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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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LIMITATIONS OF QUANTITATIVE CREDIT ANALYSIS

Credit analysis, by definition, looks forward. All looks into the future will be subjective and involve many unique industry and issuer factors. This process cannot be reduced to a formulaic methodology or quantitative model.

Drawing from the past, credit analysts attempt to focus on a longer-term, future perspective. They must look through the cycle and through any potential accounting distortions. Finally, they must examine a variety of reasonably adverse scenarios to incorporate sensitivity to risk. Sovereign, economic, and industry factors influence risk. Soft facts, or subjective judgments, add valuable information to the credit analysis process.3 Quantitative and qualitative pitfalls exist in the quantitative portion of any analysis.

Finally, it is also important to note the difference between relative and absolute quantitative credit analysis. Relative analysis of comparable credits allows us to understand whether, after controlling for all differences in (for example) size, financial leverage, profitability, cash flow and liquidity, the credit is rated consistently with its group of comparables. But this does not answer whether the entire group of comparables is rated appropriately. This question may only be answered through an absolute default and recovery analysis to gauge investor risk and reward.

Relevant Data

Quantitative analysis is subject to a high degree of judgment in developing relevant data; comparables, history, and ...

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