What it means
Lending is the exchange of money now for a promise of money later, and credit analysis is the examination of the promise. It asks two questions: can the borrower pay (capacity, from cash flow, assets and access to other finance) and will the borrower pay (character, from track record, incentives and the legal structure that compels payment).
The answers determine whether the loan is made, its size, its term, its security, its covenants and its price, since the interest margin is the compensation for the risk the analysis has measured. The business analysis comes first, because cash flow comes from the business.
The analyst asks what the company does, how it makes money, how stable the industry is, where the company stands in it, what could change (technology, regulation, competition, customer concentration), and whether management has the competence and integrity to run it through difficulty. A strong balance sheet in a dying industry is a weaker credit than a leveraged one in a growing one with a defensible position.
The financial analysis then tests capacity. Profitability and its trend; cash flow from operations and its relationship to profit (the quality of earnings); leverage (debt to EBITDA, debt to equity, debt to capital); coverage (interest, debt service, fixed charges); liquidity (current ratio, cash and undrawn facilities against near-term obligations); working capital behaviour (are receivables and inventory growing faster than sales); capital expenditure against depreciation (is the business maintaining itself); and the maturity profile of existing debt.
Each is compared with the sector, with the proposed covenants and with the analyst's stress case: what happens to coverage if EBITDA falls 25%, if the largest customer leaves, if rates rise. The analysis produces a view of the primary source of repayment (operating cash flow), the secondary (refinancing, which depends on the company's continued creditworthiness), and the tertiary (asset sales, security, guarantees).
The structural analysis examines what protects the lender: security over assets and its value in a distressed sale; ranking relative to other creditors; guarantees from parents or owners; covenants that give early warning and the right to act; conditions on distributions and further borrowing; and the term, which should match the asset or cash flow being financed. A well-structured loan to a weak borrower can be a better credit than an unsecured loan to a strong one.
The output is a rating: internal grades at banks (mapped to probability of default and loss given default under regulatory models), public ratings from agencies (AAA to D), or a credit limit and terms for a trade creditor. The rating sets the price and the monitoring: high-grade borrowers are reviewed annually; weaker ones quarterly with covenant tests and management meetings; watch-list credits monthly.
Credit analysis is continuous. The decision to lend is followed by monitoring: covenant compliance, financial reporting, news, payment behaviour, and the early warning signs of deterioration (late accounts, auditor changes, management departures, stretched creditors, requests for waivers).
Most losses arise not from bad initial analysis but from failure to act on deterioration that the monitoring showed.
In practice
Real-world examples
Example 1
A rating agency assigns a BBB rating to a manufacturer's bonds after analysing its leverage of 2.5 times EBITDA, its stable margins and its customer diversification.
Example 2
A distributor's credit controller sets a $50,000 limit for a new customer after reviewing its filed accounts, a credit agency report and two trade references, and reviews it at six months.
Example 3
A bank downgrades a retailer to its watch list after two quarters of falling like-for-like sales, a stretched payables balance and a request for a covenant waiver.
Think of it
Credit analysis is like checking references and income before renting an apartment. You want confidence the tenant can and will pay.
Formula
Calculation
Capacity: Debt / EBITDA; Interest coverage = EBITDA / Interest; Debt service coverage = (EBITDA minus Tax minus Maintenance capex) / (Interest + Principal); Cash flow to debt = Operating cash flow / Debt
Capital: Debt / Equity; Tangible equity / Total assets
Collateral: Loan / Value of security (loan-to-value)
Liquidity: (Cash + Undrawn committed facilities) / Next 12 months' obligations
Stress: Recompute coverage with EBITDA reduced by the sector's downturn experience (20% to 40%)
Expected loss = Probability of default x Loss given default x Exposure
Worked example. A bank assesses a $15,000,000 five-year term loan to a regional food manufacturer to fund a new production line.
Business: a 40-year-old company with branded and private-label chilled products and revenue of $120,000,000. Its top three supermarket customers account for 55% of sales, which is a concentration risk. Margins are stable, management is long-standing and the industry is stable but under retailer pricing pressure.
Financials: EBITDA $14,000,000 (11.7% margin); operating cash flow $11,500,000 (82% of EBITDA); capex $5,000,000 against depreciation of $4,500,000; existing debt $18,000,000 with $3,000,000 of annual principal and $1,100,000 of interest; equity $42,000,000.
Pro forma with the new loan at 7% (principal of $3,000,000 a year from year 2): total debt $33,000,000; interest $2,150,000 ($1,100,000 + 7% x $15,000,000); principal $6,000,000 a year from year 2; EBITDA expected to reach $17,000,000 by year 2.
Year 2 ratios: Debt / EBITDA = $30,000,000 / $17,000,000 = 1.8; interest coverage = $17,000,000 / $2,150,000 = 7.9; debt service coverage = ($17,000,000 minus $2,500,000 tax minus $4,500,000 maintenance capex) / ($2,150,000 + $6,000,000) = $10,000,000 / $8,150,000 = 1.23; debt to equity = 0.7.
Stress: losing the largest customer (25% of sales), with half the volume recovered elsewhere, cuts EBITDA to $13,000,000. Debt service coverage becomes ($13,000,000 minus $1,800,000 minus $4,500,000) / $8,150,000 = 0.82, so scheduled principal could not be met from cash flow, while interest coverage of 6.0 stays safe.
Collateral: a first charge over the new line (cost $15,000,000, distressed value perhaps $6,000,000 because food equipment is specialised) gives a loan-to-value of 250% on the specific security, so this is largely a cash flow loan.
Decision: approve with conditions. The bank lengthens the term to six years (principal of $2,500,000 a year on the new loan, lifting stressed debt service coverage to about 0.9), sets covenants of debt to EBITDA below 3.0 and debt service coverage above 1.15 tested quarterly, and requires quarterly reporting of customer concentration with a review trigger if any customer exceeds 30%. It prices the loan at a 2.75% margin over the benchmark, reflecting a 1.5% annual probability of default and a 45% loss given default (an expected loss of about 0.7% a year). Monitoring consists of quarterly covenant certificates, monthly management accounts in year 1, and audited accounts within 120 days of year end.Case study
Seen in the real world
This is a fictional, illustrative scenario. A bank lent $40,000,000 to a rapidly growing courier company on the strength of three years of 30% revenue growth, an EBITDA margin of 12% and a management presentation showing the trajectory continuing. The credit analyst's report noted that operating cash flow had been negative in each of the three years (working capital absorbing the growth), that receivables had lengthened from 40 to 65 days, that the company's largest customer, an online retailer, was 45% of revenue and had a contract terminable on 90 days' notice, and that the company's founder owned 90% and had guaranteed nothing. The report recommended a smaller facility, a receivables-based structure, and a guarantee.
The bank's credit committee, under pressure to grow lending and impressed by the growth story, approved the full amount unsecured with a single leverage covenant. Fourteen months later the online retailer moved to a competitor, revenue fell 40%, the receivables that had funded the growth turned out to include $6,000,000 of disputed amounts from the lost customer, and the company entered administration owing the bank $37,000,000, of which the bank recovered $9,000,000. The bank's post-mortem found that the analyst's report had identified every element of the loss and that the decision had been made on the presentation rather than the analysis. The credit policy was amended to require that any override of an analyst's recommendation be documented with reasons by the committee chair, and the committee's incentives were changed to include loss experience.
Watch out
Common mistakes
- Lending on profit growth without examining cash flow, working capital and customer concentration, which is how fast-growing companies fail their lenders.
- Treating security as a substitute for repayment capacity. Collateral is the tertiary source of repayment; its distressed value is usually far below its book value; and enforcing it is slow and costly.
- Completing the analysis at the decision and neglecting monitoring, when most losses come from deterioration that the monitoring showed and nobody acted on.
Questions
People also ask
What are the five Cs of credit?
Character (the borrower's integrity and track record), capacity (cash flow to repay), capital (the borrower's own equity at risk), collateral (security), and conditions (the terms of the loan and the economic environment). They are a checklist for the analysis, not a formula.
What is the most important measure in credit analysis?
Cash flow available for debt service against the debt service required, stress-tested for the borrower's plausible downside. Everything else is context for that number.
How does credit analysis differ for a trade creditor?
The scale is smaller and the information thinner (filed accounts, agency reports, references, payment history), but the questions are the same: can and will this customer pay, how much exposure is prudent, and what monitoring will show deterioration in time to act.