What is Credit Analysis?
Credit analysis is the process of determining the ability of a company or person to repay their debt obligations. In other words, it is a process that determines a potential borrower’s credit risk or default risk. It incorporates both qualitative and quantitative factors. Credit analysis is used for companies that issue bonds and stocks, as well as for individuals who take out loans. To learn more, check out CFI’s Credit Analyst Certification program.
- Credit analysis is a process that determines the ability of a company or individual to fulfill their financial obligations.
- The process contains both qualitative and quantitative factors such as amounts owed, character, and capacity to make payments.
- Credit analysis is used to determine whether a company or individual qualifies for a loan or mortgage. It is also used to determine the quality of a bond.
Uses for Credit Analysis
Credit analysis is important for banks, investors, and investment funds. As a corporation tries to expand, they look for ways to raise capital. This is achieved by issuing bonds, stocks, or taking out loans. When investing or lending money, deciding whether the investment will pay off often depends on the credit of the company. For example, in the case of bankruptcy, lenders need to assess whether they will be paid back.
Similarly, bondholders who lend a company money are also assessing the chances they will get their loan back. Lastly, stockholders who have the lowest claim priority access the capital structure of a company to determine their chance of being paid. Of course, credit analysis is also used on individuals looking to take out a loan or mortgage.
Credit analysis is used by:
- Creditors to determine a corporation’s ability to pay back loans
- Creditors to determine an individual’s ability to pay back a loan or mortgage
- Investors to determine a corporation’s financial stability
- A Commercial Banking & Credit Analyst (CBCA)
Credit Analysis for Loans
When a corporation is in need of capital, it can ask banks for a loan. Banks, or creditors, can be secured or unsecured. As briefly mentioned before, there is an order of priority for claims during bankruptcy. Secured lenders have the first claim on assets used as collateral. They are followed by unsecured creditors.
Of course, creditors would like to avoid a bankruptcy scenario, which is why they utilize a credit analysis process to determine a corporation’s ability to pay back the loan. Loans can also be given to individuals and individuals also go through a credit check.
For corporate loans, the 5 C’s of Credit are often used to determine credit quality:
For individual loans, credit scores are used, which include:
- Payment history
- Amounts owed
- Length of credit history
- Credit mix
- New credit
Bondholders look at a corporation’s bond rating to determine the default risk. Popular rating systems that perform credit analysis include Moody’s and S&P. Bonds that are ranked high are investment grade and have low default risk. Those that are non-investment grade are called high yield or junk bonds. They are dependent on favorable business, financial, and economic conditions to meet financial commitments.
A company that already has high levels of debt will have a lower bond rating, as they are considered to have a higher level of risk. Bondholders are usually behind creditors for claim priorities. So, in the case of bankruptcy, they have less claim on a company’s assets. That’s another reason why high levels of existing debt are a risk.
Equity investors buy stock in a company and benefit from a rise in stock price and from dividends. The credit of a company affects investors in two ways: (1) the value of the stock; (2) their claim on assets.
Firstly, the value of the stock depends on the growth and stability of a company. Balancing growth and stability is important and debt plays a role. Debt can drive investment and growth but too much debt will decrease the stability of a company. If a company has too much debt, then the stock value will decrease due to lower perceived stability. Higher debt can signify that there is a higher risk the company will not be able to satisfy its financial commitments and that its stock price will drop.
On the other hand, if a company has no debt at all, then investors will wonder if the company has the ability to expand and grow. If not, then stock prices will not appreciate. Credit analysis helps determine both the growth potential and stability of a company.
The second concern for equity holders about credit quality is the claim on assets. Equity holders have the least claim on assets of a company in the case of bankruptcy. If the company goes bankrupt, shareholders will get their claim only if secured and unsecured creditors did not already take all the remaining assets. This is why the level of existing debt is important for equity holders as well.
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