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What is Credit?

  1. Credit
  2. Credit Analysis
  3. Zero Liability Policy
  4. Borrowing Base
  5. Merton Model

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Credit Analysis: Definition & An Overview

Updated: November 25, 2022

Have you ever applied for a credit card and got denied? What about applying for a loan to help fund future business expansion? There are certain criteria that lenders look at when deciding to issue debt to someone. It’s important for debt issuers to weigh the risks and the probability of someone being able to pay back their debts. 

That’s where credit analysis comes into play. So how exactly does it work and what do you need to know? Read on to learn more, including some different uses and special considerations.

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    KEY TAKEAWAYS

    • Credit analyses help to show insights into how risky a debt instrument might be that’s issued by a company or debt-issuing entity. It measures the overall ability to meet certain debt obligations. 
    • Once a credit analysis is conducted, it will determine a risk rating to give to a borrower or debt issuer. 
    • A credit analysis identifies the level of detail disk that might come from a particular investment.

    What Is Credit Analysis?

    Credit analysis is used by a bond portfolio manager or investor as a type of financial analysis. It can be performed on municipalities, governments, companies, or another type of debt-issuing entity to help determine the ability of an issuer to meet debt obligations. 

    By using the credit analysis process, it can uncover and identify the levels of default risk that might be associated with certain investments. This relates directly to an entity’s debt instruments.

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    How Credit Analysis Works 

    It’s important to know and understand how well a company will be able to pay off its debt prior to issuing any type of credit. Analysts, bond investors, and banks will conduct a credit analysis on a company. 

    They use certain financial ratios, financial projections, cash flow analysis, and trend analysis to do this. This allows analysts the opportunity to evaluate the ability of a company to pay off any future debt obligations. As well, reviewing things such as collateral and credit scores will help determine the creditworthiness of a company. 

    Once the credit analysis is complete, it will then determine a risk rating for the borrower or debt issuer. Depending on the risk rating, it will determine if credit or a loan is worth extending and how much to lend. 

    Uses for Credit Analysis

    Investment funds, investors, analysts, and banks will rely on the importance of credit analysis in order to determine the risk of a company and how much to lend. If a corporation is looking into expansion, for example, it will likely look for ways to raise extra capital. 

    To do this, they have opportunities through taking out loans or issuing bonds or stocks. This is why when lending money there becomes a high level of importance to determine if the investment will pay off, and this is going to depend on the credit of the company. 

    Bondholders that lend a company money are going to need to determine and assess whether or not they will get their loan back and if there is a risk of bankruptcy, for example. 

    Here are a few of the most common ways that credit analysis can get used:

    • By creditors to determine the ability of an individual to pay back credit such as a mortgage or loan
    • By creditors to determine the ability of a corporation to pay back a loan 
    • By investors to determine the financial stability of a company 

    Loans 

    If a company needs to raise additional capital, it often will ask a bank or financial institution for a loan. These loans can either be secured or unsecured. 

    Bonds 

    Bondholders are going to look into the bond rating of a company to determine its default risk. Bonds that are ranked high usually have a low default risk and are investment grade. Other bonds that are not investment graded are considered to be junk bonds or high yield. 

    These bonds are dependent on the financial and economic conditions of a business to meet its financial commitments. 

    Equity 

    The overall credit of a company is going to affect investors through the value of the stock as well as their claim on assets. Equity investors are going to purchase stock to benefit from any increases in stock price and through dividends. 

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    Special Considerations 

    One thing to consider is that a credit analysis can be used to determine if a bond issuer’s credit rating might change. Identifying a company that might experience a change in debt rating can lead to an investor speculating on the possibility of making a profit. 

    For example, let’s say that an investor is looking into purchasing junk bonds. They think that the debt rating of the company could improve which might indicate lower default risk. The investor could purchase the bond before any rating changes take place and then sell it off at a higher price.

    Summary

    Credit analysis is a financial analysis that an investor or bond portfolio manager would perform. They do this to determine and measure the ability of a debt issuer to meet its obligations. These can include the likes of municipalities, companies, and governments. 

    Essentially, credit analysis helps identify the level of default risk that might come with a potential investment. Having an understanding of things like credit score and credit standing can help an investor or credit analyst determine a good investment from a bad one. Having a strong credit rating when going through a credit check is going to be important to avoid bad debt losses. 

    As well, by uncovering potential risk, investors can have a better chance at stronger equity returns when it comes to things like high-yield bonds or government bonds, for example.

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    FAQs About Credit Analysis

    Why Is Credit Analysis Important?

    Credit analysis helps to predict the probability of a borrower defaulting on any potential debt they might have. As well, it can assess the level of risk associated with losses should the borrower default.

    What Are the 5 C’s of Credit Analysis?

    The 5 C’s of credit analysis include character, capacity, capital, conditions, and collateral.

    How Do You Conduct a Credit Analysis?

    The first thing to do for credit analysis is to collect the right information when it comes to credit history. From here, you will have to analyze the information to determine possibilities of risk, and then either move forward or reject the investment.

    What is Credit?

    1. Credit
    2. Credit Analysis
    3. Zero Liability Policy
    4. Borrowing Base
    5. Merton Model

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