Analysis of Financial Statements, 3rd Edition

CHAPTER 8

Corporate Credit Analysis

Corporate credit analysis involves the analysis of a multitude of quantitative and qualitative factors over the past, present, and future. The past and present are introductions to what the future may hold. Corporate bond credit analysis involves an analysis of an issuer, and is not done in isolation but in conjunction with a review of the issuer's place within the industry and an overall analysis of where the industry fits within the national economy and, with increasing frequency, the global economy.

Corporate bond credit research and equity research areas historically have been viewed as separate areas, but with the development and application of option theory, these two areas of financial research are now considered to be complementary. In addition, credit risk models that are grounded in option theory are commercially available to investors.

Our purpose in this chapter is to discuss the general principles of corporate credit analysis. We begin with a discussion of the types of credit risk an investor faces when investing in a bond. We then explain the factors to consider in credit analysis: character, capacity, collateral, and covenants.

TYPES OF CREDIT RISK

An investor who lends funds to a corporation by purchasing its debt obligation is exposed to credit risk. But what is credit risk? Credit risk encompasses three types of risk:

1. Default risk

2. Credit downgrade risk

3. Credit spread risk

Default risk is the likelihood that the issuer ...