Decoding the Basic Fundamentals of Credit Analysis

What is Credit Analysis

It is the procedure to know the exact risk and invest accordingly. In technical terms it is the procedure of assessing the risk of investments and pricing them accordingly. The pricing remains constant under normal circumstances. However whenever the risk frame changes the pricing also gets updated accordingly.

Hence credit analysis helps to assess the risk and take investing related decisions.

Credit Risk (Default Risk and Loss Severity)

Risk in terms of Credit analysis has two types. One is Default risk and another is severity loss. The credit risk is associated with the defaulting pattern of borrowers in terms of interest payments.

Default risk is the risk of the issuer defaulting in the interest payments. Issuers of bonds or securities may default in payment of interest every year or quarter or month. Hence the default risk category covers that scenario.

Security loss occurs when the issuer defaults in the securities bought. In simpler words when the company defaults in managing the bonds and the investment fails, it goes under severity loss. At the end of this procedure every investor gets some money on investments made based on the investor class.

What is Yield Spread (Knowing About Spread Risk)

When two bonds with the same date of maturity but different risk classes are measured in terms of their performance and returns, it is referred to as yield spread.

Let’s consider a simple example for understanding. If there are two securities A and B. A gives 9 % return on investments and is risk bearing security and B gives 5% return and is a risk free security. Hence the yield spread between these securities is 9% – 5% = 4%.

Any bond or security pricing structure under the same category but different risk class is inversely proportional to such spread. This means that when the gap of returns between risky and risk free securities is small, the bonds are available at cheaper costs. Thereon is if they are valuable at higher prices than people will opt for safer and less risky securities. Similarly bigger the gap of spread more is the bond or security pricing.

Claims Hierarchy

The claims are made in a hierarchy based on their investors class. This is the similar scenario wherein the preference shares get payment before equity shares in times of liquidation of a company.

The debt in the companies has been sub classified into two categories which is secured and unsecured. The secured gets priority than unsecured always.

If the pattern is looked at then :

Senior Secured Debt > Junior Secured Debt > Senior Unsecured Debt > Senior Subordinated Debt > Subordinated Debt > Junior subordinated Debt.

Maximum recovery is possible with the senior secure debt and lowest is possible with Junior Subordinate debt category.

Credit Rating Agencies and Their Parameters

Credit rating agencies provide a wide understanding of the rankings and classes allocated to various securities. These companies evaluate the entire company and its debt instruments or bonds or other securities and present their ratings in accordance to market standards and competition in the market.

The widely used parameters to estimate the ratings are Creditworthiness of Issuer, Debt classes available, Seniority of bond, Previous history, Return capacity and many more.

These agencies classify the bonds and securities under various classes of categories like AAA, Aaa, Baa3 till D. AAA is the highest class and most secured class of securities and D being the vice versa.

CREDIT ANALYSIS TACTIC (C-4 :- Capacity, Collateral, Covenant, Character)

The credit analysis involves 4 elements. These are :

Collateral
Capacity
Covenant (Agreement)
Character

Capacity

It is the issuers ability to pay the interest and other borrowings on time. This is a very soft area as any defaults leads to heavy downgrading of a security. This analysis is based on Industrial structure & fundamentals. It also involves studying the company fundamentals.

These factors refer to Industrial class in regards to the future scope and current market requirements. It also involves growth prospects of the industry on CAGR basis.

The fundamentals of a firm depends on its position in the market among the competitors, the operating pattern and its historic data. The management’s decision and strategies placed at regular intervals for deep study of ratio and analysis.

Collateral

It involves the background check on a company’s creditworthiness. The elements one should look at while referring to it are : Intangible Assets, Depreciation usage, Market capitalization in Exchanges, Usage of Human resources.

Character

This is all about the type of people one is dealing with. The management of the company needs to be ethical to show the investors that they work in good faith. Such features are noticeable through timely payments of interest to investors and repayment of loans borrowed.

Covenant

These are the terms and conditions that the issuer offers to the investors. This provides the issuer with minor flexibility and investors the right to get into the company’s administration. The covenants are classified under Positive and negative covenants. The covenants present themselves from the viewpoint of the investor and not the issuer of the bond.

Usage of Ratio Analysis

The Ratios signify the capacity of a firm. It presents the cash flow requirements and many other information that the company is hiding in current times and pastimes. The ratios make comparison easy for various diversified elements.

Financial Ratios are the measuring tool for a company’s various activities. It not only helps in identifying the rate of progress for the company but also makes it easy to know about the internal changes made to speed up the procedure of work. There are numerous ratios that a company encounters. The important ones are Debt to equity ratio, P/E ratio, return on equity ratio, asset turnover ratio and operating profit margin ratio. There are others such as dividend ratio, P/E growth ratio and more. These ratios help to know the segment wise position of a company. For example the operating profit margin ratio of two years helps the investor to know about the profit margins the company operates into. It displays the company’s ability to make profit from every rupee invested and every sale undertaken.