Credit Analysis Fundamentals: How Banks & Lenders Assess Creditworthiness Part 1 | CFI Course

Summary

This course introduces credit fundamentals, focusing on both personal and commercial credit. It covers key topics such as credit creation, types of interest payments, loan characteristics, capital expenditures (capex), and the Five C’s of credit risk assessment. The course explores how debt is used in business financing, how it compares to equity, and why debt is generally considered a lower-risk, more cost-effective funding option. By the end of the course, learners will understand how credit supports business operations, and how financial analysis and underwriting processes work, including key ratios and techniques for evaluating creditworthiness.

Takeaways

• 💳 Credit is created whenever one party receives resources from another without immediate payment, forming the basis for both loans and trade credit.
• 🏦 Borrowers can receive credit either from direct lenders—like banks—or from vendors providing trade credit through delayed payment terms.
• 📊 Trade credit results in accounts payable for buyers and accounts receivable for sellers, making it a major component of working capital financing.
• 🏠 Personal credit commonly takes the form of mortgages, credit cards, and car loans, while commercial credit supports business operations and growth.
• 🏗️ Businesses use debt to finance both short-term needs like inventory and long-term investments like property, plant, and equipment (CapEx).
• 💰 Companies fund operations through three sources: existing cash, issuing equity, or taking on debt—each with its own advantages and drawbacks.
• 📉 Equity is expensive because it carries higher risk and dilutes ownership, whereas debt is cheaper due to tax-deductible interest and no ownership loss.
• ⚖️ Debt introduces liquidity risk because interest and principal payments must be made on time, and lenders often impose covenants to manage risk.
• 📚 The capital stack ranks funding sources by seniority—debt is senior and lower-risk, while equity is junior and higher-risk, which affects return expectations.
• 🔒 In liquidation, senior lenders have first claim on assets due to collateral charges, making debt holders more likely to recover funds than equity holders.
• 📈 Commercial lenders aim to align debt repayment schedules with the cash inflows generated by the funded assets to ensure sustainable borrowing.
• 🎓 The course covers credit fundamentals, structure, risk assessment via the five C’s, and key financial ratios through lectures, exercises, and case studies.

Q & A

What is the primary purpose of the course on credit?

The course aims to provide a comprehensive understanding of credit, including how it is created, its role in personal and corporate finance, and how professionals assess and manage credit risk.

How does credit get created in a financial transaction?

Credit is created when one party receives resources from another without immediate payment. The borrower (debtor) may receive resources either from a direct lender (e.g., a bank) or from a vendor providing goods or services (trade credit).

What are the two types of credit covered in the course?

The two types of credit are loans, typically provided by banks or financial institutions, and trade credit, which is extended by vendors for goods or services sold to customers with deferred payment terms.

What is the difference between personal (retail) credit and commercial (corporate) credit?

Personal credit is typically used by individuals for day-to-day expenses (e.g., credit cards, mortgages), while commercial credit involves corporate borrowing to fund operations and growth, often through loans or trade credit.

What is the importance of aligning loan repayments with cash inflows from investments?

Aligning loan repayments with cash inflows is crucial to ensure that a company can meet its debt obligations without compromising its liquidity. The goal is to match repayment schedules with the revenue generated from the underlying investments that funded the debt.

What is capital expenditure (CapEx), and how does it relate to debt financing?

Capital expenditure (CapEx) refers to investments in long-term assets such as property, plant, and equipment. Debt financing is often used to fund these investments because they generate long-term revenue and cash flow that can support loan repayments.

What are the three primary sources of funding for a company?

The three primary sources of funding are cash reserves, equity (through issuing shares), and debt (through borrowing). Each source has distinct benefits and trade-offs depending on the company's financial situation and growth strategy.

Why is debt generally considered a cheaper source of capital compared to equity?

Debt is considered cheaper because it is lower risk for lenders and offers tax advantages (interest payments are tax-deductible). Additionally, debt does not dilute ownership or control of the company, unlike equity, which involves giving up a portion of the company.

What is the capital stack, and how does it help explain the difference between debt and equity?

The capital stack represents the hierarchy of funding sources used by a company. Debt sits at the top of the stack as the most senior form of capital, meaning it gets repaid first in both good and bad times, while equity sits at the bottom and carries higher risk but offers potentially higher returns.

What are some of the risks associated with using debt as a source of funding?

Using debt introduces financial risks, including the obligation to make interest and principal repayments, which can strain a company's liquidity. High-risk companies may face high-interest rates, and debt agreements often include covenants that restrict the company’s operations.