'Credit Analysis' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Credit analysis refers to a kind of detailed consideration of a corporation or similar agency which issues debt. It is performed by managers of bond portfolios and investors. They seek to determine the ability of the borrower to cover their obligations of debt with this type of analysis. The ultimate goal is to discern the correct amount of default risk which investing in that specific agency or company will entail.
There are a number of different considerations in performing this credit analysis. Some of these are fixed expenses, operating margins, cash flows, and overhead costs. These are also considered in equity analysis, yet with a different emphasis. It is true that stronger credit ratings do not equate to any guarantee of impressive share price performance. Yet when investors grasp a company’s credit ratings and the implications, they are able to better assess both the debt and equity results for a given corporation.
Financial elements of a particular company are extremely important in credit analysis. Analysts will consider incoming revenues as well as costs and expenses of the corporation. These will be assessed both as stand-alone values and versus the competitors in the industry. For a firm to be considered strong where credit is concerned, its overhead must permit it to attain better than average profit levels in all points of the business life cycle. Even in a downturn in the economy, stronger companies can deliver results which are higher than average for the industry. Stronger firms also can demonstrate pricing power. This represents the capability of passing on cost increases for inputs and raw materials to the customers via higher prices.
Competitive position is also important in a thorough credit analysis. Only companies which are strong competitively will be capable of maintaining their financial performances in the future. Companies which are highly competitive show long-running positive trends and abilities with quality of service, development of new products, and customer retention and satisfaction levels. It also helps a company’s competitive position when there are effective barriers to competition. These can be in the form of protective regulations, substantial copyright and/or patent protections, or agreements on licensing, permits, and franchising.
The business environment is a third area of consideration for those performing credit analyses. This refers to three primary areas known as country risk, currency risk, and industry risk. Country risk relates to the ways in which the business activities of the enterprise can be negatively impacted by changes in the tax, regulatory, social, legal, and political regimes in those nations where they have a significant business presence.
Currency risk simply refers to the effects of drastic foreign exchange movements on both the corporate balance sheet and the company’s capabilities of sourcing raw materials and other inputs or of selling their goods and products abroad. Industry risk pertains to the dynamics of the business, regulatory regime, and legal and market elements within the industry. These considerations can impact not only the industry but a particular company being evaluated by credit analysis.
Looking at some examples of this can help to better understand the concept. Where there are currency exposures throughout the supply chain, the company could hedge these appropriately in the futures markets. Another example is that the company may know its earnings will not change much even as their industry segment progresses along a change in technology.
There are many parallels between credit ratings of even different borrowing entities. This is why though the risk profile on an AAA-rated state government is less than that of an AAA-rated corporation, triple A rated borrowers in either scenario will always be far safer and less risky than the comparable B- and especially C-rated borrowers in each field. As an example, the A-rated S&P 500 companies boasted an average return of 10.74% in the period ending August 30th of 2013. For those same S&P companies with BB or lower credit ratings, their average return over the identical time period proved to be only 6.53%.