Credit Analysis – In layman terms, Credit analysis is more about identification of risks in situations where a potential for lending is observed by the Banks. Both quantitative and qualitative assessment forms a part of overall appraisal of the clients (company/individual). This in general, helps to determine the entity’s debt servicing capacity, or its ability to repay.
In this article, we look at Credit Analysis from Beginner’s point of view –
What is Credit Analysis?
Credit Analysis Definition –
Credit analysis is a process of drawing conclusions from available data (both quantitative and qualitative) regarding the credit – worthiness of an entity, and making recommendations regarding the perceived needs, and risks.
Credit Analysis is also concerned with the identification, evaluation and mitigation of risks associated with an entity failing to meet financial commitments.
Credit Analysis Process
Below diagram shows the overall Credit Analysis Process.
What does a Credit Analyst looks for?
Ever wondered why bankers ask so many questions and make you fill so many forms, when you apply for a loan. Don’t some of them feel intrusive and repetitive and the whole process of submission of various documents seems cumbersome. You just try to fathom, as to what they do with all this data and what they are actually trying to ascertain! It is definitely not only your deadly charm and attractive personality that makes you a good potential borrower; obviously there is more to that story. So here we will try to get an idea about what exactly a Credit Analyst is looking for.
The 5 C’s of Credit Analysis
- This is the part where the general impression of the protective borrower is analysed. The lender forms a very subjective opinion about the trust – worthiness of the entity to repay the loan. Discrete enquires, background, experience level, market opinion, and various other sources can be a way to collect qualitative information and then an opinion can be formed, whereby he can take a decision about the character of the entity.
- Capacity refers to the ability of the borrower to service the loan from the profits generated by his investments. This is perhaps the most important of the five factors. The lender will calculate exactly how the repayment is supposed to take place, cash flow from the business, timing of repayment, probability of successful repayment of the loan, payment history and such factors, are considered to arrive at the probable capacity of the entity to repay the loan.
- Capital is the borrower’s own skin in the business. This is seen as a proof of the borrower’s commitment to the business. This is an indicator of how much the borrower is at risk if the business fails. Lenders expect a decent contribution from the borrower’s own assets and personal financial guarantee to establish that they have committed their own funds before asking for any funding. Good capital goes on to strengthen the trust between the lender and borrower.
Collateral (or Guarantees)
- Collateral are form of security that the borrower provides to the lender, to appropriate the loan in case it is not repaid from the returns as established at the time of availing the facility. Guarantees on the other hand are documents promising the repayment of the loan from someone else (generally family member or friends), if the borrower fails to repay the loan. Getting adequate collateral or guarantees as may deem fit to cover partly or wholly the loan amount bears huge significance. This is a way to mitigate the default risk. Many times, Collateral security is also used to offset any distasteful factors that may have come to the fore-front during the assessment process.
- Conditions describe the purpose of the loan as well as the terms under which the facility is sanctioned. Purposes can be Working capital, purchase of additional equipment, inventory, or for long term investment. The lender considers various factors, such as macroeconomic conditions, currency positions, and industry health before putting forth the conditions for the facility.
Credit Analysis Case Study
From times immemorial, there has been an eternal conflict between entrepreneurs/businessmen and bankers, regarding the quantification of credit. The resentment on the part of the business owner arises when he believes that the banker might not be fully appreciating his business requirements/needs and might be underestimating the real scale of opportunity that is accessible to him, provided he gets sufficient quantum of loan. However, the credit analyst might be having his own reasons to justify the amount of risk he is ready to bear, which may include bad experiences with that particular sector, or his own assessment of the business requirements. Many times there are also internal norms or regulations which force the analyst to follow a more restrictive discourse.
The most important point to realize is that banks are in the business of selling money and therefore risk regulation and restrain are very fundamental to the whole process.Therefore, the loan products available to prospective customers, the terms and conditions set for availing the facility and the steps taken by the bank to protect its assets against default, all have a direct forbearance to the proper assessment of the credit facility.
So, let’s have a look at what does a loan proposal looks like:
The exact nature of proposals may vary depending on subsequent clients, but the elements are generally the same.
**To put things into perspective let’s consider the example of one Sanjay Sallaya, who is credited to being one of the biggest defaulters in recent history along with being one of the biggest businessmen in the world. He owns multiple companies, some sports franchises, and few bungalows in all major cities.
- Who is the client? Ex. Sanjay Sallaya, reputed industrialist, owning majority share in XYZ ltd., and some others.
- Quantum of credit they need and when? Ex. Starting a new airline division, which would cater to the high end segment of society. Credit demand is $25 mil, needed over the next 6 months.
- The specific purpose the credit will be employed for? Ex. Acquiring of new aircrafts, and capital for day to day operations like fuel costs, staff emoluments,airport parking charges, etc.
- Ways and means to service the debt obligations (which include application and processing fees, interest, principal and other statutory charges) Ex. Revenue generated from flight operations, freight delivery and freight delivery.
- What protection (collateral) can the client provide in the event of default? Ex. Multiple bungalows in prime locations offered as collateral, along with personal guarantee of Sanjay Sallaya, one of the most reputed businessmen in the world.
- What are the key areas of the business and how are they operated, and monitored? Ex. Detailed reports would be provided on all key metrics related to the business.
Answers to these questions, helps the credit analyst to understand the broad risks associated with the proposed loan. These questions provide the basic information about the client and help the analyst to get deeper into the business and understand any intrinsic risks associated with it.
Credit Analyst – Obtaining Quantitative Data of the Clients
Other than the above questions the analyst also needs to obtain quantitative data specific to the client:
- Borrower’s history – A brief background of the company, its capital structure, its founders, stages of development, plans for growth, list of customers, suppliers, service providers, management structure, products, and all such information are exhaustively collected to form a fair and just opinion about the company.
- Market Data – The specific industry trends, size of the market, market share, assessment of competition, competitive advantages, marketing, public relations, and relevant future trends are studied to create a holistic expectation of future movements and needs.
- Financial Information – Financial statements (Best case/ expected case/ worst case), Tax returns, company valuations and appraisal of assets, current balance sheet, credit references, and all similar documents which can provide an insight into the financial health of the company are scrutinized in great detail.
- Schedules and exhibits – Certain key documents, such as agreements with vendors and customers, insurance policies, lease agreements, picture of the products or sites, should be appended as exhibits to the loan proposal as proofs of the specifics as judged by above mentioned indicators.
**It must be understood that the credit analyst once convinced will act as the client’s advocate in presenting the application to the bank’s loan committee and also guiding it through the bank’s internal procedures. The details obtained are also used to finalize the loan documentation, terms, rates and any special covenants which need to be stipulated, keeping in mind the business frame-work of the client as well the macro – economic factors.
Credit Analysis – Judgement
After collating all the information, now the analyst has to make the real “Judgement”, regarding the different aspects of the proposal which will be presented to the sanctioning committee:
- Loan – After understanding the need of the client, one of the many types of loans, can be tailored to suit the client’s needs. Amount of money, maturity of loan, expected use of proceeds can be fixed, depending upon the nature of the industry and the credit worthiness of the company.
- Company – The market share of the company, products and services offered, major suppliers, clients and competitors, should be analysed to ascertain its dependency on such factors.
- Credit History – Past is an important parameter to predict future, therefore, keeping in line with this conventional wisdom, client’s past credit accounts should be analysed to check any irregularities or defaults. This also allows the analyst to judge the kind of client we are dealing with, by checking the number of times late payments were made or what penalties were imposed due to non compliance with stipulated norms.
- Analysis of market – Analysis of the concerned market is of utmost importance as this helps us in identifying and evaluating the dependency of the company on external factors. Market structure, size and demand of the concerned client’s product are important factors that analysts are concerned with.
Credit Analysis Ratios
A company’s financials contain the exact picture of what the business is going through, and this quantitative assessment bears utmost significance.Analysts consider various ratios and financial instruments to arrive at the true picture of the company.
- Liquidity ratios – These ratios deal with the ability of the company to repay its creditors, expenses, etc. These ratios are used to arrive at the cash generation capacity of the company. A profitable company does not imply that it will meet all its financial commitments.
- Solvability ratios – These ratios deal with the balance sheet items and are used to judge the future path that the company may follow.
- Solvency ratios – These ratios are used to judge the risk involved in the business. These ratios take into picture the increasing amount of debts which may adversely affect the long term solvency of the company.
- Profitability ratios – These ratios show the ability of a company to earn satisfactory profit over a period of time.
- Efficiency ratios – These ratios provide insight in the management’s ability to earn a return on the capital involved, and the control they have on the expenses.
- Cash flow and projected cash flow analysis – Cash flow statement is one of the most important instrument available to a Credit Analyst, as this helps him to gauge the exact nature of revenue and profit flow. This helps him get a true picture about the movement of money in and out of the business
- Collateral analysis – Any security provided should be marketable, stable and transferable. These factors are highly important as failure on any of these fronts will lead to complete failure of this obligation.
- SWOT analysis – This is again a subjective analysis, which is done to align the expectations and current reality with market conditions.
If you wish to learn more about financial analysis, then click here for this amazing Financial Statement analysis guide
Credit rating is a quantitative method using statistical models to assess credit worthiness based on the information of the borrower. Most banking institutions have theirown rating mechanism. This is done to judge under which risk category the borrower falls. This also helps in determining the term and conditions and various models use multiple quantitative and qualitative fields to judge the borrower. Many banks also use external rating agencies such as Moody’s, Fitch, S&P etc. to rate borrowers, which then forms an important basis for consideration of the loan.
Lesson Learned – Mr. Sanjay Sallaya
So, let’s illustrate the whole exercise with the help of an example of Mr. Sanjay Sallaya, who is a liquor barron, and a hugely respected industrialist, who also happens to own a few sports franchises and has bungalows in the most expensive locals. He now wants to start his own airline, and has therefore approached you for a loan to finance the same.
The loan is for a meagre $1 million. So, as a credit analyst we have to assess whether or not to go forward with the proposal. To begin, with we will obtain all the required documents which are needed to understand the business model, working plan and other details of his new proposed business. Necessary inspection and enquires are undertaken to validate the veracity of his documents. A TEV i.e Techno Economic Viability can also be undertaken to get an opinion from the experts in aviation industry about the viability of the plan.
When finally we are satisfied with the overall efficacy of the plan, we can discuss the securities that will collaterally cover our loan (partly/fully). Mr. Sanjay Sallaya being a well-established industrialist holds a good reputation in the business world and therefore will hold good recommendations. Such a proposal if it meets all other aspects can be presented for sanction, comfortably, and generally enjoys good terms from the bank’s side as the risk associated with such personalities are always assessed to be less.
Therefore, to conclude, Mr. Sanjay Sallaya will get a loan of $1 million approved and will go on to start his airline business, however, what the future holds can never be predicted, when a loan is sanctioned.
also, checkout the difference between Equity Research vs Credit Research
Credit Analysis is about making decisions keeping in mind the past, present and the future. As a Credit analyst, two days in life are never the same. The role offers a plethora of opportunities to learn and understand different types of businesses as one engages with a multitude of clients hailing from different sectors. Not only is the career monetarily rewarding but also helps an individual grow along with providing good opportunities to build one’s career.
Filed Under: Risk Management, Fixed Income, Ratio Analysis, Credit Analysis, Investment Banking