Credit analysis is a financial study or assessment conducted by a bond portfolio manager or investor to determine the capacity of businesses, institutions, governments, municipalities, or other debt-issuing organizations to live up to their debt commitments. The credit analysis process is often used to determine the proper degree of risk upon default when investing in a company's debt instruments.
A credit analyst may adopt a range of methodologies like trend analysis, ratio analysis, financial predictions, cash flow analysis, and risk analysis during the credit analysis process. The methods often help assess a borrower’s financial performance and the extent of losses that the lender will incur if the borrower defaults on their financial obligation.
Debt financing is key to economic development as it helps businesses acquire assets, improving the elements of production. It helps governments execute capital projects like the construction of factories, hospitals, airports, roads, bridges, and other social facilities. In light of the foregoing, credit analysis is an important aspect of the debt capital market. It allows lenders to allocate capital effectively and judiciously upon accurately assessing credit risk.
Credit analysis often involves a wide range of steps. The first step consists of collecting and evaluating applicants’ data like their repayment history, organizational reputation, and transaction records with financial institutions. The lender may also evaluate the borrower's potential to produce extra cash flows for the company by looking at how well they used the previous borrowing to expand their primary business operations.
In addition, the lender collects data about the loan's purpose and viability. The lender is often interested in knowing if the project is feasible and profitable. The credit analyst assigned to the borrower must determine if the loan amount is sufficient to execute the project and whether the borrower has a viable strategy.
The accuracy of the data acquired in the first phase is checked. Trade licenses, passports, business charters, corporate resolutions, customer and supplier agreements, and other legal documents are all examined to determine their authenticity and validity.
In the credit analysis process, the decision-making stage is the last step. During this stage, the credit analyst assigned to the specific borrower is either convinced or not convinced that the degree of risk evaluated is manageable and that the lender will have no trouble servicing the loan. Hence, they submit a report on their review's findings to the credit committee, which then approves or rejects the loan request.
Lenders often adopt the “5 Cs of Credit” when determining a borrower's credit risk. These 5 Cs serve as indicators to determine whether a borrower will repay credit. The 5 Cs assess the lender’s character, capacity or cash flow, condition, capital, and collateral. In addition, the 5 Cs assess the borrower's character and loan terms to determine the likelihood of default and the resulting risk of financial loss.
The 5 Cs also include a qualitative and quantitative financial examination. For example, the lender may examine personal data like the borrower's balance sheet, income statement, credit reports, and other financial records.
