CFA Level 1: Four Cs of Credit Analysis & Credit Ratios (2024)

The 4 Cs of credit analysis include:

1. capacity,
2. collateral,
3. covenants, and
4. character.

Capacity

Capacity is the ability of the issuer to make debt payments according to the payment schedule.

To analyze the capacity of the issuer to service its debt, the credit analysts use the following process:

1. Analyzing industry structure (e.g. using Porter's five forces).
2. Analyzing industry fundamentals (e.g. growth prospects, cyclical vs non-cyclical, etc.).
3. Analyzing company fundamentals (e.g. competitive position, operating history, management’s strategy & execution, ratio analysis, etc.)

Collateral

Collateral is the quality and value of the assets that serve as collateral for the issued debt.

Assets of a company vary in value, e.g. intangible assets like goodwill should be perceived as assets of lower quality. What is more, for publicly traded companies, if the market value is below the book value, it should be perceived as a warning sign.

Covenants

Covenants are terms and conditions of lending agreements, introduced to protect creditors, that the borrower has to comply with.

We distinguish between negative covenants which state what the issuer cannot do and affirmative covenants which state what the issuer must do.

Character

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