Credit analysis is not entirely unlike equity research. In both cases the analyst is trying to answer questions about the firms financial health today and in the future. This includes its cash flows, key ratios (debt-equity, for a simple example), industry and macroeconomic conditions, and general character as well as other concerns. Credit Analysis generally lumps many of these areas of concern into five “C’s” of credit analysis, the exact definitions of which vary slightly across different companies:
- Capacity
- Capital
- Collateral
- Conditions
- Character
Breaking down the five C’s
- Capacity is the ability of the target firm to service (make payments on) its debt. This can be thought of as the history, probability, and timing of payments to the lender from cash flows, as well the cash flows generated themselves and will often include examining past and projected future cash flows.
- Capital is fairly self explanatory. This represents the funds invested by the owner(s) of the firm. It’s necessary to examine this because if the owners of the business have very little of their own capital invested, they have very little at risk if the business performs poorly or fails.
- Collateral should be fairly self explanatory, much like capital. This is simply alternative guarantees of payment in the form of assets (think equipment, inventory or real property) or insurance from a third party. A simple and common example is that of a mortgage where the homeowners house is collateral on the loan. Collateral provides the party lending the money with an additional layer of protection if the borrower fails to make successive payments or becomes completely insolvent.
- Conditions examine the background in which the loan exists, the industry and even macroeconomic conditions as well as the original purpose of the loan. What’s this money going to be used for and does that project make sense? Analyzing current economic conditions that the borrower has to operate in is also important. As an example, retailers as a group face difficult competition from online sellers such as Amazon – these conditions affecting the whole industry would be taken into account when analyzing the credit of one specific firm because these competitive forces are a major risk.
- Character (sometimes called Credit History) speaks to how the borrower is viewed by the lender in terms of their business relationship, the borrowers history, reputation (can the firm be trusted to honor its commitments?) and standing in its industry. Has this firm repaid its debt obligations in the past? Does it employ seasoned professionals? How long has it been around? Relationships and trust both matter in business and firms that are perceived to misrepresent their financial condition slightly (even within the law) are penalized by lenders.