Question

Q: Discuss the credit analysis process.

What must key questions usually be answered as part of the process?

What are the benefits of utilizing a bankruptcy prediction model such as Altman’s Z score and how would you apply it to a company? (Use a

specific company such as Microsoft to implement it).

Answer 1

Credit analysis is the process that helps in assessing the borrower's creditworthiness. This is the process that determines how likely is an individual or an organisation to live up to their obligations. Broadly there are three stages, the information collection stage, the information analysis stage and the decision making stage. Considering the information collected over various parameters the decision whether to approve of not is made.

The key questions that usually must be answered as a part of the process can also be regarded as the five C's:

• Firstly, the character of the borrower is assessed through questions regarding the background, experience, market opinion and such other subjective and qualitative questions.
• The next step is to assess the repaying capacity of the borrower. To get an idea about this knowledge about timing of repayment, cash flow and profits of the business, payment history and such other factors are considered.
• The lender would want to know how much of the borrower's own funds or capital is being invested. This helps the lender to be secure enough that the borrower would certainly be responsible regarding the business as it does involve a major portion of his own capital.
• One major step to help lessen or mitigate risk is to have a collateral or a guarantee. This should also be taken care of.
• The conditions put forth for the credit to be sanctioned should be clear between both the lender and the borrower as these form the crux of the loan agreement.

To be introduced to the Altman's Z score model analysis, one should know that it utilises multiple discriminant analysis. It predicts whether a company would face bankruptcy in the coming five years. The Z-score of a company is calculated using five factors and this score helps predict bankruptcy of a company if its score falls below a 'parameter'.

The five factors are represented by:

• Working capital to total assets ratio
• Retained profit to total assets ratio
• Profit before interest and tax to total assets ratio
• Market value of equity to book value of debt ratio
• Sales to total assets ratio

Each of the above ratios indicate bankruptcy if the result seems to be absurd. The Z-score being a score based on all the above parameters definitely enjoys the advantage of predicting bankruptcy better. The following could be considered as few advantages of the Z-score:

1. Investors can consider the Z-score of a company to decide whether to buy of sell the stock of a company.
2. It is used as a performance indicator of a company.
3. It analyses the financial health of private companies.
4. It also helps in assessing the credit worthiness of companies.
5. It helps in loan evaluation.
6. Financial managers can manage the items of the balance sheet in various scenarios by paying attention to losses, sale of fixed assets and such transactions that have an impact on the financial condition of the company.
7. The Z-score helps to measure how effective the business decisions are.
8. The outstanding receivables can be managed better and liquidity can be improved.