Fundamentals of Credit Analysis: Fundamentals of Credit Analysis What is credit analysis?: What is credit analysis?

Credit analysis is the method by which one calculates the creditworthiness of a business or organization. For Example, a bank may analyze the financial statements of a small business before making or renewing a commercial loan. Financial Tools: Financial Tools Credit analysis involves a wide variety of financial analysis techniques. Financial statement analysis Trend analysis Ratio analysis Cash flow analysis Debt service coverage ratio: D ebt service coverage ratio A typical measurement of repayment ability is the debt service coverage ratio. Debt service coverage ratio = (EBIT)/debt service debt service both principal and interest payments on all loans Debt service coverage ratio: Commercial Bankers like to see debt service coverage of at least 120 percent. In other words, the debt service coverage ratio should be 1.2 or higher to show that an extra cushion exists and that the business can afford its debt requirements. D ebt service coverage ratio Credit Analyst: Credit Analyst a credit analyst is responsible for assessing a loan applicant's credit worthiness. Credit analysts are typically employed by commercial and investment banks credit card issuing institutions, credit rating agencies and investment companies. What Does a Credit Analyst Do? : What Does a Credit Analyst Do? A credit analyst is responsible for gathering and analyzing financial data about clients, including paying habits or history, earnings and savings information, and purchase activities . After the data has been gathered, a credit analyst evaluates the data and recommends a course of action for the customer. Slide 8: For example, a credit analyst who works with a bank or organization that issues credit cards collects data about clients who have defaulted in their payments. After analyzing the data, the analyst might recommend closing the card or reducing the credit line. Credit analysts are not limited to clients who have defaulted in their payments . A credit analyst can also be responsible for potential customers seeking new credit or customers who are being considered for credit line extensions . Credit Analysis Process: Credit Analysis Process credit analysis is a process that creditors use to determine whether an applicant should be permitted to borrow money, either in the form of a loan or the generation of debt. In cases where creditors are in favor of issuing credit, this process can also be used to determine how much credit to grant. Such processes are used to determine the creditworthiness of both individuals and businesses. Slide 10: Any entity that is interested in receiving credit or a loan can be subject to a credit analysis. The purpose of this process is to assess whether or not a potential borrower can afford to repay the debt and whether he is likely to do so. This determination is often made by a credit analyst or a credit analysis department. Items reviewed in credit analysis: Items reviewed in credit analysis Income Expenditure Instability Payment history Reason for credit Borrowers habit income: income A creditor almost always wants to know about a borrower's sources of income and the amounts that are received. Even if a borrower appears to have enough income to cover the amount of the payment installments, credit can be denied. This is because the borrower may have too much existing debt.

expenditures: expenditures A credit analysis also commonly considers expenditures. Creditors generally assess what debts a potential borrower is responsible for. A borrower may have a large income, but if a large portion of it is needed to make payments to existing creditors, this can be viewed as reducing the chances of repayment for other lenders. amount of income due to instability: amount of income due to instability Another reason that a credit analysis may be unfavorable despite the amount of income is due to instability. A person may have sufficient resources for repayment at the moment, but perhaps he has not been on his job for long or he has a history of changing jobs. This can cause creditors to assess the person as being at high risk for defaulting on his payments. payment history: payment history A credit analysis also generally looks at payment history. Creditors usually consider a potential borrower's habits when paying his bills. If the potential borrower has a history of not paying certain bills, of missing payments, or of making late payments, his credit analysis may be unfavorable. Components (5 Cs) of credit analysis:: C omponents (5 Cs) of credit analysis : There are five basic components of credit analysis : 1.Capacity to repay 2.Collateral or guarantee 3.Capital 4.Conditions 5.Character and background capacity to repay : capacity to repay The most critical factor amongst five factors is the capacity to repay; it is the primary source of repayment of cash. The lenders prime concern is the ability of borrower to repay the loan during credit analysis . Other possible sources of repayment are also the interest of the lender. The future payment performance also depends on payment history on existing credit relationships . collateral or guarantees: collateral or guarantees You can also provide additional forms of security to lenders, such as collateral or guarantees. You pledge an asset you own, such as your home, to the lender as collateral on contract that if you cant repay the loan, the collateral will be the repayment source. On other hand, guarantee is a different phenomenon. In guarantee, someone else signs a guarantee document promising to repay the loan if you cant. Capital: Capital Capital is the indicator to lender that how much of the risk of borrower is involved in the business. Capital is the money that you invest in the business. Capital has a great significance during the process of credit analysis . conditions: conditions The purpose of the loan is described by conditions; either loan is used for additional equipment or for working capital. character: character The general impression of you on the lender is known as character. Lender will consider your educational background and business experience to evaluate you during credit analysis . The characteristics of your business and employees will also be considered by the lender in the process of credit analysis . Importance of Credit Analysis of Individual Borrowers: Importance of Credit Analysis of Individual Borrowers In case of the individual borrowers the system of credit analysis is used in order to measure the economic capability. The system tries to find out if the borrower would be able to pay his debts at the proper time. With the help of credit analysis the lenders can also find out if the debtor would at all be able to pay back the debt.

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Financial Statement Analysis: Learning Objectives: 1. 2. 3. 4. Prepare and interpret financial statements in comparative and common-size form. Compute and interpret financial ratios that would be most useful to a common stock holder. Compute and interpret financial ratios that would be most useful to a short-term creditor Compute and interpret financial ratios that would be most useful to long -term creditors.

Definition and Explanation of Financial Statement Analysis: Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in thefinancial statements is of immense use in making decisions through analysis and interpretation offinancial statements. Tools and Techniques of Financial Statement Analysis: Following are the most important tools and techniques of financial statement analysis: 1. Horizontal and Vertical Analysis 2. Ratios Analysis 1. Horizontal and Vertical Analysis: Horizontal Analysis or Trend Analysis: Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form. Click here to read full article. Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years' financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base. Click here to read full article. Vertical Analysis:

Vertical analysis is the procedure of preparing and presenting common size statements.Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements. Click here to read full article. 2. Ratios Analysis: Accounting Ratios Definition, Advantages, Classification and Limitations: The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. Click here to read full article. Profitability Ratios: Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under: y y y y y y y y y y y Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) Ratio Dividend yield ratio Dividend payout ratio Earnings Per Share (EPS) Ratio Price earning ratio

Liquidity Ratios: Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most important liquidity ratios. y y Current ratio Liquid / Acid test / Quick ratio

Activity Ratios: Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios: y y y y y Inventory / Stock turnover ratio Debtors / Receivables turnover ratio Average collection period Creditors / Payable turnover ratio Working capital turnover ratio

y y

Fixed assets turnover ratio Over and under trading

Long Term Solvency or Leverage Ratios: Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios. y y y y y y y Debt-to-equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage ratio Capital gearing ratio Over and under capitalization

Financial-Accounting- Ratios Formulas: A collection of financial ratios formulas which can help you calculate financial ratios in a given problem. Click here. Limitations of Financial Statement Analysis: Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Click here to read full article. Advantages of Financial Statement Analysis: There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time throughfinancial statements analysis.