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Concept
Credit analysis
Summary
Credit analysis is the method by which one calculates the creditworthiness of a business or organization. In other words, It is the evaluation of the ability of a company to honor its financial obligations. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan. The term refers to either case, whether the business is large or small.
A credit analyst is the finance professional undertaking this role.
One objective of credit analysis is to look at both the borrower and the lending facility being proposed and to assign a risk rating. The risk rating is derived by estimating the probability of default by the borrower at a given confidence level over the life of the facility, and by estimating the amount of loss that the lender would suffer in the event of default.
Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows.
Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability.
As mentioned, analysts attempt to predict the probability that a borrower will default on its debts, and also the severity of losses in the event of default.
The credit spread is the difference in interest rates between theoretically "risk-free" investments such as U.S. treasuries or LIBOR and investments that carry some risk of default—reflect credit analysis by financial market participants.
Before approving a commercial loan, a bank will look at all of these factors with the primary emphasis being the cash flow of the borrower. A typical measurement of repayment ability is the debt service coverage ratio or DSCR.
A credit analyst at a bank will measure the cash generated by a business (before interest expense and excluding depreciation and any other non-cash or extraordinary expenses).
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