Credit Management

Analysis of Credit Information - financial and non-financial factors, Financial Statement analysis.

What Is Credit Analysis? How It Works With Evaluating Risk

What Is Credit Analysis?

Credit analysis is a type of financial analysis that an investor or bond portfolio manager performs on
companies, governments, municipalities, or any other debt-issuing entities to measure the issuer's
ability to meet its debt obligations. Credit analysis seeks to identify the appropriate level of default
risk associated with investing in that particular entity's debt instruments.

Key Takeaways

 Credit analysis evaluates the riskiness of debt instruments issued by companies or entities to
measure the entity's ability to meet its obligations.
 The credit analysis seeks to identify the appropriate level of default risk associated with
investing in that particular entity.
 The outcome of the credit analysis will determine what risk rating to assign the debt issuer or
borrower

How Credit Analysis Works

To judge a company’s ability to pay its debt, banks, bond investors, and analysts conduct credit
analysis on the company. Using financial ratios, cash flow analysis, trend analysis, and financial
projections, an analyst can evaluate a firm’s ability to pay its obligations. A review of credit scores and
any collateral is also used to calculate the creditworthiness of a business.

The outcome of the credit analysis will determine what risk rating to assign the debt issuer or
borrower. The risk rating, in turn, determines whether to extend credit or loan money to the
borrowing entity and, if so, the amount to lend.

Credit Analysis Example

An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The
DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest,
principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow.

For example, a debt service coverage ratio of 0.89 indicates that the company’s net operating income
is enough to cover only 89% of its annual debt payments. In addition to fundamental factors used in
credit analysis, environmental factors such as regulatory climate, competition, taxation, and
globalization can also be used in combination with the fundamentals to reflect a borrower's ability to
repay its debts relative to other borrowers in its industry.

Special Considerations

Credit analysis is also used to estimate whether the credit rating of a bond issuer is about to change.
By identifying companies that are about to experience a change in debt rating, an investor or manager
can speculate on that change and possibly make a profit.

For example, assume a manager is considering buying junk bonds in a company. If the manager
believes that the company's debt rating is about to improve, which is a signal of relatively lower
default risk, then the manager can purchase the bond before the rating change takes place, and then
sell the bond after the change in rating at a higher price. On the other side, an equity investor can buy
the stock since the bond rating change might have a positive impact on the stock price.

Default Risk: Definition, Types, and Ways to Measure

What Is Default Risk?

Default risk is the risk that a lender takes on in the chance that a borrower will be unable to make the
required payments on their debt obligation. Lenders and investors are exposed to default risk in
virtually all forms of credit extensions. A higher level of default risk leads to a higher required return,
and in turn, a higher interest rate.

Key Takeaways

· Default risk is the risk that a lender takes on in the chance that a borrower won’t be able to make
required debt payments.
· A free cash flow figure that is near zero or negative could indicate a higher default risk.
· Default risk can be gauged by using FICO scores for consumer credit and credit ratings for corporate
and government debt issues.
· Rating agencies break down credit ratings for corporations and debt into either investment grade or
non-investment grade.

Understanding Default Risk

Whenever a lender extends credit to a borrower, there is a chance that the loan amount will not be
paid back. The measurement that looks at this probability is the default risk. Default risk does not only
apply to individuals who borrow money, but also to companies that issue bonds and due to financial
constraints, are not able to make interest payments on those bonds. Whenever a lender extends
credit, calculating the default risk of a borrower is crucial as part of its risk management strategy.
Whenever an investor is evaluating an investment, determining the financial health of a company is
crucial in gauging investment risk.

Default risk can change as a result of broader economic changes or changes in a company's financial
situation. Economic recession can impact the revenues and earnings of many companies, influencing
their ability to make interest payments on debt and, ultimately, repay the debt itself. Companies may
face factors such as increased competition and lower pricing power, resulting in a similar financial
impact. Entities need to generate sufficient net income and cash flow to mitigate default risk.

Default risk can be gauged using standard measurement tools, including FICO scores for consumer
credit, and credit ratings for corporate and government debt issues. Credit ratings for debt issues are
provided by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's
(S&P), Moody's, and Fitch Ratings.

Determining Default Risk

Lenders generally examine a company's financial statements and employ several financial ratios to
determine the likelihood of debt repayment. Free cash flow is the cash that is generated after the
company reinvests in itself and is calculated by subtracting capital expenditures from operating cash
flow. Free cash flow is used for things such as debt and dividend payments. A free cash flow figure
that is near zero or negative indicates that the company may be having trouble generating the cash
necessary to deliver on promised payments. This could indicate a higher default risk.

The interest coverage ratio is one ratio that can help determine the default risk. The interest coverage
ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its periodic
debt interest payments. A higher ratio suggests that there is enough income generated to cover
interest payments. This could indicate a lower default risk.

The aforementioned measure reflects a high degree of conservatism, reflective of non-cash expenses,
such as depreciation and amortization. To assess coverage based purely on cash transactions, the
interest coverage ratio can be calculated by dividing earnings before interest, taxes, depreciation, and
amortization (EBITDA) by periodic debt interest payments.

Types of Default Risk

Rating agencies rate corporations and investments to help gauge default risk. The credit scores
established by the rating agencies can be grouped into two categories: investment grade and non-
investment grade (or junk). Investment-grade debt is considered to have low default risk and is
generally more sought-after by investors. Conversely, non-investment grade debt offers higher yields
than safer bonds, but it also comes with a significantly higher chance of default.

While the grading scales used by the rating agencies are slightly different, most debt is graded
similarly. Any bond issue given a AAA, AA, A, or BBB rating by S&P is considered investment grade.
Anything rated BB and below is considered non-investment grade.

Understanding Trend Analysis and Trend Trading Strategies

What Is Trend Analysis?

Trend analysis is a technique used in technical analysis that attempts to predict future stock price
movements based on recently observed trend data. Trend analysis uses historical data, such as price
movements and trade volume, to forecast the long-term direction of market sentiment.

Key Takeaways

 Trend analysis tries to predict a trend, such as a bull market run, and then ride that trend
until data suggests a trend reversal, such as a bull-to-bear market.
 Trend analysis is based on the idea that what has happened in the past gives traders an idea
of what will happen in the future.
 Trend analysis focuses on three typical time horizons: short-; intermediate-; and long-term

Understanding Trend Analysis

Trend analysis tries to predict a trend, such as a bull market run, and ride that trend until data
suggests a trend reversal, such as a bull-to-bear market. Trend analysis is helpful because moving with
trends, and not against them, will lead to profit for an investor. It is based on the idea that what has
happened in the past gives traders an idea of what will happen in the future. There are three main
types of trends: short-, intermediate- and long-term.

A trend is a general direction the market is taking during a specified period of time. Trends can be
both upward and downward, relating to bullish and bearish markets, respectively. While there is no
specified minimum amount of time required for a direction to be considered a trend, the longer the
direction is maintained, the more notable the trend.

Trend analysis is the process of looking at current trends in order to predict future ones and is
considered a form of comparative analysis. This can include attempting to determine whether a
current market trend, such as gains in a particular market sector, is likely to continue, as well as
whether a trend in one market area could result in a trend in another. Though a trend analysis may
involve a large amount of data, there is no guarantee that the results will be correct.
Types of Trends to Analyze

There are three main types of market trend for analysts to consider:

1. Upward trend: An upward trend, also known as a bull market, is a sustained period of rising
prices in a particular security or market. Upward trends are generally seen as a sign of
economic strength and can be driven by factors such as strong demand, rising profits, and
favorable economic conditions.
2. Downward trend: A downward trend, also known as a bear market, is a sustained period of
falling prices in a particular security or market. Downward trends are generally seen as a sign
of economic weakness and can be driven by factors such as weak demand, declining profits,
and unfavorable economic conditions.
3. Sideways trend: A sideways trend, also known as a rangebound market, is a period of
relatively stable prices in a particular security or market. Sideways trends can be
characterized by a lack of clear direction, with prices fluctuating within a relatively narrow
range.

Trend Trading Strategies

Trend traders attempt to isolate and extract profit from trends. There are many different trend
trading strategies using a variety of technical indicators:

 Moving Averages: These strategies involve entering into long positions when a short-
term moving average crosses above a long-term moving average, and entering short
positions when a short-term moving average crosses below a long-term moving average.
 Momentum Indicators: These strategies involve entering into long positions when a security
is trending with strong momentum and exiting long positions when a security loses
momentum. Often, the relative strength index (RSI) is used in these strategies.
 Trendlines & Chart Patterns: These strategies involve entering long positions when a security
is trending higher and placing a stop-loss below key trendline support levels. If the stock
starts to reverse, the position is exited for a profit.

Trend Analysis Pros and Cons

Pros

 Can help identify opportunities for buying or selling securities

 Can identify potential risks or warning signs that a security or market may be headed for a
downturn
 Provides insight into market psychology and momentum

Cons

 If markets are efficient, trend analysis is not as useful

 If the data is incomplete, inaccurate, or otherwise flawed, the analysis may also be
misleading or inaccurate
 May not take into account changes in a company's management, changes in industry
regulations, or other external factors that could affect the security's performance
 Different statistical measures can yield different results

Quantitative and Qualitative Fundamental Analysis

The problem with defining the word fundamentals is that it can cover anything related to the
economic well-being of a company. They include numbers like revenue and profit, but they can also
include anything from a company's market share to the quality of its management.

The various fundamental factors can be grouped into two categories: quantitative and qualitative. The
financial meaning of these terms isn't much different from well-known definitions:

 Quantitative: information that can be shown using numbers, figures, ratios, or formulas
 Qualitative: rather than a quantity of something, it is its quality, standard, or nature

In this context, quantitative fundamentals are hard numbers. They are the measurable characteristics
of a business. That's why the biggest source of quantitative data is financial statements. Revenue,
profit, assets, and more can be accurately measured.

The qualitative fundamentals are less tangible. They might include the quality of a company's key
executives, brand-name recognition, patents, and proprietary technology.

Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them
together.

Qualitative Fundamentals to Consider

There are four key fundamentals that analysts always consider when regarding a company. All are
qualitative rather than quantitative. They include:

The Business Model

What exactly does the company do? This isn't as straightforward as it seems. If a company's business
model is based on selling fast-food chicken, is it making its money that way? Or is it just coasting on
royalty and franchise fees?

Competitive Advantage

A company's long-term success is primarily driven by its ability to maintain a competitive advantage—
and keep it. Powerful competitive advantages, such as Coca-Cola's brand name and Microsoft's
domination of the personal computer operating system, create a moat around a business allowing it
to keep competitors at bay and enjoy growth and profits. When a company can achieve a competitive
advantage, its shareholders can be well rewarded for decades.

Management

Some believe management is the most important criterion for investing in a company. It makes sense:
Even the best business model is doomed if the company's leaders fail to execute the plan properly.
While it's hard for retail investors to meet and truly evaluate managers, you can look at the corporate
website and check the resumes of the top brass and the board members. How well did they perform
in previous jobs? Have they been unloading a lot of their stock shares lately?

Corporate Governance

Corporate governance describes the policies in place within an organization denoting the
relationships and responsibilities between management, directors, and stakeholders. These policies
are defined and determined in the company charter, its bylaws, and corporate laws and regulations.
You want to do business with a company that is run ethically, fairly, transparently, and efficiently.
Particularly note whether management respects shareholder rights and shareholder interests. Make
sure their communications to shareholders are transparent, clear, and understandable. If you don't
get it, it's probably because they don't want you to.

Industry

It's also important to consider a company's industry: its customer base, market share among firms,
industry-wide growth, competition, regulation, and business cycles. Learning how the industry works
will give an investor a deeper understanding of a company's financial health.

Quantitative Fundamentals to Consider: Financial Statements

Financial statements are the medium by which a company discloses information concerning its
financial performance. Followers of fundamental analysis use quantitative information from financial
statements to make investment decisions. The three most important financial statements are income
statements, balance sheets, and cash flow statements.

The Balance Sheet

The balance sheet represents a record of a company's assets, liabilities, and equity at a particular
point in time. It is called a balance sheet because the three sections—assets, liabilities, and
shareholders' equity—must balance using the formula:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources the business owns or controls at a given time. This includes items such
as cash, inventory, machinery, and buildings. The other side of the equation represents the total
financing value the company has used to acquire those assets.

Financing comes as a result of liabilities or equity. Liabilities represent debts or obligations that must
be paid. In contrast, equity represents the total value of money that the owners have contributed to
the business—including retained earnings, which is the profit left after paying all current obligations,
dividends, and taxes.

The Income Statement

While the balance sheet takes a snapshot approach in examining a business, the income statement
measures a company's performance over a specific time frame. Technically, you could have a balance
sheet for a month or even a day, but you'll only see public companies report quarterly and annually.

The income statement presents revenues, expenses, and profit generated from the business'
operations for that period.

Statement of Cash Flows

The statement of cash flows represents a record of a business' cash inflows and outflows over a
period of time. Typically, a statement of cash flows focuses on the following cash-related activities:

 Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the
sale of other businesses, equipment, or long-term assets
 Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
 Operating Cash Flow (OCF): Cash generated from day-to-day business operations

The cash flow statement is important because it's challenging for a business to manipulate its cash
situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to
fake cash in the bank. For this reason, some investors use the cash flow statement as a more
conservative measure of a company's performance.

Credit Analysis Ratios

What are Credit Analysis Ratios?

Credit analysis ratios are tools that assist the credit analysis process. These ratios help analysts and
investors determine whether individuals or corporations are capable of fulfilling financial obligations.
Credit analysis involves both qualitative and quantitative aspects. Ratios cover the quantitative part of
the analysis.

Key ratios can be roughly separated into four groups: (1) Profitability; (2) Leverage; (3) Coverage; (4)
Liquidity.

Profitability Ratios

As the name suggests, profitability ratios measure the ability of the company to generate profit
relative to revenue, balance sheet assets, and shareholders’ equity. It is important to investors, as
they can use it to help project whether stock prices are likely to appreciate. They also help lenders
determine the growth rate of corporations and their ability to pay back loans.

Profitability ratios are split into margin ratios and return ratios.

Margin ratios include:

 Gross profit margin

 Operating profit margin

Return Ratios include

 Return on assets
 Return on equity

Higher margin and return ratios are an indication that a company has a greater ability to pay back
debts.

Leverage Ratios

Leverage ratios compare the level of debt against other accounts on a balance sheet, income
statement, or cash flow statement. They help credit analysts gauge the ability of a business to repay
its debts.

Common leverage ratios include:

 Debt to assets ratio

 Asset to equity ratio
 Debt to equity ratio
 Debt to capital ratio

For leverage ratios, a lower leverage ratio indicates less leverage. For example, if the debt to asset
ratio is 0.1, it means that debt funds 10% of the assets and equity funds the remaining 90%. A lower
leverage ratio means less asset or capital funded by debt. Banks or creditors like this, as it indicates
less existing risk.
Example

Imagine if you are lending someone $100. Would you prefer to lend to a person that already owes
someone else $1000 or someone who owes $100, given both of them make the same amount of
money? It is likely you would choose the person that only owes $100, as they have less existing debt
and more disposable income to pay you back.

Coverage Credit Analysis Ratios

Coverage ratios measure the coverage that income, cash, or assets provide for debt or interest
expenses. The higher the coverage ratio, the greater the ability of a company to meet its financial
obligations.

Coverage ratios include:

 Interest coverage ratio

 Debt-service coverage ratio
 Cash coverage ratio
 Asset coverage ratio

Example

A bank is deciding whether to lend money to Company A, which has a debt-service coverage ratio of
10, or Company B, with a debt service ratio of 5. Company A is a better choice as the ratio suggests
this company’s operating income can cover its total outstanding debt 10 times. It is more than
Company B, which can only cover its debt 5 times.

Liquidity Ratios

Liquidity ratios indicate the ability of companies to convert assets into cash. In terms of credit analysis,
the ratios show a borrower’s ability to pay off current debt. Higher liquidity ratios suggest a company
is more liquid and can, therefore, more easily pay off outstanding debts.

Liquidity ratios include:

 Current ratio
 Quick ratio
 Cash ratio
 Working capital

Example

The quick ratio is the current assets of a company, less inventory and prepaid expenses, divided by
current liabilities. A person is deciding whether to invest in two companies that are very similar
except that company A has a quick ratio of 10 and the other has a ratio of 5. Company A is a better
choice, as a ratio of 10 suggests the company has enough liquid assets to cover upcoming liabilities 10
times over.