Lecture 10: Credit Analysis

Question 1

What is credit analysis?

Answer 1

credit analysis is the process used to assess the creditworthiness of a company

i.e. the likelihood of paying/not paying financial obligations to third parties (such as interest payments and/or debt face value to the bank)

Question 2

If a firm is not credit worthy they have a higher likliehood of entering into what?

Answer 2

If the firm is not creditworthy
Higher likelihood to enter in default (missed scheduled payments i.e. interest payment)

& Higher likelihood to go bankrupt (company is closed)

Question 3

How mnay methods of credit analysis are there?

Answer 3

There are 3 credit analysis methods:

1) financial ratio analysis
2) Z score
3) Distance to default

Question 4

What are the limitiations of financial ratio analysis?

Answer 4

The llimitations of financial ratio analysis are:

1) they do not quantify the riskieness/creditworthiness of the company

2) difficult to asses which ratios are more importnat than others

3) time consuming to analyse

Question 5

What is the Z score also called?

Answer 5

The z score is also called discriminant analysis (DA)

Question 6

What is discriminant analysis?

Answer 6

DA assigns a score (called Z-score) to each firm using a linear combination of five financial ratios and its a weighted sum.

Question 7

What ar ethe limitiations of z score analysis?

Answer 7

Estimated in 1968 thus it is outdated
Weights and/or financial ratios may need re-estimation

Does not contain enough information other than financial
Macroeconomic factors etc

Not a universal model and may not apply everywhere
Model estimated using US companies may not apply on UK companies

Purely an empirical model lacking theoretical framework

Question 8

what is the distance to default?

Answer 8

Black and Scholes (1973) and Merton (1974) showed that four major variables affect the probability of default:
The market value of the firm or the market value of its assets (V)
The face value of its liabilities (F)
The growth of the market value of assets (μ)
The volatility of the market value of assets (σ)

According to their theory, the firm defaults/ goes bankrupt if V falls below F at the time of maturity

In this context, the likelihood of bankruptcy is the distance-to-default