Importance of

Credit Analysis
Credit analysis is a type of financial analysis that an investor or bond portfolio
manager performs on companies, governments, municipalities, or any other debt-
issuing entities to measure the issuer's ability to meet its debt obligations. Credit
analysis seeks to identify the appropriate level of default risk associated with
investing in that particular entity's debt instruments.
Importance
1. For borrowers, it offers insight into their personal finances and creditworthiness,
as well as the opportunity to make necessary changes in order to qualify for future
loans.
2. For lenders, performing a credit analysis helps ensure that they are taking on
minimal risk when considering a potential borrower. By looking at factors such as
credit history, debt-to-income ratio, and collateral value, lenders will be able to
determine whether or not the applicant meets their lending criteria.
3. Lenders can make better-informed decisions on how much money to lend out and
at what interest rate. This helps reduce the risk associated with any given loan and
keeps lenders protected from default payments.
4. Borrowers can identify areas where improvements need to be made in order to
increase their chances of being approved for additional loans in the future.
5. Credit analysis is essential for both lenders and borrowers alike because it
provides each party with vital information that would otherwise remain hidden
from view without it.
Stages of Credit
Analysis
The credit process evaluates the ability and willingness of a borrower to repay the debt,
underwrites the risk, prices the loan, and determines whether the loan fits the bank’s
portfolio. An integral part of the credit process is analysis of the borrower’s cash flows and
financial statements.
The credit process involves several steps that can be broken down into initial and later
stages.
1. Generating a Loan Opportunity
In the initial stage, the loan opportunity is generated. Thereafter, the credit team undertakes
a risk assessment that involves an initial analysis of the potential borrower’s business.
Credit analysis covers business risk and financial risk as part of the initial risk assessment.
2. Reviewing the Five Cs of Credit
Financial institutions attempt to mitigate risk by reviewing the five Cs of credit – capacity,
capital, conditions, character, and collateral. These five Cs provide lenders a framework for
identifying and mitigating risk.
3. Structuring the Loan
The point of structuring a loan is to mitigate risk and includes details such as the identity of
the borrower, any complexities in the borrower’s corporate structure, and a payment
schedule that matches the borrower’s future cash flows.
4. Preparing a Credit Memo
The memo includes details such as the borrower’s debt capacity, clarification of risks
involved, and how those risks will be mitigated.
5. Loan Syndication
in the case of a larger loan, a syndicate team will price the loan and distribute exposure to a
group of banks called a syndicate.
Leverage Ratios
A leverage ratio is any one of several financial measurements that look at how
much capital comes in the form of debt (loans) or assesses the ability of a company to meet
its financial obligations.
Too much debt can be dangerous for a company and its investors. However, if a company's
operations can generate a higher rate of return than the interest rate on its loans, then the debt
may help to fuel growth. Uncontrolled debt levels can lead to credit downgrades or worse.
The Debt-to-Equity (D/E) Ratio
This is expressed as:
Debt-to-Equity Ratio= Total Liabilities​
​ Total Shareholders’ Equity
A high debt/equity ratio generally indicates that a company has been aggressive in financing
its growth with debt.

The Debt-to-Capitalization Ratio

An indicator that measures the amount of debt in a company’s capital structure is the debt-to-
capitalization ratio, which measures a company’s financial leverage.
It is calculated as:
Total debt to capitalization= (SD+LD)​
(SD+LD+SE)
where:
SD=short-term debt
LD=long-term debt
SE=shareholders’ equity​
Degree of Financial Leverage
DFL= EBIT​
EBIT−Interest
This ratio indicates that the higher the degree of financial leverage, the more volatile
earnings will be. This is good when operating income is rising, but it can be a problem when
operating income is under pressure.

The Debt-To-EBITDA Leverage Ratio

The Debt-to-EBITDA leverage ratio measures a company's ability to pay off its incurred
debt. Commonly used by credit agencies, this ratio determines the probability of defaulting
on issued debt.
EBITDA is earnings before interest, taxes, depreciation, and amortization

The Interest Coverage Ratio

This ratio, which equals operating income divided by interest expenses, showcases the
company's ability to make interest payments.

The Debt-To-Capital Ratio

The debt-to-capital ratio is a measurement of a company's financial leverage. It is one of the
more meaningful debt ratios because it focuses on the relationship of debt liabilities as a
component of a company's total capital base. If a company has a high debt-to-capital ratio
compared to its peers, it may have a higher default risk due to the effect the debt has on its
operations.
Analysis of Working
Capital
Working capital is the amount of an entity's current assets minus its current
liabilities. This represents the amount of assets that can be liquidated in the near
future to pay off a firm’s more pressing obligations.
Working capital analysis is used to determine the liquidity and sufficiency of
current assets in comparison to current liabilities. This information is needed to
determine whether an organization needs additional long-term funding for its
operations, or whether it should plan to shift excess cash into longer-term
investment.
The first part of working capital analysis is to examine the timelines within
which current liabilities are due for payment. This can be done by examining an
aged accounts payable report, which divides payables into 30-day time buckets.
By revising the format of this report to show smaller time buckets, it is possible
to determine cash needs for much shorter time intervals. The timing of other
obligations, such as accrued liabilities, can then be layered on top of this
analysis to provide a detailed view of exactly when obligations must be paid.
Next in the same analysis is for accounts receivable, using the aged accounts
receivable report, and also with short-term time buckets. The outcome of this
analysis will need to be revised for those customers that have a history of
paying late, so that the report reveals a more accurate assessment of probable
incoming cash flows.
A further step is to examine any investments to see if there are any
restrictions on how quickly they can be sold off and converted into
cash. Finally, review the inventory asset in detail to estimate how
long it will be before this asset can be converted into finished
goods, sold, and cash received from customers. It is quite possible
that the period required to convert inventory into cash will be so
long that this asset is irrelevant from the perspective of being able
to pay for current liabilities.
The next major activity is to net these analyses together into a
modified short-term cash forecast, using very brief time periods,
such as intervals of every three to five days. If there is a shortage in
the amount of available cash in any time bucket, it will be
necessary to either plan for a delayed payment to a supplier, or to
obtain sufficient cash from new debt or equity to offset the
shortfall.
Liquidity
Liquidity refers to the efficiency or ease with which an asset or security can be
converted into ready cash without affecting its market price. The most liquid asset of all
is cash itself.
The more liquid an asset is, the easier and more efficient it is to turn it back into cash.
Less liquid assets take more time and may have a higher cost.
Cash is universally considered the most liquid asset because it can most quickly and
easily be converted into other assets. Tangible assets, such as real estate, fine art, and
collectibles, are all relatively illiquid. If markets are not liquid, it becomes difficult to
sell or convert assets or securities into cash.
Market Liquidity
Market liquidity refers to the extent to which a market, such as a country’s stock market
or a city’s real estate market, allows assets to be bought and sold at stable, transparent
prices.
The stock market, on the other hand, is characterized by higher market liquidity. When
the spread between the bid and ask prices tightens, the market is more liquid; when it
grows, the market instead becomes more illiquid. Markets for real estate are usually far
less liquid than stock markets.
Accounting Liquidity
Accounting liquidity measures the ease with which an individual or company can meet
their financial obligations with the liquid assets available to them—the ability to pay
off debts as they come due. In investment terms, assessing accounting liquidity means
comparing liquid assets to current liabilities, or financial obligations that come due
within one year.
Financial analysts look at a firm’s ability to use liquid assets to cover its short-term
obligations. When using these formulas, a ratio greater than one is desirable.

Current Ratio
The current ratio is the simplest and least strict. It measures current assets (those that can
reasonably be converted to cash in one year) against current liabilities. Its formula would
be:
Current Ratio = Current Assets / Current Liabilities

Quick Ratio (Acid-Test Ratio)

The quick ratio, excludes inventories and other current assets, which are not as liquid as
cash and cash equivalents, accounts receivable, and short-term investments. The formula
is:
Quick Ratio =Liquid Assets / Current Liabilities
Liquid assets = Current assets – Closing Stock – Prepaid

Cash Ratio
The cash ratio assesses an entity’s ability to stay solvent in case of an emergency.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Cash Cycle Risk
The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) that it
takes for a company to convert its investments in inventory and other resources into cash
flows from sales. Also called the net operating cycle or simply cash cycle, CCC attempts to
measure how long each net input rupee is tied up in the production and sales process before it
gets converted into cash received.
This metric takes into account how much time the company needs to sell its inventory, how
much time it takes to collect receivables, and how much time it has to pay its bills.
The CCC is one of several quantitative measures that help evaluate the efficiency of a
company’s operations and management. A trend of decreasing or steady CCC values over
multiple periods is a good sign, while rising ones should lead to more investigation and
analysis based on other factors.

INVENTORY

PAYABLES RECEIVABLE

CASH
All cash collections must be properly identified, control totals developed,
and collections promptly deposited to limit risks associated with
recording cash receipts or withholding or delaying the recording of cash
receipts. All transactions should be promptly and accurately recorded in
sufficient detail on proper accounting records and appropriate reports
issued to prevent unauthorized transaction substitution with unsupported
credits or fictitious expenditures.
Common risks associated with cash cycle include:
• The authorization or accuracy of cash receipts, the failure to record
cash receipts or withholding or delaying the recording of cash receipts.
• diverted cash receipts; unauthorized cash disbursements or loss of
funds
• Covering unauthorized transactions by substituting unsupported credits
or fictitious expenditures to cover misappropriated collections; under
or over estimating cash or receivables.
• Misstating cash balances; covering unauthorized transactions by
falsifying bank reconciliation.
Measurement of Risk
Risk management is a crucial process used to make investment decisions. Risk management
involves identifying and analyzing risk in an investment and deciding whether or not to
accept that risk given the expected returns for the investment. Some common measurements
of risk include Standard Deviation, Sharpe ratio, beta, Value at risk (VaR), Conditional
value at risk (CVaR), and R-squared.

Standard Deviation
Standard deviation measures the dispersion of data from its expected value. The standard
deviation is commonly used to measure the historical volatility associated with an
investment relative to its annual rate of return. It indicates how much of the current return is
deviating from its expected historical normal returns. For example, a stock that has high
standard deviation experiences higher volatility and is therefore considered riskier.
Sharpe Ratio
The Sharpe ratio measures investment performance by considering associated risks. To
calculate the Sharpe ratio, the risk-free rate of return is subtracted from the overall expected
return of an investment. The remaining return is then divided by the associated investment’s
standard deviation. The result is a ratio that compares the return specific to an investment
with the associated level of volatility an investor is required to assume for holding the
investment. The Sharpe ratio serves as an indicator of whether an investment's return is
worth the associated risk.
The Sharpe ratio is most useful when evaluating differing options. This measurement
allows investors to easily understand which companies or industries generate higher returns
for any given level of risk.
Beta
Beta measures the amount of systematic risk an individual security or sector has relative to
the entire stock market. the market always has a beta of one.
If a security's beta is equal to one, the security has exactly the same volatility profile as the
broad market. A security with a beta greater than one means it is more volatile than the
market. A security with a beta less than one means it is less volatile than the market.

Value at Risk (VaR)

Value at Risk (VaR) is a statistical measurement used to assess the level of risk associated
with a portfolio or company. The VaR measures the maximum potential loss with a degree of
confidence for a specified period. For eg. a portfolio of investments has a one-year 10% VaR
of $5 million. Therefore, the portfolio has a 10% chance of losing $5 million over a
one-year period.

R Squared
R-squared is a measure of the correlation between the asset and the underlying
benchmark. R-Squared is most useful when attempting to determine why the price of an
investment changes. For fixed-income securities and bond funds, the benchmark is the
government fixed deposits. The BSE and NIFTY Index are the benchmark for equities
and equity funds.
An R-squared value of 0.9 means 90% of the analysis accounts for 90% of the variation
within the data. Risk models with higher R-squared values indicate that the independent
variables being used within the model are explaining more of the variation of the dependent
variable.
Objectives of Rating
Following are the objectives of credit rating:
1. To rate the debt instruments as objectively as possible in order to build market
confidence in them.
2. To protect the interests of investors especially the small and gullible investors by
giving adequate clues in the form of ratings regarding safety and/or profitability
of investments.
3. Ratings are chalked out exclusively for the purpose of grading debentures,
bonds, Government bonds, municipality bonds, public deposits, commercial
paper etc. according to their investment qualities.
4. Current assessment of the creditworthiness of an issuer of securities with respect
to specific obligations.
5. Credit rating is an opinion of credit rating agencies indicating relative safety of
timely payment of interest and principal on a debenture, preference share, fixed
deposit or short- term instrument by a company.
6. A specific disclosure reflecting the opinion on repayment capacity of the issuer
body.
7. To help investors in investment decisions.
8. To assist the regulators in promoting the transparency in the financial market.
Internal and External Rating
A credit rating is a measure of the credit quality of an organization's or an
individual's obligations.

Internal Rating
Done by the institution themselves. Most banks have models for rating the
creditworthiness of their corporate and retail clients. Also, there is an
internal-ratings-based (IRB) approach in the norms used by banks to gauge
their own credit risk and proceed accordingly. Undertaken internally by the
staff of Bank independently by Risk Management department.

External Rating
Certain organizations called Credit Rating Agencies such as such as
CRISIL,ICRA, CARE, FITCH, SMERA,ONICRA, BRICKWORK have
professional analysts who provide credit ratings on a contractual basis.
Credit ratings, however, are mainly done for companies that have publicly
traded debt and are usually paid for by institutional investors.
Model Credit Rating
Credit Rating Model is a generic description for Credit Risk models applied principally
to commercial (corporate) lending. Risk rating models are tools used to assess
the probability of default. Risk rating models use several factors and implement a set of
rules to assess the default probability of a borrower or debt security. The models
generally use these factors and rules to generate a numerical or symbol-based rating that
summarizes the level of default risk of the borrower or debt security involved.
A risk rating model is a key tool for lending decisions and portfolio
management/portfolio construction. They give creditors, analysts, and portfolio managers
a rather objective way of ranking borrowers or specific securities based on their
creditworthiness and default risk.
They also allow a bank to set and monitor the level of risk in their credit portfolio and
assess whether specific adjustments are needed.

Factors Used in Risk Rating Models

Risk rating models generally use a variety of factors as inputs. They may be purely based
on statistical evidence and subjective elements. Most of the factors used in the models are
quantitative.
The factors used in risk rating models generally look at a borrower’s health, industry
characteristics and conditions, and macroeconomic factors.
1. Judgment vs. Data
The methodology used to develop the risk rating model can give more weight to
judgment or statistics. It will depend on the availability of relevant data, the integrity and
accuracy of the data, and the ease of storage and access to such data.
2. Borrower’s Financial Health
The factors that assess a borrower’s financial health generally include a variety of ratios:
Liquidity, to determine whether a borrower is able to pay off their current obligations.
Eg. cash ratio, current ratio, and acid ratio.
Leverage ratios, also called solvency ratios, to assess a company’s ability to meet its
long-term financial obligations. These ratios look at a company’s capital structure and
include the equity ratio or the debt ratio.
Profitability ratios, to determine whether the company generates profits in its ordinary
business activities. Eg. operating margin, EBITDA margin, and return on invested
capital.
Cash flow ratios, to assess a company’s ability to generate cash flows that can be used
to pay off its obligations. Eg. cash flow coverage ratio or cash flow to net income ratio.

3. Industry Characteristics
Industry characteristics and macroeconomic factors can affect a company’s
creditworthiness.
In an industry with low barriers to entry, a company’s ability to generate cash flows may
be subject to more significant risks.
For any industry, the current phase of the industry or business cycle can affect a
company’s creditworthiness. In the recession phase of the industry cycle, even
companies that are financially healthy may face a deterioration in creditworthiness.
4. Management’s Quality and Reliability
Many risk rating models give a score to a company’s management
based on a combination of objective and subjective factors.
Assessment of the management’s tenure and experience, which
comprise elements, such as the management’s seniority and years of
experience, and relevance of the experience and qualifications.
A deeper analysis of a management’s history of value creation, clarity
of communication, quality and frequency of information disclosed,
and capital allocation decisions.

5. Political and Environmental Risks

Risk rating models use risk factors like Political risks, which consider
aspects such as the risks of war, the rule of law, and the reliability of
the institutions. Environmental risks related to the potential
consequences of pollution or destruction of the natural environment
due to the company’s activity.
Methodology of
Credit Rating
The process of credit rating begins with the prospective issuer approaching the rating
agency for evaluation. The experts collect data and investigate the business strength
and weaknesses in detail. The rating is based on the investigation analysis, study and
interpretation of various factors. The key factors generally considered are listed below:
1. Business Analysis or Company Analysis
This includes an analysis of industry risk, market position of the company, operating
efficiency of the company and legal position of the company.
Industry risk: Nature and basis of competition, key success factors; demand supply
position; structure of industry; government policies, etc.
Market position of the company within the Industry: Market share; competitive
advantages, selling and distribution arrangements; product and customer diversity etc.
Operating efficiency of the company: Locational advantages; labor relationships; cost
structure and manufacturing as compared to those of competition.
Legal Position: Terms of prospectus; trustees and then responsibilities; system for
timely payment and for protection against forgery/fraud, etc.

2. Economic Analysis
Economic factors are analysed as the individual companies are always exposed to
changing environment and the economic activities affect corporate profits, attitudes and
expectation of investors and the price of the instrument. Economic variables such as
growth rate, national income and expenditure cannot be ignored.
3. Financial Analysis
This includes an analysis of accounting quality, earnings protection adequacy of cash flows
and financial flexibility.
Accounting Quality: Overstatement/under statement of profits; auditors qualification;
methods of income recognition, inventory valuation and depreciation policies of balance
sheet, liabilities etc.
Earnings Protection: Sources of future earnings growth; profitability ratios; earnings in
relation to fixed income changes.
Adequacy of cash flows: In relation to debt and fixed and working capital needs;
variability of future cash flows; capital spending flexibility working capital
management etc.
Financial Flexibility: Alternative financing plans in times of stress; ability to raise funds
asset redeployment.

4. Management Evaluation
Track record of the management planning and control system, depth of managerial
talent, succession plans.
Evaluation of capacity to overcome adverse situations
Goals, philosophy and strategies.

5. Geographical Analysis
Location advantages and disadvantages
Backward area benefit to the company/division/unit
6. Fundamental Analysis
This includes an analysis of liquidity management, profitability and
financial position and interest and tax sensitivity of the company.
Liquidity Management: Capital structure, matching of assets and
liabilities policy and liquid assets in relation to financing
commitments and maturing deposits.
Asset Quality: Quality of the company’s credit-risk management;
system for monitoring credit; sector risk; exposure to individual
borrower; management of problem credits etc.
Profitability and financial position: Historic profits, spread on fund
deployment revenue on non-fund based services accretion to reserves
etc.
Interest and Tax sensitivity: Exposure to interest rate changes, hedge
against interest rate and tax low changes, etc.
Internal & External
Credit Rating
Comparison
 Internal Credit Rating External Credit Rating
Done by institutions themselves. Given by independent agencies.
To analyse a borrower’s repayment Done for companies that have publicly
ability based on information about a traded debt and are usually paid for by
customer’s financial condition. institutional investors.
Undertaken internally by the staff of Undertaken by approved External credit
Bank independently by Risk risk rating agencies such as
Management department CRISIL,ICRA, CARE, FITCH,
SMERA,ONICRA, BRICKWORK
Guidelines require internal credit risk Guidelines require external credit risk
rating to be done of borrowers for rating to be done by RBI approved
moving to Advanced approach agencies under Standardised approach
Undertaken for all borrowers based on Generally undertaken for all viz.
bank policy such as Retail SME Mid- Individual borrower, Portfolio
corporate, Corporate, Agriculture
Use internally developed rating models Use rating models developed by
by respective banks respective rating agency
Credit Rating Model
Formats
Credit score represents credit behaviour. Generally ranging from 300 to 900 , it indicates
creditworthiness and credit history. Lenders check the credit score to determine if you can
repay loan on time.
The credit bureau generates two main types of credit score models, FICO Score and Vantage
Score. These credit score models indicate a person’s financial stability and repayment ability.

FICO Score Model

Fair Issac Corporation first developed the FICO score in 1989. FICO score is a 3 digit number
ranging from 300 to 850. according to this scoring model having a good credit rating above
750 is considered excellent and help to get a personal loan at low interest rates.

Credit Score Table according to FICO Score Model

Score Range Credit ratings
800 to 850 Exceptional

740 to 799 Very Good

670 to 739 Good

580 to 669 Fair

300 to 579 Poor

How does the FICO Score Model calculate the credit score?

New
credit
Credit Mix 10%
10% Payment
History
Length of
Credit History 35%
15% Amounts
owed
30%
Vantage Score Model
Vantage Score Model was created as an alternative to the FICO Score Model.
Though Vantage score and FICO score gives weightage to payment history, Vantage
score emphasizes more on other factors such as utilization ratio, credit balance etc.

Credit Score Table according to Vantage Score Model

Score Range Credit ratings

781 to 850 Excellent
661 to 780 Good
601 to 660 Fair
500 to 600 Poor
300 to 499 Very Poor
How does Vantage score model calculate your credit score?

Influence Credit Factors

Extremely Influential Total credit usage,
balance and available
credit
Highly Influential Credit mix and
Experience
Moderate Influential Payment History
Less Influential Age of Credit History
Less Influential New Accounts