Reviewed by Aug 27, 2020| Updated on
Meaning of Credit Analysis
Credit analysis is a kind of analysis that an investor or bond portfolio manager conducts on corporations or other debt issuing organizations to determine the capacity of the company to satisfy its debt obligations. The aim of the credit analysis is to determine the correct level of default risk associated with investing in that particular entity.
How Does Credit Analysis Function?
To assess the ability of a company to pay its debts, banks, bond investors, and analysts conduct a credit analysis of the company. Using cash flow analysis, financial ratios, financial forecasts, and trend analysis an analyst may assess the willingness of the company to fulfill its obligations. The analysis of credit scores and any collateral shall also be used to measure the creditworthiness of a company.
The results of the credit review will decide which risk rating is given to the issuer or borrower of the debt. The risk ranking, in effect, decides whether to extend the loan money or credit to a borrowing entity and, if so, the amount to be lent.
The debt service coverage ratio (DSCR) is an example of the financial ratio used in the credit review. The DSCR is a measure of the cash flow level available for the payment of current debt obligations, such as principal, lease, and interest payments. Debt service coverage below 1 implies a negative cash flow.
Special Considerations Concerning Credit Analysis
Credit analysis is often used to predict whether a bond issuer's credit rating is about to shift. By finding businesses that are about to undergo a shift in the rating of the debt, an investor or manager may bet on the shift and potentially make a profit.
Assume , for example, that the manager is considering buying junk bonds in a business. If the manager assumes that the company's debt rating is about to increase, which is a sign of a relatively lower default risk, then the manager will buy the bond before the change in rating takes place and then sell the bond at a higher price after the change in rating.