Hi d3donahue,
While a lot of ground has already been covered by the above posts, a structured approach could be useful (especially if you are given a case study):
Segment the credit risk analysis into different types as below :
(a) Define your counterparty. Who are the parties on whom you have a legal recourse to (include here the borrowers, co-borrowers and guarantors, CDS providers). Who are the other parties, whose continued well-being is important for your credit exposure (typically includes subsidiaries, holding companies, suppliers, customers etc). You would not have legal recourse to these, but need to be covered in your credit assessment.
(b) Structure risk : These include :
(i) level of finance : is the debt at holdco level or operating company level. If at holdco level, servicing of the debt would be affected by possible cash upstreaming restrictions by debt providers at the opco level. To that extent your debt will be structurally sub-ordinated to the opco level with regard to level of finance
(ii) Your relative position in the overall debt profile : other debt maturing before yours (structural subordination in terms of tenor); other debt enjoying better collateral protection (structural sub-ordination in terms of collateral);
(iii) Check whether inter-creditor arrangements are in place and if there is subordinated debt in the balance sheet, whether it is indeed completely sub-ordinated in terms of claim on cashflow, security etc.
(c) Business risk assessment: Typically involves industry analysis, counterparty’s competitive position within the industry, cyclicality (latter very important especially in commodities)
(d) Financial analysis :
(i)Typically leverage (Debt/EBITDA), Gearing (Debt/Tangible Networth), Interest Cover ((EBITDA -Taxes)/Interest)) and Debt Service Coverage Ratio (DSCR) i.e. ((EBITDA-Taxes)/(Interest + Principal amortization)); Collateral coverage are considered important.
(ii) More important is cashflow analysis and checking if Net Cashflow From Operations (NCFO) exceed the financing payments due (i.e. interest and principal amortizations)
(iii) If there are periods when the NCFO is inadequate for financing payments (due to say bullet loan redemptions) a.k.a refinancing risk; check if there are sources of back-up liquidity in the form of (cash + marketable securities) and available revolver bank lines which can be drawn to meet liquidity mismatches. Also check if the financial profile of the company is projected to be healthy enough to raise the required refinance.
(iv) It is normal to draw up projected financials, especially for long term debt analysis. In such cases, the profitability assumptions should be closely linked to the business drivers (for e.g. commodity prices, input cost parameters etc.). It is also common to run stress scenarios on these drivers and then examine debt serviceability
(e) Evaluation of covenants : whether the covenants are tight enough and provide adequate protection. Ideally, the covenants should breach in a projected stress case (the idea being that if such a stress scenario actually occurs, you can get the counterparty to the table early enough on covenant breach; without actually waiting for a payment default).
(f) Do look out for significant investments planned for capex, M&A etc. as this can significantly alter the current credit profile of the counterparty
(g) In addition to the more quantitative assessments mentioned above; assessment of management quality, legal jurisdictions and risks thereon, compliance/policy requirements need to be looked at.
If the counterparty has an external rating available, that is a useful reference point as well(though this remains very debatable !!)
Trust the above is useful and all the best for your interview.