Credit Analysis

A common way to categorize the key components of credit analysis is by the four Cs of credit analysis: capacity, collateral, covenants, and character.

Capacity

Capacity refers to a corporate borrower’s ability repay its debt obligations on time. Analysis of capacity is similar to the process used in equity analysis. Capacity analysis entails three levels of assessment: (1) industry structure, (2) industry fundamentals, and (3) company fundamentals.

Industry structure

The first level of a credit analyst’s assessment is industry structure. Industry structure can be described by Porter’s five forces: threat of entry, power of suppliers, power of buyers, threat of substitution, and rivalry among existing competitors.

Industry fundamentals

The next level of a credit analyst’s assessment is industry fundamentals, including the influence of macroeconomic factors on an industry’s growth prospects and profitability. Industry fundamentals evaluation focuses on:

• Industry cyclicality: Cyclical industries are sensitive to economic performance. Cyclical industries tend to have more volatile earnings, revenues, and cash flows, which make them more risky than noncyclical industries.
• Industry growth prospects: Creditworthiness is most questionable for the weaker companies in a slow-growing or declining industry.
• Industry published statistics: Industry statistics provided by rating agencies, investment banks, industry periodicals, and government agencies can be a source for industry performance and fundamentals.

Company fundamentals

The last level of credit analysts’ assessment is company fundamentals. A corporate borrower should be assessed on:

• Competitive position: Market share changes over time and cost structure relative to peers are some of the factors to analyze.
• Operating history: The performance of the company over different phases of business cycle, trends in margins and revenues, and current management’s tenure.
• Management’s strategy and execution: This includes the soundness of the strategy, the ability to execute the strategy, and the effects of management’s decisions on bondholders.
• Ratios and ratio analysis: As we will discuss later in this reading, leverage and coverage ratios are important tools for credit analysis.

Collateral

Collateral analysis is more important for less creditworthy companies. The market value of a company’s assets can be difficult to observe directly. Issues to consider when assessingcollateral values include:

• Intangible assets: Patents are considered high-quality intangible assets because they can be more easily sold to generate cash flows than other intangibles. Goodwill is not considered a high-quality intangible asset and is usually written down when company performance is poor.
• Depreciation: High depreciation expense relative to capital expenditures may signal that management is not investing sufficiently in the company. The quality of the company’s assets may be poor, which may lead to reduced operating cash flow and potentially high loss severity.
• Equity market capitalization: A stock that trades below book value may indicate that company assets are of low quality.
• Human and intellectual capital: These are difficult to value, but a company may have intellectual property that can function as collateral.

Covenants

Covenants are the terms and conditions the borrowers and lenders agree to as part of a bond issue. Covenants protect lenders while leaving some operating flexibility to the borrowers to run the company. There are two types of covenants: (1) affirmative covenants and (2) negative covenants.

Affirmative covenants

Affirmative covenants require the borrower to take certain actions, such as using the proceeds for the for the stated purpose; paying interest, principal, and taxes; carrying insurance on pledged assets; continuing in its current business activity; and following relevant laws and regulations. Affirmative covenants have, basically, administrative purposes.

Negative covenants

Negative covenants restrict the borrower from taking certain actions that may reduce the value of the bondholders’ claims. While affirmative covenants do not impose significant costs on the issuer (besides making the promised payments), negative covenants constrain the issuer’s business activities and may thereby impose significant costs on the issuer. Examples of negative covenants include:

• Restrictions on the payment of dividends and share repurchases, for example, restricting distributions to shareholders to a certain percentage of net income.
• Restrictions on the amount of additional debt the borrower can issue, for example, setting a maximum debt-to-equity ratio or minimum interest coverage ratio.
• Restrictions on issuing any debt with a higher priority than the subject debt issue.
• Restrictions on pledging any collateral that is currently unencumbered as collateral for new borrowing.
• Restrictions on assets sales, for example, limiting asset sales to a certain percentage of total asset value.
• Restrictions on company investment, for example, requiring that a company not invest outside its current primary business activities.
• Restrictions on mergers and acquisitions.

Covenants that are overly restrictive of an issuer’s operating activities may reduce the issuer’s ability to repay; for example, prohibiting asset sales that could provide the cash to pay bondinterest and principal. On the other hand, covenants create a legally binding contractual framework for repayment of the debt obligation, which reduces uncertainty for the debt holders. A careful credit analysis should include an assessment of whether the covenants
protect the interests of the bondholders without unduly constraining the borrower’s operating activities.

Character

Character refers to management’s integrity and its commitment to repay the loan. Factors such as management’s business qualifications and operating record are important for evaluating character. Character analysis includes an assessment of:

• Soundness of strategy: Management’s ability to develop a sound strategy. Track record. Management’s past performance in executing its strategy and operating the company without bankruptcies, restructurings, or other distress situations that led to additional borrowing.
• Accounting policies and tax strategies: Use of accounting policies and tax strategies that may be hiding problems, such as revenue recognition issues, frequent restatements, and frequently changing auditors.
• Fraud and malfeasance record: Any record of fraud or other legal and regulatory problems.
• Prior treatment of bondholders: Benefits to equity holders at the expense of debt holders, through actions such as debt-financed acquisitions and special dividends, especially if they led to credit rating downgrades.