What is Credit Analysis?

Credit analysis is when people at a bank or another place that gives loans look closely at a company’s financial information. They do this to figure out if the company will be able to pay back the money it wants to borrow.

Why Credit Analysis is Important

Credit analysis is really important. Banks need to be super careful about who they lend money to. They don’t want to give a loan to a company that won’t be able to pay it back! That would be bad news for the bank. They could lose a lot of cash that way.

So, the bank needs to do its homework first. It has to be a money detective and investigate the company that wants a loan. The bank looks for clues in the company’s financial statements. These special papers show how much money the company makes and spends.

The Goal: Figuring Out Creditworthiness

The whole point of studying a company’s financial statements is to figure out “creditworthiness.” Creditworthiness means: Is this company suitable for the money? Can we trust them to pay us back?

It’s like when you want to borrow your friend’s favorite toy. Your friend has to decide if you’re “toyworthy”. Will you take good care of the toy and give it back when you promised? If your friend thinks you will, then you’re “toyworthy”. If they think you’ll break it or forget to return it, then you’re not “toy-worthy.”

Banks have to figure out if companies are “creditworthy” in the same way. But instead of toys, it’s money on the line. And there’s a lot more money involved!

How Credit Analysis Works

Credit analysis always starts with the company’s financial statements. The main ones are:

• The income statement: Shows how much money the company made or lost
• The balance sheet: Shows what the company owns and owes
• The cash flow statement: Shows how cash moves in and out of the company

Think of these statements like a company’s diary. They tell the story of how the company is doing with money.

Connecting the Dots

Credit analysts read the “diary” super carefully to see if there are any red flags. They play connect the dots to get the full picture.

For example, let’s say the income statement shows the company had a huge increase in sales. That sounds great! But then the analyst sees in the balance sheet that the company also has a big jump in the amount of money owed to it. Hmmm, that’s a little worrying. Maybe the company is having trouble collecting payments from customers.

The cash flow statement adds another piece to the puzzle. It shows how much actual cash is coming into the company. Sales and profits are nice, but a company needs cold, hard cash to pay back loans.

So the analyst has to look at the big picture. No single statement tells the whole story. It’s all in how the numbers connect.

Ratios and Benchmarks

To help make sense of all the numbers, analysts calculate special ratios. A ratio is just a comparison between two numbers.

Some important ratios are:

• Debt-to-income: How much the company owes compared to how much it earns
• Current ratio: Can the company pay its bills on time?
• Return on assets: How good is the company at using what it has to make money?

Analysts then compare these ratios to benchmarks. A benchmark is a standard, like an average in the company’s industry. If the company’s ratios are way off from the benchmarks, that’s a warning sign.

The Final Decision

After a lot of number crunching and head scratching, the analyst makes a judgment call. Is the company creditworthy or not?

If the analyst gives the thumbs up, the bank will probably approve the loan. If it’s a thumbs down, the company is out of luck.

The analyst’s report might also suggest ways to make the loan less risky. For example, the bank could charge a higher interest rate or require collateral (something valuable the company promises to give the bank if it can’t repay the loan).

Credit Ratings

Credit ratings are like a company’s money report card. They’re grades given to a company by special organizations called credit rating agencies. The grades show how likely the company is to pay back its debts.

The most famous credit rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch. They use letter grades like A, B, C. The higher the grade, the more creditworthy the company.

Investors pay a lot of attention to credit ratings. They help investors decide if a company’s bonds (a type of loan) are safe to buy.

If a company’s credit rating gets downgraded (moved to a lower grade), that’s a big deal. It means the company is having money troubles and might not be able to pay what it owes. This can scare investors away.

Final Thoughts

Credit analysis is the bank’s way of being careful with its money. It’s how banks avoid making bad loans.

By studying a company’s financial statements, analysts get a sense of the company’s financial health. They look for warning signs and compare the company’s numbers to benchmarks.

The analyst’s final report helps the bank make the big decision: to lend or not to lend. And if the bank does lend, the report guides how to structure the loan to minimize risk.

Credit ratings boil down this complex analysis into simple grades. They signal a company’s creditworthiness to the whole financial world.

So while credit analysis might seem like boring bean counting, it’s really important stuff. It helps keep the economy humming by making sure money goes to companies that can handle the responsibility.