What is the process for credit analysis?
Overview
Credit analysis is the process of evaluating an applicant’s loan request or a corporation’s debt issue in order to determine the likelihood that the borrower will live up to their financial obligations. In other words, credit analysis is the method by which one calculates the creditworthiness of an individual or organisation.
The objective of credit analysis is to look at both the borrower and the lending facility being proposed and to assign a risk rating. The risk rating is derived by estimating the probability of default by the borrower at a given confidence level over the life of the facility, and by estimating the amount of loss that the lender would suffer in the event of default.
For this process Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability.
The audited financial statements of a large company might be analysed when it issues or has issued bonds. Or, a bank may analyse the financial statements of a business with the emphasis being the cash flow of the borrower before making, renewing or approving a commercial loan.
A typical measurement of repayment ability is the debt service coverage ratio. A credit analyst at a bank will measure the cash generated by a business before interest expense and excluding depreciation and any other non-cash or extraordinary expenses. The debt service coverage ratio divides this cash flow amount by the debt services both principal and interest payments on all loans that will be required to be met.
Whereas for an individual the lenders look at an individual debt-to-income ratio this percentage helps them decide whether or not an individual is a good credit risk. If applying for a mortgage, lenders look for certain defining financial characteristics about an applicant.
