Impaired credit occurs when there has been a deterioration in the creditworthiness of an individual or entity. This is usually reflected through a lower credit score, in the case of an individual, or a reduction in the credit rating assigned to an entity or debt issued by a rating agency or lender. The borrower whose credit has been impaired will generally have lesser accessibility to credit facilities and will have to pay a higher rate of interest on loans. Impaired credit may either be a temporary situation that can be reversed, or an early sign that the borrower could face potential major financial distress down the road.
Breaking Down Impaired Credit
Impaired credit is usually the result of financial stress brought on by a change in circumstances for an individual or entity. In the case of an individual, impaired credit may be the end result of a job loss, long illness, a steep decline in asset prices and so on. For a corporate entity, creditworthiness may decline if its financial position deteriorates over time due to poor management, increased competition or a weak economy. In either case, impaired credit could be the result of internal forces, or self-inflicted wounds. Or at other times, external factors are at play which may be out of an individual's or management's control.
Impaired credit, whether at the personal level or the corporate level, may require drastic changes to operations or procedures to alleviate financial stress leading to eventual improvements in a balance sheet's condition. These changes generally include reducing expenses, selling assets and using cash flow to pay down outstanding debt to bring it to a manageable level.
Several techniques are available to assess credit impairment, or more specifically, credit analysis. Common methods begin the four "Cs" of credit:
- Capacity: The ability to service debt levels
- Collateral: Any posted collateral as a buffer against market value losses
- Covenants: Loose or tight covenants to indentures
- Character: Management's experience, values, and aggressiveness