Credit analysis is the method by which one calculates the creditworthiness of a business or organization. In other words, It is the evaluation of the ability of a company to honor it financial obligations. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan. The term refers to either case, whether the business is large or small. Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability. Analysts attempt to predict the probability that a borrower will default on its debts, and also the severity of losses in the event of default. Credit spreads--the difference in interest rates between theoretically "risk-free" investments such as U.S. treasuries or LIBOR and investments that carry some risk of default--reflect credit analysis by financial market participants. Before approving a commercial loan, a bank will look at all of these factors with the primary emphasis being the cash flow of the borrower. A typical measurement of repayment ability is the debt service coverage ratio. A credit analyst at a bank will measure the cash generated by a business (before interest expense and excluding depreciation and any other non-cash or extraordinary expenses). The debt service coverage ratio divides this cash flow amount by the debt service (both principal and interest payments on all loans) that will be required to be met. Commercial Bankers like to see debt service coverage of at least 120 percent. In other words, the debt service coverage ratio should be 1.2 or higher to show that an extra cushion exists and that the business can afford its debt requirements Typical education credentials often require a bachelor degree in business (to include an emphasis in accounting, finance or economics). An MBA is not required however is increasingly being held or pursued by analyst, often to become more competitive for advancement opportunities. Commercial Bankers also undergo intense credit training provided by their Bank or a third-party company.
First things first. Sine qua non to any credit analysis is the gathering of all available information about the applicant. Owing to the complexity if not the number of facts and data sought, the task of gathering credit information is far from an easy task.
The principal sources of credit information may be observed as follows: A. From Internal Sources
a. Debtor’s previous credit record with the business firm b. Credit man’s personal knowledge of debtors character and reputation c. Personal contacts with debtor
1. Through correspondence
2. Through personal visits by credit man or his representatives 3. Reports of salesman
d. Analysis of debtor’s financial statement
e. Audits or surveys of the business
B. From external sources
a. Mercantile agencies
b. Trade references
d. Newspaper clippings
e. Court cases
f. Report from competitors of the borrower (in the case of a business firm Personal Interviews
A personal interview is initially started when a prospective borrower applies for a loan (or for the purchases of goods and/or services on credit in the case of a business firm). The most prudent credit extension is based upon complete investigation and competent analysis. Each application for a loan requires a different type of investigation.
Personal Interviews may be conducted with or without the assistance of a carefully-prepared questionnaire. In some instances, the interviewer may be armed with a certain degree of authority with respect how he should conduct the interview in accordance with the...