Introduction to Credit Management

The income statement shows the revenues, expenses and income of a company for a certain period of time.  Important positions from the income statement are used to compute the profitability ratios and most importantly EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of cash flows from operations. It is important to assess whether net income has been determined based on conservative accounting policies or on liberal accounting policies which might not reflect economic reality and hence result in lower quality of earnings. High nonrecurring income as well as nonrecurring costs will bias the trend in earnings. An overstatement of revenues will distort profits. Revenue recognition practices vary across industries.

The various steps of the analysis do not apply to banks and financial institutions; these differ from other companies, because they are highly leveraged due to the nature of their business, as their main business is to manage their assets. An indepth analysis of the credit risk of banks will follow later.

There are several documents which can be used to assess the credit quality of a company. These are the 10K (Annual Statement), 10Q (Quarterly Statement) and the annual report and quarterly financial report presented to the shareholders. If a company has a public offering of a new security it has to provide a prospectus. Every prospectus has a section where all current and potential risks to the company have to be disclosed.

Regulated companies like utilities and banks must also prepare documents for regulators. Besides useful financial data, the annual report contains the shareholder’s letter where the management discusses business strategies.