Chapter 4

Question 1

why do companies demand credit for operating, investing, + financing activities

Answer 1

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)

Question 2

why is cash needed for operating activities not always low risk

Answer 2

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

Question 3

what are the parties that supply credit and types of credit they supply

Answer 3

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

Question 4

define revolving credit lines, lines of credit, term loans, mortgages

Answer 4

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.

Question 5

what’s the formula of expected credit loss

Answer 5

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

Question 5

what’s the purpose of credit risk analysis

Answer 5

quantify the expected credit losses to inform lending decision - focus on downside risk, the risk of loss from the company’s debt

Question 6

who performs credit risk analysis

Answer 6

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

Question 7

why can the chance of default can be highly correlated among customers for trade creditors

Answer 7

bc trade credits often extend credit to many customers in the same industry

Question 8

what’s the chance of default

Answer 8

depends on the company’s ability to repay the debt - which depends on the company’s future performance + cash flow

Question 9

what are the 4 steps to evaluating the chance of default

Answer 9

1. evaluate nature + purpose of the loan - affects the focus + depth of lender’s credit analysis emphasis on ratios will differ from each lender
2. 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.
3. 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
4. perform prospective analysis: creditors must forecast the borrower’s cash flows to estimate its ability to repay its obligations.

Question 10

what are porter’s 5 forces

Answer 10

1. industry competition: increased rivalry raises cost of doing business as companies must compete for workers, advertise products, research + develop new products.
2. buying power: buyers w/strong bargaining power can extract price concessions + demand a higher level of services or delayed payments terms
3. 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
4. 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.
5. 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.

Question 11

what does a creditor’s potential loss depend on?

Answer 11

the priority of the claim compared with all other existing claims.

Question 11

what happens when a company defaults on its obligations

Answer 11

creditors seek to claim the remaining assets owed.

Question 12

how do lender minimize potential oss

Answer 12

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.

Question 13

define credit limit

Answer 13

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

Question 14

what’s unique about trade creditor’s credit limits

Answer 14

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

Question 15

how do banks limit potential losses frim credit

Answer 15

banks commonly specific that credit line will be reduced in size on a revolving line of credit if the customer’s credit rating declines

Question 16

define collateral

Answer 16

property that borrower pledges to guarantee repayment -

Question 17

what can act as collateral

Answer 17

most common: real estate (land, buildings, improvement) + equipment.

can also be marketable securities, A/R, inventory or other personal property.

Question 18

does collateral lead to there being credit risk

Answer 18

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.

Question 19

define repayment terms

Answer 19

the length of time the creditor has to repay the debt. nature of loan influences the repayment terms.

Question 20

how long is loan usually

Answer 20

lenders try to match the length of the loan to the useful life of the asset that’s financed with the loan proceeds

Question 21

what do companies do with long term debt vs short term debt

Answer 21

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.

Question 22

why do creditors need a higher return for a longer term

Answer 22

the longer the term, the higher the chance of default, the greater the credit risk

Question 23

define covenants

Answer 23

terms + conditions of a loan designed to limit credit risk after the loan is made

Question 24

why are loan covenants used

Answer 24

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

Question 25

what happens when a borrower violates 1 or more covenants?

Answer 25

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

Question 26

what are 3 types of loan covenants

Answer 26

1. covenants that require the borrower to take certain actions - lenders often require that borrowers take certain actions to help the lender monitor the loan quality + ensure that the borrower continues to operate smoothly + repay the loan. borrowers = required to submit financial statements at least annually, maintain hazard + content insurance on inventory, plant + equipment. pay all taxes + other required operating fees + licenses. avoid any liens on the property. 2. covenants that restrict the borrower from taking certain actions: the lender might use loan covenants to prevent the borrower from taking certain actions unless the lender gives prior approval - commonly restricted actions; changing the management team, increasing dividends/owner's withdrawals/management salaries, making major investments/capital expenditures, merging or acquiring other entities, taking on additional loans or debt 3. covenants that require the borrower to maintain specific financial ratios: lender often require borrowers to maintain certain levels in key financial ratios; minimum working capital/current ratio/quick ratio to ensure ongoing liquidity, minimum ROA/ROE to give lender an early warning + allow the lender to call the loan before financial troubles grow, 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

Question 27

why do we scrutinize current + prior years' financial statements before the analysis process of credit risk

Answer 27

we scrutinize to be sure that they accurately reflect the company's financial condition + operating performance. bc general purpose financial statements prepared in conformity w/GAAP do not always accurately reflect our estimate of the true financial condition + operating performance of the company

Question 28

what are the adjustments needed to make before credit anlaysis

Answer 28

1. transitory item - one time occurrences that are not expected to recur- we take it out bc credit analysis focuses on borrowers future profitability + cash flow, so transitory items =/= forecasted. 2. acquisitions - when companies acquire other companeis they report the results of the acquired company in their financial statements only from the date of the acquisition - thus acquired company's net income is only included for the part of the year it's acquired. companies are required to disclose the results of operations would have been had the acquisition taken place at the start of the year (pro forma disclosure). forecasts would be more accurate if they are based on this full-year pro forma income statement. 3. 52/53 week years - some companies close their books on a specific day in a given month than a specific date - year end dates varies and it's possible for the company to report 53 weeks in some fiscal years - we need to make sure that our forecasts don't extrapolate a company's 53 week year into future sale forecasts

Question 29

what do creditors have in common terms of a questions and what do they focus on?

Answer 29

questions: will the company be able to pay back the amount borrowed (pincipal + interest) as it matures and what is the downside risk if the company fails to make the required payments. creditors focus on the following: capital structure (solvency) - amount of debt that the company owes and when it matures, coverage - magnitude and stability pf the company's cash flows in relation to its required debt payments (principal + interest), liquidity - amount of cash available + cash it can generate or raise in the short run

Question 30

what's the aim of the credit analysis

Answer 30

to forecast the company's free operating cash flows (net cash flows from operating activities less capital expenditures) and to compare that forecast with the expected maturities of the company's debt -

Question 31

what's the idea scenario in a credit analysis

Answer 31

large + stable free cash flows that provide a comfortable margin over required principal + interest payments

Question 32

what are the time horizons of credits from different creditors

Answer 32

trade creditors: focus on short-term (can company pay it's AP w/in the credit period - 30-60 days) bans: extend term loans to finance ewquipment purchases are on an intermeditae horizon (5-10 yrs) investors w/publicly traded bonds holding for a long time have long time horizon (20 yr or longer)

Question 33

what are some other factors a credit analysis takes into account other than financial statements

Answer 33

Risk of the countries in which the company operates. ■ Regulatory risk associated with the company’s business. ■ Industry risk, company size, and competitive position. ■ Diversification of revenue and cash-flow streams. ■ Capital structure and financial policy. ■ Company management and governance.

Question 34

is a credit analysis an absolute credit rating

Answer 34

no, it's a relative credit rating as it's designed to inform investors whether the company is more or less risky than other companies seeking to raise funds in the public debt markets.

Question 35

define capital strcuture

Answer 35

the specific mix of debt + equity used to finance a company's assets + operations - from corporate perspective, equity = a more expensive, permanent source of capital with greater financial flexibility + financial flexibility allows a company to raise capital on reasonable terms when capital is needed. while debt represents a cheaper, finite-to-maturity capital sources that legally obligates a company to make a promised cash outflows on a fixed schedule with the need to refinance at some future date at an unknown cost.

Question 36

what's the formula to liabilities to equity ratio + what does this ratio mean

Answer 36

liabilities to equity ratio: total liabilities/stockholder's equity ratio conveys how reliant a company is on creditor financing compared with equity financing higher ratio indicates a more highly financially leveraged company.

Question 37

what was the median ratio of liabilities to equity ratio? what does it mean?

Answer 37

median ratio of total liabilities to equity is 1.5 this means that the average company was financed w/60% debt + 40% equity

Question 38

what's total debt to equity ratio

Answer 38

total debt-to-equity = total debt/stockholders' equity refine the analysis for capital structure, this ratio assumes that current operating liabilities will be repaid from current assets (self-liquidating) such that lenders should focus on the relative proportions of debt and equity. total debt = short + long term interest bearing obligations

Question 39

total debt to equity vs total liabilities to equity

Answer 39

liabilities to equity ratio doesn't distinguish between operating creditors (A/P) and debt obligations

Question 40

define coverage analysis

Answer 40

estimates the likelihood that the company will be able to make its required principal + interest payments. focuses on company's ability to earn a profit and generate cash from its operating activities (bc debt must be repaid with cash) two general categories; coverage ratios based on income, coverage ratios based on operating cash flow

Question 41

what's the times interest earned ratio

Answer 41

reflects the operating income available to pay interest expense times interest earned = EBIT (earnings before interest and tax)/ gross interest expense underlying assumption is that only interest must be paid bc the principal will be refinanced

Question 42

what's the EBITDA coverage ratio

Answer 42

non-GAAP performance metric. EBITDA coverage = (EBIT + depreciation + amortization) / (gross interest expense) we add depreciation + amortization bc EBIT doesn't include that in the income statement

Question 43

why is the EBITDA coverage ratio used more than the times interest earned ratio

Answer 43

EBIDTA is similar but more widely used bc deprecation + amortization do not require cash outflow and thus more cash is available to "cover fixed debt chargers than GAAP earnings would suggest, thus EBIDTA coverage ratio > than times interest earned bc of depreciation and amortization

Question 44

what's the cash from operations to total debt ratio

Answer 44

cash from operations to total debt = cash from operations/ total debt used to measure a company's ability to repay principal in the short + longer term

Question 45

why is the EBIDTA coverage + TIE ratio assumption not always correct

Answer 45

ratios assume that the company needs to “cover” annual interest payments because the principal owing will be refinanced

Question 46

what does a company's liquidity critically depend on

Answer 46

company's ability to generate additional cash to cover debt payments as they come due.

Question 47

what's the free operating cash flow to total debt

Answer 47

free operating cash flow to total debt = (cash from operations - CAPEX)/ total debt Companies typically replace tangible assets each year. Any excess operating cash flow after cash spent on capital expenditures (CAPEX) is considered “free” cash flow in that the company is free to use the cash for other purposes including debt repayments. The following ratio uses free cash flow to measure coverage. this ratio reflects a company's ability to repay debt from the cash flows remaining after CAPEX

Question 48

what does liquidity refer to

Answer 48

refers to cash availability: how much cash a company has, how much cash the company generates, and how it can raise on short notice

Question 49

what's the current ratio

Answer 49

current ratio = current assets/current liabilities Positive working capital implies more expected cash inflows than cash outflows in the short run 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. A current ratio less than 1.0 (negative working capital) is not always a bad sign. For example, retailers carry inventory that is about the same value as accounts payable and, thus, working capital is near zero. If the inventory is sold as anticipated, sufficient cash will be gen- erated to pay current liabilities. Some companies are especially efficient at managing working capital by minimizing receivables and inventories and maximizing payables. These companies will report a small or negative cash conversion cycle (CCC) as we discuss in Module 3, and they would be viewed positively despite their low current ratios

Question 50

what's working capital

Answer 50

current assets - current liabilties

Question 51

what's quick ratio

Answer 51

quick ratio = (cash + marketable securities + A/R)/ current liabilities It focuses on quick assets, which are those assets likely to be converted to cash within a relatively short period of time. The quick ratio gauges a company’s ability to meet its current liabilities without liquidating inventories that could require markdowns. It is a more stringent test of liquidity than the cur- rent ratio.

Question 52

what's the root cause of most debt defaults

Answer 52

a lack of cash bc of w/out sufficient cash, a company might fail to make required debt payments, putting debt into default

Question 53

what's another measure of liquidity credit rating agencies look at

Answer 53

the company's ability to raise additional cash quickly by borrowing under existing credit facilities (backup credit lines)

Question 54

what are some common typical credit facility covenants

Answer 54

max debt to equity ratio minimum TIE or EBIDTA coverage to minimum cash from operations or free operations cash flows, relative to total debt

Question 55

why are back up credit facilities looked as a band-aid

Answer 55

bc they provide short term solution to a liquidity crunch - we must be mindful that poor operating performance + low liquidity can trigger a covenant violation such that the company will not have access to additional funds when it needs them the most. thus credit rating agencies analyze the reliability of these backup lines of credit as part of credit analysis of the company

Question 56

define credit ratings

Answer 56

an opinion of a company's creditworthiness - ability to meet its financial commitments as they come due come as a grade from AAA to D

Question 57

what's the creud ratings of AAA/Aa/A

Answer 57

0% bc these high quality borrowers rarely default

Question 58

what's the lowest investment-grade security

Answer 58

Baa

Question 59

what's the importance of credit ratings

Answer 59

credit ratings affect cost of debt, as risk premium depend son company's credit risk and cost of debt = risk free rate+ risk premium credit ratings affect investment decisions - investment grade vs non investment grade

Question 60

how are credit ratings determined

Answer 60

includes 3 types of inputs (macroeconomic statistics, industry data, company specific info) for country/industry/firm specific risk then analyst team gather financial statement data + computes and analyzes financial ratios

Question 61

why could there be a conflict of interest in credit rating

Answer 61

the rated organizations pay the credit rating agencies for a rating

Question 62

what's the general approach to credit analysis from S&P global ratings

Answer 62

1. business risk - including the country risk for the mar- kets in which the company does business, the industry risk that is particular to the company’s lines of business, and the company’s competitive position. 2. financial risk - focus on cash flow + leverage ratios 3. anchor - business risk profile + financial rise profile = combined 4. credit rating: anchor credit rating = adjusted for 5 additional modifiers

Question 63

what are the hierarchy of ratios that S&P evaluations financial risk

Answer 63

1. core ratios (FFO/debt and DEBT/EBITDA) 2. supplementary ratios - CFO/debt, FOCF/debt, DCF/debt, (FFO + cash interest paid)/cash interest paid, EBITDA/interest expense 3. profitability ratios - EBIT/revenues, EBITDA/revenues, EBIT/avg.capital

Question 64

what's the altman z-score

Answer 64

a well-known bankruptcy prediction model z-score = [(1.2 * (working capital/total assets)] + [1.4 * (retained earnings/total assets)] + [ 3.3 * (EBIT/total assets)] + [0.6*(market value of equity/total liabilities)] + [0.99*(sales/total assets)] each variable in the z-score model relates to financial strength. The first variable provides a mea- sure of liquidity, while the second and third variables measure long-term and short-term profit- ability. The fourth variable captures the company’s levered status, while the fifth variable reflects its total asset efficiency.

Question 65

what does of z-score values mean

Answer 65

z-score > 3.00 = company is health + low bankruptcy potential in teh short term 2.99 > z-score > 1.8, gray area - company is exposed to some risk of bankruptcy, caution is adbised 1.8 > z-score - company is in financial distress and there is high bankruptcy potential in short term these values only predict bankruptcy accurately up to 2 years in advance. model is 95% accurate 1 year and 72% accurate 2 yrs

Question 66

what's Moody's credit rating metholodology?

Answer 66

assigns weights to the 5 factors 1. Scale Scale is measured using total revenue. Moody’s considers size to be an important indicator because size typically drives the breadth of a company’s customer base, the depth of its business, economies of scale, operational and financial flexibility, and greater pricing power. Larger companies may have a greater ability to perceive and harness business trends, support and improve market position, and withstand competitive pressures. 2. Business profile Business profile considers three dimensions. (a) Business model, competition, and tech- nology . A company with a diversified business model can generally compete more effectively and sustain stronger product development, enabling them to rapidly respond to evolving technologies and customer needs. (b) Regulatory environment can influence its competitive position and help or hinder the company’s ability to predictably earn a return on its investment. (c) Market share assesses the company’s relative position within its segments and its sustainability. 3. Profitability and Efficiency This factor reflects on the sustainability in revenue growth and the ability to maintain margins on a go-forward basis. As revenues decline, a company may be able to cut costs to maintain margins on a short-term basis, but this may not be sustainable. Conversely, high margins may be supported by strong revenue growth, but a company may have little pricing power or cost control to mitigate the margin impacts of a market slowdown. 4. Leverage and Coverage Leverage and coverage reflect a company’s financial flexibility and long-term viability. Financial flexibility is critical to respond to changing consumer preferences, regulatory changes, competitive challenges, and unexpected events. Moody’s profitability and cash flow-based ratios are similar to those we discussed previously. 5. Financial policy Financial policy focuses on management’s and the board of directors’ tolerance for finan- cial risk. A high score on this dimension means management is committed to sustaining, and/or improving, its credit profile.

Question 67

what's fitch's rating factors

Answer 67

1. Sector Risk & Operating Environment Companies can succeed in inhospitable environments and fail in the most hospitable environments. Yet, a higher-risk environment can actively constrain a company’s potential. In general, a company’s credit rating will only be impacted when the sector risk and/or operating environment risk is high. 2. Business Profile Management, Market, Diversification, Technology, and Regulatory. Fitch considers management’s historic record of creating a healthy business mix, maintaining operating efficiency, and strengthening market position. Strategy and future goals also figure into Fitch’s rating process with risk tolerance and consistency being important elements. 3. Financial Profile Profitability and Cash Flow. Fitch puts more weight on cash flow measures of coverage and capital structure than on equity-based ratios such as debt-to-equity and debt-to-capital. Financial structure. Fitch considers an issuer’s reliance on external financing. The process assesses finan- cial leverage, the business environment, and operating cash flows. Financial flexibility. Financial flexibility allows an issuer to meet its debt-service obligations and man- age periods of volatility without eroding credit quality. The more conservatively capitalized an issuer, the greater its financial flexibility. Other factors that contribute to financial flexibility are the ability to revise plans for capital spending, strong banking relationships, the degree of access to a range of debt and equity markets (domestic or international), committed, long-dated bank lines, and the proportion of short-term debt in the capital structure