Credit analysis
Encyclopedia
Credit analysis is the method by which one calculates the creditworthiness of a business or organization. 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.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. Or, a bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
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
Ratio
In mathematics, a ratio is a relationship between two numbers of the same kind , usually expressed as "a to b" or a:b, sometimes expressed arithmetically as a dimensionless quotient of the two which explicitly indicates how many times the first number contains the second In mathematics, a ratio is...
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
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
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
Debt service coverage ratio
The debt service coverage ratio , also known as "debt coverage ratio," is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt payments...
. A credit analyst at a bank will measure the cash generated by a business (before interest expense and excluding depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
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
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
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.