Financial modeling and Credit Analysis

Financial modeling and Credit Analysis

Globally credit markets are larger in market capitalization than the equity markets. However in India, unlike their equity counterparts, the credit or debt markets are not mature enough. Credit markets include markets where the participants issue new debt, or buy and sell debt securities. These markets operate with the primary objective of providing long term funding to government and corporate entities.

Credit analysis consists of evaluation of the creditworthiness of a business. Companies may have to take loans for various purposes such as a new project, working capital requirements, etc. Interest for these loans need to be paid off at the appropriate times. Credit Analysis hence can also be interpreted as the evaluation of the ability of a company to honor its financial obligations.

Credit Analysis is usually undertaken for businesses that want to raise money. This money can be raised by seeking a loan from a bank or by issuing new debt securities. When loan is sought from the bank, the bank’s credit team will carry out the credit analysis. When the company issues debt securities, credit rating is carried out by an independent credit rating agency.

A financial model, based on the historical data and estimates for the future years, is a handy tool for analysis. When credit analysis is carried out, detailed analysis of the borrower and the lending facility is done. The focus is on evaluating the cash flows that are expected to be generated over the future years and whether they are sufficient to cover for the interest and principal payments during the period.

Credit analysis involves a wide variety of financial analysis techniques. These include ratio and trend analysis of the historical data. Looking at these trends and the expectations of the future based on industry and economic scenarios, detailed cash flow projections are carried out. Ratio analysis for the future projections is also done to check if the desired credit ratios of the company are healthy. If these ratios indicate high risk, the projections are modified to find optimal cash flow scenarios.

Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability. As the analysis is done a risk rating is assigned based on the model. The risk rating is derived by estimating the probability of default by the borrower and by estimating the amount of loss that the lender would suffer in the event of default.

Often credit analysis is carried out using an objective, quantitative credit scoring system. In an accounting-based credit-scoring system, the credit analyst compares various key accounting ratios of potential borrowers with industry or group norms and trends in these variables. Often the financial model is used to directly provide the inputs to the credit scoring system. However practitioners are now moving towards a model of more rigorous statistical techniques based on the financial model developed.

Thus credit analysis demands use of rigorous financial models based on solid understanding of financial statements and expert modeling skills. An expert in financial modeling will possess both these desired skills.