Credit analysis is the process of reviewing a borrower’s ability to repay a loan or other debt obligations. This analysis is often used by investors to make fixed-income investments, such as when assessing the creditworthiness of a company issuing a bond.
Definition and Examples of Credit Analysis
Credit analysis involves assessing the likelihood of another party being able to pay back a loan or similar debt obligation. For example, if a company issues bonds to raise capital for its business, credit analysis might be used to assess that company’s ability to fulfill its bond obligations.
In general, the more the credit analysis shows that the company can be trusted to pay back the borrowed money, the lower the interest will be on the bonds. That’s because there’s less risk to compensate investors for, whereas a company with low creditworthiness might have to pay higher interest on its bonds to incentivize investors.
For instance, a company like Apple tends to have a high credit rating and thus, relatively low yields.
How Does Credit Analysis Work?
In the investment world, credit analysis also often revolves around ratings from a company such as Fitch, Moody’s, or Standard & Poor’s. Generally, the higher the rating, the more likely the borrower is able to fulfill its obligations. This can apply to anything from rating a country’s creditworthiness as it relates to government debt securities to rating a specific company’s bonds.
Credit ratings are often based on both hard data and qualitative metrics. A credit analyst might look at information like a company’s cash flow to get a sense of its ability to repay a loan, as well as intangibles like the quality of a company’s management.
These ratings provide an indication to investors as to the risk/reward. A low rating, for example, typically means there’s a higher risk the borrower will default on the loan, which means the investor could lose their principal. However, these lower-rated bonds tend to pay higher interest rates to attract investors. So it’s possible that earning such interest from several bond investments more than compensates for a few defaults.
What Credit Analysis Means for Individual Investors
Understanding credit analysis can help individuals in their personal and investment lives.
From a personal perspective, if you’re trying to take out a loan, apply for a credit card, lease an apartment, etc., you’ll want to make yourself as attractive a borrower as possible. In many cases, these decisions are largely based on your credit score, so you’ll want to see how you can improve in that area. But it’s also possible that factors similar to business credit ratings come into play, such as proving you can pay a lease by showing you have a steady source of income.
For investments, understanding credit analysis can help you determine whether you’re comfortable with certain fixed-income investments. Some investors might prefer investing in highly rated bonds, even if they earn low interest, but others might be willing to take the risk implied with lower-rated bonds in exchange for higher yields.
- Credit analysis involves reviewing a borrower’s ability to repay a loan or fulfill similar obligations—whether the borrower is a corporation or an individual.
- Credit analysis also can include assigning ratings for specific types of bonds, with higher ratings generally indicating less risk of default.
- Credit analysis as used in investing may be based on several factors, ranging from cash flow to the quality of a company’s management.