Credit Analysis Basics and Risk Definition -Basic Analysis

Credit analysts are called upon to review and approve potential counterparties for money market products and capital market products / investments: money market investments usually have a term of one year or less, while capital market transactions have a duration that exceed one year.
Not all corporations, financial institutions or investments look the same.

However, there is a common approach to at least commencing the process and there is some similarity in the presentation of the information. First, it is ideal to obtain at least the past three years of audited financial statements, annual reports, SEC filings (10-K, 10-Q, etc.), along with the most recent quarter's financials and any projections for the coming period(s) for the counterparty. The point to this is that you never know what you are going to need and you never know what you are going to find. Always ask for audited statements.If the company has recently terminated its relationship with an auditor then it must adequately explain the situation.In addition, credit analysts are blessed with the existence of the World Wide Web, which provides one with the opportunity to locate sources of information that were unheard of in the past.

 Learn how to conduct searches via the WWW correctly by keyword manipulation and searching within search results.
Research the industry that the company operates in: you cannot understand the company unless you understand what its products are, who it sells to, where it fits into the larger world and what is the future for its product(s) or service. 

Similarly, always look at the competitors / peer group of the subject. What is it doing right and wrong compared to similar companies within the same industry sector?
Financial Statements normally present three successive years of entries in columns, which makes a comparison easier. If the statements do not come that way to you then re-spread them (MS EXCEL or a proprietary program) into comparative columns. Become familiar enough with macro construction within MS EXCEL in order to have the spread sheet automatically compute ratios for you as the annual financial data is entered.
Work directly and cordially with the Account / Relationship Manager. Credit applications do not fall from heaven. Rather, a relationship with a company must be nurtured. However, never allow the Account / Relationship Manager to dictate what should be included in a credit analysis: everything should be included in an analysis. 

Similarly, do not be hesitant or afraid to contact the subject directly to get their views and input on information about them that either you located within the financial documents or is issued in a public news release. Try to speak directly with those who are responsible for speaking with analysts or whoever prepared the information that is in your possession. Again, work cordially with the Account / Relationship Manager but do not give him / her list of questions to contact the subject with and then get his / her interpretation of the answer from the company. Speak directly, but competently and cordially, with the company on your own in order to obtain primary data. Be cognizant of, and confidential with, information that is public and that which is non-public. 

Never be hesitant in being either critical of or expressing an opinion of the operations of a company, even if it may jeopardize the business relationship with the management of the subject. If you are sure you are accurate or the opinion is legitimate, then it is your duty to present the argument or position. However, there is a nautical saying that is appropriate as once one is in the middle of the ocean and you have a problem with your equipment there is no one else to turn to except yourself: check, double check, check again and then re-check. The point is that you had better be sure about the accuracy of your work before you raise any issue or even present an application or report for review.
One will actually learn more about industries, companies, management and credit analysis during recessions and restructurings as it is more difficult and challenging to be a success, for all those involved, during adverse conditions.


 Credit analysts must be proficient in basic accounting concepts, GAAP guidelines and FASB statements and interpretations. The key for credit analysts is that although the financial statements are a history lesson by the time one sees them, they do provide data to indicate the trend of a company's earnings and condition, and the trend indicates as to whether past strategic decisions by management are now producing positive results.

The GAAP acronym stands for Generally Accepted Accounting Principles, which are the accounting rules and guidelines as articulated by the Financial Accounting Standards Board (FASB). The United Kingdom has its own GAAP guidelines and there is presently the movement toward the adoption of a global common International Accounting Standards (IAS).

Financial statements are a record of a company's accounts, financial condition and the results of its operations at a given point in time. The financial statements include the Balance Sheet, Income Statement (also sometimes referred to as a Profit and Loss statement), and the Statement of Cash Flows. Many large companies also include a Statement of Change in Stockholder's Equity or Statement of Retained Earnings. The Balance Sheet is divided into three accounts: Assets, Liabilities and Stockholder's Equity. The Income Statement has 2 major accounts: Income or Revenue and Expenses. The Statement of Cash Flows has 3 accounts: Net Cash Provided/Used by Operating Activities, Net Cash Provided/Used by Investing Activities and Net Cash Provided/Used by Financing Activities. In the U.S., at the very least a company must present a balance sheet and an accompanying income statement for the period together to meet a minimum GAAP requirement.

In the United States, GAAP accounting is based on the accrual system, which is an estimate of booking income when earned (not actually received) and expenses when incurred (not actually paid). This requires that a company accurately estimate any non-cash revenue was earned within a given period (revenue recognition) and accurately estimate how much in related expenses were incurred in earning that revenue.
Accounting and bookkeeping in the United States is based on the a double entry system for recording financial transactions any copmpany may engage in. Accounting is also based on the accrual concept (as opposed to a cash concept). The individual entry for the transaction describes its reason (for instance, wages paid, rent paid, payment for services dispensed or goods sold), and the source of the transaction (cash or credit).
The double entry system means that there are always 2 entries per a transaction. The basic accounting equation is:
Assets = Liabilities + Stockholder's Equity
For instance, if a company is started with a $50,000 investment, the accounting equation would mandate.
Assets = Liabilities + Stockholder's Equity
$50,000 (Cash) = $50,000 (Equity)
If the company purchases $4,500 in production equipment with a $4,500 bank loan, then the new balance of the accounts looks like:
Assets = Liabilities + Stockholder's Equity
$54,500 (Cash + Equipment) = $4,500 (Loan) +$50,000 (Equity)
The basic accounting equation can be solved for its various components:
Assets = Liabilities + Owners' Equity
Liabilities = Assets - Owners' Equity
Owners' Equity = Assets - Liabilities
The Asset, Liability and Stockholder's Equity accounts all have transaction accounts that are included under these three main accounts. For instance, under Assets one would find Cash, Accounts Receivable, Inventory, Equipment, etc., or any type of asset that was created during the normal course of the company's business operation.
The accounting process begins with basic bookkeeping, which involves recording financial transaction in order of occurrence in a General Journal and then recording (posting) the same transaction in the proper account (i.e., rent payment, equipment purchase) in a General Ledger. Each transaction posted to the Ledger account must update the running balance in the account. The balance in the Ledger on a given date is what will be entered into the financial statements. For instance, a Ledger balance of $3,575 in the Accounts Receivable ledger account on March 31st would be entered onto the Asset account of the Balance sheet for those monthly or quarterly March 31st financial statements.
Entries into the Journal and Ledger follow the Debit and Credit accounting guidelines. Debit and Credit refers to a column entry in the Journal or Ledger, and Debit refers to the Left Column and Credit refers to the Right Column. A typical Journal entry would look like:
Date    Account    Debit    Credit

Date    Description    Debit    Credit    Balance
It is sometimes difficult to remember when to use a Debit or Credit in a journal or Ledger. First, it should be remembered that there are Journal and Ledger account entries for both Assets, Liabilities and Stockholder's Equity accounts. Additionally, for ever entry in an Asset Journal or Ledger account there must be a matched (double) entry into either a Liability or Stockholder's Equity Journal or Ledger account.
An Asset account (for instance, Cash) will increase with an entry in the Debit / Left column.
Date    Description    Debit    Credit    Balance
March 7    Payment received for services    $750         $750
An Asset account (again, Cash) will decrease with an entry in the Credit / Right column.
Date    Description    Debit    Credit    Balance
March 8    Payment disbursed for office supplies         $200    $550
However, a Liability account (for instance, Accounts Payable) will increase with an entry in the Credit / Right column.
Date    Description    Debit    Credit    Balance
March 8    Payment (Check No. 301) disbursed for office supplies         $200    $200
Thus, Asset accounts and Liability accounts always increase through opposite entries (Debit for Asset accounts and Credit for Liability accounts). They will also decrease through opposite accounts (Credit for Asset accounts and Debit for Liability accounts).
Revenue accounts will also increase with a Credit entry with a corresponding increase (Debit) in an Accounts Receivable (Asset) account.
Most companies conduct sales and services on granted terms (credit sales, for instance, payment is due in 30 days of receipt of the service or goods by the customer). Conversely, the same company may pay its bills based on the terms accorded to it by its own supplier(s). Thus, the Income statement will indicate accumulated income and expenses as of a certain date while the Accounts Receivable account and Accounts Payable account on the Balance sheet will indicate what still is pending.

Cash Flow Statement (GAAP)
The Cash Flow Statement was first defined by the Financial Accounting Standards Board (FASB) in 1987. The Cash Flow Statement has three cash flow accounts:
1) Operating Cash Flow generated by normal business operations.
2) Investing Cash Flow from the purchase or disposal of assets such as plant buildings, real estate, investment portfolios, and equipment.
3) Financing Cash Flow from investors or long-term creditors.
Operating Cash Flow
Net Income After Tax
+ Depreciation and amortization
+/- Decrease (Increase) in Accounts Receivable
+/- Decrease (Increase) in Inventory
+/- Decrease (Increase) in Other Current Assets
+/- Increase (decrease) in Accounts Payable
+/- Increase (decrease) in Accrued Expenses
+/- Increase (decrease) in Other Current Liabilities
Total Operating Cash Flow
Investing Cash Flow
+/- Decrease (Increase) in Fixed Assets
+/- Decrease (Increase) in Notes Receivable
+/- Decrease (Increase) in securities, investments
+/- Decrease (Increase) intangible, noncurrent assets
Total Investing Cash Flow
Financing Cash Flow
+/- Increase (decrease) in Borrowings
+/- Increase (decrease) Capital Stock
- Dividends Paid
Total Financing Cash Flow
Cash at beginning of period
Cash at end of period
Ratio Analysis
Asset Quality
Average Assets
Total assets (previous year) + Total assets (present year)

Net Charge-offs to Loans (Charge-offs net of recoveries)
Net Charge-offs
Total Loans

Net Charge-offs to Total Assets (Charge-offs net of recoveries)
Net Charge-offs
Total Assets

Profitability / Earnings
Sales Growth Rate
Sales in Period 2 - Sales in Period 1
Sales in Period 1

Gross Profit Margin
Gross Profit (Sales minus Cost of Goods Sold)

Operating Profit Margin
Operating Profit

Pretax Profit Margin
Income before Taxes

Return on Sales (Net Income Margin)
Annual or period net income

Return on Average Assets (ROAA) (measures how effectively an institution utilized its assets)
Annual or period net income
Total Average Assets

Return on Average Equity (ROAE) (measures what an institution earned on its shareholders' investment)
Annual or period net income
Total Average Shareholders' Equity
ROAE can be manipulated by increasing net income from asset sales (a one-time event) or by reducing equity through share buy-backs or write-downs. When a company purchases another company and creates intangible goodwill, the equity side of the balance sheet also increases.
Dupont ROA
EBIT - Tax

Dupont ROE
EBIT - (Taxes + Interest)
Shareholder's Equity

Cash Flow
Cash Flow
Net Income before + Depreciation Expense

Operating Cash Flow
Income before Interest and after Taxes + Depreciation

Interest Coverage
Operating Cash Flow
Interest Expense

Debt Service
Operating Cash Flow
Interest + Principal

Debt Service after Non-discretionary CAPEX (Capital Expenditures)
Operating Cash Flow Net of CAPEX
Interest + Principal

Working Capital, Liquidity and Funding
Working Capital (measures the amount of cushion that current assets provide)
Current Assets - Current Liabilities

Current Ratio (should be greater than 1 : 1 to provide better coverage)
Current Assets
Current Liabilities

Quick Ratio (should be greater than 1 : 1 to provide better coverage; cash + marketable securities + receivables)
Current Assets - Inventory
Current Liabilities

Cash Ratio
Cash + Marketable Securities)
Current Liabilities

Receivables Collection Period (measures the length of time it takes to convert receivables to cash)
Period End Receivables x Days in Period
Sales for Period

Days in Inventory
Period End Receivables x Days in Period
Cost of Goods Sold for Period

Days Payables
Period End Accounts Payables x Days in Period
Cost of Goods Sold for Period

Cash Conversion Cycle
Days Inventory + Collection Days - Days Payables

Average Equity
Total stockholder's equity (previous year) + Total stockholder's equity (present year)

Book Value per Common Share
Shareholders' Equity at the end of a period
Number of common shares outstanding at the end of that period

There are several ways to determine Leverage. One ratio is Total Liabilities to Equity. Overall, the ratio indicates what proportion of equity and debt the company is using to finance its assets. The higher the debt/equity ratio is then the greater amount or debt that the company is using to finance its growth. The credit is that in an economic down turn the company will not generate sufficient earnings to pay interest or amortizing principal. This ratio can be very high for financial institutions, however it’s important to adjust the liabilities for matched repurchase agreement / reverse REPO financing.
Debt to Equity
Total Liabilities

Another is Total Debt (all short-term and long-term interest bearing debt, including commercial paper, bonds and bank borrowings) to Equity.
Total Debt

Another is Long-term Debt to Equity.
Total Long-Term Debt (Total Debt less Short-Term Debt)

Another is Senior Debt to Capital
Total Liabilities - Subordinated Debt
Equity + Subordinated Debt

Another is Debt plus Preferred Securities (due to their debt-like interest payments and long-term maturity feature) to Capital
Total Debt + Preferred Securities
Equity - Preferred Securities

Another is "Gearing", which is the U.K. term for this same ratio. Similarly, a high gearing ratio indicates a high level of debt as a percentage to equity. The U.K. balance sheet terms may look something like:
Loan Capital (Debt)
Capital Employed (Shareholders Equity)

Market Valuation

Price Earnings Ratio (P/E) (Historically, a stock's price has been a multiple of 14 to 15 times earnings; Suggests the number of years necessary for a company to earn its present market capitalization; The "earnings" denominator includes items that do not affect cash flow, such as depreciation, thus the figure is somewhat misleading)
Market Price per Share
Earnings per Share

Dividend Yield
Dividends per Share
Price per Share

Market to Book Value
Market Price per Share
Book value per share

Tobin's Q
Market Value of Assets
Estimated Replacement Cost

Merger and Acquisition Value (Theoretical takeover price relative to generated cash)
Enterprise Value (Company's market capitalization + Debt - Cash)

S.G. Warburg originally developed an Enterprise Value (EV) defined as the sum of the company's debt and the market value of its equity less the market value of non-core assets, all compared to cash flow before interest and depreciation.