What Is Credit Analysis?
Credit analysis is a type of financial analysis that an investor or bond portfolio manager performs on companies, governments, municipalities, or any other debt-issuing entities to measure the issuer's ability to meet its debt obligations. Credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity's debt instruments.
- Credit analysis evaluates the riskiness of debt instruments issued by companies or entities to measure the entity's ability to meet its obligations.
- The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.
- The outcome of the credit analysis will determine what risk rating to assign the debt issuer or borrower.
How Credit Analysis Works
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, but it's 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.
Credit Analysis Example
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. On the other side, an equity investor can buy the stock since the bond rating change might have a positive impact on the stock price.