Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability.
Analysts attempt to predict the probability that a borrower will default on its debts, and also the severity of losses in the event of default. They do so through the different types of credit analysis techniques these include.
A ratio analysis
Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency. It’s a quantitative analysis of information contained in a company’s financial statements.
Ratio analysis is a useful management tool that will improve understanding of financial results and trends over time, and provide key indicators of organisational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed.
Whereas an analyst will look at the company itself, with the help of common-size statements and objectivity tool like a ratio analysis they’ll then try to determine how they believe the business will perform within its sector.
A trend analysis
There are three main types of trends: short-, intermediate- and long-term.
Trend analysis is a mathematical technique that uses historical results to predict future outcome. This is achieved by tracking variances in cost and schedule performance. Based on the idea that what has happened in the past gives traders an idea of what will happen in the future.
Trend analysis is the widespread practice of collecting information and attempting to spot a pattern.
- Environmental factors
In addition to fundamental factors used in credit analysis, environmental factors such as regulatory climate, competition, taxation, and globalisation can also be used in combination with the fundamentals to reflect a borrower’s ability to repay its debts relative to other borrowers in its industry.