WHAT IS CREDIT ANALYSIS

Credit Analysis entails researching and analyzing the debt profile and debt servicing
abilities of individuals, companies or even sovereigns (i.e. countries). A Credit
Analyst, therefore, is someone who finds out the creditworthiness of an entity (either
an individual or company or country) depending on the demands of the situation. In
the case of issuing loans, companies / individual borrowers are appraised to see if
they have the ability to service the debt and also if it is safe to give out the loan. In
the case of a credit card application, income streams and previous defaults etc. will
be analyzed. In the case of countries, although more complex to analyze, the end
result is the same – an assessment of risk – also called a ‘Credit Rating’. Below is a
chart with rating categories used by 3 leading global Credit Rating Agencies.

Credit Analyst
Credit analyst operates for banks and financial institutions and work with customers
to manage their credit history, credit score and decide whether or not and how much
credit they are allowed for. Credit analyst uses computer programs and research
financial records, and keep financial records up to date.
What is Credit Analysis?
Credit analysis is a type of analysis an investor or bond portfolio manager performs
on companies or other debt resulting entities to regulate the entity’s capacity to
reach its mortgage commitments. The credit analysis endeavours to distinguish the
relevant level of oversight uncertainty correlated with investing in that appropriate
entity.
Credit Analysis basically applies to study the credit-worthiness of a borrower it could
be a large or a small firm or even an individual. For example, this kind of analysis
could be expected by a bank when it requires to investigate whether a loan would be
reimbursed by a borrower, or by a financial investor who wants to examine whether
a corporation would honour the interest and principal repayment on bonds issued by
it.
  The process of Credit Analysis
 Firstly, credit analysts review the past records of the borrower, the market
reputation or any negative news issue to evaluate the repayment capability.
 Next, in order to implement effective credit analysis, the analyst should
necessarily be proficient at studying the financial statements of a firm and
analyzing the ratios intimated by the statements.
 Further, the analyst also requires to check whether the borrower will have
enough free cash flows to honor his responsibilities.
  And finally, the analyst applies statistical tools to indicate a risk rating to the
borrower and also checks the amount of potential loss to the lender in the event
of an error.
Job Profile of a Credit Analyst
Business Credit Analysts
1.Evaluate risks in disbursing business loans.
2.To manage an on-site evaluation of client’s business and competitors.
3.To study the assets and liabilities statements, profits and losses, and net
sales.
4.To assess the security of the client’s business based on the management
activity, economic status, and potential growth.
5.To approve loans for the client after adequate analysis of risks.
6.To provide the documents related to disbursement of loans.
7.To render a complete report of their findings to the bank.
8.To guide the client through the application process.
Consumer Credit Analyst
1.Analyze personal loan risks.
2.Provide details to the ban
3.Does a background check for financial status and compliance?
4.Study credit history, assets and liabilities.
Opportunities for Credit Analyst
 Banks
 Corporates
 Industries
 Investment Banks
 Financial Institutions
 Insurance Companies
 Government Loan Divisions
 Credit Rating Agencies
 Fixed Income Domain
 Private Equity Firms
Skills Required to become a Credit Analyst
 Good mathematical skill
 Computing skills
 Adept at organizing, analyzing and reporting data
 Strong interpersonal skill
 Skill in working with details and numbers
 Interest in the market activity
 Good communication skill
 Problem-solving skill
 Good interviewing skills
3 Steps of Credit Analysis
Credit analysis is the process of evaluating an applicant’s loan request or a
corporation’s debt issue in order to determine the likelihood that the borrower will
live up to his/her obligations.
In other words, credit analysis is the method by which one calculates the
creditworthiness of an individual or organization.
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.
1. Steps During the Information Collection Stage
Collecting information about the applicant
The first step in credit analysis is to collect information of the applicant regarding
his/her past record of loan repayment, character, individual and organizational
reputation, financial solvency, ability to utilize the load (if granted) etc.
The bank may inquire into the transaction record of the applicant with the bank and
other banks. The repayment history of loans previously granted may also reveal
useful information in this regard.
Collecting information about the business for which loan is required
The loan officer should know the purpose of the loan, the amount of the loan and if it
is possible to implement the project by that amount.
The banker should make sure the project is feasible. It is important that the project
has a good potential and the applicant has a good plan to execute the project.
Related: Financial Statements Paints a Picture of a Company’s Financial Situation
Collecting information about the recovery process
The loan officer should collect information about the sources from which the
borrower would repay the loan.
Information for this purpose may include the profitability of the project, the payback
period, the sensitivity of the project cash flow to different economic factors etc.
Collecting information about the security
Banks, most often than not, lend money against personal and non-personal
securities.
A bank would always prefer getting the loan repaid by the borrower to realizing the
loan from the sale proceeds of the security.
However, should the borrower default in repaying the loan the lender will have to fall
back on the security. Hence, it is always advisable to know information like price
stability, etc. about the security before advancing the loan.
Collecting additional information if necessary
When the loan under consideration is for a large amount a bank may find it
necessary to gather additional information like the overall business activities in the
economy, probably political and economic condition of the country, efficiency, and
candidness of the management team, likely effect of local and international
competition on the project etc.
Related: 7’Cs of Creditworthiness
2. Steps During the Information Analysis Stage
Analyzing the accuracy of information
The information given in and along with the application is analyzed to judge their
accuracy.
In this regard, the analyst would scrutinize the national identity card, driver’s license,
trade license, partnership deed, corporate charters, resolutions, and other legal
documents attached with the application.
Analyzing the financial ability of the applicant
In this stage, the financial ability of the applicant is taken into consideration. The
financial solvency of the applicant and his skill and capability are important factors in
this regard.
The analyst works out different financial ratios from the past and proforma income
statements, balance sheets, cash flow statements, and other financial statements of
the applicant and analyzes them to reach about a conclusion about the applicant’s
financial ability.
Related: Difference between Bank Overdraft and Cash Credit
Analyzing the effectiveness of the project
One aspect of credit analysis is the analysis of quality, purpose, and future prospect
of the project for which loan has been applied. The banker will be at ease to grant
loans if the project is productive, expandable, and of course profitable.
On the other hand, if the project is in a declining stage, is up against the intense
competition, or is confronted by adverse conditions the bank is likely to be reluctant
to grant any loan.
Analyzing the possibility of loan repayment
The analyst looks at what effect the proposed loan will have on increasing the
liquidity and income of the applicant.
The net cash flow is a good indicator of the ability of the applicant to repay the loan
along with interest and other expenses within due time.
An analyst may also have interested to see the- interest burden and fixed charge
burden of the applicant.
3. Decision-Making Stage
Depending on the analysis the analyst identifies and measures the credit risk
associated with a loan application and determines whether the level of risk inherent
is acceptable or not.
If the analyst is satisfied that the risk is acceptable and is convinced that the loan will
be repaid, he/she prepares and submits a recommendation to the appropriate loan
approval authority for sanctioning the loan.
 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.

1. 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.
2. Solvability ratios – These ratios deal with the balance sheet items and are used
to judge the future path that the company may follow.
3. 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.
4. Profitability ratios – These ratios show the ability of a company to earn
satisfactory profit over a period of time.
5. 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.
6. 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
7. 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.

8. SWOT analysis – This is again a subjective analysis, which is done to align

Liquidity Ratios
These ratios indicate the ease of turning current assets into cash. Liquidity refers a
company's ability to meet current obligations with cash or other assets that can be
quickly converted to cash. Liquidity ratios give an indication of a company's ability to
retire debts as they come due. Liquidity ratios include the Current Ratio, and the
Quick Ratio.
*The Current ratio formula is: Current assets divided by current liabilities. 
The current ratio is one of the best-known measures of financial liquidity. The
current ratio is the standard measure of any business' financial health. It will tell you
whether your business is able to meet its current obligations by measuring if it has
enough assets to cover its liabilities.
*The Quick ratio formula is: (Current assets less inventories) divided by current
liabilities. The quick ratio (also sometimes called the acid test ratio) measures a
business' liquidity. However, many financial planners consider it a tougher measure
than the current ratio because it excludes inventories when counting assets. It is a
more strenuous version of the "current ration indicating whether current liabilities
could be paid without selling inventory.
Leverage ratios
Leverage ratios measure the relative contribution of stockholders and creditors.
Leverage ratios indicate the extent to which the business is reliant on debt financing
(debts owed to creditors versus owner's equity). Leverage ratios show the extent
that debt is used in a company's capital structure.
*The Debt to Equity ratio formula is: Total liabilities divided by total equity. 
This ratio indicates how much the company is leveraged (in debt) by comparing
what is owed to what is owned. A high debt to equity ratio could indicate that the
company may be over-leveraged, and should look for ways to reduce its debt.
*The interest coverage ratio formula is: Earnings before Interest, Taxes,
Depreciation and Amortization divided by Interest Expense. 
This ratio indicates what portion of debt interest is covered by a company's cash
flow situation.
Profitability ratios
Profitability refers to a company's ability to generate revenues in excess of the costs
incurred in producing those revenues.
*The Gross profit margin formula is: Gross Profit divided by Total Sales. 
Net sales minus cost of goods sold equals gross profit. The gross profit margin ratio
indicates how efficiently a business is using its materials and labor in the production
process. It shows the percentage of net sales remaining after subtracting the cost of
goods sold.
*The Return on sales formula is: Net profit [net income after tax] divided by
Sales. 
This ratio compares after tax profit to sales. It can help you determine if customers
are making an adequate return on sales.
*The return on equity ratio formula is: Net income divided by Shareholders equity
It indicates what return a company is generating on the owners' investment.
*The return on assets formula is: Net Income divided by Average total assets.
The higher the rate of return on assets, the better from a creditor’s point of view.
Efficiency ratios
Efficiency ratios measure how well the company and its management uses the
assets under their control to generate sales and profits.
*The Payables turnover ratio formula is: Cost of sales divided by trade payables 
This number reveals how quickly a company under review pays its bills. The
payables turnover ratio reveals how often payables turn over during the year. A high
ratio means there is a relatively short time between purchase of goods and
payment. The importance of this ratio to creditors should be apparent.
*The Inventory turnover ratio formula is: Cost of goods sold divided by Average
inventory.
In general, the higher the turnover ratio the better the company under review is
performing.
*The Return on assets (ROA) ratio formula is: Earnings before interest and taxes
(EBIT) divided by net operating assets.
This efficiency ratio indicates how effective a company has been in utilizing its
assets. The ROA ratio is a test of capital utilization - how much profit (before interest
and income tax) a business earned on the total capital employed.
*The Asset turnover formula is: Net sales divided by Average total assets.
Asset turnover is an indicator of how efficiently a firm utilizes its assets. If the ratio is
high, it implies that the firm is using its assets efficiently to generate sales – and
ultimately profits.