Credit analysis is a method used to calculate creditworthiness. Essentially an evaluation of credit risk, it attempts to predict default probability as well as how severe the losses may be in the event of default.
It involves an exploration of factors such as collateral, capacity, credit history, the ability to manage credit and how debt will be repaid.
By using the 5Cs of credit, analysts are able to gauge the likelihood of default. This method delves deeper into an understanding of assets that are put up for sale if a debtor cannot afford repayments. If also looks into the amount of credit the debtor has and whether or not they will afford repayments.
Credit analysis techniques include:
Ratio analysis– This examines information that is contained in a company’s financial statements. It includes an evaluation of financial performance measures such as efficiency, liquidity, solvency and profitability. Data is used to compare performance over time. The use of these ratios is useful because it provides a thorough look into company financial standing. This is one of the more popular credit analysis techniques because it provides a quantitative view of where the business stands, rather than just relying on qualitative information.
Trend analysis – This is used to analyse monetary statements of a company. Financial statements of over several years are compared. The sales of each year are converted into percentage form. This method is ideal because it can be used to predict future events. Projections are a handy tool for determining likelihood of affordability.
Analysis of cash flows – This is useful for analysing your firm’s financial health. It examines the movement of cash through your business.