LO 16.5: Com pare the credit analysis o f consumers, corporations, financial

LO 16.5: Com pare the credit analysis o f consumers, corporations, financial institutions, and sovereigns.
Four basic types of borrowers for which credit analysis must be performed are as follows:
1. Consumers the analyst evaluates the creditworthiness of individuals.
2. Corporations the analyst evaluates the creditworthiness of nonfinancial firms.
Businesses are typically more difficult to analyze than individuals, although the process is similar.
3. Financial institutions the analyst evaluates the creditworthiness of financial
institutions, including banks and nonbank firms such as insurance companies and investment companies.
4. Government or government-related entities (i.e., sovereigns) the analyst evaluates
the creditworthiness of nations, government bodies, and municipalities. Non-state entities in specific locations or jurisdictions are also subject to analysis in the sovereign category.
2018 Kaplan, Inc.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
There are similarities and differences in the approaches taken to analyze the creditworthiness of the various groups. Figure 1 details some specific aspects of each type of analysis.
Figure 1: Comparison of Borrowers
Corporations Consumers Capacity Wealth (i.e., net Liquidity, cash worth), salary, or flow combined incoming cash per with earnings capacity and period, expenses profitability, per period, assets capital position such as houses and cars, amount (solvency), state of debt (e.g., of the economy, credit card debt), strength of the net cash available industry. to service debt (i.e., cash flow minus household and mortgage expenses).
illingness Reputation
of individual, payment history.
Quality of management, historical debt service.
Financial Institutions Similar to nonfinancial firms but bank specific. Liquidity (the banks access to cash to meet obligations), capital position, historical performance including earnings capacity over time (and ability to withstand financial stress), asset quality (affects the banks likelihood of being paid back and by extension the banks lenders likelihood of being paid back), state of the economy, strength of the industry. Quality of management; qualitative analysis is even more important for financial firms than for nonfinancial firms.
Sovereigns Financial factors including the countrys external debt load and debt relative to the overall economy; tax receipts are important.
Credit analysis for sovereigns is often more subjective than for financial and nonfinancial firms because the legal system and the enforcement of creditor rights is critical to the analysis. Sovereign legal risk ratings, as discussed previously, are often considered in the analysis.
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2018 Kaplan, Inc.
Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
Figure 1: Comparison of Borrowers (Cont.)
Methods of evaluation
Loan size/type
Credit scoring models that consider income, duration of employment, and amount of debt for unsecured debt like credit cards. Credit scoring and some manual input and review for large exposures such as mortgage loans or automobile loans.
Large exposures are typically secured (e.g., mortgage loans). Smaller exposures are unsecured (e.g., credit card loans).
Financial Institutions Similar to nonfinancial firms.
Detailed manual analysis including financial statement analysis, interviews with management. More complex than consumer analysis because companies are so diverse in terms of assets, cash flow, financial structure, etc. Typically larger exposures (sometimes considerably larger) than firms (i.e., loans to consumers. Debt may be secured or unsecured.
large). Similar to
Similar to financial and nonfinancial firms but with increased subjective analysis of the political environment. Similar to nonfinancial nonfinancial and
Similar to
financial firms (i.e., large).
The two primary differences between nonfinancial firm credit analysis and financial firm credit analysis are (1) the importance of the quality of assets in financial firms and (2) cash flow as an indicator of capacity to repay for nonfinancial firms but not a key indicator of creditworthiness for financial firms. It is clear from the 20072009 financial crisis that asset quality is a key indicator of a banks financial health. The ability to withstand financial stress is critical for a bank. That is why earnings capacity over time is a more relevant indicator of creditworthiness than cash flow. A bank must be able to withstand periods of financial stress/crisis in order to repay debts.
Professors Note: Sovereign credit analysis is not explicitly discussed in this topic. However, in contrast to consumers and financial and nonfinancial firms, consider the political issues/concerns that would arise when lending to a foreign government. Even a financially healthy sovereign may he a risky loan candidate due to the legal systems strength (or lack thereof); a lack of legal protections for creditors and other factors might negatively affect the lender and the lenders rights. I f you have to compare credit analysis across the four groups (i. e., consumers, nonfinancial firms, financial firms, and sovereigns), think about the differences between the groups and the various factors that explain and/or increase!decrease the lenders risk in each case.
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