Credit analysis is the process of evaluating how likely a borrower is to repay money that has been lent to them.
Banks, bond investors, and other lenders perform credit analysis before lending money and while monitoring existing loans. The central questions are:
- Can the borrower repay? This involves examining income or cash flow relative to required interest and principal payments.
- Will the borrower repay? Credit history, payment behavior, and management quality can help assess this.
- What happens if the borrower cannot repay? Analysts examine collateral, guarantees, and how much money might be recovered in a default.
For a company, a credit analyst might examine financial statements and calculate measures such as:
Debt-to-Equity=DebtEquity\text{Debt-to-Equity}=\frac{\text{Debt}}{\text{Equity}}
and
Interest Coverage=EBITInterest Expense.\text{Interest Coverage}=\frac{\text{EBIT}}{\text{Interest Expense}}.
For example, suppose two companies each want to borrow $1 million. Company A has stable cash flow, little existing debt, and earnings comfortably covering its interest payments. Company B has declining cash flow, substantial debt, and difficulty covering interest. All else equal, Company A represents the lower credit risk and would normally be able to borrow on more favorable terms.
A traditional framework is the Five Cs of Credit: character, capacity, capital, collateral, and conditions.
In short, credit analysis measures the risk that a borrower will fail to meet its financial obligations and helps a lender decide whether to lend, how much to lend, and what interest rate and other terms are appropriate.
