Credit Risk Analysis

Credit risk analysis determines whether a company will be able to repay a debt under the agreed terms. It doesn't ask whether the company is profitable, but whether it generates sufficient, stable cash to cover the payment even as the scenario deteriorates. Profitability and ability to pay aren't the same thing: a company can be profitable on the income statement and run out of cash because of a collection cycle that's too long.

The result of the analysis isn't a yes or a no. It's a ranking: how much risk this deal carries, at what price that risk is compensated, what safeguards make it acceptable, and what signals should be monitored after the deal closes.

The classic framework organizes the evaluation into five dimensions, and it's still the best way to make sure nothing gets left out:

1. 1Character. The track record of the borrower and its principals. Prior payment behavior, protested instruments, delinquencies, reputation in the market.
2. 2Capacity. Cash generation to service the debt. The most quantitative dimension, and where operating cash flow and the DSCR come in.
3. 3Capital. How much the owners have put in. Thin equity relative to debt means the lender is carrying most of the business risk.
4. 4Collateral. The guarantees. They define the expected loss if the loan deteriorates, not the probability that it will.
5. 5Conditions. The context: the industry, the economic cycle, customer or supplier concentration, the regulatory framework.

The first three are read in the financial statements and the track record. The last two require judgment, and they're the ones that tend to end up poorly documented when the analysis is done against the clock.

Ratios translate the balance sheet and income statement into magnitudes comparable across companies of different sizes. These are the ones that carry most credit decisions, with the thresholds banking typically uses as reference:

These thresholds are general market references, not universal rules: a retail company and an infrastructure concessionaire tolerate very different balance sheet structures. They're useful for spotting deviations, not for deciding on their own.

A risk score summarizes the evaluation into a number comparable across companies. It's built in four steps: ratios are calculated on normalized financial statements, each is weighted by how well it discriminates between good and bad payers, the result is adjusted for the industry's typical balance sheet structure, and the analyst's qualitative judgment is incorporated.

The industry adjustment is the step most often skipped, and the one that distorts the most when it's missing. A leverage of 2.5x is alarming for a professional services firm and perfectly normal for a real estate company or a transportation company with financed assets. Comparing against the overall average instead of the sector's pattern penalizes asset-intensive industries and rewards ones that lease everything.

The qualitative component should carry weight, but bounded. At CreditIQ the parametric score contributes 85% and qualitative factors the remaining 15% — enough for the analyst's judgment to correct the model, not so much that it overrides it.

Debts are paid with cash, not accounting profit. The income statement includes items that don't move money, like depreciation, and excludes movements that do, like principal repayment or working capital investment. A fast-growing company can show rising profits and consume cash every period, because it finances inventory and receivables before collecting the sale.

That's why the indicator that drives the decision is the DSCR: operating cash flow divided by the period's debt service. A DSCR of 1.0x means cash flow is exactly enough for the payment, with no margin for a bad month. The usual banking reference is 1.25x. How that cash flow is projected is a topic in its own right.

A committee report has to let someone who didn't do the analysis make a decision and, above all, let the decision be reconstructed a year later. The minimum contents:

• Identification of the borrower, its economic group and the requested deal.
• Financial statements for the last three periods, with material variances explained.
• Liquidity, leverage, coverage and profitability ratios, with their trend over time.
• Cash flow projection and the resulting DSCR under the base scenario.
• Stress test: what happens to those same indicators if sales drop or rates rise.
• Qualitative assessment: industry, concentration, information quality, business risks.
• Risk score and the recommendation, with proposed covenants and collateral.

Analyzing a single period. An isolated balance sheet shows no trend. Deterioration almost always shows up as a series: margin declining for three straight periods, collections stretching out, short-term debt growing.

Confusing profitability with ability to pay. Profit doesn't make payments. Without a cash flow projection there's no credit evaluation, just accounting analysis.

Evaluating without an industry reference. Without the sector's pattern, ratios get compared against an average that doesn't exist.

Spending the analyst's time on data entry. When most of the hours go into moving figures from a PDF into a spreadsheet, the analysis gets done with whatever's left over.

CreditIQ runs the mechanical parts of the analysis and leaves the decision to the analyst. It reads balance sheets and income statements automatically, calculates the full battery of ratios on the loaded periods, projects cash flow, applies the parametric score with industry adjustment, runs the stress scenarios, and assembles the committee report from all of it.

The analyst steps in where it matters: validating the account mapping, weighing the qualitative factors, setting the covenants, and signing off on the recommendation.