Financial Statement Analysis, 5th Edition

CHAPTER 13Credit Analysis

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 the 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 ...