Credit Analysis | What Credit Analyst Look for?

5 C’s |
Ratios
wallstreetmojo.com/credit-analysis/

Dheeraj Vaidya August 11, 2016

Credit Analysis – In layman terms, Credit analysis is more about identification of risks in
situations where a potential for lending is observed by the Banks. Both quantitative and
qualitative assessment forms a part of overall appraisal of the clients
(company/individual). This in general, helps to determine the entity’s debt servicing
capacity, or its ability to repay.

In this article, we look at Credit Analysis from Beginner’s point of view –

What is Credit Analysis?

Credit Analysis Process
What does a Credit Analyst looks for?
The 5 C’s of Credit Analysis
Credit Analysis Case Study
Credit Analyst – Obtaining Quantitative Data of the Clients
Credit Analysis – Judgement
Credit Analysis Ratios
Credit Rating
Lesson Learned from Credit Analysis Case Study

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What is Credit Analysis?

Credit Analysis Definition –

Credit analysis is a process of drawing conclusions from available data (both quantitative and
qualitative) regarding the credit – worthiness of an entity, and making recommendations
regarding the perceived needs, and risks.

Credit Analysis is also concerned with the identification, evaluation and mitigation of risks
associated with an entity failing to meet financial commitments.

Credit Analysis Process

Below diagram shows the overall Credit Analysis Process.
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What does a Credit Analyst looks for?
Ever wondered why bankers ask so many questions and make you fill so many forms,
when you apply for a loan. Don’t some of them feel intrusive and repetitive and the whole
process of submission of various documents seems cumbersome. You just try to fathom,
as to what they do with all this data and what they are actually trying to ascertain! It is
definitely not only your deadly charm and attractive personality that makes you a good
potential borrower; obviously there is more to that story. So here we will try to get an idea
about what exactly a Credit Analyst is looking for.

The 5 C’s of Credit Analysis

Character
This is the part where the general impression of the protective borrower is analysed.
The lender forms a very subjective opinion about the trust – worthiness of the entity
to repay the loan. Discrete enquires, background, experience level, market opinion,
and various other sources can be a way to collect qualitative information and then an
opinion can be formed, whereby he can take a decision about the character of the
entity.

Capacity
Capacity refers to the ability of the borrower to service the loan from the profits
generated by his investments. This is perhaps the most important of the five factors.
The lender will calculate exactly how the repayment is supposed to take place, cash
flow from the business, timing of repayment, probability of successful repayment of
the loan, payment history and such factors, are considered to arrive at the probable
capacity of the entity to repay the loan.

Capital
Capital is the borrower’s own skin in the business. This is seen as a proof of the
borrower’s commitment to the business. This is an indicator of how much the
borrower is at risk if the business fails. Lenders expect a decent contribution from the
borrower’s own assets and personal financial guarantee to establish that they have
committed their own funds before asking for any funding. Good capital goes on to
strengthen the trust between the lender and borrower.

Collateral (or Guarantees)

Collateral are form of security that the borrower provides to the lender, to appropriate
the loan in case it is not repaid from the returns as established at the time of availing
the facility. Guarantees on the other hand are documents promising the repayment of
the loan from someone else (generally family member or friends), if the borrower fails
to repay the loan. Getting adequate collateral or guarantees as may deem fit to cover
partly or wholly the loan amount bears huge significance. This is a way to mitigate the
default risk. Many times, Collateral security is also used to offset any distasteful

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 factors that may have come to the fore-front during the assessment process.

Conditions

Conditions describe the purpose of the loan as well as the terms under which the
facility is sanctioned. Purposes can be Working capital, purchase of additional
equipment, inventory, or for long term investment. The lender considers various
factors, such as macroeconomic conditions, currency positions, and industry health
before putting forth the conditions for the facility.

Credit Analysis Case Study

From times immemorial, there has been an eternal conflict between
entrepreneurs/businessmen and bankers, regarding the quantification of credit. The
resentment on the part of the business owner arises when he believes that the banker
might not be fully appreciating his business requirements/needs and might be
underestimating the real scale of opportunity that is accessible to him, provided he gets
sufficient quantum of loan. However, the credit analyst might be having his own reasons to
justify the amount of risk he is ready to bear, which may include bad experiences with that
particular sector, or his own assessment of the business requirements. Many times there
are also internal norms or regulations which force the analyst to follow a more restrictive
discourse.

The most important point to realize is that banks are in the business of selling money and
therefore risk regulation and restrain are very fundamental to the whole process.Therefore,
the loan products available to prospective customers, the terms and conditions set for
availing the facility and the steps taken by the bank to protect its assets against default, all
have a direct forbearance to the proper assessment of the credit facility.

So, let’s have a look at what does a loan proposal looks like:

The exact nature of proposals may vary depending on subsequent clients, but the elements
are generally the same.

**To put things into perspective let’s consider the example of one Sanjay Sallaya, who is
credited to being one of the biggest defaulters in recent history along with being one of the
biggest businessmen in the world. He owns multiple companies, some sports franchises,
and few bungalows in all major cities.

1. Who is the client? Ex. Sanjay Sallaya, reputed industrialist, owning majority share in
XYZ ltd., and some others.
2. Quantum of credit they need and when? Ex. Starting a new airline division, which
would cater to the high end segment of society. Credit demand is $25 mil, needed
over the next 6 months.
3. The specific purpose the credit will be employed for? Ex. Acquiring of new
aircrafts, and capital for day to day operations like fuel costs, staff emoluments,airport
parking charges, etc.
4. Ways and means to service the debt obligations (which include application and
processing fees, interest, principal and other statutory charges) Ex. Revenue
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 generated from flight operations, freight delivery and freight delivery.
5. What protection (collateral) can the client provide in the event of default? Ex.
Multiple bungalows in prime locations offered as collateral, along with personal
guarantee of Sanjay Sallaya, one of the most reputed businessmen in the world.
6. What are the key areas of the business and how are they operated, and
monitored? Ex. Detailed reports would be provided on all key metrics related to the
business.

Answers to these questions, helps the credit analyst to understand the broad risks
associated with the proposed loan. These questions provide the basic information about
the client and help the analyst to get deeper into the business and understand any intrinsic
risks associated with it.

Credit Analyst – Obtaining Quantitative Data of the Clients

Other than the above questions the analyst also needs to obtain quantitative data specific
to the client:

Borrower’s history – A brief background of the company, its capital structure, its
founders, stages of development, plans for growth, list of customers, suppliers,
service providers, management structure, products, and all such information are
exhaustively collected to form a fair and just opinion about the company.
Market Data – The specific industry trends, size of the market, market share,
assessment of competition, competitive advantages, marketing, public relations, and
relevant future trends are studied to create a holistic expectation of future movements
and needs.
Financial Information – Financial statements (Best case/ expected case/ worst
case), Tax returns, company valuations and appraisal of assets, current balance
sheet, credit references, and all similar documents which can provide an insight into
the financial health of the company are scrutinized in great detail.
Schedules and exhibits – Certain key documents, such as agreements with
vendors and customers, insurance policies, lease agreements, picture of the products
or sites, should be appended as exhibits to the loan proposal as proofs of the
specifics as judged by above mentioned indicators.

**It must be understood that the credit analyst once convinced will act as the client’s
advocate in presenting the application to the bank’s loan committee and also guiding it
through the bank’s internal procedures. The details obtained are also used to finalize the
loan documentation, terms, rates and any special covenants which need to be stipulated,
keeping in mind the business frame-work of the client as well the macro – economic
factors.

Credit Analysis – Judgement

After collating all the information, now the analyst has to make the real “Judgement”,
regarding the different aspects of the proposal which will be presented to the sanctioning
committee:

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 Loan – After understanding the need of the client, one of the many types of loans,
can be tailored to suit the client’s needs. Amount of money, maturity of loan,
expected use of proceeds can be fixed, depending upon the nature of the industry
and the credit worthiness of the company.
Company – The market share of the company, products and services offered, major
suppliers, clients and competitors, should be analysed to ascertain its dependency
on such factors.
Credit History – Past is an important parameter to predict future, therefore, keeping
in line with this conventional wisdom, client’s past credit accounts should be analysed
to check any irregularities or defaults. This also allows the analyst to judge the kind of
client we are dealing with, by checking the number of times late payments were
made or what penalties were imposed due to non compliance with stipulated norms.
Analysis of market – Analysis of the concerned market is of utmost importance as
this helps us in identifying and evaluating the dependency of the company on
external factors. Market structure, size and demand of the concerned client’s product
are important factors that analysts are concerned with.

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 the
expectations and current reality with market conditions.

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If you wish to learn more about financial analysis, then click here for this amazingFinancial
Statement analysis guide

Credit Rating
Credit rating is a quantitative method using statistical models to assess credit worthiness
based on the information of the borrower. Most banking institutions have theirown rating
mechanism. This is done to judge under which risk category the borrower falls. This also
helps in determining the term and conditions and various models use multiple quantitative
and qualitative fields to judge the borrower. Many banks also use external rating agencies
such as Moody’s, Fitch, S&P etc. to rate borrowers, which then forms an important basis for
consideration of the loan.

Lesson Learned – Mr. Sanjay Sallaya

So, let’s illustrate the whole exercise with the help of an example of Mr. Sanjay Sallaya,
who is a liquor barron, and a hugely respected industrialist, who also happens to own a few
sports franchises and has bungalows in the most expensive locals. He now wants to start
his own airline, and has therefore approached you for a loan to finance the same.

The loan is for a meagre $1 million. So, as a credit analyst we have to assess whether or
not to go forward with the proposal. To begin, with we will obtain all the required documents
which are needed to understand the business model, working plan and other details of his
new proposed business. Necessary inspection and enquires are undertaken to validate the
veracity of his documents. A TEV i.e Techno Economic Viability can also be undertaken to
get an opinion from the experts in aviation industry about the viability of the plan.

When finally we are satisfied with the overall efficacy of the plan, we can discuss the
securities that will collaterally cover our loan (partly/fully). Mr. Sanjay Sallaya being a well-
established industrialist holds a good reputation in the business world and therefore will
hold good recommendations. Such a proposal if it meets all other aspects can be presented
for sanction, comfortably, and generally enjoys good terms from the bank’s side as the risk
associated with such personalities are always assessed to be less.

Therefore, to conclude, Mr. Sanjay Sallaya will get a loan of $1 million approved and will go
on to start his airline business, however, what the future holds can never be predicted,
when a loan is sanctioned.

also, checkout the difference between Equity Research vs Credit Research

Conclusion
Credit Analysis is about making decisions keeping in mind the past, present and the future.
As a Credit analyst, two days in life are never the same. The role offers a plethora of
opportunities to learn and understand different types of businesses as one engages with a
multitude of clients hailing from different sectors. Not only is the career monetarily
rewarding but also helps an individual grow along with providing good opportunities to build
one’s career.
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