C_redit riski a_nalyysi Flashcards
What are 3 typical factors that lead firms to financial distress when crisis hits?
- High amount of fixed costs
- Illiquid assets
- Non-diversified customer portfolio
It is legally binding to avoid insolvency beforehand by being aware of what 2 things?
- Being aware early on of liquidity requirements and
2. anticipating early signs of solvency is extremely important.
What liquidity means?
Liquidity refers to the ability of a firm to meet its SHORT-TERM financial obligations when they fall due.
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.
What are the most and least liquid assets?
Cash is the most liquid of assets, while tangible items are less liquid.
On vaikee muutta rahaksi nopeesti vaikka joku rakennus :D
What are the different types of liquidity?
The two main types of liquidity include
- Short-term liquidity
- Long-term liquidity
What is the relation between short-term liquidity and working capital?
Managing working capital is extremely important when managing short-term liquidity, because it can be used to buffer against short-term sudden events.
How firms can measure their short-term liquidity?
Firms can measure their short-term liquidity using RATIOS!
Short-term liquidity measures can be divided into:
A) Liquidity ratios and B) Activity ratios
What ratios Liquidity ratios include?
Liquidity ratios include:
- Current ratio
- Quick ratio
In these ratios we divide highly liquid assets with the current liabilities ELI short-term liabilities to measure how well the firm can manage its short-term liquidity.
- Both ratios contain the assets in the numerator to include items that potentially can be converted into cash
- The higher both the ratios, the higher the liquidity position of the firm
- These ratios are often overlooked.
What is Current ratio?
Current ratio = Current assets / Current liabilities
- Frequently used measure of liquidity
- Assumes that current assets have a liquidation value, i.e. the firm could sell all its current assets to pay back its current liabilities, if it runs out its business
What is Quick ratio?
Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities
TAI
= (Current assets −Inventories) / Current liabilities
- Another frequently used measure of liquidity
- Assumes that inventories do not necessarily have any liquidation value, if they are sold
What does a Current or Quick ratio of 1 tell us?
Ratio of 1 means that the firm is just able to cover its short-term obligations with its liquid assets.
What Activity ratios tell us?
Activity ratios measure the efficiency of the firm to leverage its assets on the balance sheet for revenue generation.
Give an example of Activity ratio?
Accounts receivable turnover = Net credit sales / Average accounts receivable
What is solvency?
Solvency is long-term liquidity in other words.
Solvency is the ability of a company to meet its long-term debts and financial obligations.
Solvency looks at the financial structure of the company, its capital employed, longterm borrowing and financing, retained earnings etc.
More on solvency.
It is concern about the long-term financial health of the company and its ability to pay all of its future obligations.
Solvency looks at the financial structure of the company, its capital employed, longterm borrowing and financing, retained earnings etc.
Solvent company
A solvent company owns more than it has debt.
How can solvency be measured?
With these ratios:
a) Debt to Equity (D/E)
b) Long-term debt to assets
c) Interest coverage
What is formula for D/E ratio?
Debt to Equity (D/E) = Total debt / Total equity
What does rising D/E ratio imply?
Rising D/E ratio implies higher amount of interest expenses. And it can impact the company’s credit rating. And it can make it less or more expensive to raise new debt.
What is formula for Long-term debt to assets ratio?
Long-term debt to assets = Long-term debt / Total assets
What Long-term debt to assets ratio tell us?
It specifies the percentage of company’s assets that have been financed with debt.
What is formula for Interest coverage ratio?
Interest coverage = Operating income before interest and taxes / Interest expenses
What Interest coverage ratio describes?
Interest coverage ratio describes the company’s ability to cover its interest expenses of its debts.
The higher the ratio, the better the company is able to cover its interest expenses.
If a crisis hits, it is highly important that companies have a high enough interest coverage, as it acts as a buffer for sudden events.
Financially stable company is…
Is solvent and has sufficient short-term liquidity.
TRUE OR FALSE:
Comparing ratios should be done by comparing companies from the same industry.
TRUE!
What is credit risk?
Credit risk refers to the risk of default by the borrower. It is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.
Traditionally, it refers to the risk that a lender may not receive the owed loan principal and interest payments, which results in an interruption of cash flows and increased costs for collection.
Company’s ability to pay debt is determined by what?
Company’s ability to pay debt is determined by its capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs.
When does insolvency happen?
Insolvency is a state of financial distress in which a business is unable to pay their debts. Insolvency in a company can arise from various situations that lead to poor cash flow.
A company’s willingness to repay debt depends on what?
A company’s willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment.
Regarding cash, with what do the companies need to balance?
Firm has to balance between cash sources and needs.
Can you name 3 sources of cash?
- Operating: Cash from operations
- Investing: Cash from asset sales
- Financing: Cash from external financial markets (debt or equity)
Can you name 3 cash needs?
- Operating: Sustain existing operations (working capital and plant capacity).
- Investing: Growth from new products and services or plant and market expansion.
- Financing: Buy back stock or pay dividends, debt principal, or interest.
What are the 6 steps of credit analysis?
- Understand the business: Business model and strategy, key risks and success factors, industry competition
- Evaluate accounting quality: Spot potential distortions, adjust reported numbers as needed
- Evaluate current profitability and health: Examine ratios and trends, Look for changes in profitability, financial conditions, or industry position
- Prepare “pro forma” cash flow forecasts: Develop financial statement forecasts, Assess financial flexibility
- Due diligence: kick the tires (it is the opposite of conducting serious, in-depth research or due diligence)
- Comprehensive risk assessment: Likely impact on ability to pay, Assess loss if borrower defaults, Set loan terms.
When does a firm default?
A firm defaults when it fails to make principal or interest payments.
What can lenders do if a company that owes them money defaults?
Lenders can then
A) Adjust the loan payment schedule
B) Increase the interest rate and require loan collateral
C) Seek to have the firm declared insolvent
Financial ratios play what two roles in credit analysis?
Financial ratios play two roles in credit analysis:
1) They help quantify the borrower’s credit risk before the loan is granted
2) Once granted, they serve as an early warning device for increased credit risk
Level of Current ratio:
What is Good, Satisfactory or Weak?
Level of Current ratio:
CR > 2 Good
1<= CR <=2 Satisfactory
CR < 1 Weak
Level of Quick ratio:
What is Good, Satisfactory or Weak?
Level of Quick ratio:
QR > 1 Good
0,5 <= QR <= 1 Satisfactory
QR < 0,5 Weak
What is Net working capital ratio formula?
eka net working capital ja sitten ratio
In credit risk analysis, net working capital is usually defined as follows (without time subscripts):
Net working capital = Current asset − Current liabilities
Net working capital RATIO is calculated as follows:
Net working capital ratio = Net working capital / Sales
What does Net working capital ratio measure?
Net working capital ratio measures the difference between current assets and current liabilities.
Turnover ratios
A firm should minimize the amount of working capital
-> Reduces invested capital, and hence, increases EVA
On the other hand, a firm must meet all its obligations when they are due
What do Turnover ratios measure?
These ratios measure how effectively a firm uses the components of net working capital.
Can you name 3 frequently used Turnover ratios?
A) Account receivables turnover rate
B) Account payables turnover rate
C) Inventory turnover rate
What does Account receivables turnover rate measure?
How quickly (or slowly…) the firm receives its receivables from sales.
What is the Account receivables turnover rate formula?
Account receivables turnover
= Sales / Account receivables
What does Account payable turnover rate measure?
How quickly (or slowly…) the firm pays its bills.
What is the Account payable turnover rate formula?
Account payable turnover
= Purchases / Account payables
What does Inventory per sales-% measure?
How effectively inventory management works.
What is Inventory per sales-% formula?
Inventory per sales %
= Inventory / Sales
What do Financial ratios predict related to credit risk?
Financial ratios predict:
1) Profitability: Weakened earnings may launch the process that leads firms into financial distress (early warning signs)
2) Financial leverage: All too much debt is a signal of already-existing financial troubles (mid-term warning signs)
3) Liquidity and working capital: Liquidity straits are a strong signal of anticipated distress (final warning signs)
What are Multivariate distress prediction models?
Multivariate distress prediction models combine several financial ratios.
Multivariate models perform better than univariate models.
Can you name classical multivariate distress prediction models?
Classical multivariate models
- Altman’s model
- Ohlson’s model
Can you name recent multivariate distress prediction models?
More recent models include other variables but financial ratios:
- Stock-market based variables
- Executives’ personal traits
What is Altman’s Z-score for LISTED firms?
Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + 0.6X_4 + 1.0X_5, where
X_1 = Working Capital / Total Assets X_2 = Retained Earnings / Total Assets X_3 = Earnings Before Interest and Taxes / Total Assets X_4 = Market Value of Equity / Book Value of Total Liabilities X_5 = Sales/ Total Assets
What are the Zones of discrimination between the firms in Altman’s Z-score for LISTED firms?
Zones of discrimination between the firms are:
Z > 2.99. “Safe” Zone
1.81 < Z < 2.99 “Grey” Zone
Z < 1.81 “Distress” Zone
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Tulee varmaan tenttiin :D
What is the Altman’s Z-score for PRIVATE firms?
Z = 0.717X_1 + 0.847X_2 + 3.11X_3 + 0.42X_4 + 0.998X_5, where:
X_1 = Working Capital / Total Assets X_2 = Retained Earnings / Total Assets X_3 = Earnings Before Interest and Taxes / Total Assets X_4 = Book Value of Equity / Total Liabilities (AINOO MIKÄ EROAA LISTED:IIN!) X_5 = Sales/ Total Assets
What are the Zones of discrimination between the firms in Altman’s Z-score for PRIVATE firms?
Zones of discrimination between the firms are
Z > 2.9 “Safe” Zone
1.23 < Z < 2.9 “Grey” Zone
Z < 1.23 “Distress” Zone
Altman’s Z-score for other firms and countries
Altman (1968) estimated the original Z-score for the sample of 66 manufacturing firms.
Since then, the model has been estimated for other industries and for firms in different countries.
Parameters of the model vary in these updates.
What are Credit ratings?
Debt rating = Credit rating.
- Credit ratings indicate the risk of default
- ELI: Credit rating is an indicator of the likelihood of timely repayment of principal and interest by a borrower
- The more likely is the timely repayment, the higher is the rating.
How are credit ratings usually expressed?
Credit rating is usually expressed in terms of certain categories.
Commercial debt ratings:
- Moody’s and Standard&Poors in US
- Suomen Asiakastieto in Finland
Research evidence on distress prediction by Kallunki and Pyykkö.
Kallunki and Pyykkö (2013) explore whether appointing CEOs and directors with past personal payment default entries increases the likelihood of financial distress of the firm
“If managers cannot manage their own money, how could they manage the money of their company…?”
So far, distress prediction and credit rating models have based solely on financial ratios or similar firm-level data
This is the first paper to use information on managers’ PERSONAL characteristics in distress prediction
MITÄ NE LÖYSI?
Results show that it pays to check CEOs’ and directors’ personal credit defaults! -> Managers’ personal characteristics affect default risk!
