India experienced many loan defaults in the last decade which shook the banking sector and raised doubts about the system’s financial stability. These cases involved eminent personalities like Mallya, Nirav Modi, and Anil Ambani. It showcased the deficiencies in the entire credit assessment framework. The banks dispersed large amounts of money to borrowers without verifying their repayment capacity, causing severe trauma to the banks.
Even in 2008, the global financial crisis is another instance that reminded investors of what can occur when credit risk assessment is poor. These poor decisions lead to widespread defaults, economic collapse, and a global recession. Fast forward now, learning from these lessons, there are rigorous credit analyses to prevent the emergence of disastrous financial problems. For those looking to pursue careers in financial analysis, pursuing CFA after 12th can be an excellent way to gain expertise in credit analysis and investment decisions.
Therefore, what is credit analysis, Credit Analysis Process and why is it crucial in the making of lending and investment decisions? Let’s get into that.
Table of Contents:
What is Credit Analysis?
So, what is Credit Analysis? Credit analysis is an integral part of finance, banking, and risk management. It helps in determining the creditworthiness of borrowers be it individuals or businesses who need financial assistance. It is a systematic procedure that evaluates the borrower’s credit history, financial history, and capacity to repay the loan.
Credit analysis plays a crucial role in deciding whether to extend credit or not. Aspiring financial professionals, especially those considering the CFA eligibility criteria, often find that credit analysis is an essential skill for making informed investment and lending decisions.
Why is Credit Analysis Important?
Credit analysts play a crucial role because their ineffectiveness can cause bad debts, financial losses, and economic instability. So, effective credit analysis helps lenders, investors, and financial institutions make informed decisions about extending credit. There are many reasons why credit analysis is essential:
Prevents Loan Defaults
It is one of the major reasons for credit analysis as bad debts are the biggest challenge faced by banks and financial institutions. High-profile defaulters cause massive financial losses, while proper credit analysis helps in identifying high-risk borrowers before granting loans.
Protects from Losses
Credit analysis determines whether the borrower will be able to pay back the credit or not. It helps banks and other financial institutions to minimise the risk of financial distress and ensures profitability.
Stable Economy
Bad debts cause financial instability at a national economic level. Poor credit decisions lead to widespread defaults and economic collapse. For example, the IL&FS crisis triggered liquidity issues across multiple sectors. So, effective credit analysis helps prevent such economic disruptions by ensuring responsible lending.
Informed Decisions
Investors assess the risks through credit analysis and for that credit ratings by agencies like CRISIL, ICRA, and CARE help investors determine the safety of their investments.
Responsible Borrowing
Before applying for loans individuals must also understand their creditworthiness. Only a strong credit profile leads to better interest rates, higher loan approvals, and financial credibility.
Reduces Fraud and Misconduct
Loopholes in credit assessment lead to many financial frauds. What happens in reality is that defaulters often manipulate their financial statements to secure loans that they cannot repay. So, only rigorously conducted financial analysis helps detect red flags and prevents fraud.
Credit analysis is the foundation of a strong financial system. Whether it’s a bank approving a home loan, an investor buying corporate bonds, or a business seeking funding, proper credit evaluation ensures stability, minimizes risk and promotes responsible financial practices.
Credit Analysis Process and Its Working
Analysing the creditworthiness of a borrower be it a company, an individual or any other entity is a step-by-step process. It helps bring effectiveness in preventing bad debts and economic instability.
The credit analysis process starts by collecting the financial data of the applicant who needs the loan. The data includes financial statements, income details, debt obligations and industry and economic conditions affecting the borrower. Then while in the process current debts and financial history, are both analyzed for credit scoring to reject their loan application or charge a higher interest rate. If any EMI is missed banks may renegotiate loan terms or take legal action to recover funds.
Credit Analysis Example
A perfect credit analysis example to better understand the importance of credit analysis is the IL&FS Crisis. It happened in India in 2018. The company, Infrastructure Leasing & Financial Services (IL&FS) was a major player in India’s infrastructure sector. It borrowed hefty loans to fund its large-scale projects but failed to maintain sufficient funds to meet its debt obligations. Ultimately, IL&FS defaulted on multiple loan repayments, and in 2018 it triggered panic in the financial markets.
But what was shocking is that before the crisis actually happened, IL&FS received high credit ratings from agencies like ICRA and CARE Ratings. But later revealed severe liquidity issues, excessive debt, and mismanagement. This whole situation highlighted flaws in the credit analysis process. Banks and various rating agencies failed to detect the financial instability early on.
These recurring defaults led to a liquidity crisis in India’s NBFC sector. It also affected companies like DHFL and Yes Bank and forced the government to intervene. This case became a classic credit analysis example of how inaccurate credit analysis leads to major financial disruptions.
The 5 Cs of Credit Analysis
The 5 Cs of credit analysis determine the risk involved with lending money or extending credit.
Character deals with the past credit and payment behaviour of a borrower. For individuals, one method evaluated will be a credit score like FICO, while for corporate borrowers, consideration of reputation and credibility is vital. Hence loan officers will be assessing the character of the borrower to evaluate future creditworthiness.
Capacity checks to see whether a borrower can still generate cash flow about the size of total obligations measuring against income or liabilities. For the commercial lender, capacity defines the borrower’s ability to retain control over pricing, margins, and cash flow.
Capital refers to a borrower’s financial strength; the presence of capital assets to support debt repayment. Personal borrowers consider marketable securities or real estate to get the cash-but for business borrowers, the capital structure of that company is to be considered.
Collateral is an asset pledged against a loan to minimize credit risk; credit risk is assessed to ascertain the prospect of full repayment in case of default. An asset’s characteristics, conditions, and desirability will then affect the loan-to-value (LTV) ratio and the terms of the loan structure.
Conditions relate to the macroeconomics and industry risks affecting the repayment of credit. All “borrower strengths/weaknesses” should be tested against cyclical factors, political or technological risks, and other issues pertinent to the borrower’s cash flow and risk assessment.
Challenges and Risks of Credit Analysis
Credit risk management faces many challenges which arise from manual, repetitive work done in older credit application systems that lack automation or customization, making it difficult to mitigate risk efficiently.
Lack of Online Credit Risk Monitoring
There is no real-time credit risk monitoring in the software. It leads to increased risk exposure and less credit management impacting a business’s financial health and reducing operational efficiency.
Incomplete Information
Many borrowers do not even maintain their proper financial records especially individuals and small businesses, so such records lead to bad debts.
Economic Volatility
Fluctuating inflation, and interest rates impact a borrower’s ability to repay which also distorts the credit risk assessment.
Absence of blocked-order prediction
Predicting blocked orders is all about anticipating which orders are likely to get obstructed or delayed in the order-processing supply chain. Microsoft works well in reviewing orders held up and decision-making based on knowledge for the release of orders that liberate sales and reduce bad debt while allowing for better customer experience.
Unfortunately, legacy credit tools severely lack this basic feature, and the end result is a timed reaction on credit issues, a disrupted cash flow, inefficiencies, and operational issues. It greatly impacts customer satisfaction, sales, and overall business performance.
Manual finance data integration
Credit terms would manually collate finance data from different sources like Edgar, S’nk, etc. and apply it to credit risk analysis. This amounts to inaccurate and inconsistent financial assessments, delays in decision-making, cash flow forecasting getting disrupted, and compliance getting compromised.
Lack of credit data integration
Most credit management software relies on basic data integration, like pulling in reports from credit agencies, which is grossly deficient. This causes inconsistent credit assessment, delayed responses to credit problems, and inefficient risk management when it comes to adjusting a credit limit.
Inefficient handling of online credit application
The delays in turnaround, poor customer experience, tracking, and reporting issues in the credit application software module that allow for online applications make the whole setup ripe for fraud.
Final Thoughts
The credit assessment is all about responsible lending and the success of the financial system. It plays a crucial role in preventing crises. The financial world has faced crises and bad debts in elitist credit assessments. So, accurate analysis and informed decisions on credit-seeking loans by individuals, and businesses seeking financing, or investors in credit risk evaluations allow less financial loss and life-cycle growth.
FAQ’s
What do credit analysts do?
Credit analysts basically analyse whether the borrower be it any individual or an organization is able to return the money back.
What skills should a credit analyst have?
Credit analysts must possess some basic skills required in their field like accounting, communication, problem-solving, and paying attention to detail.
Is a credit analyst a good job?
No job is bad, until and unless you dislike it. So obviously many aspire to become a credit analyst as they get a highly competitive salary compensation as per experience, and location.
