Level 1 CFA® Exam:
Four Cs of Credit Analysis & Credit Ratios
The 4 Cs of credit analysis include:
- capacity,
- collateral,
- covenants, and
- character.
Capacity
Capacity is the ability of the issuer to make debt payments according to the payment schedule.
To analyze the capacity of the issuer to service its debt, the credit analysts use the following process:
- Analyzing industry structure (e.g. using Porter's five forces).
- Analyzing industry fundamentals (e.g. growth prospects, cyclical vs non-cyclical, etc.).
- Analyzing company fundamentals (e.g. competitive position, operating history, management’s strategy & execution, ratio analysis, etc.)
Collateral
Collateral is the quality and value of the assets that serve as collateral for the issued debt.
Assets of a company vary in value, e.g. intangible assets like goodwill should be perceived as assets of lower quality. What is more, for publicly traded companies, if the market value is below the book value, it should be perceived as a warning sign.
Covenants
Covenants are terms and conditions of lending agreements, introduced to protect creditors, that the borrower has to comply with.
We distinguish between negative covenants which state what the issuer cannot do and affirmative covenants which state what the issuer must do.
Character
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Here are 4 financial ratios used in credit analysis that you should know in your level 1 CFA exam:
Leverage Ratios
Coverage Ratios
Credit Quality of Issuer/Bond in Comparison to Industry
In your CFA exam, you might be asked to compare the credit quality of a company in comparison to the industry using different ratios. To do this right, always pay attention to the form of a given ratio, i.e. what’s in the numerator and what’s in the denominator.
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Level 1 CFA Exam Takeaways: Four Cs of Credit Analysis & Credit Ratios
star content check off when done- The 4 Cs of credit analysis include capacity, collateral, covenants, and character.
- Capacity is the ability of the issuer to make debt payments according to the payment schedule.
- Collateral is the quality and value of the assets that serve as collateral for the issued debt.
- Covenants are terms and conditions of lending agreements, introduced to protect creditors, that the borrower has to comply with.
- We distinguish between negative and affirmative covenants.
- Character is the quality of the issuer’s management.
- For debt ratios if debt is given in the denominator of the ratio, then the higher the ratio, the higher the credit quality, and vice versa. If debt is given in the numerator of the ratio, then the higher the ratio, the lower the credit quality.
- For coverage ratios, the higher the ratio, the higher the credit quality.