The basics of credit analysis and types of risks

The basics of credit analysis and types of risks

Credit analysis is utilised by lenders to assess the finances of an organisation before granting it credit. It is used to determine whether or not it will be able to afford repayments. It is also useful for highlighting potential red flags in terms of business-functioning and credit standing. 

Techniques used include the utilisation of financial ratios, trend analysis and examination of cash flow. 

Key elements that are analysed during this process include: 

Financial circumstances – this examines if there are any profits or not. Does the organisation have the flexibility to adjust costs in response to changing market conditions?  How much cash flow is there? 

Competitive position – this assesses the current business strategy. It looks at whether or not the company has a good track record in terms of service quality, product development and customer retention. 

Business environment –factors such as country risk, currency risk and industry risk come into play. 

It’s also vital to keep in mind that it is partially-reliant on information provided by the institution in question. 

The 5Cs of credit can be highly useful for avoiding risk. These include: 
  • Collateral 
  • Character 
  • Capital 
  • Conditions 
  • Capacity 
Types of risk that it mitigates: 

Credit risk for a lender is linked to potential default on a debt. Credit analysis is used to identify it, along with how much impact it would have on a creditor. 

The greater the risk involved, the higher the interest rate that will be charged. 

Risks such as high debt to income ratio, late payments and poor credit scores will impact credit analysis. If a company has a history of paying creditors late, or if it has too much debt to its name already, then this is likely to hamper its efforts at qualifying for additional finance.

Categories: Financial tips