What is credit analysis?

Credit analysis is essential to mitigate risk.  It involves an examination of key factors that may predict possible default by borrowers. Risk is inherent in any transaction, but fortunately there are ways to manage it. 

In a credit transaction, where there is a borrower and a lender, the latter party will want to find the best ways to prevent any potential loss of money. There is an inherent risk that a borrower may not be able to afford to repay, which is why it is so vital. 

Credit analysis is typically used to determine the creditworthiness of companies. 

Typically involving the use of the 5Cs of credit, it also considers quantitative and qualitative measures as part of the process. 

Financial ratios often examine factors such as profitability, efficiency, liquidity and solvency. They are used to get an in-depth view into the finances of an organisation. The results of this credit analysis help with making decisions about granting credit. The ratios used are a combination of financial results from financial statements and are used to indicate trends. They are also used for comparisons to competitors within the same industry. 

By analysing factors such as character, collateral, conditions, capital and capacity, credit analysts are able to determine whether or not a borrower will be able to afford a particular loan. The most important factor analysed is typically Capacity. Cash flow is assessed, along with the number of debt obligations currently outstanding and this is compared to revenue that is expected every month. 

Stricter loan application processes mean that lenders have to be a lot more discerning about credit granting, which is why credit analysis has gained even more prominence in recent years as a financial risk management tool.