What you need to know about credit analysis…
What is credit analysis?
Credit analysis is a method used to assess default risk and a company’s ability to repay its debts.
In order to secure lending or investment, businesses of all sizes must undergo credit analysis to evaluate the business in isolation, and in relation to industry benchmarks.
Where have you heard about credit analysis?
You may have come across this term when applying for finance, whether in a personal capacity, via a loan or mortgage, or in business.
As an investor you can use credit analysis to evaluate the default risk associated with an investment and identify potential opportunities. For example, if you can buy stock or bonds before a company’s debt rating increases you may be able to sell for a higher price afterwards, although it’s worth remembering that ratings may not be comparable across industry sectors, therefore companies with low levels of default risk can still cause losses if not researched thoroughly.
Five factors are used to assess risk:
- Character – looks at a business’ reputation and may involve suppliers and customers
- Capital – examines how invested an owner is in their business’ success in monetary terms
- Capacity – measures a business’ ability to repay based on historical and projected cash flow and similar debts
- Conditions – refers to the purpose of the loan and the market conditions in which a business operates
- Collateral – identifies tangible assets that can be used to repay the loan should something go wrong
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