Credit analysis is the process conducted by funders, bond managers, banks, and financial institutions that desire to calculate a corporation’s creditworthiness or any debt issuing entity to calculate the corporation’s debt and previous default rate. It helps them to calculate the risk associated with investing in corporations.

It is a procedure in which the lender conducts an analysis of the corporation or individual that requested the loan or debt instrument. This activity is conducted to provide the lender with an insight into the company’s financial performance requesting the loan.

This activity consists of many techniques, like cash flow analysis, trend analysis, risk analysis, ratio analysis, and many others.

Each and every one of these techniques is conducted to determine the level of risk the lender will be exposed to in case they provided the requested loan or debt tool to the requesting corporate or individual.

We have to understand that a corporation with debt does not mean a negative indication, actually, it can mean the opposite which is growth. But too much debt and weak cash flows can translate to many issues which can mean unhealthy financial performance by the corporate. 

Credit analysis is not only done for corporations or individuals wanting to run a business but it can also be conducted by banks on individuals who simply want to borrow money for personal matters.

The bank will need to know the rate of defaulting and the creditworthiness of the individual requesting the loan.

How does credit analysis work & examples?

This analysis is not an easy task, it needs a long period of time ranging from weeks to a full month. It also consists of many stages, the following stages are the key stages taken in order to conduct a full credit analysis of different institutions.

•  Gathering of information

This stage is the first and most crucial stage in this analysis. The history of loan applicants is put under a microscope, and information regarding repayment records, financial solvency, and transactions history with banks is analyzed thoroughly.

In addition, lenders will also gather information about the purpose of the requested sum or loan, and the available collaterals that can be presented by the loan applicant whether it is an individual or a corporate.

This information is up to date and the lender will take the best approach to gather accurate information.

• Information analysis

The second most important stage is information analysis. At this stage, the lender or the loan provider will analyze the gathered information about the applicant. This analysis will place an emphasis on the accuracy of the information collected.

This is done in variable ways. It can be done through the applicant’s bank, company, and any other entity the applicant had financial transactions.

It is crucial for this stage to ensure the accuracy of the gathered information as the following stages will rely on this collected information.

• Approval or rejection

For the typical credit analysis process, this is the last stage conducted. At this level, the lender will be formulating a decision regarding the applicant’s request for the loan. This is done solely by the credit provider or the lender.

At this stage, the lender would have gone through the applicant’s information and conducted an analysis of the information gathered.

The lender will measure or compare the risk associated with the applicant and the level of risk they are willing to take or they usually consider at a suitable rate.

Let’s take an example to help us better understand this analysis process. Our example will take the elements of a financial ratio’s debt service coverage ratio utilized in the analysis process.

The debt service coverage ratio is utilized to calculate the level of cash flow ready with the loan applicant to pay back the debt.

The DSCR under 1 translates to negative cash flow, and the DSCR above 1 translates to positive cash flow.

A DSCR of 0.78 demonstrates that the corporation possesses enough cash flow to cover 78% of the annual debt payment.

Alongside fundamental elements utilized in credit analysis, natural or environmental elements like competition, taxation, regulatory climate, and globalization can also display the loan applicant’s readiness or capability to repay the taken loan.

Credit analysis ratios

Multiple ratios are utilized in the process of credit analysis, this is to assist in the decision-making stage.

These ratios will be an eye factor to look for by lenders and investors as they indicate different things related to the performance of the corporation.

Here is a list of the ratios used in credit analysis:

• Liquid Ratios: These ratios engage with a corporation’s capability to pay back its expenses, creditors, and any other short-period obligations.
• Solvability Ratios: These ratios engage with a company’s balance sheet elements.
• Solvency Ratios: This ratio is concerned with the corporate’s capability to pay back its long-term debt. If it is not good enough, then there are possibilities that the business solvency is negatively impacted in the long run.
• Profitability Ratios: These ratios demonstrate the corporate’s possibilities to make profits.
• Efficiency Ratios: These ratios display the corporate’s capability to make and how they manage its expenses.

Analysis:

• Cash Flow Analysis: This analysis displays a fair picture of the flow of cash in the business.
• Collateral Analysis: The collateral or asset provided as a security against the loan should consist of the qualities of stability, transferability, and marketability.
• SWOT Analysis: This analysis is conducted to manage the expectation and reality of the situation in the market.

5 c’s of credit analysis

These five C’s represent the major elements looked upon by any credit analysis personnel in order to be able to analyze accounts or loan applicants. They vary in nature but the end goal is to be able to identify a bad account or account that would likely default in loan repayment vs an account that has a high chance of repaying the debt.

• Character

This section analyzes the overall impression of the borrower. A very subjective belief or opinion regarding the trustworthiness of the individual or corporate to repay the loan is formulated by the lender.

Separate requests, background, experience, market view, and other streams of information can be an approach to gathering qualitative information, then an opinion can be articulated whereby the lender can make a decision about the character of the applicant.

• Capacity

It means the borrower’s capability to repay the loan from his profits which were generated by his business endeavors. Perhaps, this is one of the most crucial elements of the five elements.

Through statements like cash flow from operations, the lender can calculate the exact amount of repayment that should be paid.

Factors like the probability of successful repayments, payment history, and timing of repayments can all be estimated at the probable capacity of the applicant to repay the loan.

• Capital

It represents the applicant’s capital invested in the business. It is considered to be proof of the applicant’s commitment to the business. It is also a sign of how much the loan applicant is at risk in case of failure of the business.

It is expected that loan applicants will contribute to their businesses with their own assets to a certain level as a financial guarantee. Good capital contribution by loan applicants will create and strengthen the trust bond between them and lenders.

• Collateral & guarantees

It is a form of security the borrower will provide to the lender as financial security in case the debt is not repaid.

On the other hand, guarantees are documents that bind the loan applicant to conduct loan repayment through other individuals like family members or friends.

Receiving sufficient collateral or guarantees may deem suitable to cover part or the whole amount loan bears a big significance. This is an approach to lower default risk.

Multiple times, collateral security can also be used to kick off any distasteful elements which may have come to the forefront during the screening process.

• Conditions

This provides a description of the purpose of the loan request, along with the terms under which the entity is sanctioned. purposes could be working capital or for purchase of additional equipment or inventory or for a long-term investment.

The loan provider will take into consideration many elements such as macroeconomics conditions, currency status-quo, and the industry’s overall performance, before labelling the entity.

Use of credit analysis and why it’s important

The use of credit analysis depends on the purposes of the conducting party, usually, this is a financial institution that wants to establish a financial connection with the account or the individual who represents the account. The values are many but for a financial institution, it’s direct.

• It is beneficial for the loan providers as it assists them to specify the borrower’s capability to pay back the loan.
• It is beneficial for investors as it assists them in specifying a corporation’s financial situation.
• It assists corporations to satisfy their need for capital by which they can scale their business.

It is beneficial for banks, corporations, investors, etc. As for the expansion of the business, corporations need capital that can be fulfilled by issuing bonds, shares, or by taking a loan.

From the lender’s point of view, it is essential to have some sort of safety and surety against the loan being granted.

For this, the credit analysis helps both the corporation and the lender as it will provide surety to the lender by providing creditworthiness of the corporation, and the lender can invest the money depending upon the level of risk.

In conclusion

Credit analysis is an approach for analyzing risk. For an individual or a corporation that provides credit services or loaning services, studying risk and analyzing its level is a crucial task, as it will determine whether they will have profits from their services or they will carry many bad debts and defaults.

Credit analysis if understood can be conducted even by individuals, but it will require experience as it is not an easy nor a short task. Yet, despite its complexity and duration needed, this analysis is needed to ensure the mitigation of risk.

Conducting this analysis relies on information, the more accurate this information is, the more accurate the results are.

In the end, it does not guarantee absolute, but it tries to bring decision makers to the most right decision that can be taken regarding a loan request as much as possible.

For you as a corporate or an individual, you should be aware that any institution you will request a loan or a loan tool from, will run your company through a background check to see the overall financial performance of the company or your financial performance as an individual.

Today, credit analysis is looked upon differently as the source of the needed information is changing.

For instance, your mortgage payments would play a major role in your creditworthiness score, while today your credit card repayments might carry a much heavier value for lenders than a mortgage. Nonetheless, both are still used for credit analysis.

More and more elements are being included to provide lenders with an accurate risk ratio or cash flow analysis which translates to a more accurate decision making regarding which loan or loan tools applicants the lenders should provide them or grant their requests.

Credit analysis will always exist even if the form and elements change, as it’s a crucial approach to understanding the probabilities of pay-back vs defaults.

Defaults can occur due to many factors but knowing the probabilities can save your cash and provide you with good investment probabilities.

There are different types of analysis that can be conducted to mitigate the risk associated with borrowers.

Wall – Street Oasis offers a list of courses that can assist you with this task, here is one of the courses that can assist you with this task and it will provide you with the needed fundamentals for understanding your financial statements.

Researched and Authored by CEO of NeuralWize Ahmed Fagiry