Introduction to Credit Management

The main anchors of credit analysis are cash flows, asset value, profitability, management assessment and covenants. Every company has to be able to generate positive cash flows in the long run. Companies with permanently negative cash flows will face liquidity constraints at some point in future. Another focus lies on balance sheet strength. The value of assets is very important for bondholders because they can be pledged against liabilities. For particularly high leveraged companies a situation might evolve where asset sales are the last option for deleveraging. The management assessment is another important factor for credit analysis particularly for assigning probabilities to various event risks. Finally, covenants have the main purpose of limiting event risk in terms of a company undertaking bondholder-unfriendly actions.  Another focus lies on the equity-market performance and the implied volatility of a company’s stock. We can identify periods where equity and corporate bonds move in the same direction and times where they decouple; in distressed cases the decoupling will be permanent because equity will have no value and the remaining value will reside with debt.