Unit 5: Credit Analysis & Rating

Importance of Credit Analysis

Reason	Explanation
Assess Creditworthiness	Helps determine if borrower can repay loan on time.
Minimize Risk of Default	Reduces the chance of financial loss to the bank.
Loan Structuring	Helps in deciding loan amount, tenure, collateral, and repayment schedule.
Regulatory Compliance	Ensures bank follows RBI or regulatory norms for lending.
Support Pricing Decisions	Accurate risk assessment helps in setting proper loan interest rates.
Better Resource Allocation	Bank can focus funds on high-quality borrowers for higher returns.
Strengthens Credit Portfolio	Reduces NPAs (Non-Performing Assets) and ensures long-term bank stability.

Stages of Credit Analysis

Stage	Details
1. Preliminary Screening	Quick check of borrower’s profile, purpose of loan, eligibility.
2. Collection of Information	Financial statements, business details, credit history, bank statements.
3. Financial Analysis	Analyze profitability, liquidity, solvency (ratios: current, debt-equity, etc.).
4. Credit Scoring/Risk Rating	Assign rating based on risk factors (internal/external scoring models).
5. Assessment of Loan Repayment Capacity	Cash flow analysis, past repayment record.
6. Collateral Evaluation	Assess value and legal validity of security offered.
7. Loan Decision	Approve/reject loan or recommend modifications (amount/tenure/collateral).
8. Documentation	Draft and sign loan agreements, security papers, guarantees, etc.
9. Disbursement	Loan is disbursed in one or more tranches.
10. Monitoring	Periodic review of borrower’s performance, repayment, and collateral value.

Profitability Analysis and Pricing of Loans

A. Profitability Analysis

Purpose	Ensure that the loan earns sufficient return after costs and risks.
Key Factors Considered	✔ Interest income ✔ Cost of funds ✔ Risk premium ✔ Operational costs
Tools Used	Net Interest Margin (NIM), Return on Assets (ROA), Cost-Income Ratio
Outcome	Helps in maximizing bank’s profits and ensures sustainable lending.

B. Pricing of Loans

Factors Influencing Loan Pricing	Explanation
Base Rate or MCLR	Minimum interest rate set by bank (e.g., RBI guidelines)
Credit Risk Premium	Higher risk borrower = higher interest rate
Loan Tenure	Longer tenure = higher rate due to increased risk
Cost of Funds	Bank’s own cost of raising funds (deposits, borrowings)
Operational Costs	Cost of loan processing, staff, administration
Profit Margin	Desired profit over and above costs and risks
Collateral Quality	Better security = lower risk = lower pricing
Competition	Market rates and competitor pricing strategies

Formula (Simplified)

Loan Interest Rate = Cost of Funds + Operating Cost + Credit Risk Premium + Profit Margin

 Summary Table

Component	Key Role
Credit Analysis	Assess borrower risk, avoid bad loans
Profitability Analysis	Ensure loan generates net profit
Loan Pricing	Fair interest rate considering risk and market

Credit Risk Analysis (Debt Ratios & Risk of Leverage)

A. Credit Risk

Credit Risk is the risk that a borrower may fail to repay loan interest or principal on time.

B. Debt Ratios (Used in Credit Risk Analysis)

Ratio	Formula	Purpose
Debt-Equity Ratio	Total Debt / Shareholders’ Equity	Indicates financial leverage; high ratio = high risk
Total Debt Ratio	Total Debt / Total Assets	Measures how much of assets are financed by debt
Interest Coverage Ratio	EBIT / Interest Expense	Shows ability to pay interest; < 1.5 is risky
Debt Service Coverage Ratio (DSCR)	Net Operating Income / Total Debt Service (Interest + Principal)	Measures ability to repay loan with cash flows

Risk of Leverage

• Leverage means using debt to finance operations.
• High leverage = high fixed financial cost = higher default risk if earnings fall.

Analysis of Working Capital

Working Capital	Formula	Purpose
Working Capital	Current Assets – Current Liabilities	Measures short-term financial health.
Current Ratio	Current Assets / Current Liabilities	Ideal: 1.5 to 2; below 1 = liquidity problem.
Quick Ratio (Acid Test)	(Current Assets – Inventory) / Current Liabilities	Stricter liquidity check; ideal: 1 to 1.5

Good working capital = smoother day-to-day operations & better creditworthiness.

Liquidity Analysis

Term	Explanation
Liquidity	Ability to meet short-term obligations without raising new capital.
Cash Ratio	(Cash + Cash Equivalents) / Current Liabilities
Liquidity Risk	Risk of cash shortage; can lead to delayed payments/defaults.
Liquidity Management	Ensures adequate cash is available at the right time.

Operating Cycle & Cash Cycle Risk

Term	Definition
Operating Cycle	Time taken to convert inventory into cash through sales.
Operating Cycle Formula	Inventory Days + Receivables Days – Payables Days
Cash Conversion Cycle	Time gap between cash outflow for raw material and cash inflow from sales
Risk	Long cycle = cash locked in operations = higher working capital need
	Short cycle = better cash flow and lower risk

Risk Indicators from Cycle Analysis

Indicator	Risk
High Inventory Days	Slow-moving stock, tying up funds
High Receivable Days	Late payments from customers = cash shortage
Low Payables Days	Company must pay suppliers quickly, increasing pressure

Summary Table

Component	Key Insight
Debt Ratios	Assess leverage and repayment risk
Working Capital	Measures financial health for daily operations
Liquidity Ratios	Ensure ability to pay short-term dues
Cash Cycle Analysis	Shows efficiency in managing cash flow and operating risk

Credit Rating: Measurement of Risk

Definition	Credit Rating is a symbolic risk measure showing the creditworthiness of a borrower.
What it Measures	Likelihood of default by borrower (on interest or principal payment).
Scale of Measurement	Ranges from AAA (lowest risk) to D (default).
Issued By	Independent credit agencies (external) or banks (internal).

Objectives of Credit Rating

Objective	Details
Risk Assessment	Evaluate credit risk and default probability.
Pricing of Loans	Helps set interest rates – higher risk = higher rate.
Portfolio Quality	Maintain sound lending portfolio (avoid NPAs).
Compliance	Fulfills regulatory norms (e.g., Basel, RBI guidelines).
Investor Confidence	Builds trust for bond issues or market borrowing.

Internal & External Credit Rating

Type	Who Does It?	Purpose
Internal Rating	Bank’s own risk team or software	Loan approval, pricing, exposure decisions
External Rating	Credit Rating Agencies (CRAs) like CRISIL, ICRA, CARE, Fitch, Moody’s	Public risk opinion for bonds, large loans

Model Credit Rating (MCR)

Definition	A structured scoring model used internally by banks to assess borrower risk.
Objective	Standardize risk assessment across all loan proposals.
Result	Borrower is rated (e.g., A, B, C or 1 to 10) to aid decision-making.
Use	For credit sanctioning, loan pricing, and exposure limits.

Methodology of Credit Rating

Key Components	Details
A. Quantitative Factors	Financial ratios: profitability, liquidity, leverage, cash flow, turnover.
B. Qualitative Factors	Industry risk, management quality, business model, market position.
C. Credit History	Past repayment record, defaults, delays.
D. Security Offered	Quality and value of collateral/security.
E. External Environment	Regulatory risk, economic conditions.
Weightage & Scoring	Points are assigned; final score = rating category.

Internal vs External Rating Comparison

Point of Comparison	Internal Rating	External Rating
Issuer	Bank itself	Independent Rating Agency
Purpose	For loan approval/pricing	For market borrowing, investor use
Audience	Internal (bank) use only	Publicly available to investors/regulators
Frequency	Done for all borrowers	Usually done for large loans, bonds
Methodology	Tailored to bank’s policy	Standardized by SEBI/Global Norms
Regulatory Role	No external obligation	SEBI/RBI regulated

Model Rating Formats (Sample)

Rating Factor	Weight (%)	Score (1–5)	Weighted Score
Financial Risk	30%	4	1.2
Industry Risk	20%	3	0.6
Management Risk	20%	4	0.8
Collateral Coverage	10%	5	0.5
Repayment Capacity (DSCR)	20%	4	0.8
Total Score	100%		3.9
Rating Grade			A (Low Risk)

Note: Formats may vary by bank but follow a similar weighted-scoring model.