Credit Analysis and Demand-Supply Dynamics

Credit Analysis

• Credit analysis is the process of determining a borrower's ability and willingness to meet financial obligations.
• The primary purpose of credit analysis is to evaluate the likelihood of a borrower repaying debt on time and in full.
• Credit risk is the risk of a borrower failing to meet their financial obligations, leading to a loss for the lender.

Demand and Supply of Credit

• The demand for credit comes from various entities such as banks, bond investors, corporations, suppliers, customers, and individuals.
• Suppliers of credit include internal corporate credit teams, bank credit analysis teams, credit rating agencies (S&P, Moody's, Fitch), fixed income research firms, and consulting firms.
• Companies need credit for operating activities like manufacturing, seasonal purchases, and covering operating losses.
• Investing activities such as acquiring property, plant, and equipment, intangible assets, mergers & acquisitions, and leverage buyouts also require credit.
• Financing activities like maturing bank loans or bonds, stock repurchases, and other corporate financing activities can create demand for credit.
• Trade credit, a form of supplier credit, is generally non-interest bearing, with terms specifying early payment discounts, credit limits, payment terms, and other conditions.
• Banks provide various credit facilities, including revolving credit lines for seasonal shortfalls, lines of credit for backup funding, term loans for financing fixed assets, and mortgages for real estate transactions.
• Other forms of financing include lease financing, publicly traded debt (commercial paper, bonds, debentures), and credit rating agency-rated debt.

Credit Risk Analysis Process

• The credit risk analysis process quantifies potential credit losses to inform lending decisions.
• Expected credit loss considers both the debtor's ability to repay and the size of the loss if the debtor defaults.
• The chance of default is determined by a company's ability to repay its obligations, which is a function of future cash flow and profitability.
• Loss Given Default (LGD) is the potential amount lost if a company defaults on its obligations.
• LGD depends on the priority of the claim compared to other existing claims, determined by the U.S. Bankruptcy Code.
• Lenders mitigate potential losses through credit limits, collateral requirements, repayment terms, and covenants.

Credit Rating Analysis

• Credit rating agencies such as Moody's and S&P Global Ratings analyze macroeconomic, industry, and firm-specific information to assess the chance of default and expected payment in the event of default.
• They provide ratings on both debt issues and issuers, aiming to predict loan defaults accurately.
• Moody's 9-step credit rating process involves identifying the issuer, reviewing financial statements, conducting industry analysis, determining the borrower's financial risk, assessing key business risk factors, analyzing financial flexibility, evaluating management, incorporating governance and environmental and social considerations, and determining the rating.
• S&P Global Ratings uses a similar approach, including financial risk assessment with cash flow ratios, leverage ratios, and other metrics.

The Z-Score Model

• Altman's Z-Score model is used to predict bankruptcy risk using various financial ratios.
• The Z-Score considers working capital, retained earnings, EBIT, market value of equity, total assets, and sales.
• A Z-Score above 3.0 suggests low bankruptcy risk in the short term.

This quiz explores the fundamentals of credit analysis, including the assessment of a borrower's ability to repay debt and the associated risks. It also delves into the demand and supply mechanisms of credit within various entities, highlighting their roles in the financial ecosystem.