Chapter 4 Flashcards
why do companies demand credit for operating, investing, + financing activities
operating: many companies have cyclical operating cash need (having to pay before selling their product + collecting revenue - as some purchase are made before expected sales) - seasonal cash needs are routine in nature and credit risk is low
investing: companies require large amounts of cash for investments (new equipment - CAPEX, acquisition of other companies)
financing: need credit for financing activities (issuance of debt for repayment of maturing debt obligations, or repurchase of common stock)
why is cash needed for operating activities not always low risk
if there’s recurring losses that a company needs to cover operating losses makes it difficult to raise capital. finding a willing lender = difference between bankruptcy + continued operations
what are the parties that supply credit and types of credit they supply
trade credit supplies trade credit for purchases of G+S from supplies is route = non-interest bearing - specifies credit limit, payment terms, early payment discounts
bank loans - meet specific client needs
supplies: revolving credit lines, lines of credit, term loans, mortgages
non bank financing: companies borrowing nonbank lenders as private lender might fund higher risk ventures, these lender might creatively structure loan repayment or act as an ongoing management consultant to the borrower
lease financing: lease firms finance capital expenditures. these lease. these companies are often publicly traded + not governed by restrictive banking regulations so they have more latitude to tailor the lease to meet the borrower’s needs
publicly traded debt: issuing dent securities in capital markets - cost-efficient way to raise funds; commercial paper, bonds/debentures
define revolving credit lines, lines of credit, term loans, mortgages
revolving credit lines (revolvers): means to find cash shortages when companies manufacture or purchase inventories in advance of the selling season and carry AR after sale - banks commit to a credit line w/max amount that the company can borrow on demand, with stipulation that the loan balance will be paid in full at some point during the year
lines of credit (back-up credit facilities): means to increase liquidity by providing a gaurantee (by the bank) that duns will be available when needed - lines of credit are often used to support the issuance of commercial paper
term loans (bank loans): typically used to fund purchases of equipment (serving as collateral for the loan). duration fo the loan general matches the useful life of the equipmetn purchased + frequently carries loan covenants
mortgages: longer temr loans (20 yrs) used to finacne real estate transaction (land + buildings). the lender takes a secrutiy interst in the prucahse property - allowing it to foreclose on and sell the property if the borrower fails to make the required mortgage payments.
what’s the formula of expected credit loss
expected credit loss = chance of default x loss given default
looking at whether the loan will be repaid and the size of their potential exposure
what’s the purpose of credit risk analysis
quantify the expected credit losses to inform lending decision - focus on downside risk, the risk of loss from the company’s debt
who performs credit risk analysis
trade creditors: acquire information via credit applications = check applicant’s references (trade + bank references)
financial institutions: have access to info that managers don’t release to the public - bankers negotiate the loan + adjust loan terms to fit the change of default for each client - can monitor bank balances + act on early warning signs
public debt markets: have little access to additional info - decide to buy/sell the debt at current price w/publicly available data. public-debt investors can avail themselves of credit ratings on the debt issue
credit rating agencies: have access to more + better info than other lenders. credit analysts routinely meet w/borrowers (conference calls + in-person). credit rating agencies can refine the risk analysis for individual companies + compare statistics + trends across companies
why can the chance of default can be highly correlated among customers for trade creditors
bc trade credits often extend credit to many customers in the same industry
what’s the chance of default
depends on the company’s ability to repay the debt - which depends on the company’s future performance + cash flow
what are the 4 steps to evaluating the chance of default
- evaluate nature + purpose of the loan - affects the focus + depth of lender’s credit analysis emphasis on ratios will differ from each lender
- asses macroecon environment + industry conditions - consider the broader business context in which a company operates. nature of competitive intensity in industry affects the expected level of profitability. external forces affect companies’ strategies planning + expected short-term + long0term profits. company’s relative strength w/in its industry + vis-a-vis its suppliers/customers can determine profitability + its asset base, as competition intensifies, profitability likely declines + level of assets needed to compete likely increases. changes to I/S + B/S can adversely impact operating performance + cash flow + company’s ability to repay its debts.
- analyze financial ratios - 3 classes of credit risk ratios: capital structure - relative proportion of debt + equity to finance assets + operations, coverage; the ability to make required payments of interest + principal, liquidity; ability to generate cash quickly
- perform prospective analysis: creditors must forecast the borrower’s cash flows to estimate its ability to repay its obligations.
what are porter’s 5 forces
- industry competition: increased rivalry raises cost of doing business as companies must compete for workers, advertise products, research + develop new products.
- buying power: buyers w/strong bargaining power can extract price concessions + demand a higher level of services or delayed payments terms
- supplier power: suppliers w/strong bargaining power can demand higher prices + earlier payments; a company that faces strong suppliers has decreased profits/operating cash flows
- threat of substitution: as # of substitution products increase, sellers have less power to raise prices/pass on costs to buyers threat of substitution places downward pressure on seller’s profits.
- threat of entry: new market entrants increase competition; to mitigate threats, companies expend monies on activities (new tech, promotion, human development) to erect barriers to entry + create economies of scale.
what does a creditor’s potential loss depend on?
the priority of the claim compared with all other existing claims.
what happens when a company defaults on its obligations
creditors seek to claim the remaining assets owed.
how do lender minimize potential oss
lenders structure credit terms that typically include some or all of the following: credit limits, collateral, repayment terms, covenants. the higher the chance of default, the stricter the credit terms a lender will impose - there’s a tradeoff of the lender not setting credit terms so strict that the terms themselves cause the borrower to default.
define credit limit
the max that a creditor will allow a customer to owe at any point in time - limits = set based on the lender’s experience with similar borrowers + firm specific credit analysis
what’s unique about trade creditor’s credit limits
set low credit limits for new customers + higher limits for customers with repayment histories of prompt payments of amounts owed - reduces size of a loss but trade creditors must monitor their customers for signs of bankruptcy + act quickly to limit potential loses
how do banks limit potential losses frim credit
banks commonly specific that credit line will be reduced in size on a revolving line of credit if the customer’s credit rating declines
define collateral
property that borrower pledges to guarantee repayment -
what can act as collateral
most common: real estate (land, buildings, improvement) + equipment.
can also be marketable securities, A/R, inventory or other personal property.
does collateral lead to there being credit risk
yes the credit risk remains, as collateral will limit the amount of the loss but amounts owing in excess of the fair-value of the collateral will be lost. the time + costs incurred to gain control of + liquidate collateral can be substantial.
define repayment terms
the length of time the creditor has to repay the debt. nature of loan influences the repayment terms.
how long is loan usually
lenders try to match the length of the loan to the useful life of the asset that’s financed with the loan proceeds
what do companies do with long term debt vs short term debt
long term debt is used to purchase or improve PP&E. short term debt is used to raise cash for cyclical inventory needs, A/P, and working capital.
why do creditors need a higher return for a longer term
the longer the term, the higher the chance of default, the greater the credit risk
define covenants
terms + conditions of a loan designed to limit credit risk after the loan is made
why are loan covenants used
allow the lender to monitor the loan + receive early warnings when borrowers run into financial trouble, helps lender to detect deteriorating loan quality.
loan covenants prevent deteriorating loan quality by limiting the borrower’s behaviour to avoid situations leading to financial trouble
what happens when a borrower violates 1 or more covenants?
lender can consider the loan in default and change the loan pricing (increate interest rate) or alter the repayment terms. in extreme, the lender can demand repayment in full
