Credit Rating Analyst Foundation Training (CRAFT)

• Prudence (Conservatism): Recognize expenses/liabilities ASAP; revenues/assets only when certain. Critical for credit.
• Going Concern: Assume business continues operating. Affects asset valuation.
• Materiality: Report all info that could reasonably impact decisions.
• Full Disclosure: Reveal all relevant material information, including in footnotes.
• Others: Regularity, Sincerity, Permanent Methods, Non-Compensation, Periodicity.

Accrual Method of Accounting

• Revenues recognized when earned (performance obligations met).
• Expenses recognized when incurred (resources consumed).
• Follows the Matching Principle. More accurate economic picture.

The Three Financial Statements

• Core reports providing a comprehensive view of a company's financial health.

• Definition: A snapshot of financial position at a specific point in time.
• Equation: Assets = Liabilities + Stockholders' Equity.
• Assets: What company owns (cash, A/R, inventory, PP&E). Listed by liquidity.
• Liabilities: What company owes (A/P, debt). Listed by immediacy.
• Stockholders' Equity: Residual interest (owners' stake). Common stock, retained earnings.

• Definition: Reports financial performance over a specific period.
• Structure (Top-Down):
  • Revenue (Sales)
  • Cost of Goods Sold (COGS) → Gross Profit
  • Operating Expenses (SG&A, R&D) → Operating Income (EBIT)
  • Interest Expense & Taxes → Net Income ("Bottom Line")

• Definition: Tracks actual inflows/outflows of cash. The "truth-teller."
• Sections:
  • Cash Flow from Operations (CFO): From principal revenue activities. Starts Net Income, adjusts for non-cash & NWC changes.
  • Cash Flow from Investing (CFI): From purchase/sale of long-term assets (PP&E).
  • Cash Flow from Financing (CFF): From debt, equity, dividends.

Key Linkages:

• Net Income (IS): Flows to Retained Earnings (BS) and starts CFO (CFS).
• Working Capital Changes (BS): Adjust Net Income to arrive at CFO (CFS).
• Capital Expenditures (CFI): Affect PP&E (BS) and Depreciation (IS).
• Debt & Equity Transactions (CFF): Impact Debt and Equity accounts (BS).
• Ending Cash (CFS): Must equal Cash on Balance Sheet. Fundamental model check.

Understanding these links is vital for building financial models and spotting discrepancies.

Revenue Recognition (ASC 606)

• A 5-step model: Identify contract, performance obligations, transaction price, allocate price, recognize revenue when/as satisfied.
• Crucial for assessing earnings quality; be wary of aggressive practices.

Expense Analysis

• COGS vs. Operating Expenses (SG&A, R&D).
• Depreciation & Amortization (non-cash). Analyze trends for margin insights.

Notes to Financial Statements:

• Provide crucial details and context often "hidden." REQUIRED READING.
• Key Disclosures: Accounting Policies, Debt Schedules (terms, covenants), Commitments & Contingencies, Segment Info, Fair Value, Related Party Transactions.
• Red Flags: Frequent accounting changes, opaque language, large Level 3 assets, significant off-BS items.

Purpose of the 3-Statement Model

• Forecast financial performance.
• Test assumptions and their impact.
• Assess debt service capacity and overall financial health.

Modeling Best Practices

• Clear Structure: Inputs, Historicals, Projections (IS, BS, CFS), Schedules.
• Color-Coding: Blue for inputs, Black for formulas.
• Periodicity: Annual or Quarterly.
• Explicit Formulas & Error Checks (Balance Sheet must balance!).

Populating Historical Data

• Typically 3-5 years from public filings or private statements.
• Crucial for understanding trends, seasonality, and informing forecasts.

Supporting Schedules ("Engine Room")

• Debt & Interest: Tracks tranches, repayments, interest. Critical.
• Fixed Asset (PP&E): Beg. PP&E + CapEx - Dep. = End. PP&E.
• Working Capital: Forecasts A/R, Inv, A/P via activity ratios (DSO, DIH, DPO).
• Others: Equity, Tax.

Forecasting with Purpose

• Assumptions based on history, management guidance, industry/economic outlook, analyst judgment.

Order of Operations:

1. Forecast Income Statement (Revenue → Expenses → Net Income).
2. Forecast Balance Sheet (Operational items, link to IS, project equity).
3. Forecast Cash Flow Statement (Derived from IS & BS changes).
4. Balance the Model: Ending Cash (CFS) links to Cash (BS). "Plug" is often Revolver.

Beware of circular references (e.g., interest expense).

Leverage Ratios (Measure Debt Burden)

• Total Debt / EBITDA: Years of OpCF to repay debt. Lower is better.
• Net Debt / EBITDA: Gives credit for cash.
• Debt / Capital: Debt as % of total capital.

Coverage Ratios (Measure Repayment Capacity)

• Interest Coverage (TIE): EBIT or EBITDA / Interest Expense. Higher is better.
• Debt Service Coverage Ratio (DSCR): Broader measure.
• Fixed Charge Coverage Ratio (FCCR): Most comprehensive.

Liquidity Ratios (Measure Short-Term Solvency)

• Current Ratio: Current Assets / Current Liabilities.
• Quick Ratio (Acid-Test): (Cash + Marketables + A/R) / Current Liabilities. Stricter.

Profitability Ratios (Support Debt Repayment)

• Gross/Operating/Net Margins.
• Return on Assets (ROA) & Return on Equity (ROE).

Analyst Tip: Always compare ratios to history, peers, and covenants. Understand the "why."

Sensitivity Analysis ("What-if" Analysis)

• Purpose: How changes in a *single* assumption affect key outputs (Net Income, ratios, FCF).
• Examples: Impact of 1% revenue growth change on Interest Coverage.
• Value: Identifies model's most critical assumptions.
• Tools like Tornado Diagrams can visually show impact.

Scenario Analysis

• Changes *multiple* inputs for a plausible future state (e.g., "mild recession").
• Typical Scenarios: Base Case, Upside Case, Downside Case (critical for credit).

Stress Testing

• More extreme form; gauges impact of *severe but plausible* crises.
• Assesses capital adequacy and borrower survivability under extreme conditions.

The Capital Ecosystem

Venues matching capital providers (investors) with capital users (issuers).

Debt instruments vary by risk, seniority (claim priority), security, and cost.

• Senior Secured Debt: Highest claim, collateral-backed (Revolvers, Term Loans). Lowest risk/cost.
• Senior Unsecured Debt: General claim, no specific collateral (Bonds/Notes).
• Subordinated Debt (Junior): Ranks below senior debt (Sub. Bonds, Mezzanine).
• Equity: Ownership, residual claim. Highest risk/potential return.

Leveraged Loans Defined

• Syndicated bank loans to companies already highly levered or non-investment grade.
• Purpose: LBOs, M&A, recapitalizations, refinancing.

Characteristics

• Higher risk & higher interest rates (typically floating, e.g., SOFR + spread).
• Most are secured (first or second lien).
• Investor Base: CLOs (largest), loan mutual funds, hedge funds.

The Syndication Process

• Large loans distributed by Lead Arrangers to spread risk.
• Involves Information Memorandums (IMs), bank meetings, "price flex."

Credit Agreement - The Rulebook

• Legally binding. Key Sections:
  • Definitions: CRITICAL (EBITDA, Debt).
  • Loan Terms, Reps & Warranties, CPs, Covenants, EoDs.

Covenant Types

• Affirmative: Borrower *must do*.
• Negative: Borrower *cannot do* without consent/baskets.
• Financial: Maintain specified ratios.
  • Maintenance: Tested regularly.
  • Incurrence: Tested on action.

"Covenant-Lite" (Cov-Lite)

• Loans lacking financial *maintenance* covenants.
• Offers borrower flexibility but delays lender EWS.

A company's performance, strategy, and creditworthiness are profoundly shaped by its industry environment.

Why Industry Analysis is Crucial:

• Provides context for judging company performance (vs. peers).
• Assesses realism of financial projections.
• Identifies industry-specific risks and opportunities.
• Helps understand sources of profitability & competitive advantage.

A framework for analyzing industry structure and attractiveness by assessing five fundamental competitive forces that determine long-term profit potential.

1. Threat of New Entrants
2. Bargaining Power of Buyers (Customers)
3. Bargaining Power of Suppliers
4. Threat of Substitute Products or Services
5. Rivalry Among Existing Competitors (Central Force)

1. Threat of New Entrants

• High barriers (capital, scale, brand, regulation) protect incumbents.
• Low barriers invite competition, erode profits.

2. Bargaining Power of Buyers

• High when: Buyers concentrated, products undifferentiated, low switching costs.
• High power squeezes industry margins.

3. Bargaining Power of Suppliers

• High when: Suppliers concentrated, critical/unique input, high switching costs.
• High power increases costs for industry players.

4. Threat of Substitute Products/Services

• Alternatives from *outside* traditional industry.
• High if substitute offers attractive price-performance or low switching cost.

5. Rivalry Among Existing Competitors

• Intensity of price wars, ad battles, new product intros.
• Most intense when: Many competitors, slow growth, undifferentiated products, high fixed/exit costs.
• Erodes profitability, increases cash flow volatility.

Analyst Tip: Use Porter's to question long-term stability and cash flow predictability.

Industry-Specific KPIs

• Unique metrics for performance/health (e.g., Retail: SSS; SaaS: ARR).

Broad Industry Risks & Mitigants

• Cyclicality: Sensitivity to business cycle. Mitigants: diversification, flexible costs.
• Technological Disruption: Vulnerability to new tech. Mitigants: innovation, R&D.

More Broad Industry Risks & Mitigants

• Regulatory Risk: Impact of law changes. Mitigants: compliance.
• Geopolitical & Macroeconomic Factors: Tariffs, FX, instability. Mitigants: hedging.
• ESG Risks: Environmental, Social, Governance. Mitigants: proactive ESG strategy.
• Supply Chain Risks: Supplier dependence, disruptions. Mitigants: diversification.

PESTLE Analysis

• Analyzes macro-environmental factors: Political, Economic, Social, Technological, Legal, Environmental.

SWOT Analysis

• Identifies internal & external factors: Strengths, Weaknesses, Opportunities, Threats.

Purpose

• Primary written analysis; persuasive document for decision-makers.

Key Characteristics

• Clarity, Conciseness, Objectivity, Thoroughness. Deep understanding of borrower, industry, financials, risks & mitigants.

1. Executive Summary & Recommendation: Most critical. BLUF. Overview, recommendation, key strengths, risks/mitigants.
2. Borrower and Management Overview: History, products, markets, management assessment.
3. Industry Analysis: Dynamics, competition (Porter's), company position.

4. Financial Analysis: Historical & projected performance, QoE, ratios.
5. Sources of Repayment: Primary (OpCF), Secondary (collateral), Tertiary (guarantees).
6. Loan Structure and Terms: Amount, type, tenor, pricing, security.
7. Proposed Covenants & Conditions: Financial, negative, affirmative; rationale.
8. Conclusion: Reiterate recommendation.

• Be Direct (BLUF): Main point first.
• Use Active Voice: More direct and impactful.
• Be Specific & Data-Driven: Back assertions with evidence. Quantify.
• Avoid Jargon, Clichés, Ambiguity: Clear, plain English.

• Structure for Readability: Headings, short paragraphs, topic sentences, bullets.
• Conciseness: Eliminate unnecessary words. Strong verbs.
• Grammar & Style Essentials: Subject-verb agreement, pronoun clarity, commas, apostrophes, consistency. Avoid common word confusions. Proofread!

The intellectual engine driving robust credit analysis.

• Disciplined Process: Actively & skillfully conceptualizing, applying, analyzing, synthesizing, and/or evaluating information.
• Core Tenets: Objectivity, Thoroughness, Logical Reasoning, Clarity, Accuracy, Relevance, Healthy Skepticism.

(Iterative Process)

1. Define Core Question/Problem.
2. Gather & Evaluate Information.
3. Analyze & Interpret Information (Quant & Qual).
4. Challenge Assumptions & Test Hypotheses.
5. Synthesize Findings & Draw Conclusions.
6. Communicate the Analysis (Narrative).

Distilling complexity into factors that truly matter.

• Key Performance Drivers (Strengths): Factors for success & repayment.
• Key Credit Risks (Weaknesses): Significant threats.
• Mitigants to Key Risks: Factors reducing risk probability/impact.

Recommendation often hinges on balance of risks vs. mitigants.

Awareness is key to mitigation. Examples:

The narrative IS the analysis translated into an actionable story. Forces critical judgments, identifies causal links, develops a thesis.

Elements:

• Clarity & Simplicity, Logical Structure, Evidence-Based.
• Balanced Perspective (leading to clear conclusion).
• Focus on Key Drivers & Answers "So What?".
• Addresses Lender's Fundamental Questions.

• Purpose: Consistent regulatory review of large syndicated loans ($100M+ & 3+ institutions) by FRS, FDIC, OCC. Monitors systemic risk.
• SNC Classifications: Pass, Special Mention (SM - early warning), Classified (Substandard, Doubtful, Loss - repayment jeopardy).
• Implications: Drives loan loss provisions, capital adequacy, risk management intensity.

Comprehensive evaluation to assess creditworthiness and decide terms.

1. Origination, Application & Initial Screening.
2. Due Diligence (in-depth investigation: financial, business, legal).
3. Credit Analysis & Memo Preparation.
4. Credit Committee Approval (decision point).
5. Documentation & Legal Review.
6. Closing & Funding.

Due Diligence Areas:

• Financial: Historicals, QoE, Projections, Cash Flow, Debt Structure.
• Business/Commercial: Market/Industry, Competition, Products, Management.
• Legal/Regulatory: Corp. Structure, Contracts, Litigation, Compliance.

Key Considerations (5 C's):

• Character, Capacity, Capital, Collateral, Conditions.

• Portfolio Management: Optimize risk-return, diversify, ensure compliance.
• Early Warning Signs (EWS):

  Quantitative (Lagging)

  • Declining ratios
  • Neg CFO/WC issues
  • Covenant breaches

  Qualitative (Leading)

  • Payment habit changes
  • Mgmt issues
  • Delayed financials
• Watchlist: For credits with increased risk. Process: updated analysis, frequent reporting, action plan.

• Shift: From reactive/historical to proactive, predictive, efficient. Drivers: data explosion, AI/ML advances.
• Machine Learning (ML): Credit scoring (PD/LGD), classification. Integrates Alternative Data.
• Natural Language Processing (NLP): Sentiment analysis, info extraction (covenants), EWS from text.

• Goes beyond basic ratios for complex companies, M&A, or potential distress.
• Quality of Earnings (QoE): Assesses sustainability, reliability, and representativeness of reported earnings.
  • High quality = sustainable, backed by cash flow, conservative accounting.

Companies have discretion; some use "aggressive" policies.

• Revenue Recognition: Premature recognition, "bill & hold," channel stuffing. (Watch DSO).
• Expense Recognition: Delaying expenses, improper capitalization, under-reserving.
• Inventory Accounting: Overstating value. (Watch DIH).
• Other: "Big Bath" charges, OBSF, Cookie Jar Reserves.

• Normalizing Earnings: Adjust for non-recurring items, M&A impacts. Goal: reflect ongoing earning capacity.
• DuPont Analysis (ROE): Profit Margin * Asset Turnover * Equity Multiplier.
• Advanced Cash Flow Ratios: CFO/Total Debt, FCF/Total Debt, Cash Interest Coverage.
• Cash Conversion Cycle (CCC): DSO + DIH - DPO.
• Altman Z-Score: Predicts bankruptcy probability (use with caution).

Key Elements Considered:

• Amount/Type, Seniority, Security, Tenor, Repayment, Pricing, Covenants.

• EBITDA Definition: Critical, heavily negotiated (add-backs).
• Covenant Headroom/Cushion: Leeway before breach (15-30% typical).
• Equity Cure Rights: Sponsor equity to fix breach (limits common).
• Negative Covenant Baskets: Fixed/builder allowances for restricted actions.
• Springing Covenants: Activate on a trigger event.

Debt Restructuring

• Triggered when company can't meet debt. Goal: viable structure, maximize recovery.
• Methods: Amend & Extend, Debt-for-Equity, Haircuts, New Money.

Why Legal Docs Matter to Analysts

• Define rights, obligations, remedies. Misinterpreting can lead to unexpected risks.

Key Documents in Secured Lending:

• Loan Agreement, Notes, Security Agreements, Mortgages, Guarantees, Intercreditor/Subordination Agreements.

(Beyond basic covenants)

• Reps & Warranties: Borrower statements of fact.
• Conditions Precedent (CPs): Must be met before funding.
• Events of Default (EoDs): Triggers for remedies (non-payment, covenant breach, MAC).
• Remedies: Acceleration, default interest, foreclosure.
• Assignments and Participations.

Security & Perfection

• Security Docs grant liens. Perfection (UCC-1) makes lien effective vs third parties.

Guarantees

• Third-party promise to pay debt. Enforceability issues (corp. benefit).

Intercreditor & Subordination Agreements

• Define rights/priorities between creditor groups.

The Art of Persuasion

• Build compelling, evidence-based case. Anticipate concerns. Highlight key drivers.

Crafting a Compelling Credit Narrative

• Clear "thesis", strategic framing, balance objectivity, weave quant & qual.

Tailoring to Audiences

• Credit Committee (risk, detail), Sr. Mgmt (strategic), RMs (client impact).

Advanced Grammar & Style

• Precision, strong verbs, parallel structure, sentence variety. Professional tone. Rigorous editing.

Internal

• Credit Committee: Know deal, anticipate Qs. RMs: Understand RM view, explain credit concerns.

External

• Borrowers/Clients: Professionalism, clear questioning, active listening.

Core Skills

• Active Listening, Clarity (Verbal), Questioning, Constructive Feedback, Conflict Mgmt.

Basic Negotiation Principles

• Preparation (objectives, BATNA). Focus on Interests, Not Positions. Separate People/Problem. Ethical.

• "One-size-fits-all" is insufficient; many industries need tailored approaches.
• Identify Unique Traits & Tailor Frameworks (FSA, Porter's, Risk).
• Key Performance Indicators (KPIs): Identify & interpret industry-specific metrics.

SaaS Overview & Key KPIs

• Subscription, cloud-hosted, scalable. High GM (mature), high upfront R&D/S&M.
• KPIs: ARR/MRR (recurring revenue), CAC (Customer Acquisition Cost), LTV (Customer Lifetime Value; LTV/CAC > 3x good).

More SaaS KPIs & Analysis Focus

• More KPIs: Churn Rate (NRR > 100% strong), CAC Payback, Rule of 40.
• Risks: High churn, cash burn, competition.
• Analysis: Recurring revenue quality, unit economics, FCF, SaaS-specific covenants.

• Importance: Ensures safety/soundness, protects borrowers, prevents financial crime.
• Key Frameworks: Capital Adequacy (Basel - RWA impact), Dodd-Frank (systemic risk), Fair Lending Laws (ECOA - non-discrimination).

• AML/KYC: Prevent illicit funds. Verify customer identity (entity & beneficial owners), understand business/fund sources.
• Data Privacy (GLBA, GDPR): Protect sensitive customer data. Adhere to security policies.
• Internal Policies: Define underwriting standards, risk ratings. Analysts must adhere.
• Ethical Conduct: Professional codes (integrity, objectivity), avoid conflicts, diligence.

Data Analytics in Credit Lifecycle:

• Underwriting, Portfolio Monitoring (EWS), Risk Modeling (PD/LGD/EAD), Reporting.

Tools (Conceptual Awareness):

• Adv. Excel (PivotTables, Power Query), Python/R (automation, modeling), BI Tools (Tableau).

Effective Visualization:

• Right chart, clarity, highlight insights, audience awareness, data integrity.

Use Cases:

• Portfolio Segmentation, EWS from Data Trends, Basic PD Modeling.

Limitations & Ethics:

• Data Quality ("GIGO"), Correlation vs. Causation, Model Risk. Ethical use: Bias, Privacy.

• Purpose: Culminating experience to integrate all CRAFT module skills.
• Role: Act as credit analyst assessing a company seeking financing.
• Objectives: Demonstrate proficiency in FSA, 3-statement modeling, industry analysis, critical thinking, underwriting, communication.

Required Deliverables:

1. 3-Statement Financial Model (Historicals, Projections, Assumptions, Ratios, Downside).
2. Comprehensive Credit Memorandum (Standard Structure, Persuasive Narrative).
3. Credit Committee Presentation Outline.

Evaluation Criteria:

• Analytical Rigor, Critical Thinking, Model Quality, Memo Clarity, Professionalism.

Glossaries & Definitions

• Global Financial Glossary: Comprehensive A-Z list at repository root.
• CRAFT Program Glossary: Specific to this training.
• Module-Specific Glossaries: In each module's "learning-materials.md".

Further Resources & Tools

• Recommended Reading: Module "learning materials" list external resources (FASB, SEC EDGAR).
• Toolkits & Checklists: Explore `Toolkits_and_Checklists/` (e.g., Due Diligence Checklist).
• Future of CRAFT: `corporate-credit-risk-analyst-training/FUTURE_IDEAS.md` outlines program enhancements.

Curated Advice

• Master fundamentals (Accounting, FSA, Market Context).
• Practice critical thinking (Question assumptions).
• Develop strong writing skills (Clarity, Narrative).
• Understand the full credit lifecycle.
• Stay curious about technology (AI, Data Analytics).
• Embrace specialization (Industry KPIs, Risks).
• Uphold ethics & compliance.
• Seek feedback & continuously learn.