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AFM 212 > Module 4 > Flashcards

Module 4 Flashcards

1
Q

what is credit analysis

A

the process of evaluating the ability and willingness of a borrower (corporation, government, or individual) to meet their financial obligations, typically in the form of loans or bonds

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2
Q

what does credit analysis involve

A

detailed assessment of the credit risk associated with lending money or extending credit to a borrower

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3
Q

what is the primary purpose of credit analysis

A

to determine the likelihood a borrower will repay their debt on time and in full

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4
Q

what is credit risk

A

risk that a borrower will fail to meet their financial obligation as they come due, leading to a loss for the lender or investors

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5
Q

who are demanders of credit

A
  • banks
  • bond investors
  • corporates
  • individuals
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6
Q

why do bond investors demand credit rating

A
  • they’re investing their money for a long time (fixed income)
  • or they might not be that knowledgeable in investments but they have money
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7
Q

who are corporate demanders of credit analysis

A
  • suppliers
  • customers
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8
Q

what are suppliers looking for in credit analysis

A
  • how reliable and stable a company is
  • they want to make sure the company wont go bankrupt soon since its expensive to find new suppliers
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9
Q

what are customers looking for in credit analysis

A

determine the credit score of companies

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10
Q

who are suppliers of credit analysis

A
  • banks’ in-house credit analysis teams
  • internal corporate credit teams
  • credit rating agencies
  • fixed income research firms
  • consulting firms
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11
Q

what are the 3 major credit rating agencies in north america

A
  • S&P
  • moody’s
  • fitch
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12
Q

why would companies demand credit for their operating activities

A
  • they have cyclical operating cash needs
  • manufacturers need cash for materials or labour (they need it to produce the products/services before they sell it, and need money)
  • advanced seasonal purchases (buying a bunch of inventory before the holiday season, and need a lot of cash to purchase)
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13
Q

what is the risk level for cyclical operating cash needs and why

A
  • low risk
  • because its a recurring need
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14
Q

why is credit needed for operating activities not always “low risk”

A
  • cash needed to cover operating losses that might not be temporary (consistently use the cash to cover operating losses) is risky
  • unless the company is able to quickly to get profit
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15
Q

what could a willing lender do for operating activities

A

make the difference between bankruptcy and continued operations for a company

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16
Q

how much credit is needed for investing activities

A

large amounts

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17
Q

what investing activities is credit needed for

A
  • new PP&E (CAPEX)
  • intangible assets
  • mergers & acquisitions
  • Leverage buy out (LBO)
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18
Q

what is an LBO

A
  • leverage buy out
  • type of acquisition that uses high amount of leverage to do
  • the entire company is usually bought then made private
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19
Q

what is LBO also considered

A
  • managers buy out (MBO)
  • where managers do it so they can own the company (high incentive to do it)
  • they can significantly increase their return with leverage
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20
Q

what financing activities is credit needed for

A
  • getting bank loans
  • getting more debt to pay off maturing debt
  • funds to repurchase stock
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21
Q

what is trade (supplier) credit like

A
  • routine
  • non-interest bearing
  • have credit terms
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22
Q

what does the credit terms suppliers give specify

A
  • amount and timing of any early payment discounts
  • maximum credit limit
  • payment terms
  • other restrictions or specifications
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23
Q

what does 2/10 net 30 mean

A

2% discount if paid within 10 days, otherwise have 30 days to pay

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24
Q

how do banks structure financing

A

to meet client needs

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25
Q

what are the different types of credit banks provide

A
  • revolving credit line (revolvers)
  • lines of credit (back up credit facilities)
  • term loans (bank loans)
  • mortgages
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26
Q

what are revolving credit line (revolvers)

A
  • cash available for seasonal shortfalls when you need cash before selling goods
  • they provide a credit line maximum (maximum amount of cash they will give) and the amount MUST be repaid in full later in the year
  • there is low fees on unused balance and high fees on used balance
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27
Q

what are lines of credit (back up credit facilities)

A
  • a guaranty that funds will be available when needed
  • used to protect companies that have commercial paper
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28
Q

what are term loans (bank loans) usually for

A
  • to fund PP&E, which serves as a collateral for the loan
  • the loan duration matches the useful life of the PP&E
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29
Q

what are mortgages usually for

A
  • longer term loans
  • usually for real estate transactions (building and land)
  • the lender takes the property as security if they fail to repay
  • they can take the property and sell ig
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30
Q

what are other forms of financing

A
  • lease financing
  • publicly traded debt
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31
Q

what is lease financing firms like

A
  • leasing firms finance CAPEX
  • leasing companies are often publicly traded
  • they aren’t limited by bank regulations
  • can tailor leases to meet borrower’s needs
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32
Q

what is public traded debt

A
  • cost efficient way to raise large amounts of funding
  • regulated by the SEC (even if a company isnt trading publicly)
  • rated for credit quality
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33
Q

what are examples of publicly traded debt

A
  • commercial paper
  • bonds and debentures
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34
Q

what is commercial paper like

A
  • for short term operating activities
  • matures within 270 days
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35
Q

what is bonds and debentures like

A
  • longer term
  • trade on major exchanges after its issued (but most aren’t)
  • the face value is paid at maturity
  • investors are concerned with the company’s ability to make semiannual interest payments and repaying principal at maturity
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36
Q

what is the purpose of credit risk analysis

A
  • to quantify potential credit losses so lending decisions are made with full information
  • to quantify risk of loss from nonpayment
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37
Q

what is the formula for expected credit loss

A

= chance of default x loss given default

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38
Q

what are the two factors that affect expected credit loss

A
  • debtor’s ability to repay debt (chance of default)
  • size of loss if debtor defaults (loss given default)
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39
Q

what is the focus of credit risk analysis and in comparison with equity analysis

A
  • credit risk analysis is to quantify a downside risk (you want the risk to go down)
  • equity analysis focuses on upside potential (you want the rate to go up to earn more returns)
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40
Q

what does the chance of default depend on

A
  • company’s ability to repay its obligations
  • ^ depends on future cash flow and profitability
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41
Q

what are the steps to determine the chance of default

A
  1. evaluate the nature and purpose of the loan
  2. assess macroeconomic environment and industry conditions
  3. perform financial analysis (financial ratios)
  4. perform prospective analysis
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42
Q

what is the first step of determining the chance of default

A
  • evaluate the nature and purpose of the loan
  • determine why the loan is necessary
  • nature and purpose of loan affects riskiness and focus and depth of credit analysis
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43
Q

how can the nature and purpose of the loan affect the riskiness of it

A

ex. more risky to lend to a troubled company for their operations compared to one that wants to expand into new profitable markets

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44
Q

what are possible loan uses

A
  • cyclical cash flow needs
  • major capital expenditures or acquisitions
  • fund temporary or ongoing operating losses
  • reconfigure capital structure
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45
Q

what is the second step of determining the chance of default

A
  • assess macroeconomic environment and industry conditions
  • use porter’s 5 forces to do it
  • the industry the company operates in will determine their profitability and therefore chance of defaulting
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46
Q

what are porter’s 5 forces

A
  • industry competition
  • bargaining power of buyers
  • bargaining power of suppliers
  • threat of substitution
  • threat of entry
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47
Q

what is industry competition

A

competition and rivalry that raise the cost of doing business

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48
Q

what is bargaining power of buyers

A

buyers with strong bargaining power can extract price concessions

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49
Q

what is bargaining power of suppliers

A

suppliers with strong bargaining power can demand higher prices

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50
Q

what is threat of substitution

A

as the number of product substitutes increases, sellers have less power to raise prices and/or pass on costs to buyers

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51
Q

what is threat of entry

A

new market entrants increase competition and companies must develop new technologies and human capital to create barriers to entry and economies of scale

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52
Q

what is the third step of determining the chance of default

A
  • analyze financial ratios
  • financial ratios play a key role in credit risk analysis
  • there is no best set of ratios to use to assess credit risk
  • there is also no correct way to calculate specific ratios
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53
Q

what is the 3 classes of credit risk ratios

A
  • profitability and coverage
  • liquidity
  • solvency/leverage
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54
Q

what is the fourth step of determining the chance of default

A
  • perform prospective analysis
  • to evaluate creditworthiness, creditors must forecast the borrower’s cash flows to estimate its ability to repay its obligations
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55
Q

why are projected cash flows especially critical

A

because a company must have sufficient cash in the future to:
- repay debts as they mature
- service those debts along the way

56
Q

what is done to perform prospective analysis

A
  • first project/forecast financial statements
  • use forecasted numbers to compute future ratios (profitability liquidity, and solvency) and coverage ratios and evaluate changes or trends
57
Q

what is the EDF model

A
  • estimates the probability of a firm defaulting within a specified time horizon, typically one year
  • made by moody’s
  • widely used in credit risk assessment by large financial institutions
58
Q

what is the determinants of chance of defaulting (asset value and obligations)

A
  • asset value > obligations = safe
  • asset value < obligations = not safe, considered defaulting
59
Q

what are key component of the edf

A
  • market value of assets (V)
  • default point (D)
  • distance to default (DD)
60
Q

what is market value of assets

A

estimated using the market value of equity and book value of liabilities

61
Q

what is the default point

A
  • threshold where liabilities > assets
  • typically calculated as short-term liabilities + 1/2 long term liabilities
62
Q

what is the distance to default

A

measure of how far the firms asset value is from the default point

63
Q

what is the formula for dd

A

(market value of firm’s asset (V) - default point (D)) / volatility of the firm’s asset value

64
Q

what is loss given default (LGD)

A

the amount that could be lost if the company defaulted on its obligations

65
Q

what do defaults include

A
  • failure to make payments
  • violation of loan covenants
66
Q

what does potential loss on default depend on

A
  • priority of claim compared with all other existing claims
  • companies must repay senior claims first
  • then follow the US bankruptcy codes’ priority of other claims
67
Q

what is the liquidity order

A
  1. administrative costs (legal fees, court costs, trustee fees)
  2. secured creditors (with claims backed by collateral)
  3. priority unsecured creditors (wages, benefits, and taxes)
  4. unsecured creditors (bondholders, suppliers, customer (when they pre-paid), etc.)
  5. subordinated debtholders
  6. preferred shareholders
  7. common shareholders
68
Q

how does lenders structure credit terms to minimize potential loss (LGD factors)

A
  • credit limits
  • collateral
  • repayment terms
  • covenants
69
Q

what are credit limits

A
  • represent maximum creditor will allow a customer to owe at any point in time
  • based on the lender’s experience with similar borrowers and by firm specific analysis
70
Q

what kind of credit limits do trade creditors have

A
  • Set low limits for new customers and higher limits for established customers
  • Bankruptcy laws protect ordinary trade creditors: goods shipped to a customer
    within 20 days before the bankruptcy have higher priority for payment
71
Q

what is collateral

A
  • property pledged by the borrower to guarantee repayment, most often real estate
  • A full credit analysis should include an assessment of the number of existing liens on the collateral
  • Bankruptcy laws protect ordinary trade creditors―seller can reclaim goods shipped within 45 days before bankruptcy to settle an unpaid balance
72
Q

what kind of credit limits do banks have

A
  • Set credit limits on revolving credit
  • Specify that if a borrower’s credit rating falls, credit limit may be reduced
73
Q

between unsecured loan and secured loan (loan with collateral), which one
usually have higher interest rate?

A
  • secured loan
  • high risk loans have collateral
  • high risk also means higher interest rates
  • high risk unsecured loans can also have high interest rates, but ones with collateral are usually more risky
73
Q

what are repayment terms

A
  • Term of loan is the length of time the creditor has to repay the debt
  • Early payment discounts often offered by trade creditors
  • To assess LGD must consider whether the economic life of the asset matches or exceeds the loan term
  • longer terms = greater chance of default = greater credit risk = higher cost of debt financing
73
Q

what is the 52 vs 53 week fiscal year adjustment

A
  • Retailers’ typically have a 53rd week every 4-5 years
  • We must adjust all affected income statement numbers
73
Q

what can collateral do to reduce loss

A
  • Collateral will limit the amount of the loss but amounts owing in excess of the fair-value of the collateral will be lost
  • Given a default, the time and costs incurred to gain control of and liquidate collateral can be substantial
74
Q

what are 3 common types of covenants

A
  • Positive/Affirmative covenants
  • Negative/Restrictive Covenants
  • Financial Covenants
74
Q

what are positive/affirmative covenants

A

Those that require the borrower to take
certain actions, such as submitting financial statements to the lender

75
Q

what are covenants

A
  • loan terms and conditions designed to limit the loss given default
  • Three common types of covenants
76
Q

what are financial covenants

A

Those requiring the borrower maintain specific
financial conditions, including certain ratios and minimum equity

76
Q

what are negative/restrictive covenants

A

Those that restrict the borrower from
taking certain actions, such as preventing mergers or other major investments

77
Q

why and how do analysts make sure current and prior years financial statements accurately reflect the company’s financial condition and operating performance

A
  • general purpose GAAP financial statements prepared don’t always accurately reflect our estimate of the “true” financial condition and operating performance
  • Before we begin the analysis process, we make appropriate adjustments
77
Q

what are the different adjustments that need to be made

A
  • transitory items (those one time occurrences)
  • acquisitions
  • 52 vs 53 week fiscal years
  • adjusts/reformulate financial statements
78
Q

how do you adjust for the 53rd week

A
  • Adjust sales and expenses that vary proportionately with sales (such as cost
    of sales and SG&A) by multiplying by 52/53
  • We do not adjust other expenses that are measured annually (such as interest, depreciation, and gains or losses)
  • We adjust tax expense proportionately based on effective tax rates (Tax expense / Pretax income)
79
Q

what are examples of adjustments moodys make to adjust/reformulate financial statements

A
  • defined benefit pension plans
  • multiemployer pension plans
  • operating leases (off balance sheet)
  • leases (on balance sheet)
80
Q

what is coverage analysis

A
  • Considers a company’s ability to generate additional cash to cover principal and interest payments when due
  • Called “flow” ratios because they consist of cash flow and income statement data
80
Q

what are the different coverage ratios

A

based on income
- Times interest earned
- EBITDA coverage ratio
based on operating cash flow
- Cash from operations to total debt
- Free operating cash flow to total debt

81
Q

what is the ebitda coverage ratio (formula)

A

(EBIT + depreciation + amortization) / interest expense, gross
- where depreciation and amortization are from the cash flow statement

81
Q

what is EBITDA coverage ratio

A
  • More widely used than the times interest earned ratio because depreciation and amortization do not require a cash outflow (so actually have more cash to pay off interest)
  • Always higher than times interest earned ratio
  • Measures company’s ability to pay interest out of current profits (same as times interest earned)
81
Q

what is the difference between the coverage ratios based on income and coverage ratios based on cash flow

A
  • income based assumes you only have interest payments
  • cash flow based is for paying off principal and interest
81
Q

what is times earned ratio

A
  • Reflects the operating income available to pay interest expense
  • Assumes only interest must be paid because the principal will be refinanced (new debt to pay off principal)
  • should be at least over 1x
  • standard for ratio will vary on industry
82
Q

what is current ratio

A
  • current assets are assets that are expected to be converted into cash within a year
  • current liabilities are those that are due within a year
  • usually want it to be higher
  • but too high can be inefficient asset use
  • current ratio < 1 not always bad if really good at managing working capital that minimizes receivables (amount ppl owe them) and maximizes payables (amount they owe to ppl)
82
Q

what is the time interest earned ratio (formula)

A

earnings before interest and tax (EBIT) / interest expense, gross

83
Q

what is liquidity

A
  • refers to cash availability
  • how much cash a company has, and how much it can generate on short notice
83
Q

what the is cash from operations to total debt formula

A

cash from operations / (short term debt + long term debt)

83
Q

what are the different liquidity ratios

A
  • current ratio
  • quick ratio
83
Q

what the is free operating cash flows to total debt formula

A

(cash from operations - capex) / (short term debt + long term debt)

83
Q

what is the current ratio formula

A

current assets / current liabilities

83
Q

what is cash from operations to total debt

A

measures the ability to generate additional cash to cover debt payments as they come due

83
Q

what is free operating cash flows to total debt

A

considers excess operating cash flow after cash is spent on capital expenditures (CAPEX)

83
Q

what are solvency ratios

A
  • Solvency refers to a company’s ability to meet its debt obligations
  • Solvency is crucial―an insolvent company is a failed company
83
Q

what is quick ratio

A
  • measures the ability to generate cash in a short period of time
  • not uncommon to have quick ratios < 1
83
Q

what is the quick ratio formula

A

(cash + marketable securities + a/r) / current liabilities

83
Q

what is liabilities to equity ratio

A
  • how reliant a company is on creditor financing compared with equity financing
  • higher ratio = more leveraged
  • drawback: doesn’t separate operating creditors (A/P)) and debt obligations
83
Q

what is liabilities to equity ratio (formula)

A

total liabilities / stockholders equity

84
Q

what are 3 common solvency ratios

A
  • liabilities to equity ratio
  • total debt to equity
85
Q

what is total debt to equity

A
  • distinguishes between operating creditors and debt obligations
  • assumes current operating liabilities will be repaid from current assets (self-liquidating)
  • #
86
Q

what is total debt to equity (formula)

A

(long term debt including current portion + short term debt) / stockholders equity

87
Q

what does solvency depend on

A
  • varies by industry
  • depends on the relative stability of cash flows
88
Q

what is credit rating

A
  • an opinion of an entity’s creditworthiness,
    captured in alpha-numeric scales
  • creditworthiness: ability to meet financial commitments as they come due
89
Q

what do credit ratings do

A
  • predict loan default
  • as the letters (ratings) get “bigger”, there is higher default risk
89
Q

what are the importance of credit ratings

A
  • they affect cost of debt; higher rating = lower chance of default = higher chance of repaying = lower interest
  • affect investment decisions; investors dont want to or cant invest in noninvestment grade bonds
89
Q

what do credit analysts at credit rating agencies do

A
  • Consider macroeconomic, industry, and firm-specific information
  • Assess chance of default and ultimate payment in the event of default
  • Provide ratings on both debt issues and issuers
  • Predict loan default with fair degree of accuracy
89
Q

what is interaction with issuer

A

analytical team and issuer or agent of the issuer conduct discussions

89
Q

what do rating agencies have access to

A

information other lenders dont have

89
Q

what is moody’s credit rating process

A
  1. rating application
  2. analytical team assigned
  3. collection of information
  4. interaction with issuer
  5. analysis
  6. rating committee
  7. rating notification
  8. rating dissemination
  9. surveillance
89
Q

what is collection of information

A

lead analyst assembles relevant information from available sources

89
Q

what is analytical team assigned

A

issuer is assigned lead analyst

89
Q

what is rating application

A

issuer requests and signs rating application

89
Q

what is rating committee

A

rating committee convenes to consider credit rating recommendation

89
Q

what is surveillance

A

monitor the credit rating on an ongoing basis if appropriate

90
Q

what is analysis

A

analysts review and evaluate relevant information and apply appropriate credit rating methodology

90
Q

what is rating notification

A

issuer is notified of the rating committee decision

90
Q

what is rating dissemination

A

credit ratings are communicated to the general public for public ratings

90
Q

whats the general approach for rating with S&P

A
  • determine the business risk profile and financial risk profile to get the anchor rating
  • then make adjustments to it with the modifiers
  • then compare with peers to get the comparable ratings analysis
  • then you get the stand alone credit profile
  • adjust with the group or government influence
  • then you get the issuer credit rating
90
Q

what do you look at for business risk

A
  • country risk
  • industry risk
  • competitive position
  • profitability/peer group comparisons
90
Q

what is the rating of issuers vs rating of issue

A
  • The issuer’s credit rating addresses the issuer’s overall creditworthiness and usually applies to senior unsecured debt
  • Issue rating refers to specific financial obligations and considers ranking in the capital structure such as secured or
    subordinated
  • However, cross-default provisions, which refer to events of default such as nonpayment of interest on one bond triggering default on all outstanding debt, may often suggest the same default probability for all issues
90
Q

what is the credit rating agency reform act

A
  • made into law in 2006
  • since companies pay credit rating agencies, there is conflict of interest, and bribery
  • there was also a lock of competition of the rating agencies
  • the act established a registration system for credit rating agencies
  • there is improved transparency like a mandate disclosure of rating methodologies, performance track records, and conflict of interest
  • they created a list of NRSRO where u need at least 3 years of experience before registering
  • out of almost 100 agencies, only about 9 are NRSRO
90
Q

how accurate is the z-scores

A
  • accurate up to 2 years
  • 95% accuracy for year 1
  • 72% accuracy for year 2
90
Q

what should the altman’s z score be used with

A
  • caution
  • use with other indicators of credit quality
90
Q

what do you look at in financial risk

A
  • accounting
  • financial governance and policies/risk tolerance
  • cash flow adequacy
  • capital structure/asset protection
  • liquidity/short-term factors
90
Q

what is bankruptcy prediction indicators

A

used to assess a company’s bankruptcy risk at a point of time

90
Q

what is the rating of issuers vs rating of issue

A
  • the issuer’s credit rating addresses the issuer’s overall creditworthiness and is usually for senior unsecured debt
  • issue rating is the specific financial obligations and considers ranking in capital structure like secured or subordinated
  • but there are cross-default provisions, where when you don’t pay interest on one bond = defaulting on all outstanding debt
  • because of this, the risk should be the same default probability for all issues
91
Q

what does it mean when the z-score is greater than 3.00

A

company is healthy and low bankruptcy potential in the short term

92
Q

what does it mean when the z score is between 1.80 and 2.99

A
  • gray area
  • exposed to some risk of bankruptcy, caution is advised
93
Q

what does it mean when the z score is less than 1.80

A

in financial distress and there is a high bankruptcy potential in the short term

94
Q

when calculating altman z score, should we use average amount of year end amount for market value of equity? how about other balance sheet items?

A

should use year end value for all

AFM 212 (7 decks)

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