Credit analysis is one of the most common uses of financial statements, reflecting the many forms of debt that are essential to the operation of a modern economy.
Merchants who exchange goods for promises to pay need to evaluate the reliability of those promises. Commercial banks that lend the merchants the funds to finance their inventories likewise need to calculate the probability of being repaid in full and on time.
The banks must in turn demonstrate their creditworthiness to other financial institutions that lend to them by purchasing their certificates of deposit and bonds. In all of these cases, financial statement analysis can significantly influence a decision to extend or not to extend credit.As important as financial statements are to the evaluation of credit risk, however, the analyst must bear in mind that other procedures also play a role. Financial statements tell much about a borrower’s ability to repay a loan, but disclose little about the equally important willingness to repay. Accordingly, a thorough credit analysis may have to include a check of the subject’s past record of repayment, which is not part of a standard financial statement. Moreover, to assess the creditworthiness of the merchant in this example, the bank must consider along with his balance sheet and income statement the competitive environment and strength of the local economy in which the borrower operates. Lenders to the bank will in turn consider not only the bank’s financial position, but also public policy. Believing that a sound banking system benefits the economy as a whole, national governments empower central banks to act as lenders of last resort. As a result, fewer bank failures occur than would be the case under pure, unrestrained competition.
An even more basic reason why analyzing a company’s financial statements may not be sufficient for determining its credit quality is that the borrower’s credit may be supported, formally or informally, by another entity. Many municipalities obtain cost savings on their financings by having their debt payments guaranteed by bond insurers with premier credit ratings.
For holders of these municipal bonds, the insurer’s creditworthiness, not the municipality’s financial condition, is the basis for determining the likelihood of repayment. Corporations, too, sometimes guarantee the debt of weaker credits. Even when the stronger company does not take on a legal obligation to pay if the weaker company fails on its debt, “implicit support” may affect the latter’s credit quality. If a company is dependent on raw materials provided by a subsidiary, there may be a reasonable presumption that it will stand behind the subsidiary’s debt, even in the absence of a formal guarantee.Keeping in mind that the final judgment may be influenced by other information as well, the analyst can begin to extract from the financial statements the data that bear on credit risk. Each of the basic statements—the balance sheet, income statement, and statement of cash flows—yields valuable insights when studied through ratio analysis techniques, as well as when used in the evaluation of fixed-income securities. In each case, the analyst must temper any enthusiasm generated by a review of historical statements with caution based on a consideration of financial ratios derived from projected statements for future years.