CH. 4 - Credit Risk Analysis and Interpretation Flashcards
Companies demand credit for _______, _______ and _______ activities
operating, investing, and financing activities
When a company purchases new PPE, what is that purchase process called?
Capital expenditures
What is trade credit?
Trade credit is from suppliers and is routine and non-interest bearing
What is a revolving credit line (aka revolvers)?
They are loans that companies from on as needed, and have the following features:
-Relatively simple to negotiate
-Similar to credit cards; the company can draw cash as needed and make payments as cash is available
-Interest rates are often floating, which limits the bank’s interest-rate risk
-Banks adjust interest according to prevailing market rate.
Lines of credit (also called back-up credit facilities) are a means to….
increase liquidity. They have the following features:
-Provide a guarantee that funds are available when needed
-Negotiated with a single bank or as a consortium of banks
-Serve as backup or interim financing, often used between commercial paper issuances.
-Company pays an average of 20 to 50 basis points on the unused portion of the line of credit as a stand-by fee
-Bank charges interest on the used portion of line of credit, typically a floating rate
-Rating agencies will not rate commercial paper that is not secured by a line of credit
Letters of credit are…
They facilitate provide private transactions primarily when parties are in different countries, and have the following features:
-Interpose a bank between the two parties to a transaction
-Provides a guarantee of payment from the buyer that is legally enforceable, and therefore, reduces the credit risk to the seller.
-Substitute the bank’s (higher) credit rating from that of the buyer
Term loan is another name for….
a bank loan. It has the following characteristics:
-Requires a formal application
-Provides a predetermined amount of cash to the borrower. This principal is the amount that must be repaid.
-Usually mature between 1 and 10 years
-Loan agreement specifies periodic payments of principal and interest
-Interest rates are either fixed or floating
-Often collateralized and carry covenants
Mortgages are…
loans secured by long-term assets such as land and buildings, which means the lender can foreclose on the mortgage and seize the property in the event of default.
What is lease financing?
It is an alternative form of borrowing. Leasing firms finance capital expenditures for equipment such as vehicles, production machinery, and IT equipment.
The leasing firm analyzes the credit risk associated with the lease, bearing in mind that the leased assets are held as collateral, and that some of the risk can be mitigated by tailoring the lease terms.
What is commercial paper?
It is short-term publicly traded debt that matures within 270 days, which exempts it from SEC regulation.
Companies use commercial paper to finance short-term operating needs. It is issued primarily by financial companies (commercial banks, mortgage companies, leasing companies, and insurance underwriters) and some large manufacturers and retailers.
Companies pay a lower rate of interest for short-term commercial paper than for linger-term bonds or notes.
What are bonds or debentures?
Issued by companies to secure longer-term funding.
Generally, the entire face amount (principal) of the bond is repaid at maturity, and tax-deductible interest payments are made in the interim (nearly always semiannually).
What are supplies of credit (aka what are the options to secure credit)?
-Trade credit
-Bank loans
-Revolving credit lines
-Lines of credit
-Letters of credit
-Term loans
-Non-bank private financing
-Lease financing
-Publicly traded debt
-Commerical paper
-Bonds/debentures
What is the overarching purpose of credit risk analysis?
To quantify expected credit losses to inform lending decisions.
What two factors make up expected credit losses?
Expected credit loss = chance of default x loss given default
(chance of default is the probability that the firm will not be able to pay its debts and the loss given default is the amount of loss the lender would incur)
What types of parties perform credit risk analysis?
-Trade creditors
-Banks and non-bank financial institutions
-Debt investors
-Credit rating agencies
The chance of default depends on…
the company’s ability to repay the debt, which, in turn, depends on the company’s future performance and cash flow.
What are the steps commonly used to determine the chance of default when assessing credit risk?
Step 1. Evaluate the nature and purpose of the loan
Step 2. Assess macroeconomic environment and industry conditions
Step 3. Analyze financial ratios
Step 4. Perform prospective analysis
(Note, these are common steps taken, but no one situation is exactly the same)
What are some factors that affect macroeconomic environments and industry conditions?
-Industry competition
-Buyer power
-Supplier power
-Threat of substitution
-Threat of entry
True or false: there are specific financial ratios used to assess credit risk
False; there is no general agreement about the best set of ratios to use to assess credit risk.
What is loss given default?
The factors that affect the amount that could be lost if the company defaulted on its obligations. They can be expressed as a percent of principal and any accrued interest that will likely be recouped in the event of default.
To minimize potential loss, lender’s structure credit terms and typically include some or all of the following:
1. credit limits
2. collateral
3. repayment terms
4. covenants
What is the definition of a credit limit?
It is the maximum that a creditor will allow a customer to owe at any point in time. These limits are set based on the lender’s experience with similar borrowes
What is the definition of a credit limit?
It is the maximum that a creditor will allow a customer to owe at any point in time. These limits are set based on the lender’s experience with similar borrowers as well as firm-specific credit analysis.
What is the definition of collateral?
It is property that the borrower pledges to guarantee repayment.
Real estate is the most common form, but bank and other creditors take marketable securities, accounts receivable, inventory, and other personal property as collateral
What are covenants?
Covenants are terms and conditions of a loan designed to limit credit risk after the loan is made.
Loan covenants allow the lender to monitor the loan and receive early warnings when the borrowers run into financial trouble, which helps the lender detect deteriorating loan quality. They can also prevent deteriorating loan quality by limiting the borrower’s behavior to avoid situations the lead to financial trouble.
What are the three most common types of loan covenants?
-Covenants that require the borrower to take certain actions (ex: submit financial statements at least annually, maintain hazard and content insurance on PPE, pay all taxes and required operating fees and licenses, and avoid liens on properties).
-Covenants that restrict the borrower from taking certain actions (ex: changing the management team, increasing dividends, owner’s withdrawals and management salaries, making major investments or capital expenditures, merging with or acquiring other entities, taking additional loans or debt).
-Covenants that require the borrower to maintain specific financial ratios (ex: minimum working capital, current ratios, or quick ratio (to ensure ongoing liquidity), minimum ROA or ROE (to give the lender an early warning and allow the lender to call the loan before financial trouble grows), minimum equity (to limit treasury stock repurchases that would erode firm equity), maximum debt-to-equity or debt-to-assets (to limit the borrower’s leverage and ensure long-term solvency).
*Companies rarely disclose information on their loan covenants
Because trade creditors extend credit to many customers in the same industry, the chance of default can be highly ________ among customers
Because trade creditors extend credit to many customers in the same industry, the chance of default can be highly correlated among customers
(if something happens in the industry, it will likely affect everyone)
Regulation fair disclosure requires that if a public company discloses material nonpublic information to individuals or to a select group, the company must also….
Regulation fair disclosure requires that if a public company discloses material nonpublic information to individuals or to a select group, the company must also simultaneously disclose the information publicly.
Chance of default is the likelihood that the company will….
Chance of default is the likelihood that the company will be unable to repay its debts as they come due
Porter’s Five Forces model are (and what is it):
- Industry competition
- Threat of new entrants (competitors) to the industry
- Threat of substitution
- Supplier power
- Buyer power
A Porter analysis helps us understand the industry in which a company operates. It’s an industry level analysis that helps a lender assess the chance of default.
Four common credit terms that lenders use to limit the loss in the event of a default are:
- Credit limits
- Repayment terms
- Covenants
- Collateral
True or false: general-purpose financial statmetns prepared in conformity with GAAP always accurately reflect an estimate of the “true” financial condition and operating performance of the company.
False, they do not. They only reflect data the way that GAAP needs it to be.
Profitability is related to credit risk because…
firms pay interest and repay their debt with cash generated from profits.
What do coverage ratios do?
Coverage ratios compare operating profits or cash flows to interest and/or principal payments.
They are used to assess the company’s ability to generate profit and cash to cover the fixed charges from debt (interest and principal) in the short and long term.
What is the times interest earned ratio, and what is it used for?
times interest earned = earnings before interest and tax (EBIT)/interest expense, gross
It reflects the operating income available to pay interest expense. The higher the ratio, the better (less risk of default).
The underlying assumption is that only interest must be paid because the principal will be refinanced.
True or false: EBIT Is not a GAAP number
True
As such, there is no “correct” definition of EBIT
What does EBIT stand for?
Earnings before interest and tax
= net profit+interest expense+tax expense
What is EBITDA?
Earnings before interest, tax, depreciation and amortization
= net profit+interest expense+tax expense+depreciation and amortization expense
It is a non-GAAP performance metric commonly used to measure the company’s ability to pay interest out of current profits. It is defined as:
EBITDA coverage = earnings before interest and tax (EBIT)+depreciation+amortization/interest expense, gross
We add the depreciation and amortization amounts reported in the statement of cash flows instead of the depreciation expense reported in the income statements, because the income statement line item is incomplete –it does not include depreciation and amortization included in other line items such as COGS or research and development expenses.
What is the operating cash flow to total debt ratio used for?
The operating cash flow to total debt ratio is used to measure a company’s ability to repay principal in the short and longer term. It is defined as:
cash from operations to total debt = cash from operations/short-term debt+long-term debt
What is CAPEX?
cash spent on capital expenditures.
Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment.
What is the free operating cash flow to total debt ratio used for?
The free operating cash flow to total debt ratio is argued to reflect a company’s ability to repay debt from the cash flows remaining after CAPEX. It is defined as:
free operating cash flow to total debt = cash from operations - CAPEX/short-term debt+long-term debt
What does liquidity refer to?
Liquidity refers to cash availability: how much cash a company has, and how much it can generate on short notice.
What is the current ratio, and what is it used for?
It is an expression of working capital as a percentage, and can be defined as:
current ratio: current assets/current liabilities
Positive working capital or a current ratio greater than 1.0 both imply more expected cash inflows than cash outflows in the short run. Generally, companies prefer a higher current ratio (more working capital); however, an excessively high current ratio can indicate inefficient asset use.
What is net working capital (aka working capital)?
An excess of current assets over current liabilities
Positive working capital or a current ratio greater than 1.0 both imply more expected cash inflows than cash outflows in the short run. Generally, companies prefer a higher current ratio (more working capital); however, an excessively high current ratio can indicate inefficient asset use.
What is the quick ratio, and what is it a variant of?
The quick ratio is a variant of the current ratio. It gauges a company’s ability to meet its current liability without liquidating inventories that could require markdowns.
It is a more stringent test of liquidity than the current ratio., and is not unusual for a company’s quick ratio to be less than 1.0
It focuses on quick assets, which are those assets likely to be converted to cash within a relatively short period of time. Specifically, quick assets include: cash, marketable securities and accounts receivable; they exclude inventories and prepaid assets.
The quick ratio can be defined as:
quick ratio = cash+marketable securities+account receivable/current liabilities
What does long-term solvency analyze?
long-term solvency analysis considers a company’s ability to meet its debt obligations, including both periodic interest payments and the repayment of the principal amount borrowed.
The general approach to measuring solvency is to assess the level of liabilities relative to equity.
What is the liabilities-to-equity ratio?
The liabilities-to-equity ratio is defined as:
liabilities-to-equity ratio = total liabilities/stockholders equity
The ratio conveys how reliant a company is on the creditor financing compared with equity financing.
A higher ratio indicates a less solvent company
What is total debt-to-equity?
Total debt-to-equity = long-term debt including current portion + short-term debt/stockholders equity
What is a drawback to the liabilities-to-equity ratio?
It does not distinguish between operating creditors (such as accounts payable) and debt obligations.
What is a credit rating?
A credit rating is an opinion of an entity’s creditworthiness; it’s ability to meet its financial commitments as they come due.
Credit analysts consider macroeconomic, industry, and firm-specific information to assess both the chance of default and the ultimate payment in the event of default.
Why do companies care about their own credit ratings?
- Credit rating affect the cost of debt. (The cost of debt is defined as the risk-free rate (the yield on U.S. Government borrowings with maturity that matches the company’s own debt) plus a risk premium (also called a spread).
Higher cost of debt not only increases interest expense, it could limit the number of new investment projects. With a higher cost of debt, some new projects might not yield a return greater than their financing cost. Thus, a decrease in credit rating can restrict a company’s growth and future profitability. Although credit ratings are only opinions, they are influential.
- Credit ratings affect investment decisions.
What are the three types of input that make up a company’s credit rating decision?
- Macroeconomic statistics
- Industry data
- Company-specific information
What is a Z-score?
A Z-score is a model used to predict the possibility that a company will go bankrupt.
