Credit Analysis and Covenants

Credit analysis is the process of assessing a borrower's creditworthiness in order to determine the probability of default (PD), loss given default (LGD), and expected loss (EL = PD × LGD × EAD). Professional credit analysis encompasses financial analysis, business analysis, and the legal structure of the transaction. For institutional lenders, credit analysis is the foundation for decisions regarding loan and bond investments.

Financial analysis. Leverage ratios: Net Debt / EBITDA (typical threshold: no more than 3-4x for investment grade, 4-6x for high-yield bonds), Debt / Equity. Coverage ratios: EBITDA / Interest Expense (no less than 3x — comfort zone), EBIT / Interest Expense. Liquidity ratios: Current Ratio, Quick Ratio. Cash flow analysis: generation of Free Cash Flow, stability of FCF, requirements for capital expenditures. Quality of earnings: non-cash items, dynamics of working capital, one-off vs recurring items.

Business analysis in the credit context. Industry analysis: cyclicality, competitive dynamics, regulatory environment. Competitive position: market share, pricing power, barriers to entry. Management: track record, strategy, attitude towards debt. Risk concentration: top clients, geographic diversification. Ownership structure: private (PE) vs public — affects financial policy.

Covenants are contractual restrictions in a credit agreement or bond prospectus. Affirmative covenants: the borrower agrees to perform certain actions — provide financial statements, maintain insurance, comply with laws. Negative covenants: prohibitions — restrictions on dividend payments, new debt, sale of assets, M&A without creditor approval. Financial covenants: maintaining certain ratios — Net Debt/EBITDA no more than 4x, Interest Coverage no less than 3x, minimum liquidity level.

Violation of a covenant is a technical default. The lender may demand early repayment or revision of terms. Covenant-lite structures — only Incurrence covenants (triggered by certain actions), without Maintenance covenants (ongoing). Became widespread in leveraged loans during periods of low rates, reducing creditor protection. Covenant analysis is an important part of credit due diligence: an investor must understand when a covenant might be breached under stress scenarios.