Corporate Credit Analysis

Corporate Credit Analysis Essentials | CFA Level I Fixed Income

Welcome back! In this lesson, we’ll dive into corporate credit analysis, focusing on the process of evaluating a company’s ability to satisfy its debt obligations.

4 Key Components: The 4 ‘C’s of Credit Analysis

To assess a company’s creditworthiness, we need to examine the four key components, commonly known as the 4 ‘C’s of credit analysis:

  1. Capacity
  2. Collateral
  3. Covenants
  4. Character

Let’s explore each of these components in detail.

1. Capacity

Capacity refers to a corporate borrower’s ability to repay its debt obligations on time. Capacity analysis entails three levels of assessment: industry structure, industry fundamentals, and company fundamentals.

Analysts need to examine factors such as Porter’s five forces, industry cyclicality, growth prospects, and published statistics to understand the industry structure and fundamentals.

For company fundamentals, analysts should assess the competitive position, operating history, management’s strategy and execution, and ratios and ratio analysis.

2. Collateral

Collateral refers to the assets of the company that will be liquidated to repay the debt holders in the event of a default. Valuing a company’s assets can be challenging, especially when considering the tangibility of assets and depreciation expenses.

Analysts should also consider the equity market capitalization and the quality of intangible assets, such as patents, goodwill, and human and intellectual capital.

3. Covenants

Covenants are the terms and conditions agreed upon by borrowers and lenders as part of a bond issue. There are two types of covenants: affirmative covenants and negative covenants.

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.

4. Character

Character refers to management’s integrity and its commitment to repay the loan. Although it can be difficult to observe and analyze objectively, an analyst can make calculated judgments in several ways, such as assessing the soundness of management’s strategy, their track record, accounting policies, any record of fraud, and the history of treatment of bondholders.

And that’s the 4 ‘C’s of credit analysis! In the next lesson, we’ll discuss a company’s ratios in assessing the company’s capacity. See you soon!

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