Credit Analysis

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 riskCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally, or default riskDebt DefaultA debt default happens when a borrower fails to pay his or her loan at the time it is due. The time a default happens varies, depending on the terms agreed upon by the creditor and the borrower. Some loans default after missing one payment, while others default only after three or more payments are missed.. It incorporates both qualitative and quantitative factors. Credit analysis is used for companies that issue bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. and stocksCommon StockCommon stock is a type of security that represents ownership of equity in a company. There are other terms – such as common share, ordinary share, or voting share – that are equivalent to common stock., as well as for individuals who take out loansLoanA loan is a sum of money that one or more individuals or companies borrow from banks or other financial institutions so as to financially manage planned or unplanned events. In doing so, the borrower incurs a debt, which he has to pay back with interest and within a given period of time.. To learn more, check out CFI’s Credit Analyst CertificationCBCA® CertificationThe Commercial Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more. program.

Uses for Credit Analysis

Credit analysis is important for banks, investors, and investment funds. As a corporationCorporationA corporation is a legal entity created by individuals, stockholders, or shareholders, with the purpose of operating for profit. Corporations are allowed to enter into contracts, sue and be sued, own assets, remit federal and state taxes, and borrow money from financial institutions. 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 bankruptcyBankruptcyBankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts, 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 structureCapital StructureCapital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's 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 mortgageMortgageA mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value.
• Investors to determine a corporation’s financial stability
• A Commercial Banking & Credit Analyst (CBCA)CBCA® CertificationThe Commercial Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more.

Credit Analysis for Loans

When a corporation is in need of capital, they 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 collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments.. 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:

• Character
• Capacity
• Capital
• Conditions
• Collateral

For individual loans, credit scoresCredit ScoreA credit score is a number representative of an individual's financial and credit standing and ability to obtain financial assistance from lenders. Lenders use the credit score to assess a prospective borrower’s qualification for a loan and the specific terms of the loan. are used, which include:

• Payment history
• Amounts owed
• Length of credit history
• Credit mix
• New credit

Bonds

Bondholders look at a corporation’s bond rating to determine the default risk. Popular rating systemsBond RatingsBond ratings are representations of the creditworthiness of corporate or government bonds. The ratings are published by credit rating agencies and provide evaluations of a bond issuer’s financial strength and capacity to repay the bond’s principal and interest according to the contract. 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 bondsJunk BondsJunk Bonds, also known as high-yield bonds, are bonds that are rated below investment grade by the big three rating agencies (see image below). Junk bonds carry a higher risk of default than other bonds, but they pay higher returns to make them attractive to investors.. 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

Equity investors buy stock in a company and benefit from a rise in stock priceStock PriceThe term stock price refers to the current price that a share of stock is trading for on the market. Every publicly traded company, when its shares are and from dividendsStock DividendA stock dividend, a method used by companies to distribute wealth to shareholders, is a dividend payment made in the form of shares rather than cash. Stock dividends are primarily issued in lieu of cash dividends when the company is low on liquid cash on hand.. 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.

Additional Resources

Thank you for reading CFI’s article on credit analysis. To keep learning and advancing your career, we recommend the following CFI resources:

• Credit EventCredit EventA credit event refers to a negative change in the credit standing of a borrower that triggers a contingent payment in a credit default swap (CDS). It occurs when an individual or organization defaults on its debt and is unable to comply with the terms of the contract entered, triggering a credit derivative such as a credit default swap.
• Leveraged LoansLeveraged LoanA leveraged loan is a loan that is extended to businesses that (1) already have short or long-term debt on their books or (2) have a poor credit rating/history. Leveraged loans are significantly riskier than traditional loans and, as such, lenders typically demand a higher interest rate
• Credit Analysis RatiosCredit Analysis RatiosCredit analysis ratios are tools that assist the credit analysis process. These ratios help analysts and investors determine whether individuals or corporations are capable of fulfilling financial obligations. Credit analysis involves both qualitative and quantitative aspects.
• Financial Analyst vs. Credit AnalystFinancial Analyst vs Credit AnalystFinancial Analyst vs Credit Analyst: A financial analyst looks at the whole picture of a company’s finances, while a credit analyst’s sole focus is on debt.