Credit analysis is the method by which one calculates the
creditworthiness
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
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
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Because ...
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.
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
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variet ...
by the borrower at a given
confidence level
In frequentist statistics, a confidence interval (CI) is a range of estimates for an unknown parameter. A confidence interval is computed at a designated ''confidence level''; the 95% confidence level is most common, but other levels, such as 9 ...
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
In mathematics, a ratio shows how many times one number contains another. For example, if there are eight oranges and six lemons in a bowl of fruit, then the ratio of oranges to lemons is eight to six (that is, 8:6, which is equivalent to the ...
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
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
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
Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt ...
is the difference in
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s 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
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...
, 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
In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
and any other non-cash or extraordinary expenses).
The DSCR divides this cash flow amount by the debt service (both principal and
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...
payments on all loans) that will be required to be met. Commercial bankers prefer a DSCR of at least 120 percent. In other words, the debt service coverage ratio should be 1.2 or higher to show that an extra cushion exists and that the business can afford its debt requirements.
Classic credit analysis
Traditionally most banks have relied on subjective judgment to assess the
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
of a corporate borrower. Essentially, bankers used information on various borrower characteristics – such as character (
reputation
The reputation of a social entity (a person, a social group, an organization, or a place) is an opinion about that entity typically as a result of social evaluation on a set of criteria, such as behavior or performance.
Reputation is a ubiquitous ...
), capital (
leverage
Leverage or leveraged may refer to:
*Leverage (mechanics), mechanical advantage achieved by using a lever
* ''Leverage'' (album), a 2012 album by Lyriel
*Leverage (dance), a type of dance connection
*Leverage (finance), using given resources to ...
), capacity to pay (
volatility of
earnings Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT (earnings before intere ...
), conditions of the customer's business (purpose of the
loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that d ...
), and
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
– in deciding whether or not to make a given loan. These characteristics are commonly referred to as the 5 Cs. Developing this type of expert system is time-consuming and expensive. Incorporating certain soft (qualitative) data in a risk model is particularly demanding, however successful implementation eliminates human error and reduces potential for misuse. That is why, from time to time, banks have tried to clone their decision-making process. Even so, in the granting of credit to corporate customers, many banks continue to rely primarily on their traditional expert system for evaluating potential borrowers.
Credit scoring systems
In recent decades, a number of objective, quantitative systems for scoring credits have been developed. In
univariate
In mathematics, a univariate object is an expression, equation, function or polynomial involving only one variable. Objects involving more than one variable are multivariate. In some cases the distinction between the univariate and multivariate ...
(one variable)
accounting
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...
-based credit-scoring systems, the credit analyst compares various key accounting ratios of potential borrowers with industry or group norms and trends in these variables.
Today,
Standard & Poor's
S&P Global Ratings (previously Standard & Poor's and informally known as S&P) is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is con ...
,
Moody's
Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides international ...
, and
Risk Management Association can all provide banks with industry ratios. The univariate approach enables an analyst starting an inquiry to determine whether a particular ratio for a potential borrower differs markedly from the norm for its industry. In reality, however, the unsatisfactory level of one ratio is frequently mitigated by the strength of some other measure. A firm, for example, may have a poor
profitability ratio but an above-average
liquidity ratio. One limitation of the univariate approach is the difficulty of making trade-offs between such weak and strong ratios. Of course, a good credit analyst can make these adjustments. However, some univariate measures – such as the specific industry group, public versus private company, and region – are categorical rather than ratio-level values. It is more difficult to make judgments about variables of this type.
Although univariate models are still in use today in many banks, most academics and an increasing number of practitioners seem to disapprove of ratio analysis as a means of assessing the performance of a business enterprise. Many respected theorists downgrade the arbitrary rules of thumb (such as company ratio comparisons) that are widely used by practitioners and favor instead the application of more rigorous statistical techniques.
Fuzzy logic and neural networks are examples of novel methods of developing credit scoring expert systems that deliver greater accuracy in estimates of future performance of a business enterprise. Beside hard data present in traditional ratio analysis, fuzzy logic can easily incorporate linguistic terms and expert opinions which makes it more adapted to cases with insufficient and imprecise hard data, as well as for modeling risks that are not fully understood.
[Brkic, Sabina and Hodzic, Migdat and Dzanic, Enis, Fuzzy Logic Model of Soft Data Analysis for Corporate Client Credit Risk Assessment in Commercial Banking (November 29, 2017). Fifth Scientific Conference with International Participation “Economy of Integration” ICEI 2017 , Available at SSRN: https://ssrn.com/abstract=3079471]
Education and training
Typical education credentials often require a
business related bachelor's degree majoring in finance, business, statistics, or accounting (to include an emphasis in finance or economics).
An
MBA
A Master of Business Administration (MBA; also Master's in Business Administration) is a postgraduate degree focused on business administration. The core courses in an MBA program cover various areas of business administration such as accounti ...
is not required, however is increasingly being held or pursued by analysts, often to become more competitive for advancement opportunities.
Commercial bankers also undergo intense credit training provided by their bank or a third-party company.
References
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Credit risk