What is Credit Analysis of a Company?
Credit analysis of a company involves evaluating the financial performance data of a corporate borrower to determine if it generates adequate cash flow to meet the debt payments, i.e., principal and interest payments. The credit analyst seeks to determine the level of risk that the lender subjects itself to by lending to a particular borrower.
For example, if a bank finds that a specific entity shows a high risk of default based on past credit payment history, it will be reluctant to extend credit to such type of borrower. The bank can either choose to reject the loan application or lend at a high interest rate to compensate for the high risk of default.
- Credit analysts are required to obtain qualitative and quantitative data when conducting credit analysis of a company to determine its ability to meet its obligations.
- The analyst relies on the available data to draw conclusions about the creditworthiness of a borrower and the perceived risks.
- Credit analysts may use various tools and techniques such as ratio analysis, cash flow analysis and financial projections to evaluate the financial ability of a borrower.
How Credit Analysis Works
Credit analysts are required to conduct credit analysis of a company to determine its ability to service its debts. It may involve using different financial analysis techniques, such as trend analysis, ratio analysis, cash flow analysis, and financial projections when evaluating the creditworthiness of the entity.
In addition, credit analysis may also involve evaluating the character of a borrower by examining various aspects, such as the collateral provided, owner’s capital in the business, and capacity of the borrower to repay the loan. The bank may also review the credit scores of the borrower by either using its internal credit scoring system or relying on third-party credit rating systems, such as FICO.
The results obtained will determine the risk rating that a borrower will be assigned. The credit rating can be a general rating for all the aspects considered or for a particular financial obligation. It is assigned based on the analyst’s assessment of the borrower’s ability to meet the debt payments in entirety.
A high credit rating shows that, according to the lender’s assessment, there is a high probability of the borrower repaying the loan in full without any difficulty. Conversely, a low credit rating shows that the credit analyst lacks confidence in the borrower’s ability to pay the loan on time and in full. The credit rating that a lender assigns to a borrower determines whether the lender will approve the loan and if so, the amount of loan to be extended.
Functions of a Credit Analyst
A credit analyst is a credit professional who is specialized in financial risk analysis and is tasked with assessing the creditworthiness of a borrower. Credit analysis professionals are typically employed by banks, investment companies, and credit card-issuing companies. Credit analysts are required to review the financial performance reports and credit history of a borrower to ensure that the borrower is able to meet their financial obligations while protecting the lender from losses arising from borrower defaults.
When evaluating the financial health of a borrower, credit analysts may consider different types of financial data, such as earnings history, assets, liabilities, and credit history of the borrower. They can use financial ratios to assess the profitability, liquidity, and financial stability of the borrower.
Afterward, they will compare the obtained results with industry data benchmarks to gauge the financial and competitive position of the entity. The analyst looks for indicators that the entity may present a level of credit risk. Depending on the level of risk that a borrower presents, the analysis will make recommendations of the loan terms and interest rate for a borrower.
Quantitative Data for Credit Analysis
When evaluating the creditworthiness of a borrower, the credit analyst is required to obtain quantitative data to help in assessing the level of risk associated with lending to a specific borrower. The following are some of the quantitative data that credit analysts are interested in:
1. Borrower’s history
The credit analyst considers key information in the credit history of the borrower. They include a background of the company, capital structure, stages of growth, management structure, and experience and qualifications of founders.
They also contain the list of customers and suppliers, the list of product and service offerings, and other information that can help the lender form an opinion about the potential borrower. The information may be required at the new client onboarding process, and the client may be required to provide such information in the loan application form.
2. Key financial information
The borrower is required to furnish the lender with the last financial reports, such as the income statement, balance sheet, and cash flow statement. Some lenders may require borrowers to provide financial statements for the last few years to obtain insights into the growth of the company over the previous financial periods. Other information that may be required includes tax returns, appraisal of assets, and credit reports.
3. Agreements and schedules
The lender may require the borrower to provide certain documents that act as proof of the entity’s financial performance. Some of the documents may include agreements with suppliers and customers, lease agreements, proprietary software licenses, trademarks, patents, among other documents.
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: