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
what are 3 types of loan covenants
- 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.
- 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
- 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
why do we scrutinize current + prior years’ financial statements before the analysis process of credit risk
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
what are the adjustments needed to make before credit anlaysis
- 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.
- 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.
- 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
what do creditors have in common terms of a questions and what do they focus on?
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
what’s the aim of the credit analysis
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 -
what’s the idea scenario in a credit analysis
large + stable free cash flows that provide a comfortable margin over required principal + interest payments
what are the time horizons of credits from different creditors
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)
what are some other factors a credit analysis takes into account other than financial statements
Risk of the countries in which the company operates.
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Regulatory risk associated with the company’s business.
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Industry risk, company size, and competitive position.
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Diversification of revenue and cash-flow streams.
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Capital structure and financial policy.
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Company management and governance.
is a credit analysis an absolute credit rating
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.
define capital strcuture
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.
what’s the formula to liabilities to equity ratio + what does this ratio mean
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.
what was the median ratio of liabilities to equity ratio? what does it mean?
median ratio of total liabilities to equity is 1.5
this means that the average company was financed w/60% debt + 40% equity
what’s total debt to equity ratio
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
total debt to equity vs total liabilities to equity
liabilities to equity ratio doesn’t distinguish between operating creditors (A/P) and debt obligations
define coverage analysis
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
what’s the times interest earned ratio
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
what’s the EBITDA coverage ratio
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
why is the EBITDA coverage ratio used more than the times interest earned ratio
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
what’s the cash from operations to total debt ratio
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
why is the EBIDTA coverage + TIE ratio assumption not always correct
ratios assume that the company needs to “cover” annual interest
payments because the principal owing will be refinanced
what does a company’s liquidity critically depend on
company’s ability to generate additional cash to cover debt payments as they come due.
what’s the free operating cash flow to total debt
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
what does liquidity refer to
refers to cash availability: how much cash a company has, how much cash the company generates, and how it can raise on short notice
what’s the current ratio
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
what’s working capital
current assets - current liabilties
what’s quick ratio
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.
what’s the root cause of most debt defaults
a lack of cash bc of w/out sufficient cash, a company might fail to make required debt payments, putting debt into default
what’s another measure of liquidity credit rating agencies look at
the company’s ability to raise additional cash quickly by borrowing under existing credit facilities (backup credit lines)
what are some common typical credit facility covenants
max debt to equity ratio
minimum TIE or EBIDTA coverage to
minimum cash from operations or free operations cash flows, relative to total debt
why are back up credit facilities looked as a band-aid
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
define credit ratings
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
what’s the creud ratings of AAA/Aa/A
0% bc these high quality borrowers rarely default
what’s the lowest investment-grade security
Baa
what’s the importance of credit ratings
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
how are credit ratings determined
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
why could there be a conflict of interest in credit rating
the rated organizations pay the credit rating agencies for a rating
what’s the general approach to credit analysis from S&P global ratings
- 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. - financial risk - focus on cash flow + leverage ratios
- anchor - business risk profile + financial rise profile = combined
- credit rating: anchor credit rating = adjusted for 5 additional modifiers
what are the hierarchy of ratios that S&P evaluations financial risk
- core ratios (FFO/debt and DEBT/EBITDA)
- supplementary ratios - CFO/debt, FOCF/debt, DCF/debt, (FFO + cash interest paid)/cash interest paid, EBITDA/interest expense
- profitability ratios - EBIT/revenues, EBITDA/revenues, EBIT/avg.capital
what’s the altman z-score
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.
what does of z-score values mean
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
what’s Moody’s credit rating metholodology?
assigns weights to the 5 factors
- 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. - 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. - 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. - 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. - 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.
what’s fitch’s rating factors
- 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. - 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. - 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
