Credit analysts want to assess a company's ability to make timely payments of interest and principal. They tend to focus more on the downside risk given the asymmetry of risk/return, whereas equity analysts focus more on upside opportunity from earnings growth.
The "four Cs" of credit analysis provide a useful framework for evaluating credit risk.
The capacity, or ability to pay, reflects the funds flow from the organization and the generation of cash sufficient to meet the interest and principal repayments.
Credit analysis starts with industry analysis followed by company analysis to assess the cash flows or the ability of the issuer to repay its financial obligation.
Industry structure. Michael Porter's framework, which is covered in Reading 48 [Introduction to Industry and Company Analysis], can be used to analyze industry structure.
Industry fundamentals. These include the industry's sensitivity to macroeconomic factors, its growth prospects, its profitability and its business needs.
Company fundamentals. These include the company's competitive position, track record, management's strategy and execution, and ratio analysis. The ratios can be categorized into three groups: profitability and cash flow ratios, leverage ratios, and coverage ratios.
How does an analyst who has calculated a ratio know whether it represents good, bad, or indifferent credit quality? The analyst must relate the ratio to the likelihood that the borrower will satisfy all scheduled interest and principal payments in full and on time. In practice, this is accomplished by testing financial ratios as predictors of the borrower's propensity not to pay (to default). For example, a company with high financial leverage is statistically more likely to default than one with low leverage, all other things being equal. Similarly, high fixed-charge coverage implies less default risk than low coverage. After identifying the factors that create high default risk, the analyst can use ratios to rank all borrowers on a relative scale of propensity to default.
An issuer's ability to access liquidity is also an important consideration in credit analysis.
Collateral analysis involves not only the traditional pledging of assets to secure the debt, but also the quality and value of those un-pledged assets controlled by the issue. Note that the value and quality of a company's assets may be difficult to observe directly. The key point is to assess the value of the assets relative to the issuer's debt level.
Covenants deal with limitations and restrictions on the borrower's activities. They are important because they impose restrictions on how management operates the company and conducts its financial assets. This term covers both affirmative (obligated to do) and negative (limited in doing) covenants.
Character relates to the ethical reputation as well as the business qualifications and operating record of the board of directors, management, and executives responsible for the use of the borrowed funds and its repayment. It covers many aspects, such as strategic direction, financial philosophy, conservatism, track record, succession planning, control systems, etc.