hand, a business may be defined as weak if its earnings are greatly affected by changes in business cycles and factors within the business environment.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: