What is 'Credit Analysis'

Credit analysis is a type of analysis an investor or bond portfolio manager performs on companies or other debt issuing entities to measure the entity's ability to meet its debt obligations. The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.

BREAKING DOWN 'Credit Analysis'

To judge a company’s ability to pay its debt, banks, bond investors, and analysts conduct credit analysis on the company. Using financial ratios, cash flow analysis, trend analysis, and financial projections, an analyst can evaluate a firm’s ability to pay its obligations. A review of credit scores and any collateral is also used to calculate the creditworthiness of a business. Not only is the credit analysis used to predict the probability of a borrower defaulting on its debt, its also used to assess how severe the losses will be in the event of default. The outcome of the credit analysis will determine what risk rating to assign the debt issuer or borrower. The risk rating, in turn, determines whether to extend credit or loan money to the borrowing entity and if so, the amount to lend.

An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest, principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow. For example, a debt service coverage ratio of 0.89 indicates that the company’s net operating income is enough to cover only 89% of its annual debt payments. In addition to fundamental factors used in credit analysis, environmental factors such as regulatory climate, competition, taxation, and globalization can also be used in combination with the fundamentals to reflect a borrower's ability to repay its debts relative to other borrowers in its industry.

Credit analysis is also used to estimate whether the credit rating of a bond issuer is about to change. By identifying companies that are about to experience a change in debt rating, an investor or manager can speculate on that change and possibly make a profit. For example, assume a manager is considering buying junk bonds in a company. If the manager believes that the company's debt rating is about to improve, which is a signal of relatively lower default risk, then the manager can purchase the bond before the rating change takes place, and then sell the bond after the change in rating at a higher price.

RELATED TERMS
  1. Credit Rating

    A credit rating is an assessment of the creditworthiness of a ...
  2. Credit Market

    Credit markets are where investors go to buy bonds, mortgages, ...
  3. Classified Loan

    A classified loan is any bank loan that is in danger of default.
  4. Debt Service

    Debt service is the cash that is required for a particular time ...
  5. Underlying Debt

    Underlying debt is a municipal bond term that reflects an implicit ...
  6. Debt-Service Coverage Ratio (DSCR)

    The Debt-Service Coverage Ratio (DSCR) states net operating income ...
Related Articles
  1. Investing

    Will Corporate Debt Drag Your Stock Down?

    Corporate debt can mean a leg up for firms, or the boot for investors. How to tell the difference.
  2. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  3. Personal Finance

    Credit And Debt Management

    America is addicted to debt. Learn how to manage your credit and keep debt from ruining your life.
  4. Personal Finance

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
  5. Insights

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  6. Personal Finance

    Analyzing a Career in Credit Analysis

    If you're a number-cruncher and responsibility doesn't scare you, this could be the job for you.
  7. Personal Finance

    Before Taking on Debt, Ask These Questions

    To understand the difference between good and bad debt, ask these questions before borrowing money.
  8. Investing

    Why Governments Issue Foreign Bonds

    Government bonds issued in foreign currency have drawn a growing amount of interest in recent years. This article explores why governments, particularly those in emerging markets, choose to denominate ...
Trading Center