Financial Analysis for Credit

Credit Analysis: Financial Analysis for Credit 💰

The Story of the Money Detective 🔍

Imagine you’re a detective, but instead of solving crimes, you solve money mysteries. When someone asks to borrow money, your job is to figure out: “Can this person really pay me back?”

This is exactly what banks do every single day. They use special tools called Financial Analysis for Credit. Let’s discover these detective tools together!

🎯 What is Credit Financial Analysis?

Think of it like this: Before you lend your favorite toy to a friend, you probably think:

• Does my friend take care of their own toys?
• Do they usually return things?
• Can they afford to replace it if it breaks?

Credit Financial Analysis is the grown-up version of these questions!

The Three Big Questions Banks Ask:

graph TD
    A["Someone Wants Money"] --> B{Can They Pay?}
    B --> C["Check Cash Flow"]
    B --> D["Check DSCR"]
    B --> E["Check ICR"]
    C --> F["Make Decision"]
    D --> F
    E --> F

Banks look at three magical numbers to answer the big question: “Should we lend money to this person or company?”

💧 Cash Flow Analysis: Following the Money River

What is Cash Flow?

Imagine money is like water flowing through a garden hose.

• Money coming IN = Water flowing into the hose 💦
• Money going OUT = Water spraying out of the hose 🚿
• Cash Flow = What’s left in the hose!

The Simple Formula

Cash Flow = Money In - Money Out

Real-Life Example: Lemonade Stand

Let’s say little Mia runs a lemonade stand:

Mia’s Cash Flow = $30

This means Mia has $30 left after paying for everything. If she wants to borrow $20, a bank would say: “Great! She makes enough to pay us back!”

Why Cash Flow Matters for Credit

graph TD
    A["Strong Cash Flow"] --> B["Easy to Pay Bills"]
    B --> C["Easy to Pay Back Loans"]
    C --> D["Bank Says YES! ✅"]

    E["Weak Cash Flow"] --> F["Hard to Pay Bills"]
    F --> G["Might Miss Loan Payments"]
    G --> H["Bank Says NO! ❌"]

Types of Cash Flow

1. Operating Cash Flow - Money from your main business (selling lemonade)
2. Investing Cash Flow - Money spent on big stuff (buying a lemonade cart)
3. Financing Cash Flow - Money from loans or investors

Pro Tip: Banks love positive operating cash flow because it shows the business actually works!

🛡️ Debt Service Coverage Ratio (DSCR): The Safety Shield

What is DSCR?

Imagine you earn $100 per week from allowance and chores. Your monthly toy subscription costs $20.

Question: How many times can you pay that $20?

$100 ÷ $20 = 5 times!

That “5” is your Debt Service Coverage Ratio - how many times over you can pay your bills!

The Magic Formula

DSCR = Money Available to Pay Debt
       ─────────────────────────────
       Total Debt Payments Needed

Understanding DSCR Numbers

Real Example: Pizza Palace Restaurant

Pizza Palace’s Numbers:

• Makes $120,000 per year (after expenses)
• Needs to pay $80,000 per year for all loans

DSCR = $120,000 ÷ $80,000 = 1.5

What this means: Pizza Palace can pay their loans 1.5 times over! They have a 50% safety cushion. The bank feels comfortable.

Why DSCR Matters

graph TD
    A["High DSCR"] --> B["More Money Than Bills"]
    B --> C["Safe to Lend"]

    D["Low DSCR"] --> E["Bills Eat All Money"]
    E --> F["Dangerous to Lend"]

The Golden Rule: Most banks want to see DSCR of at least 1.25 before lending money!

⚡ Interest Coverage Ratio (ICR): The Interest Test

What is ICR?

Let’s zoom in on just ONE part of debt payments: interest.

When you borrow money, you don’t just pay back what you borrowed. You also pay interest - a fee for using someone else’s money.

ICR tells us: “How easily can you pay JUST the interest?”

The Simple Formula

ICR = Earnings Before Interest and Taxes (EBIT)
      ──────────────────────────────────────────
      Interest Payments

Understanding ICR Numbers

Think of it as a report card:

Real Example: Sunny’s Bookstore

Sunny’s Bookstore Numbers:

• Earns $60,000 per year (before paying interest and taxes)
• Pays $15,000 per year in interest

ICR = $60,000 ÷ $15,000 = 4.0

What this means: Sunny can pay her interest 4 times over! Even if business drops by 75%, she can still pay her interest. The bank loves this!

ICR vs DSCR: What’s the Difference?

graph TD
    A["Total Debt Payment"] --> B["Interest Portion"]
    A --> C["Principal Portion"]
    B --> D["ICR looks at this"]
    B --> E["DSCR looks at"]
    C --> E

🔗 How All Three Work Together

These three tools are like a team of detectives working together:

The Credit Analysis Team

graph TD
    A["Credit Application"] --> B["Cash Flow Analysis"]
    A --> C["DSCR Calculation"]
    A --> D["ICR Calculation"]
    B --> E{All Three Pass?}
    C --> E
    D --> E
    E -->|Yes| F["Loan Approved! 🎉"]
    E -->|No| G["Loan Denied 😔"]

Complete Example: Tom’s Tech Shop

Tom wants to borrow $100,000 to expand his computer repair shop.

Tom’s Numbers:

The Three Tests:

1. Cash Flow Test: ✅

   • $100,000 positive cash flow
   • Verdict: Healthy money river!

2. DSCR Test: ✅

   • $100,000 ÷ $50,000 = 2.0
   • Verdict: Can pay debts 2 times over!

3. ICR Test: ✅

   • $80,000 ÷ $20,000 = 4.0
   • Verdict: Interest is super affordable!

Bank’s Decision: APPROVED! 🎊

🎓 Quick Summary: The Three Musketeers of Credit

Remember This Story!

Think of borrowing money like climbing a mountain:

• Cash Flow = Do you have energy to climb?
• DSCR = Do you have enough supplies for the whole trip?
• ICR = Do you at least have water for survival?

If any answer is “no,” the mountain (loan) might be too risky!

🌟 You Did It!

You now understand how banks think about lending money. You’re like a mini credit analyst!

Key Takeaways:

1. 💧 Cash Flow shows if money is coming in
2. 🛡️ DSCR shows if ALL debts can be paid
3. ⚡ ICR shows if interest can be covered

Next time you hear about someone getting a loan, you’ll know the bank checked all three of these numbers first!

Keep learning, keep growing! 🚀