How Financial Modeling Can Help In Credit Analysis?
The lifeblood of the financial sector, an entity borrowing from a lender for the express purpose of creating more worth. Whether it be through a bank loan or financial institution loan, or the issue of bonds, the concept of credit underpins the day-to-day operation of the sector and its goal; to sell money.
At its simplest, credit analysis is a process of determining, through both qualitative and quantitative data, whether an entity could commit to its financial obligations. It also highlights the risks and how they may be mitigated should the entity be unable to fulfil its commitments.
In the instance of a bank lending to a business, it is the bank’s own credit analysts that evaluate the risks of the entities proposal. If it is an issuance of bonds, however, an independent credit rating agency will assess the “creditworthiness” of the entity.
Whether it be the former or the latter, the five fundamental aspects of any credit analysis remain the same, the 5 Cs:
Character – a qualitative evaluation of how trustworthy the entity is and their behaviour in the past, for instance have they borrowed before and were they reliable in their repayments.
Capacity – the ability of the entity to honor the loan from the profits generated, taking into account cash flow, payment history and repayment timing.
Capital – what the borrower has invested in the business as a sign of commitment to it and the risks if the business or investment fails.
Collateral – any security the entity has against the loan, such as assets or other funds, or guarantees from personal accounts.
Conditions & Terms – the purpose of the loan, such as for equipment, capital investment, expansion, etc and the terms under which the loan is agreed.
Financial modelling is a core procedure for many processes where the future prospects of a business are important.
Financial Modelling uses business’ historical performance, assumptions about the future of the business and the market, and Statement Model to forecast the future performance of the business.
Corporate and accounting finance typically entail financial forecasts to produce, in the instance of credit analysis, a business valuation.
From there it is possible to produce further, more advanced, models such as the Mergers & Acquisitions model and Leveraged Buyout model.
Financial Models are used by business for a number reasons, including, but not limited to;
● raise capital
● make acquisitions
● allocate capital
● value a business
It is primarily on this final point that a credit analysis will focus to ascertain the terms on which a loan is made.
Application of Financial Models in Credit-Scoring
Credit analysts will look at different accounting ratios to determine the viability of a loan proposal. A thorough quantitative analysis, the credit-scoring system will use a financial model for a great deal of its data.
This credit-scoring system is used for small-scale businesses right through to government debt and equity ratings.
Between the years 2007 – 2017 there were no less than 16 major economic crises. This trend began with the US Sub-prime housing crisis and has included the European Economic Crisis, two Russian economy crashes and the Chinese Stock Market Crash.
The resultant financial models of several global economies has led to the downgrading of the respective countries credit rating. Including the US and UK, the crises of the past 10 years revealed a lack of Collateral and Capacity by several countries in honouring these loans.
Due to the revealed weakness of these economies, Credit Rating agencies such as Standards & Poor, Moody’s and Fitch’s downgraded countries like Greece from an A+ in the early 2000s to as low as C- in 2017.
Financial modeling isn’t just an aid to the process of credit analysis but is rather one of the key contributors to the data that is appraised in the consideration of a loan, be it a small or large-scale one.
With the advent of more rigorous and thorough models, the financial market is now applying a level of scrutiny and detail far beyond those that were in place in the years prior to the 2008 economic recessions.