What Is Credit Analysis?
Credit analysis is a type of financial analysis that an investor or bond portfolio manager performs on companies, governments, municipalities, or any other debt-issuing entities to measure the issuer's ability to meet its debt obligations. Credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity's debt instruments.
Key Takeaways
- Credit analysis evaluates the riskiness of debt instruments issued by companies or entities to measure the entity's ability to meet its obligations.
- The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.
- The outcome of the credit analysis will determine what risk rating to assign the debt issuer or borrower.
How Credit Analysis Works
To judge a company’s ability to pay its debt, banks, bond investors, and analysts conduct credit analysis on the company. Using financial ratios, cash flow analysis, trend analysis, and financial projections, an analyst can evaluate a firm’s ability to pay its obligations. A review of credit scores and any collateral is also used to calculate the creditworthiness of a business.
Not only is the credit analysis used to predict the probability of a borrower defaulting on its debt, but it's also used to assess how severe the losses will be in the event of default.
The outcome of the credit analysis will determine what risk rating to assign the debt issuer or borrower. The risk rating, in turn, determines whether to extend credit or loan money to the borrowing entity and, if so, the amount to lend.
Credit Analysis Example
An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest, principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow.
For example, a debt service coverage ratio of 0.89 indicates that the company’s net operating income is enough to cover only 89% of its annual debt payments. In addition to fundamental factors used in credit analysis, environmental factors such as regulatory climate, competition, taxation, and globalization can also be used in combination with the fundamentals to reflect a borrower's ability to repay its debts relative to other borrowers in its industry.
Special Considerations
Credit analysis is also used to estimate whether the credit rating of a bond issuer is about to change. By identifying companies that are about to experience a change in debt rating, an investor or manager can speculate on that change and possibly make a profit.
For example, assume a manager is considering buying junk bonds in a company. If the manager believes that the company's debt rating is about to improve, which is a signal of relatively lower default risk, then the manager can purchase the bond before the rating change takes place, and then sell the bond after the change in rating at a higher price. On the other side, an equity investor can buy the stock since the bond rating change might have a positive impact on the stock price.
FAQs
Credit analysis evaluates the riskiness of debt instruments issued by companies or entities to measure the entity's ability to meet its obligations. The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.
How does credit risk analysis work? ›
Credit risk analysis determines a borrower's ability to meet their debt obligations and the lender's aim when advancing credit. Expected losses, risk-adjusted return, and other considerations all serve to inform the outcome of the credit risk analysis process.
How does credit analysis work? ›
Credit analysis focuses on an issuer's ability to generate cash flow. The analysis starts with an industry assessment—structure and fundamentals—and continues with an analysis of an issuer's competitive position, management strategy, and track record.
How do you evaluate credit risk? ›
Lenders look at a variety of factors in attempting to quantify credit risk. Three common measures are probability of default, loss given default, and exposure at default. Probability of default measures the likelihood that a borrower will be unable to make payments in a timely manner.
Why is risk assessment important in credit analysis? ›
Credit risk evaluation is essential to determining if a customer is at risk of defaulting on payments. Carrying too many high-risk customers, or even just a few significant-transaction customers who are a potential default risk, can be very detrimental to your business.
What are the 5 Cs of credit risk analysis? ›
The five Cs of credit are character, capacity, capital, collateral, and conditions.
What are the steps in the credit analysis process? ›
Credit analysis involves detailed financial analysis techniques, such as ratio analysis, trend analysis, financial projections as well as a detailed cash flow analysis.
- What is the process of credit analysis? ...
- Information collection process. ...
- Analysing accuracy of the information. ...
- Decision-making process.
Here are the key factors that lenders typically consider during credit appraisal:
- Credit history. Lenders obtain credit reports from major credit bureaus, such as TransUnion CIBIL, Equifax, or Experian. ...
- Financial statements. ...
- Credit score. ...
- Debt-to-income ratio (DTI) ...
- Employment and income verification.
Concept 86: Four Cs (Capacity, Collateral, Covenants, and Character) of Traditional Credit Analysis.
What is a credit report analysis? ›
Credit report analysis involves evaluating the information contained in a credit report such as the personal details of a customer, their credit summary, any inquiries made, foreclosures and repossessions, and public records on bankruptcies. A credit report provides a credit record of an individual or corporate entity.
In conclusion, credit analysis is a critical process that helps lenders and investors assess the creditworthiness of borrowers and manage credit risk effectively. It also helps lenders and investors make informed decisions about extending credit or investing in a particular borrower or investment opportunity.
What are the key risk indicators of credit risk? ›
Credit Risk Indicators: Potential KRIs include high loan default rates, low credit quality, the percentage of high-risk loans in the portfolio, or high loan concentrations in specific sectors.
What is the credit risk value at risk? ›
Credit VaR is similarly defined but focuses on credit risk loss, which can arise from defaults, downgrades, or credit spread changes. In other words, credit risk VaR represents the potential loss in credit risk that is unlikely to be exceeded over a given period of time at a given level of confidence.
What is an example of a credit risk? ›
A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan. A company is unable to repay asset-secured fixed or floating charge debt. A business or consumer does not pay a trade invoice when due. A business does not pay an employee's earned wages when due.
How to deal with credit risk? ›
7 tips for effective credit management and avoid business risks
- Establish a direct contact with the company beyond the salesperson.
- Investigate the company.
- Stay informed by talking with your peers.
- Insure your business transactions.
- Do not grant credit overruns easily.
- Retain or request proof.
Concept 86: Four Cs (Capacity, Collateral, Covenants, and Character) of Traditional Credit Analysis.
Which technique is used in credit risk analysis? ›
Credit risk analysis models can be based on either financial statement analysis, default probability, or machine learning. High levels of credit risk can impact the lender negatively by increasing collection costs and disrupting the consistency of cash flows.
What is the salary of credit risk analyst in JP Morgan? ›
Average JPMorgan Chase & Co. Credit Risk Analyst salary in India is ₹19.2 Lakhs for less than 1 year of experience to 6 years. Credit Risk Analyst salary at JPMorgan Chase & Co. India ranges between ₹8.3 Lakhs to ₹32.0 Lakhs.
What is the difference between a credit risk analyst and a financial analyst? ›
The primary distinction between these roles lies in their focus and scope. Credit Analysts are primarily dedicated to assessing credit risk and facilitating loan approvals, whereas Financial Analysts have a broader mandate, encompassing financial planning, investment analysis, and budget management.
