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.
What is the basis and usually used in evaluating a credit risks? ›
It involves analyzing factors such as financial history, credit score, income stability, debt levels, and repayment behavior. By evaluating these factors, lenders can gauge the borrower's capacity, ability, and willingness to repay the loan, mitigating the risk of default.
Where do credit risk analysts work? ›
Credit risk analysts work in the lending and credit departments of investment houses, commercial and investment banking, credit card lenders, rating agencies, and other institutions. They use a variety of analytical techniques to evaluate the risks associated with lending to consumers and to evaluate business risks.
What are the benefits of credit risk analysis? ›
Mitigating risks: This is the primary benefit of having a credit risk management process. Lenders accessing and analyzing borrowers' financial dynamic data reduces risks. This, in turn, lowers the chances of losses to the financial institutions. Reducing Occurrences of fraud: This is another benefit of the process.
How do banks do credit analysis? ›
In summary, the bank checks credit repayment history, the character of the client, financial solvency, the client's reputation, and the ability to work with the amount granted as a loan. Part of the information is provided in credit reports obtained from reputable credit bureaus.
How is credit analysis defined in Quizlet? ›
Credit analysis is the process where a lender determines a borrower's ability and willingness to repay a loan in accordance with the terms of the contract. Methods are used to do the process via information supplied by the borrower or financial institution.
What is credit analysis also known as? ›
But what exactly is credit analysis? Credit analysis (or credit evaluation) is just one of the many terms used to describe the process that a business credit manager goes through to determine a customer's creditworthiness after they apply for a line of trade credit.
What is the credit risk management process? When a borrower applies for a loan, the lender must evaluate their reliability to make future monthly payments. Beyond requests for information on a borrower's current financial situation and income, many lenders will also want to see their borrowing and payment history.
What is credit risk examples? ›
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.
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 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.
Lenders also use these five Cs—character, capacity, capital, collateral, and conditions—to set your loan rates and loan terms.
What are the steps in credit evaluation? ›
A traditional credit analysis requires a strict procedure that involves three key steps: obtaining information, a detailed study of this data and decision-making.
What are the 4 Cs of credit analysis? ›
Concept 86: Four Cs (Capacity, Collateral, Covenants, and Character) of Traditional Credit Analysis. The components of traditional credit analysis are known as the 4 Cs: Capacity: The ability of the borrower to make interest and principal payments on time.
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.
