Capacity, Collateral, Covenants, and Character

Traditionally, many analysts evaluated creditworthiness based on what is called the “Four Cs of credit analysis”.

Capacity

Capacity is the ability of a borrower to service their debt. To be determined, an industry analysis should be conducted. Afterwards the specific issuer has to be examined (company analysis).

• Industry structure: Michael Porter’s 5 competitive forces framework: (1) Threat of entry, (2) Power of suppliers, (3) Power of buyers, (4) Threat of substitutes (5) Rivalry among existing competitors.
• Industry fundamentals: (1) Cyclical or non-cyclical, (2) Growth prospects, (3) Published industry statistics.
• Company fundamentals: (1) Competitive position, (2) Track record/operating history, (3) Management’s strategy and execution, (4) Ratios and ratio analysis

Collateral

Collateral refers to the amount of tangible assets that could be sold to recover the debt owed to bondholders. Patents can be sold to cover liability payments. Goodwill, on the other hand, is not a high-quality asset. Also, low capital expenditures relative to depreciation could imply that management is insufficiently investing in its business. It is important to note that intangible capital may not appear explicitly on the balance sheet but could be valuable.

Covenants

Covenants are meant to protect creditors. They are integral to credit agreements and state what actions management is required to take (positive covenant) and/or prevented from taking unless agreed to by the bondholder (negative covenant). Covenants are described in the bond prospectus.

Character

The character of a borrower is more of a qualitative than quantitative aspect of credit analysis. Judgments about management’s character could be based on the following parameters:

• assessment of the soundness of the management’s strategy;
• the management’s track record in executing past strategies;
• the use of aggressive accounting policies;
• any history of fraud or malfeasance; and
• previous poor treatment of bondholders

Question

Which of the following aspects of credit analysis would most likely be used to decide if a borrower has the ability to make loan payments on time?

1. Capacity.
2. Collateral.
3. Covenants.

Solution

The correct answer is A.

Capacity refers to the ability of a borrower to meet their interest and principal obligations.