Credit Analysis

What Is Credit Analysis?

Credit analysis is a type of financial analysis that an investor or bond portfolio manager performs on companies, states, districts, or some other debt-giving substances to measure the issuer's ability to meet its debt obligations. Credit analysis looks to distinguish the fitting level of default risk associated with investing in that specific entity's debt instruments.

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. Utilizing financial ratios, cash flow analysis, trend analysis, and financial projections, an analyst can assess a company's ability to pay its obligations. A survey of credit scores and any collateral is likewise used to work out the creditworthiness of a business.

Not exclusively is the credit analysis used to foresee the probability of a borrower defaulting on its debt, but on the other hand it's utilized to survey how serious the losses will be in the event of default.

The outcome of the credit analysis will figure out what risk rating to assign the debt issuer or borrower. The risk rating, thusly, decides if to stretch out credit or loan money to the borrowing entity and, provided that this is true, the amount to loan.

Credit Analysis Example

An illustration of a financial ratio utilized in credit analysis is the debt service coverage ratio (DSCR). The DSCR is a measure of the level of cash flow accessible to pay current debt obligations, like interest, principal, and lease payments. A debt service coverage ratio below 1 shows a negative cash flow.

For instance, a debt service coverage ratio of 0.89 shows that the company's net operating income is sufficient to cover just 89% of its annual debt payments. Notwithstanding fundamental factors utilized in credit analysis, environmental factors like regulatory climate, competition, taxation, and globalization can likewise be utilized in combination with the fundamentals to mirror a borrower's ability to repay its debts relative to different borrowers in its industry.

Special Considerations

Credit analysis is likewise used to estimate whether the credit rating of a bond issuer is going to change. By distinguishing companies that are going to experience a change in debt rating, an investor or manager can conjecture on that change and potentially create a gain.

For instance, expect a manager is thinking about buying junk bonds in a company. Assuming that the manager accepts that the company's debt rating is going to improve, which is a signal of relatively lower default risk, then the manager can purchase the bond before the rating change happens, and afterward sell the bond after the change in rating at a higher price. On the opposite side, an equity investor can buy the stock since the bond rating change could decidedly affect the stock price.

Features

• The outcome of the credit analysis will figure out what risk rating to assign the debt issuer or borrower.
• The credit analysis tries to recognize the fitting level of default risk associated with investing in that specific entity.
• Credit analysis assesses the riskiness of debt instruments issued by companies or substances to measure the entity's ability to meet its obligations.