Let us face it, most businesses cannot survive without leverage today. In a quest for survival and expansion, companies need to resort to debt as equity alone cannot suffice the requirements. Whether it is financing a new project, meeting working capital or expanding to a new market, a company requires funding at each stage. In India the credit or debt markets are not mature as compared to global standards, hence there is excessive dependence on the traditional banking system. However, companies issuing bonds to raise finance in India is also not uncommon.
Credit default or in simple words, inability to honour the debt repayment, is one of the most dreaded risks in the financial world since time immemorial. Sovereign debt crisis in the Eurozone in 2009, the Subprime crisis in the US in 2007 have caused bloodbath in the markets in the recent past.
On the domestic front, the blaring examples of Kingfisher airlines (outstanding debt of more than Rs.7,500 crore) and Sahara (outstanding debt of Rs 11,136 crore) are fresh in everyone’s mind. The banks have really had a tough time chasing these cases and much of it is still unresolved.
Therefore, credit risk is something that needs to be analysed very minutely. Credit analysis is defined as the as the evaluation of the ability of a company to honour its financial obligations.
Credit analysis is applicable in 2 major cases:
(1) When a company issues bonds in the market
(2) When a company seeks loan from banks/ financial institution for business purpose
When loan is sought from the bank, the bank’s credit team needs to carry out the credit analysis. When the company issues bonds or debt securities, credit rating is carried out by an independent credit rating agency.
The credit analysis mainly looks at 3 particular things:
- Assessing the probability of default by the borrowing company
- Assigning a risk rating to aid decision making
- Assessing the amount of loss that the lender/ bond investor would suffer in the event of default.
In a nutshell, banks and credit rating agencies look at the 5Ps viz People, Purpose, Payment, Protection and Prospects to analyse the credit worthiness of the borrower. The banks and credit rating agencies employ a lot of techniques for credit analysis such as-
- Financial statement analysis
Bank should ask for updated firm’s financial statements or additional financial information such as such as working capital, reserves, debtors, creditors, other bank loans etc, and comparative list with the previous year levels.
- Ratio and trend analysis
Initial projection of basic financial ratios such as accounts receivables days, inventory days, accounts payable days using scenario analysis. Have major implications for the cash position of the company. One of the most important ratio to watch out for is the Debt-service ratio. 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. The debt service coverage ratio should be 1.2 or higher which means that business can afford to pay its debt requirements with an extra cover for other contingencies.
- Detailed analysis of cash flow
The asset would include a balancing Projected Cash surplus would check whether the firm will have liquidity issues or whether it generates adequate cash to address its need. The current liabilities section of the balance sheet would another balancing account entitled “additional short-term debt” indicating the projected borrowing needs for the next year.
- Collateral Analysis
A collateral is an instrument to mitigate Credit Risk. In unfortunate events when the Cash flow cannot repay the loan, then the collateral can be sold to recover funds to repay the outstanding principal balance and other accrued items. The estimated worth of the collateral should always be valued by an acclaimed valuer and the market price must always exceed the amount of the loan. Also, the secured party should have an undisputed lien against the collateral.
- Credit history and repayment ability analysis
The banks or credit rating agencies analyse the historical records to check whether the company has honoured its debt repayments in the past. Any history of default of negotiated terms of loan are scrutinized thoroughly. This gives the agencies an idea about the repayment ability of the company.
- Credit Scoring system
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.
Making projections: The most challenging task
Projections are the most important instrument for any credit decision. However, projections can be one of the most challenging areas of credit assessment. 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.
The first step in this direction is understanding how to consider assumptions about against the backdrop of the risk factors. The accuracy of projections directly depends on the underlying assumptions. The basic steps in the credit evaluation of a loan is as follows:
The bank uses its credit rating model which analyses the risk of the borrower based on financial, business, industrial and management risks. After the due completion of the technical, financial and commercial viability of the loan is checked, and after the bank is convinced of a borrower’s financial strength, the bank chooses to sanction the loan. However, in certain cases, the bank still chooses to sanction the loan even though the financial performance is weak. In these cases, the bank considers parameters like strong order pipeline, number of profit making units, support from a public sector unit etc.
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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. Credit analysts today find opportunities in banks, credit departments of NBFCs, credit rating companies and consultancy firms. With courses like financial modelling and Post Graduate Program Investment Banking & Capital Markets by NSE Academy, IMS Proschool offers a practical curriculum for careers in Credit Analysis.