Understanding the basics of credit analysis is important when raising debt financing for commercial real estate projects. Credit analysis is one step in the credit approval process a bank goes through to evaluate a corporate borrower, but it also comes in handy when evaluating the financial strength of tenants, corporate guarantors, and other individual operating businesses. In this article we’ll take a deep dive into the topic of credit analysis, provide a clear framework you can use to perform your own credit analysis, and we will also clear up some common misconceptions.
But before we get too far into the world of credit analysis, we have a handy financial statement analysis template that will allow you to analyze the financial statements for any company over multiple time periods. It comes complete with side-by-side comparison and it also automatically calculates several helpful credit analysis ratios, which we discuss in detail below.
The 5 C’s of Credit Analysis
First of all, let’s quickly go over some credit analysis basics. Every newly minted credit analyst inside of a bank is indoctrinated with the 5 C’s of Credit Analysis. This is essentially a high level checklist that any firm will be evaluated by when requesting a commercial loan.
Credit Analysis: Capacity
Capacity measures the ability of a company to pay it’s debt service obligations. In others words, how can a borrower demonstrate it’s ability to pay back the requested loan? Analyzing capacity traditionally comes down to looking at historical and projected cash flows. Typically a lender will review the past 3-5 years of financial statements and tax returns in order to determine a cash flow figure, which will depend on the context but is typically defined as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). It recognizes that depreciation and amortization are non-cash expenses and therefore adds them back to the cash flow figure, along with interest and taxes, to arrive at a dollar amount that’s available to service the debt.
Depending on the type of business, additional capital expenditure estimates can also be included to account for the real effect of depreciation of machinery and other capital goods. Once this cash flow figure is calculated, the Debt Service Coverage Ratio (DSCR) is calculated, which simply divides EBITDA by all existing and proposed debt service obligations. Most banks will require an adequate cushion between available cash flow and total debt service. While the actual DSCR requirement will ultimately depend on the type of business being evaluated as well as the bank’s internal loan policy, a 1.20x DSCR is usually a good approximation.
Credit Analysis: Collateral
Collateral is a bank’s plan B. It answers the question “what happens if the borrower can’t generate enough cash flow to meet its debt service obligations?” To protect its depositors, lenders like to be covered in case things don’t work out as planned and a company’s cash flow is unable to service its debt obligations. Collateral gives lenders extra assurance that their loan won’t go bad if the borrowing company doesn’t operate as expected.
In the case of liquidation, sufficient collateral value will ensure that a lender is covered if things go south. Collateral includes tangible assets, such as accounts receivable, inventory, equipment, and real estate. During the underwriting process a dollar value is placed on collateral, usually by a third-party appraisal, and the loan amount is typically capped at a certain Loan to Value (LTV) ratio.
Credit Analysis: Capital
Capital ensures that the owners of the company have sufficient “skin in the game.” Capital measures how much the owners stand to lose should the business fail. The more capital there is, the higher the chance that the owners will do everything in their power to not fail. Having sufficient capital also ensures that there is a “cushion” in case the company’s cash flows turn negative for a season. While there is no magic number, this is typically quantified using the debt-to-equity ratio, and is usually no higher than 3x.
Credit Analysis: Conditions
Conditions address the the economics of your industry and the larger macro economic environment. Your bank will want to ensure that your company has competitive advantages and will not be adversely affected by industry trends. Typically a report from First Research or a similar service is used to understand industry economics and trends, as well as the banks own internal understanding of broader market conditions.
Credit Analysis: Character
Character assessment is arguably the most important factor when performing credit analysis. Banks want to know that you are trustworthy and aren’t involved in any ethically questionable activities. Most of this assessment comes from lenders being involved in the community and understanding the history of real estate developers and local businesses. Sometimes your lender will reach out to your other banks, customers, or suppliers, but more often than not character assessment is simply based on a gut feeling.
Financial Statement Spreads
Usually the first step in the credit analysis process is to gather the past 3-5 years of financial statements and tax returns for the company under review. Then the analyst creates credit spreads by “spreading” the financial statements. This involves manually inputting each line item on the financial statements into Excel or specialized credit spreading software.
What this does is provide the analyst with a side by side comparison of financials over several time periods. This will allow you to spot trends in certain line items on the income statements and balance sheets, as well as calculate common credit analysis ratios, which are discussed in detail below. As mentioned above, to make this easy, you can download our free credit analysis template.
Credit Analysis Ratios
After the credit analyst spreads the financial statements for the company under review, questions are usually asked of the CEO/CFO and then a full written financial analysis is performed. This written analysis will involve general commentary and trends affecting the company, an explanation of both positive an negative trends in the financial statements, as well as a discussion of key credit analysis ratios. Below we discuss the mechanics and intuition of some of the most common credit analysis ratios across 4 categories: liquidity ratios, coverage ratios, leverage ratios, and operating ratios.
Liquidity refers to the ability of a company to pay off short-term obligations as they come due. The purpose of measuring a company’s liquidity is to provide a level of comfort to lenders in the case of liquidation. For companies with more stable operations and cash flow (like utilities), liquidity ratios are less important. But for other companies that are exposed to ups and downs in revenue, getting comfortable with liquidity becomes very important.
Current Ratio: The current ratio shows the total assets that can be sold (i.e., converted to cash) in a year to pay debts incurred during a year. It gives you a rough indication of a company’s ability to cover it’s short-term liabilities. In general, the higher the ratio, the greater the cushion. The current ratio is easily calculated with the following formula:
Quick Ratio: This ratio is a stricter measure of liquidity as compared to the current ratio above. Often called the “Acid-test” ratio, it relies strictly on the most liquid of current assets, which can be converted into cash immediately. This typically removes inventory from the liquidity calculation. If this ratio is less than 1 it implies that the firm is dependent on inventory and other less liquid assets to cover it’s short-term obligations.
The quick ratio formula is as follows:
Sales/Receivables: This credit ratio measures how many times a firm’s trade receivables turn over in one year. The higher the ratio, the shorter the time period between sale and cash collection. For example, if a company has sales of $1,000,000 and receivables of $100,000, then its Sales/Receivables ratio would be 10. This means the company turns over receivables 10 times per year, which may or may not be favorable depending on the industry standards.
One potential limitation you should be aware of with this ratio is that it only takes into account a snapshot of receivables outstanding on a particular date, and then compares it to sales for the entire year. If sales for the company are seasonal or otherwise fluctuate then this could cause a problem. Also, when a company takes a large portion of sales in cash, then this ratio can also be thrown off.
You can calculate the Sales/Receivables ratio as follows:
Days’ Receivable: This credit ratio expresses the average number of days receivables outstanding. The greater the number of days outstanding, the more likely it is that receivables are delinquent. Overall, this ratio will give you an indication of how much control a company has over its receivables and collections.
This ratio can be calculated as follows:
Cost of Sales/Inventory: This ratio measures how many times a company’s inventory is turned over in a given year. High inventory turnover may indicate that a company is efficient at moving through its inventory. On the other hand, sometimes it could indicate a possible shortage of inventory to meet demand. Low inventory turnover most likely indicates inferior or obsolete products or overstocking, however, it is also possible that low inventory turnover is the result of planned inventory buildup.
One limitation of the Cost of Sales/Inventory ratio is that it uses a snapshot of inventory from one specific period of time and does not take into account any seasonal fluctuations.
The Cost of Sales/Inventory ratio is calculated as follows:
Days’ Inventory: This credit analysis ratio measures the average number of days a unit of inventory is outstanding.
The Days’ Inventory ratio can be calculated as follows:
Cost of Sales/Payables: This ratio measures how many times a firm’s payables turnover in a year. The higher the ratio, the shorter the time between purchase and payment. If a company’s payables are turning slowly as compared to its peer group, then it could indicate that the company is experiencing cash shortages or disputing invoices. On the other hand, it could be more favorable and indicate that the company is enjoying extended terms with suppliers.
The payables turnover ratio can be calculated as follows:
Days’ Payables: This ratio simply divides the above payables turnover ratio into 365 to get the average number of days payables are outstanding.
The days’ payables ratio can be calculated as follows:
Coverage ratios measure a company’s ability to service its debt obligations. While the liquidity ratios above focused on what could happen in a liquidation, coverage ratios provide an indication that a firm can remain a viable operating business.
Earnings Before Interest and Taxes (EBIT)/Interest: This ratio measures a firms’ ability to meet interest payments and to take on additional debt. A high ratio indicates that a firm can easily meet all of its interest obligations.
This ratio can be calculated as followed:
Net Profit + Depreciation, Depletion, Amortization/Current Maturities Long-Term Debt: This ratio indicates how well cash flow from operations can cover current maturities. Since cash flow from operations is the primary source of principal repayment, this ratio can provide you with a level of comfort about how well a firm can cover debt payments and also take on new debt. One thing to note with this ratio is that it isn’t always safe to assume all cash flow from operation can be put toward debt service. Nonetheless, this can still be a very useful indicator.
This ratio can be calculated as follows:
Leverage ratios help assess a firm’s vulnerability to downturns. Highly leveraged company’s are more vulnerable than those that are less dependent on debt. Firms that require less debt are also better credit risks for lenders.
Fixed/Worth: This ratio indicates how much owners’ equity has been invested in plant and equipment (fixed assets). A low ratio indicates a smaller investment in fixed assets and therefore more cushion for creditors in the case of liquidation. A higher ratio would indicate the opposite. However, note that if a company has a lot of leased equipment then this may end up resulting in a deceptively low ratio.
The fixed/worth ratio can be calculated as:
Debt/Worth: This credit ratio measures how much protection the owners of a company are providing creditors. A higher ratio indicates that a firm is highly leveraged and therefore that creditors are assuming a greater portion of risk. A lower ratio generally indicates that a firm will be more financially resilient in the long-term.
The debt/worth ratio is calculated as follows:
Operating ratios are designed to provide a measure of management performance.
Profit Before Taxes/Tangible Net Worth: This ratio expresses the rate of return on tangible capital employed and indicates management performance. Normally, a higher return suggests more effective management and a lower return suggests inefficient management performance. However, note that a high return might also indicate an under-capitalized firm. Conversely, a low return could indicate a highly capitalized and conservatively managed business.
This ratio can be calculated as follows:
Profits Before Taxes/Total Assets: This ratio measures the pre-tax return on total assets and provides a measure of the effectiveness of management. Note that a large portion of intangible assets or unusual income or expense items will distort this ratio.
This ratio can be calculated as:
Sales/Net Fixed Assets: This ratio indicates how productively a firm uses it’s fixed assets. Heavily depreciated assets and/or a labor-intensive operation could cause distortions in this ratio.
This ratio is calculated as:
Closing Thoughts on Credit Analysis
Understanding the basics of credit analysis can be an overwhelming task, but credit analysis is also an important and useful skill set to develop. This guide was intended to help demystify credit analysis and give you some practical tools and intuition to help you day to day. If you have any specific questions regarding credit analysis, please let us know in the comments below.