CH. 4 - Credit Risk Analysis and Interpretation

Question 1

Companies demand credit for _______, _______ and _______ activities

Answer 1

operating, investing, and financing activities

Question 2

When a company purchases new PPE, what is that purchase process called?

Answer 2

Capital expenditures

Question 3

What is trade credit?

Answer 3

Trade credit is from suppliers and is routine and non-interest bearing

Question 4

What is a revolving credit line (aka revolvers)?

Answer 4

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.

Question 5

Lines of credit (also called back-up credit facilities) are a means to….

Answer 5

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

Question 6

Letters of credit are…

Answer 6

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

Question 7

Term loan is another name for….

Answer 7

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

Question 8

Mortgages are…

Answer 8

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.

Question 9

What is lease financing?

Answer 9

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.

Question 10

What is commercial paper?

Answer 10

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.

Question 11

What are bonds or debentures?

Answer 11

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).

Question 12

What are supplies of credit (aka what are the options to secure credit)?

Answer 12

-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

Question 13

What is the overarching purpose of credit risk analysis?

Answer 13

To quantify expected credit losses to inform lending decisions.

Question 14

What two factors make up expected credit losses?

Answer 14

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)

Question 15

What types of parties perform credit risk analysis?

Answer 15

-Trade creditors
-Banks and non-bank financial institutions
-Debt investors
-Credit rating agencies

Question 16

The chance of default depends on…

Answer 16

the company’s ability to repay the debt, which, in turn, depends on the company’s future performance and cash flow.

Question 17

What are the steps commonly used to determine the chance of default when assessing credit risk?

Answer 17

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)

Question 18

What are some factors that affect macroeconomic environments and industry conditions?

Answer 18

-Industry competition
-Buyer power
-Supplier power
-Threat of substitution
-Threat of entry

Question 19

True or false: there are specific financial ratios used to assess credit risk

Answer 19

False; there is no general agreement about the best set of ratios to use to assess credit risk.

Question 20

What is loss given default?

Answer 20

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

Question 21

What is the definition of a credit limit?

Answer 21

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

Question 22

What is the definition of a credit limit?

Answer 22

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.

Question 23

What is the definition of collateral?

Answer 23

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

Question 24

What are covenants?

Answer 24

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.

Question 25

What are the three most common types of loan covenants?

Answer 25

-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

Question 26

Because trade creditors extend credit to many customers in the same industry, the chance of default can be highly ________ among customers

Answer 26

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)

Question 27

Regulation fair disclosure requires that if a public company discloses material nonpublic information to individuals or to a select group, the company must also….

Answer 27

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.

Question 28

Chance of default is the likelihood that the company will….

Answer 28

Chance of default is the likelihood that the company will be unable to repay its debts as they come due

Question 29

Porter’s Five Forces model are (and what is it):

Answer 29

1. Industry competition
2. Threat of new entrants (competitors) to the industry
3. Threat of substitution
4. Supplier power
5. 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.

Question 30

Four common credit terms that lenders use to limit the loss in the event of a default are:

Answer 30

1. Credit limits
2. Repayment terms
3. Covenants
4. Collateral

Question 31

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.

Answer 31

False, they do not. They only reflect data the way that GAAP needs it to be.

Question 32

Profitability is related to credit risk because…

Answer 32

firms pay interest and repay their debt with cash generated from profits.

Question 33

What do coverage ratios do?

Answer 33

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.

Question 34

What is the times interest earned ratio, and what is it used for?

Answer 34

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.

Question 35

True or false: EBIT Is not a GAAP number

Answer 35

True

As such, there is no “correct” definition of EBIT

Question 36

What does EBIT stand for?

Answer 36

Earnings before interest and tax
= net profit+interest expense+tax expense

Question 37

What is EBITDA?

Answer 37

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.

Question 38

What is the operating cash flow to total debt ratio used for?

Answer 38

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

Question 39

What is CAPEX?

Answer 39

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.

Question 40

What is the free operating cash flow to total debt ratio used for?

Answer 40

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

Question 41

What does liquidity refer to?

Answer 41

Liquidity refers to cash availability: how much cash a company has, and how much it can generate on short notice.

Question 42

What is the current ratio, and what is it used for?

Answer 42

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.

Question 43

What is net working capital (aka working capital)?

Answer 43

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.

Question 44

What is the quick ratio, and what is it a variant of?

Answer 44

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

Question 45

What does long-term solvency analyze?

Answer 45

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.

Question 46

What is the liabilities-to-equity ratio?

Answer 46

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

Question 47

What is total debt-to-equity?

Answer 47

Total debt-to-equity = long-term debt including current portion + short-term debt/stockholders equity

Question 48

What is a drawback to the liabilities-to-equity ratio?

Answer 48

It does not distinguish between operating creditors (such as accounts payable) and debt obligations.

Question 49

What is a credit rating?

Answer 49

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.

Question 50

Why do companies care about their own credit ratings?

Answer 50

1. 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.

2. Credit ratings affect investment decisions.

Question 51

What are the three types of input that make up a company’s credit rating decision?

Answer 51

1. Macroeconomic statistics
2. Industry data
3. Company-specific information

Question 52

What is a Z-score?

Answer 52

A Z-score is a model used to predict the possibility that a company will go bankrupt.