Credit Analysis

An investor or a lender, before making any choice, must analyze a company’s or borrower’s creditworthiness to accurately estimate the level of default risk associated with the transaction. They must invest only in those entities which are expected to meet their debt obligations in time. Otherwise, it would turn into losses.

There are five basic components of credit analysis, commonly known as 5 C’s. Capacity to repay the debt is one of the most significant factors. The investor must be aware of the cash flows of the company. He must analyze the probability of successful repayment of the loan, alternative sources of repayment and payment history of the company. This would give him an idea of the company’s future performance. Another component is the capital that has been invested in the business by the owner. Higher the capital, higher is his personal assets. The person with higher personal assets is more likely to repay big amounts on time. Collateral, as a security of loan, is provided to the lender with the agreement that it would be owned by the lender in case the borrower fails to repay the loan on time. The investor or the lender also takes into conditions or the purpose of loan and local economic conditions. The investor or a lender also checks the character of the borrower. His qualification, personality, characteristics, background and references must be taken into account. These five components help the investor/lender to compute the intensity of risk involved in giving loans.

To help the investors and lenders with the task of credit analysis, CRAs (Credit Rating Agencies) have come into picture. The ratings, according to the creditworthiness of the company, are provided by such agencies. They help analyzing risks involved in different kinds of investments in different companies and different countries. But the story doesn’t end here. The probability of the CRAs to be bias is considerably high. They are likely to be corrupted since they are profit making firms. Even if they aren’t involved in unethical practices, there is no surety of the predicted consequences stated by the firm. Hence, one must rely less on CRAs and involve his personal judgment and his insight for such decisions.

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