F i n a n c e & I n v e s t m e n t C l u b

i i m r o h t a k
Finance and Investment Club, IIM Rohtak

TABLE OF CONTENTS

INTRODUCTION TO CREDIT ANALYSIS ................................................................................ 2

IMPORTANCE OF CREDIT ANALYSIS IN RISK MANAGEMENT ....................................... 2
ROLE OF CREDIT ANALYSTS ................................................................................................... 3
COMPONENTS OF CREDIT ANALYSIS ................................................................................... 5
FINANCIAL STATEMENTS ANALYSIS ................................................................................. 5
CREDITWORTHINESS ASSESSMENT................................................................................... 5
ECONOMIC CONDITIONS EVALUATION ............................................................................ 5
INDUSTRY AND MARKET ANALYSIS.................................................................................. 6
RISK MITIGATION STRATEGIES ........................................................................................... 6
PROCESS OF CREDIT ANALYSIS ............................................................................................. 7
TECHNIQUES USED IN CREDIT ANALYSIS........................................................................ 8
RATIO ANALYSIS ..................................................................................................................... 8
CASH FLOW ANALYSIS .......................................................................................................... 8
RISK ASSESSMENT MODELS ................................................................................................ 9
PEER COMPARISON ANALYSIS ............................................................................................ 9
SENSITIVITY ANALYSIS ........................................................................................................ 9
CREDIT ANALYSIS IN BANKING ........................................................................................ 10
CREDIT ANALYSIS IN INVESTMENT................................................................................. 10
CREDIT RATINGS ...................................................................................................................... 12
FINANCIAL RISK RATIOS FOR CREDIT ANALYSIS .......................................................... 14
LEVERAGE RATIOS ............................................................................................................... 16
COVERAGE RATIOS .............................................................................................................. 16
TRADITIONAL CREDIT ANALYSIS MODELS ...................................................................... 17
MODERN APPROACHES TO CREDIT ANALYSIS ................................................................ 18
CREDIT ANALYSIS AND DILIGENCE ................................................................................... 19
DEBT COVENANTS IN CREDIT ANALYSIS ......................................................................... 20

1 | Credit Analyst
Finance and Investment Club, IIM Rohtak

INTRODUCTION TO CREDIT ANALYSIS

Credit analysis is a form of financial analysis performed on companies, governments,

municipalities, or any other debt-issuing entities to assess the issuer's ability to meet its debt
obligations. It aims to identify the appropriate level of default risk associated with investing in that
particular entity's debt instruments.
Credit analysis is also undertaken by lenders to evaluate the creditworthiness of a potential
borrower, determining how capable and likely they are to repay principal and interest obligations.
A range of qualitative and quantitative techniques, including risk models, are employed when
conducting credit analysis to quantify and effectively price risk.

IMPORTANCE OF CREDIT ANALYSIS IN RISK MANAGEMENT

Credit analysis plays a crucial role in risk management by enabling financial institutions to
effectively identify, evaluate, and manage credit risk. Through comprehensive credit analysis,
financial institutions can determine the creditworthiness of borrowers and gauge the likelihood of
default or non-payment. This process allows them to make well-informed decisions about granting
credit, setting credit limits, and defining loan terms and conditions. Additionally, credit analysis
helps identify potential risks and weaknesses within loan portfolios, allowing institutions to apply
risk mitigation strategies to minimize potential losses. By actively managing credit risk through
thorough analysis, financial institutions can safeguard their assets, uphold financial stability, and
protect themselves against unfavorable economic conditions or market changes. In summary,
credit analysis is a vital component of risk management, helping financial institutions make sound
lending choices, protect their interests, and sustain their operations.

2 | Credit Analyst
Finance and Investment Club, IIM Rohtak

ROLE OF CREDIT ANALYSTS

1. Financial Institutions
This includes traditional commercial banks of all sizes, as well as credit unions. Numerous
roles in relationship management, analysis, and risk management within financial
institutions are available for individuals with strong credit skills, allowing them to develop
a highly rewarding career.

2. Private Lenders
Private, non-bank lenders operate in various forms, such as residential and commercial real
estate lending, equipment financing, and asset-based lending, among others. Additionally,
there are numerous opportunities for individuals with lending experience to explore roles
within private loan and mortgage brokerage firms.

3. Corporations
Many businesses that sell B2B extend credit terms to their customers; this is what’s called
trade credit. Many large corporations employ entire teams of credit analysts to assess the
creditworthiness of prospective customers and to set reasonable limits on their accounts.

4. Rating Agencies
Rating agencies like Fitch and Moody’s employ teams of credit analysts to assess the credit
risk of publicly traded companies. This fixed income credit analysis supports debt ratings
that are used to price fixed income securities, which are traded publicly (like corporate
bonds).

5. Institutional Investors
These firms also hire credit analysts to manage risk in their investment portfolios, or even
to manage the balance sheets of individual private companies that the firm has invested in
and which employ debt in their capital structures.

3 | Credit Analyst
Finance and Investment Club, IIM Rohtak

6. Fintech
Fintech is an abbreviation of two words – “financial technology.” For decades, technology
applications have disrupted traditional products and services across a variety of sectors;
financial services are no exception. Many technology companies are developing AI
(artificial intelligence) and machine learning-driven algorithms and programs to analyze
and underwrite credit more quickly and efficiently than traditional financial services firms,
which rely heavily on human intermediaries and considerable paperwork. While much of
the disruption and development has occurred in personal lending (where underwriting
credit is more homogenous and generally involves fewer data points), some companies are
also trying to innovate in the commercial credit space, particularly at the smaller end of the
business landscape.

4 | Credit Analyst
Finance and Investment Club, IIM Rohtak

COMPONENTS OF CREDIT ANALYSIS

FINANCIAL STATEMENTS ANALYSIS

Financial statements analysis is a fundamental component of credit analysis, involving the

examination of an entity’s financial documents to assess its financial health and performance. Key
financial statements, including the balance sheet, income statement, and cash flow statement, are
analyzed to evaluate liquidity, solvency, profitability, and cash flow generation. By scrutinizing
financial ratios, trends, and anomalies, analysts can gain insights into the borrower’s ability to
meet its debt obligations and assess its overall financial stability.

CREDITWORTHINESS ASSESSMENT

The creditworthiness assessment entails evaluating the borrower’s ability and willingness to repay
debt obligations based on their past credit history, financial behavior, and overall financial
capacity. Credit reports, credit scores, and payment histories are examined to gauge the borrower’s
creditworthiness and reliability in fulfilling its financial commitments. Additionally, factors such
as income stability, debt-to-income ratio, and collateral availability are considered in assessing the
borrower’s creditworthiness and risk profile.

ECONOMIC CONDITIONS EVALUATION

Assessing economic conditions is a critical aspect of credit analysis as it provides insights into the
macroeconomic factors that could impact the borrower’s ability to repay debt. Analysts examine
factors such as economic growth, inflation rates, industry trends, and regulatory changes to assess
the overall risk environment and potential challenges that may affect the borrower’s financial
stability. By considering economic indicators and external factors, analysts can better understand
the broader economic landscape and its implications for the borrower’s creditworthiness.

5 | Credit Analyst
Finance and Investment Club, IIM Rohtak

INDUSTRY AND MARKET ANALYSIS

Industry and market analysis involves evaluating the specific industry or market in which the
borrower operates to assess its competitive position, growth prospects, and risk factors. Analysts
examine industry trends, competitive dynamics, regulatory environment, and market conditions to
understand the opportunities and challenges facing the borrower’s business. By conducting a
thorough industry analysis, analysts can assess the borrower’s ability to withstand industry-
specific risks and adapt to changing market conditions, thereby informing credit decisions.

RISK MITIGATION STRATEGIES

Risk mitigation strategies are implemented to manage and mitigate the various risks associated
with extending credit to borrowers. These strategies may include diversification of credit
portfolios, collateralization of loans, imposition of credit limits, and implementation of risk
management policies and procedures. By identifying potential risks and implementing appropriate
risk mitigation measures, lenders and investors can minimize the likelihood of default and protect
their interests in the event of adverse developments.

6 | Credit Analyst
Finance and Investment Club, IIM Rohtak

PROCESS OF CREDIT ANALYSIS

The credit analysis process involves several key steps aimed at evaluating the creditworthiness of
borrowers and assessing credit risk. Here’s an overview:

● Gathering Information: Analysts collect relevant data, including financial statements,

credit reports, market information, and qualitative factors such as management quality and
industry dynamics. Financial solvency, profitability, and financial performance indicators.

● Risk assessment: Evaluating credit risk factors such as industry trends, economic
conditions, borrower characteristics, and collateral quality to quantify the likelihood of
default.

● Credit Rating: Assigning credit ratings or scores based on the assessment of credit risk,
indicating the borrower’s creditworthiness and likelihood of default.

● Decision Making: Making informed decisions based on the credit analysis findings, such
as approving or denying credit, setting lending terms, or making investment
recommendations.

● Monitoring and Review: Continuously monitoring borrower creditworthiness, market

conditions, and macroeconomic factors to update credit assessments and adjust risk
management strategies as needed.

7 | Credit Analyst
Finance and Investment Club, IIM Rohtak

TECHNIQUES USED IN CREDIT ANALYSIS

RATIO ANALYSIS

Ratio analysis is a fundamental technique used in credit analysis to evaluate the financial health
and performance of a borrower. It involves calculating and interpreting various financial ratios
derived from the borrower’s financial statements, such as the balance sheet and income statement.
These ratios provide insights into key aspects of the borrower’s financial position, including
liquidity, solvency, profitability, and efficiency. Commonly used ratios in credit analysis include
liquidity ratios (e.g., current ratio, quick ratio), leverage ratios (e.g., debt-to-equity ratio, interest
coverage ratio), profitability ratios (e.g., return on assets, return on equity), and efficiency ratios
(e.g., inventory turnover, accounts receivable turnover). By analyzing these ratios, analysts can
assess the borrower’s financial strengths and weaknesses, identify trends, and make informed
decisions regarding creditworthiness.

CASH FLOW ANALYSIS

Cash flow analysis is another essential technique used in credit analysis to evaluate the cash flow
generation and management capabilities of a borrower. It involves examining the borrower’s cash
flow statement to assess the sources and uses of cash over a specific period. By analyzing cash
flows from operating, investing, and financing activities, analysts can determine the adequacy of
cash flows for meeting debt obligations, funding capital expenditures, and supporting business
operations. Key metrics used in cash flow analysis include operating cash flow, free cash flow,
cash flow coverage ratios, and cash flow to debt ratios. Cash flow analysis helps analysts assess
the borrower’s ability to generate sufficient cash flows to support debt repayment and maintain
financial stability.

8 | Credit Analyst
Finance and Investment Club, IIM Rohtak

RISK ASSESSMENT MODELS

Risk assessment models are quantitative techniques used in credit analysis to quantify credit risk
and predict the likelihood of default by a borrower. These models utilize statistical methods,
mathematical algorithms, and predictive analytics to assess creditworthiness and assign credit
ratings or scores to borrowers. Commonly used risk assessment models include credit scoring
models, probability of default models, and loss-given default models. These models incorporate
various factors such as credit history, financial ratios, economic indicators, and industry trends to
estimate the probability of default and assign a credit risk rating. By utilizing risk assessment
models, analysts can standardize the credit evaluation process, improve decision-making accuracy,
and efficiently manage credit risk.

PEER COMPARISON ANALYSIS

Peer comparison analysis involves comparing the financial performance and credit metrics of a
borrower with those of its industry peers or competitors. This technique helps analysts benchmark
the borrower’s financial position and creditworthiness against industry norms and identify relative
strengths and weaknesses. By analyzing key financial ratios, credit scores, and performance
metrics of peer companies, analysts can assess how the borrower’s financial performance
compares to industry benchmarks and identify areas for improvement. Peer comparison analysis
provides valuable insights into the borrower’s competitive position, market share, and relative
credit risk, helping analysts make more informed credit decisions.

SENSITIVITY ANALYSIS

Sensitivity analysis is a technique used in credit analysis to assess the impact of changes in key
variables or assumptions on the borrower’s financial performance and credit risk. Analysts conduct
sensitivity analysis by varying input parameters such as interest rates, exchange rates, commodity
prices, and market conditions to evaluate the potential effects on the borrower’s cash flows,
profitability, and debt servicing capacity. By performing sensitivity analysis, analysts can identify
potential risks and vulnerabilities in the borrower’s financial projections and assess its ability to

9 | Credit Analyst
Finance and Investment Club, IIM Rohtak

withstand adverse scenarios. Sensitivity analysis helps analysts stress-test the borrower’s financial
position and make more robust credit decisions in uncertain or volatile environments.

CREDIT ANALYSIS IN BANKING

In the banking sector, credit analysis plays a crucial role in assessing the creditworthiness of loan
applicants and determining the terms and conditions of loans. banks rely on credit analysis to
evaluate the financial health, stability, and repayment capacity of borrowers before extending
credit facilities. Credit analysts meticulously examine the borrower’s financial statements, credit
history, cash flow projections, and collateral to assess the risk associated with lending money.
Based on the findings of the credit analysis, banks make informed decisions regarding the
approval, amount, interest rate, and repayment schedule of loans. In addition, credit analysis helps
banks identify potential risks, such as default or non-payment, and implement risk mitigation
strategies to protect their interests. By conducting thorough credit analysis, banks can minimize
the risk of loan defaults, maintain a healthy loan portfolio, and ensure the stability of their financial
operations.

CREDIT ANALYSIS IN INVESTMENT

In the investment sector, credit analysis is essential for evaluating the credit risk associated with
bonds, fixed-income securities, and other investment instruments. Investors rely on credit analysis
to assess the credit quality of issuers and determine the risks and rewards associated with
investment opportunities. Credit analysts analyze the financial strength, cash flow generation, and
debt repayment capacity of issuers to determine their ability to meet their financial obligations. By
conducting credit analysis, investors can make informed investment decisions, allocate capital
efficiently, and optimize portfolio returns. Additionally, credit analysis helps investors identify
attractive investment opportunities and avoid investments with high credit risk. Overall, credit
analysis plays a critical role in investment decision-making by providing insights into the
creditworthiness of issuers and helping investors manage investment risk effectively.

10 | Credit Analyst
Finance and Investment Club, IIM Rohtak

CREDIT ANALYSIS FRAMEWORK- THE 5Cs

A popular credit analysis framework is the 5 Cs of Credit; the 5 Cs underpin the component parts
of most risk rating and loan pricing models. The 5 Cs are:

● Character – This is about understanding who the borrower is, including what their credit
history may tell us about their likelihood of making future loan payments.

● Capacity – This speaks to the borrower’s actual ability to make payments using internally-
generated cash flow (by the company for a business borrower or by way of personal
earnings for a retail borrower).

● Capital – This is an evaluation of the borrower’s overall financial health but also an
assessment of alternative sources of liquidity should it be necessary.

● Collateral – This evaluates the quality and the overall desirability of any physical asset
that is available as security.

● Conditions – This is, in part, understanding the purpose of the loan proceeds but also
conditions in the external environment that may impact the borrower’s financial health and
cash position.

11 | Credit Analyst
Finance and Investment Club, IIM Rohtak

CREDIT RATINGS

Long-Term Ratings Matrix: Investment Grade vs. Non-Investment Grade

Grade Subgrade Moody’s S&P Fitch

Investment High-Quality Aaa AAA AAA
Grade Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA- AA-
Upper-Medium A1 A+ A+
Grade A2 A A
A3 A- A-
Low-Medium Baa1 BBB+ BBB+
Grade Baa2 BBB BBB
Baa3 BBB- BBB-

Grade Subgrade Moody’s S&P Fitch

Non-Investment Low Grade or Ba1 BB+ BB+
Grade Speculative Ba2 BB BB
Grade Ba2 BB- BB-
B1 B+ B+
B2 B B
B3 B- B-
Caa1 CCC+ CCC+
Caa2 CCC CCC
Caa3 CCC- CCC-
Ca CC CC
C C C
Default C D D

12 | Credit Analyst
Finance and Investment Club, IIM Rohtak

● Bonds rated AAA/Aaa have the highest quality, lowest credit risk, and lowest probability
of default. They have extremely low default rates.

● Bonds rated Baa3/BBB- or higher are investment grade bonds. Investment grade is further
divided into high-quality, upper-medium and low-medium.

● Bonds rated lower than Baa3/BBB- are non-investment grade bonds. Non-investment
grade includes speculative and default bonds. These have higher default risk.

● Outlook: This is an additional indicator on a rating. The outlook can be positive, stable, or
negative.

● The rating agencies may also indicate the potential direction of the ratings by including
comments like “on review for a downgrade” or “on credit watch for an upgrade”.

13 | Credit Analyst
Finance and Investment Club, IIM Rohtak

FINANCIAL RISK RATIOS FOR CREDIT ANALYSIS

The following table contains some of the more common credit analysis ratios used to assess the
default risk of borrowers, at the brink of insolvency.

Credit Metrics Formula Explanation

Total Leverage Ratio Total Debt/EBITDA • Measures Total Debt
to EBITDA
• Common
Maintenance
Covenant
Net debt Leverage Ratio Net Debt/EBITDA • Measures Total Debt
Less Cash to EBITDA
• Nets Cash Against
Debt
Senior Debt Leverage Ratio Senior Debt/EBITDA • Measures Just the
Senior Debt to
EBITDA
• Frequent Maintenance
Covenant
EBIT Coverage Ratio EBIT/Interest Expense • Ability of EBIT to
Service Interest
• Useful if Cyclical
(i.e., D&A Fluctuates)
EBITDA Interest Coverage EBITDA/Interest Expense • Ability of EBITDA to
Ratio Service Interest
• Adds-Back D&A -
But Misleading for
Capital-
Intensive Industries

14 | Credit Analyst
Finance and Investment Club, IIM Rohtak

Capex-Adjusted Coverage (EBITDA-Capex)/Interest • Ability of EBITDA

Ratio Expense Less Capex to Service
Interest
• Useful if Capital-
Intensive (Cyclical
Capex)
Cash Interest Coverage Ratio EBITDA/Cash Interest Compares FCF Proxy to
Expense Fixed, Non- Discretionary
Debt Obligations
Fixed Charge Coverage Ratio (EBITDA-Capex-Cash Average # of Days to Collect
Taxes)/ (Cash Interest Credit Payments (Quarterly)
Expense + Mandatory
Repayment)
A/R Days (AR/Revenue) *90 days Average # of Days to Pay
Suppliers / Vendors for
Credit Purchases (Quarterly)
A/P Days (AP/COGS) *90 days Average # of Days to Pay
Suppliers / Vendors for
Credit Purchases (Quarterly)
Inventory Days (inventory/COGS) *90 days Average # of Days to Sell Off
Inventory
Balance (Quarterly)
Cash Conversion Cycle A/R days + inventory days- Average # of Days to Convert
(“CCC”) A/P days Inventory into Cash from
Sales

15 | Credit Analyst
Finance and Investment Club, IIM Rohtak

LEVERAGE RATIOS

Leverage ratios place a ceiling on debt levels, whereas coverage ratios set a floor that cash flow
relative to interest expense cannot dip below.

● Total Leverage Ratio: The most common leverage metric used by corporate bankers and
credit analysts is the total leverage ratio (or Total Debt / EBITDA). This ratio represents
how many times the obligations of the borrower are relative to its cash flow generation
capacity.

● Net Leverage Ratio: Another common metric is the net leverage ratio (or Net Debt /
EBITDA), which is like the total debt ratio, except the debt amount is net of the cash
balance belonging to the borrower. The reasoning is that cash on the balance sheet could
theoretically help pay down the debt outstanding.

● (EBITDA – Capex) Leverage Ratio: Meanwhile, EBITDA, despite its shortcomings, is

the most widely used proxy for cash flow. For cyclical industries where EBITDA fluctuates
because of inconsistent capex patterns and financial performance, other metrics can be used
such as EBITDA less Capex.

COVERAGE RATIOS

While leverage ratios assess whether the borrower has an excess level of leverage on its balance
sheet, the coverage ratios confirm whether its cash flows can cover its interest expense payments.

● Interest Coverage Ratio: The most frequently used coverage ratio is the interest coverage
covenant (or EBITDA / Interest), which represents the cash flow generation of the
borrower relative to its interest expense obligations coming due. Lenders desire a higher
interest coverage ratio in all cases as it represents more “room” to meet its interest
payments, especially for borrowers operating in more cyclical industries.

16 | Credit Analyst
Finance and Investment Club, IIM Rohtak

● FCCR and DSCR: Other common coverage ratios are the fixed charge coverage ratio
(FCCR) and debt service coverage ratio (DSCR). Certain creditors pay more attention to
these ratios due to how the denominator can include principal amortization and leases/rent.

TRADITIONAL CREDIT ANALYSIS MODELS

Traditional credit analysis models rely on fundamental financial analysis and qualitative
assessment to evaluate the creditworthiness of borrowers. These models have been established
over time and are widely used in the financial industry. Some common traditional credit analysis
models include:

● Altman Z-Score Model: Developed by Edward Altman, the Z-Score model uses financial
ratios such as working capital, retained earnings, and earnings before interest and taxes
(EBIT) to predict the likelihood of bankruptcy. The formula is:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = Earnings Before Interest and Taxes (EBIT) / Total Assets
D = Market Value of Equity / Total Liabilities
E = Sales / Total Assets

● Moody’s KMV Model: The Moody’s KMV model uses a structural approach to assess
credit risk, focusing on the probability of default (PD) and loss given default (LGD). It
considers factors such as asset volatility, leverage, and capital structure to estimate credit
risk metrics.

● Bond Rating Agencies Models: Credit rating agencies such as Standard & Poor’s,
Moody’s, and Fitch Ratings utilize proprietary models and methodologies to assign credit
ratings to issuers and debt instruments. These models consider financial metrics, industry
dynamics, and qualitative factors to assess credit risk.

17 | Credit Analyst
Finance and Investment Club, IIM Rohtak

MODERN APPROACHES TO CREDIT ANALYSIS

Modern approaches to credit analysis leverage advanced statistical techniques, machine learning
algorithms, and big data analytics to enhance predictive accuracy and efficiency. These approaches
enable real-time monitoring and risk management, providing valuable insights into credit risk
dynamics. Some modern credit analysis approaches include:
Machine Learning Models: Machine learning algorithms analyze large datasets and identify
complex patterns to predict credit risk more accurately. These models consider a wide range of
factors, including financial data, economic indicators, and behavioral patterns, to assess
creditworthiness.

● Big Data Analytics: Big data analytics techniques process vast amounts of structured and
unstructured data from diverse sources, such as social media, transactional records, and
alternative data sources, to identify credit risk trends and patterns.

● Predictive Analytics: These techniques use statistical models and historical data to
forecast future credit events, such as default probabilities and loan delinquencies. These
models help lenders and investors make proactive decisions and manage credit risk more
effectively.

18 | Credit Analyst
Finance and Investment Club, IIM Rohtak

CREDIT ANALYSIS AND DILIGENCE

The higher the default risk, the higher the required yield is, as investors require more compensation
for the additional risk being undertaken.

Default Risk The measurement of the default risk is

assessing the probability of the borrower
missing an interest expense payment and/or
being unable to repay the principal on the due
date
Loss-Given-Default Risk (“LGD”) LGD calculates the loss potential in the event
of default and takes into consideration such as
liens on the debt obligations (i.e., collateral
pledged as part of the lending agreement)
Maturity Risk The maturity risk is about how the lender
requires greater returns the longer the maturity
date is, as the potential for default increases
alongside the length before maturity

19 | Credit Analyst
Finance and Investment Club, IIM Rohtak

DEBT COVENANTS IN CREDIT ANALYSIS

Debt covenants represent contractual agreements from a borrower to refrain from certain activities
or an obligation to maintain certain financial thresholds. These legally binding clauses can be
found in credit documentation such as loan agreements, credit agreements, and bond indentures,
and are requirements and conditions imposed by the lenders that the borrower agrees to abide by
until the debt principal and all associated payments are paid. Intended to protect the interests of
lenders, covenants establish parameters that encourage risk-averse decisions through avoidance of
activities that could place the timely payment of interest expense and principal on the date of
maturity into question. When banks lend to corporate borrowers, they are looking first for their
loan to be repaid with a low risk of not receiving interest or principal amortization payments on
time.
Whether structuring a secured senior loan or other forms of debt lower in the capital structure,
covenants are negotiations between the borrower and the creditor to facilitate an agreement that is
satisfactory to both parties. If a borrower were to breach a debt covenant in place, this would
constitute a default stemming from the violation of the credit agreement (i.e., serving as a
restructuring catalyst). But in most cases, there will be a so-called “grace period”, whereby there
may be monetary penalties as stipulated in the lending agreement but time for the borrower to fix
the breach.

HOW COVENANTS IMPACT CREDIT RISK

Senior debt lenders prioritize capital preservation above all else, which is accomplished by strict
debt covenants and placing liens on the assets of the borrower. As a general rule, strict covenants
signify a safer investment for creditors, but at the expense of reduced financial flexibility from the
perspective of the borrower.

20 | Credit Analyst
Finance and Investment Club, IIM Rohtak

Covenants to senior lenders (e.g., banks) are crucial factors when structuring a loan to ensure:

● The borrower can service its debt commitments with an adequate “cushion”.

● Protections are in place for the worst-case scenario (i.e., liquidations in restructuring), so
if the borrower defaults, the lender has the legal right to seize those assets as part of the
agreement.

● In return for this security (and collateral protection), bank debt has the lowest expected
return, while unsecured lenders (similar to equity shareholders) demand higher returns as
compensation for the additional risk taken on. The more debt placed on the borrower, the
higher the credit risk. In addition, the less collateral that can be pledged; hence, borrowers
have to seek riskier debt tranches to raise more debt capital after a certain point. For the
lenders that do not require collateral and are lower in the capital structure, collectively these
types of creditors will require higher compensation as higher interest (and vice versa).

21 | Credit Analyst