InvestorQ : Is credit rating and credit analysis the same and how is it done and what are the factors that are considered?
Debbie Mascarenhas made post

Is credit rating and credit analysis the same and how is it done and what are the factors that are considered?

Crowny Pinto answered.
3 years ago

Credit analysis is the approach and credit rating is the outcome in the form of a code to measure the credit risk of the security. It seeks to provide a fundamental view of a company's financial ability to repay its obligations. While factors such as operating margins, fixed expenses, overhead burdens, and cash flows might be the same in equity and credit analyses, the emphasis is different for each. And while a strong credit rating does not seek to forecast strong equity performance per se, an understanding of credit ratings can help assess the equity performance potential of a company. Let us look at some of the important factors that actually go into credit analysis and the key factors impacting the same.

· What are the strengths and weaknesses of the company issuing debt?

· Competitive position in the industry

· Business environment in which the company operates

One of the most popular models used is the CAMELS model for credit rating. This is how it works. The acronym CAMELS stand for the following factors that examiners use to rate bank institutions:

Capital Adequacy Ratio

Examiners assess institutions' capital adequacy through capital trend analysis. Examiners also check if institutions comply with regulations pertaining to risk-based net worth requirement. To get a high capital adequacy rating, institutions must also comply with interest and dividend rules and practices. Other factors involved in rating and assessing an institution's capital adequacy are its growth plans, economic environment, ability to control risk, and loan and investment concentrations.

Asset Quality analysis

Asset quality covers an institutional loan's quality, which reflects the earnings of the institution. Assessing asset quality involves rating investment risk factors that the company may face and comparing them with the company's capital earnings. This shows the stability of the company when faced with particular risks. Examiners also check how companies are affected by the fair market value of investments when mirrored with the company's book value of investments. Lastly, asset quality is reflected by the efficiency of an institution's investment policies and practices.

Management quality

Management assessment determines whether an institution is able to properly react to financial stress. This component rating is reflected by the management's capability to point out, measure, look after and control risks of the institution's daily activities. It covers management's ability to ensure the safe operation of the institution as they comply with the necessary and applicable internal and external regulations.

Earnings quality

An institution's ability to create appropriate returns to be able to expand, retains competitiveness, and adds capital is a key factor in rating its continued viability. Examiners determine this by assessing the company's growth, stability, valuation allowances, net interest margin, net worth level and the quality of the company's existing assets.

Liquidity analysis

To assess a company's liquidity, examiners look at interest rate risk sensitivity, availability of assets that can easily be converted to cash, dependence on short-term volatile financial resources and ALM technical competence.

Sensitivity to risk

Sensitivity covers how particular risk exposures can affect institutions. Examiners assess an institution's sensitivity to market risk by monitoring the management of credit concentrations. In this way, examiners are able to see how lending to specific industries affects an institution. These loans include agricultural lending, medical lending, credit card lending and energy sector lending. Exposure to foreign exchange, commodities, equities and derivatives are also included in rating the sensitivity of a company to market risk.