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AFM 212 > Week 3 > Flashcards

Week 3 Flashcards

66 Cards

1
Q

What is credit analysis?

A

It’s the process of evaluating the ability and willingness of a borrower to meet their financial obligations.

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2
Q

What does a credit analysis include what type of assessment?

A

A credit analysis involves a detailed assessment of the credit risk associated with lending money or extending credit to a borrower.

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3
Q

What are some examples of some borrowers to meet their financial obligations?

A
  • Corporation
  • Government
  • Individual
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4
Q

What are some examples of financial obligations?

A
  • Loans
  • Bonds
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5
Q

What is the primary purpose of a credit analysis?

A

The primary purpose of a credit analysis is to determine the likelihood that a borrower will repay their debt on time and in full.

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6
Q

What is credit risk?

A

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

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7
Q

Who are the types of people that might demand credit analysis?

A

Banks

Bond investors

Corporates:

  • Suppliers
  • Customers

Individuals

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8
Q

Who are the people that supply credit analysis?

A

Internal corporate credit teams
Banks in house credit analysis teams
Credit rating agencies:

  • S&P
  • Moody’s
  • Fitch

Fixed income research firms
Consulting firms

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9
Q

What are some of the activities from a business that might demand for credit to help these activities ?

A

Operating activities
Investing activities
Financing activities

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10
Q

What does it mean for companies to have cyclical operating cash needs?

A

Companies, especially manufacturers or businesses with seasonal operations, have recurring needs for cash to manage operations.

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11
Q

What are some examples a company might need cyclical operating cash needs?

A
  • Manufacturers need cash for materials or labor
  • Advance seasonal purchases
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12
Q

What does it mean when we say ‘cash needed for operating activities is not uniformly “low risk”?

A

It means companies might need cash to cover any operating losses that might not be temporary.

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13
Q

Why do companies require large amounts for investing activities?

A
  • Purchase of PP&E (CAPEX) - capital expenditure
  • Corporate acquisitions
  • Intangible assets
  • Mergers & acquisitions
  • LBO-Leveraged buyout
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14
Q

What are examples on why a company may occasionally need credit for financing activities?

A
  • Bond loan
  • Bond matures
  • Funds to repurchase stock
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15
Q

What are three reasons why a company may want to supply credit?

A
  • Trade credit
  • Bank loans
  • Other forms of financing
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16
Q

What is trade (supplier) credit?

A

It’s where suppliers allow businesses to purchase goods or services now and pay later.

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17
Q

Is a trade credit routine a non-interest bearing?

A

Yes

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18
Q

What does the supplier’s credit terms specify?

A
  • The amount and timing of any early payment discount
  • The maximum credit limits
  • Payment terms
  • Other restrictions or specifications
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19
Q

What is 2/10 Net 30?

A

2/10: The buyer gets a 2% discount if the payment is made within 10 days.

Net 30: If the discount isn’t taken, the full amount is due within 30 days.

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20
Q

How does banks structure their bank loans?

A

They structure their bank loans based on the client’s needs

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21
Q

What are the different types of bank loans that banks might supply for clients?

A
  • Revolving credit line (revolvers)
  • Lines of credit (back-up credit facilities)
  • Term loans (bank loans)
    -Mortgages
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22
Q

What is a revolving credit line (revolvers)?

A

Purpose: Gives extra cash when your business needs it during slow periods.

How it works: The bank gives you a limit on how much you can borrow. You repay what you use later in the year.

Fees:
Low fees if you don’t use it much.
High fees if you borrow a lot.

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23
Q

What is line of credit? (back-up credit facilities)?

A

The bank promises to give you money if you need it.

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24
Q

What is term loans (bank loans)?

A

Purpose: Used to buy big things like equipment or buildings, which the bank can take if you don’t repay.

How it works: The loan lasts as long as the equipment or building is useful.

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25
Q

What is mortgages?

A

Purpose: Used to buy houses or buildings.

How it works: If you don’t repay, the bank can take the property.

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26
Q

What are some forms of financing?

A
  • Lease financing
  • Publicly traded debt
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27
Q

What is lease financing?

A

How it works: A lot of Leasing companies pay for big purchases (like equipment) for businesses. (capex)

Example: Many leasing companies are listed on the stock market (publicly traded).

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28
Q

What is publicly traded debt?

A

What it is: A cheaper way for companies to raise large amounts of money.

Regulation: Overseen by the SEC (Securities and Exchange Commission).

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29
Q

What are the different types of public debt there is?

A

Commercial Paper: Short-term debt that must be repaid within 270 days.

Bonds and Debentures: Long-term debt that can be bought and sold on major stock exchanges.

Credit Ratings: These debts are graded based on how safe they are for investors.

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30
Q

What is the purpose of a credit risk analysis?

A

Its to quantify potential credit losses so lending decisions are made with full information

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31
Q

How to compute expected credit loss?

A

Expected credit loss = chance of default * Loss given default?

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32
Q

What is chance of default

A

Its to quantify the risk of loss from non payment

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33
Q

What does the chance of default dependent on?

A

Its dependent on the company’s ability to repay its obligations:

  • This defends on cash flow
  • Profitability
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34
Q

How can we assess the chance of default? (4 steps)

A

Evaluate the nature and purpose of the loan

Assess macroeconomic environment
and industry conditions

Perform financial analysis

Perform prospective analysis

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35
Q

What does step 1 : Evaluate the nature and purpose of the loan mean?

A

First , must determine why the loan is necessary

Second, understand the nature and purpose of loan as it affects its riskiness

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36
Q

Give me some examples of 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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37
Q

What does it mean when we say to assess macroeconomic environment and industry conditions (step 2)?

A

Porter’s five forces:

Industry competition
Bargaining power of buyers
Bargaining power of suppliers
Threats of substitution
Threat of entry

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38
Q

What does it mean for step 3: Analyse financial ratios?

A

Financial ratios are key in a credit-risk analysis
There is no general agreement about the best set of ratios to use to assess credit risk.

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39
Q

What are the three classes of credit-risk ratios we compute under step 3 ?

A

Profitability and coverage

Liquidly

Solvency/Leverage

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40
Q

What does step 4 mean: Perform prospective analysis?

A
  1. The goal to perform a prospective analysis is to forecast the company’s future financial performance.
  2. This helps creditors determine whether the company will be able to repay its debts over time.
41
Q

Why should a company know its projected cash flows?

A

Projected cash flows are important for a company to know because a company must have sufficient cash in the future to:

  1. Repay debts as they mature
  2. Service those debts along the way
42
Q

What is the order in which a prospective analysis is done?

A
  1. Must first project (forecast financial statements)
  2. Then we can use forecasted numbers to compute future ratios (profitability, liquidity, and solvency) and coverage ratios and evaluate changes or trends.
43
Q

What is the EDF model?

A

Its a model that estimates the probability of a firm defaulting within a specified time horizon (typically one year)

44
Q

Who developed the EDF model?

A

It was developed by moody’s analytics

It is widely used in credit risk assessment by large financial institutions

45
Q

What are the key components of the EDF model?

A

Market value of assets (V)
Default point (D)
Distance to default (DD)

46
Q

What does market value of assets mean?

A
  1. This is the estimated value of the company’s assets, based on the market value of equity (like stock prices) and the book value of liabilities.
  2. It reflects how much the company’s assets are worth in the market.
47
Q

What does the default point mean?

A

This is the threshold where the company is considered likely to default. It occurs when the liabilities exceed the assets.

48
Q

What does distance to default (DD) mean?

A
  • It measures how far the firm’s asset value is from the default point.
  • A larger distance indicates a lower probability of default, while a smaller distance suggests the company is closer to default and therefore riskier.
49
Q

How cad we compute the distance to default?

A

DD = Market value of firm’s assets - default point/ volatility of the firm’s asset value

As DD increases, EDF decreases (lower probability of default).
As DD decreases, EDF increases (higher probability of default).
When dd = 0 the default is 50%

50
Q

What is the loss given default?

A

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

51
Q

What does loss given defaults include?

A

Failure to make payments

Violation of loan covenants

52
Q

What does the potential loss depend on?

A
  • It depends on priority of the claim compared with all other existing claims
  • Companies must repay senior claims first
  • US bankruptcy code specifies the priority of other claims
53
Q

What can lenders include in their structured terms to minimize potential losses?

A

Credit limits
Collateral
Repayment terms
Covenants

54
Q

What is the order of liquidity in the US bankruptcy?

A

Admin costs
Secured creditors
Priority unsecured creditors
Unsecured creditors
Subordinated debt holders
Preferred shareholders
Common shareholders

55
Q

What are credit limits?

A

A credit limit is the maximum amount a creditor will allow a customer to owe at any given time.

56
Q

What are credit limits based on?

A
  1. Lender’s experience with similar borrowers.
  2. Firm-specific analysis
57
Q

How do trade creditors set credit limits?

A

New customers: Get low credit limits.

Trusted customers: Get higher credit limits.

If a customer goes bankrupt: Goods shipped within 20 days before bankruptcy get paid first

58
Q

How does banks set their credit limits?

A

Revolving credit: Banks set limits on how much you can borrow.

If credit rating drops: The bank might reduce your credit limit

59
Q

What does collateal mean?

A

Collateral = Property (like a house or land) promised by the borrower to the lender to make sure they repay the loan.

60
Q

What if multiple people have claims on the collateral?

A

Multiple Claims: If other people (like other lenders) already have claims on the property (called liens), the value of the collateral is reduced.

61
Q

What does bankruptcy law states about when a business went bankruptcy?

A

Bankruptcy Law: If a business goes bankrupt, suppliers can take back goods shipped in the 45 days before bankruptcy if they haven’t been paid.

62
Q

What are repayment terms?

A

Loan Term: The amount of time the borrower has to pay back the loan.

Early Payment Discounts: Trade creditors (like suppliers) often give discounts if the borrower pays early.

Matching Loan and Asset Life: When checking Loss Given Default (LGD), it’s important to see if the asset being bought will last as long as or longer than the loan period

63
Q

What does collateral mean?

A

Covenants: Rules in a loan agreement to reduce the lender’s risk if the borrower cannot pay.

64
Q

What are the three types of covenants?

A
  • Positive (affirmative) covenants
  • negative (restrictive) covenants
  • financial covenants
65
Q

What does analysts must do while adjusting financial information:

A

Analysts carefully review past and current financial reports to make sure they correctly show the company’s financial health and performance.

66
Q

What do we have to understand when financial reports are prepared using GAAP rules?

A

Financial reports prepared using GAAP rules don’t always give the most accurate picture of a company’s true financial condition or performance.

67
Q

What do we have to do before starting the analysis?

A

analysts adjust the financial reports to reflect a more accurate view.

68
Q

What is an adjustment that we would make (in terms of weeks)?

A
  • Some retailers have a 53rd week every 4-5 years
  • We have to adjust the affected income statement numbers:
  • Adjust cost of sales and SG&A by multiplying by 52/53

*We do not adjust anything other expenses

*Also adjust tax expense based on effective tax rates (Tax expense/pre tax income)

69
Q

What does the coverage analysis tell us?

A

It tells us the company’s ability to generate additional cash to cover principal and interest payments whe due

70
Q

What are the ratios that fall under the coverage analysis?

A

Flow ratios

71
Q

What are the coverage ratios?

A

TIE ratio
EBIDTA coverage ratio
Cash from operations to total debt
free operating cash flow to total debt

72
Q

What is the TIE Ratio?

A

Its the operating income available to pay interest expense

  • EBIT/ gross interest expense
73
Q

What is the second adjustment (adjusting financial statements)?

A
  • Credit Analysts fix or change financial reports to get a clearer picture before calculating ratios.
  • Moody’s makes changes to show the real financial situation of a company.
74
Q

What is the EBITDA coverage ratio?

A
  • It measures company’s ability to pay interest out of current profits
  • non-GAAP metric
  • higher than TIE ratio
75
Q

How to compute EBITDA ratio?

A

EBIT + depreciation + amortization / Gross interest expense

76
Q

What is cash from operations to total debt?

A
  • it measures the ability to generate additional cash to cover debt payments as they come due
  • Cash from operations/ (short-term debt + long-term debt)
77
Q

What is free operating cash flow to total debt?

A

This ratio focuses on the cash left over after paying for capital expenditures (CAPEX), which are investments in property, equipment, or infrastructure.

It shows how much of the company’s cash can be used for debt repayment after these necessary investments.

78
Q

How to compute free operating cash flow to total debt?

A

Cash from operations - capex / Short-term debt + Long- term debt

79
Q

What does liquidity ratio mean?

A
  • cash availability
  • How much it can generate on short notice
80
Q

What is current ratio?

A

current assets/current liabilities

81
Q

What is quick ratio?

A

Cash + marketable securities + accounts receivables / current liabilities

82
Q

What are solvency ratios?

A

Its the companys ability to meet debt obligations

83
Q

What are the two most common solvency ratios?

A

Liabilities to equity ratio
Total debt to equity

84
Q

What is the liabilities to equity ratio?

A

Its how reliant a company is on creditor financing with equity financing

85
Q
A
86
Q

How to compute the liabilities to equity ratio?

A

Total liabilities/ Stockholders equity

87
Q

What is total debt to equity?

A

It helps us distinguish between operating creditors and debt obligations

88
Q

How to compute the liabilities to equity ratio?

A

Long term debt including current portion + short term debt / stockholders equity

89
Q

How does solvency vary?

A

It varies based on industry and it’s also dependent on the relative stability of cash flows

90
Q

What is a credit rating?

A

It’s an opinion of an entities creditworthiness
Its captured by alpha-numeric scales

91
Q

How is the credit rating separated?

A

Investment grade
Non-investment grade

92
Q

What does investment grade mean?

A

These are the higher-quality ratings (AAA to BBB-).

They indicate lower risk, meaning the entity is very likely to repay its debt.

Investors see these ratings as safe investments, with a low chance of default.

93
Q

What does non-investment grade mean?

A

These ratings (BB+ and lower) indicate higher risk of default.

While these investments can offer higher returns, they come with a greater chance that the borrower won’t meet its obligations.

94
Q

What do credit analysts do at rating agencies?

A

Consider macroeconomic, industry and firm-specific information

Assess chance of default and ultimate payment in the event of default

Provide rating on both debt issues and issuers

Predict loan default with fair degree of accuracy

95
Q

what is credit rating agency reform act?

A

Signed into law:

In 2006.
Purpose:

Sets up a registration system for credit rating agencies.
Separates rating work from other business activities (like consulting).

96
Q

What are bankruptcy prediction indicators?

A
  • assess a company’s bankruptcy risk at a point of time.
  • altman’s Z model used to predict bankruptcy risk

Accuracy:

95% accurate in predicting bankruptcy in the first year.
72% accurate in the second year.

97
Q

what are z-score ranges?

A

Z-Score Ranges:

Z > 3.0:
The company is healthy with low bankruptcy risk in the near term.

2.99 > Z > 1.80:
The company is in the gray zone – could face some financial trouble.
Caution is advised.

Z < 1.80:
The company is in financial distress and has a high risk of bankruptcy soon.

98
Q

how to compute z-score?

A

slideshow

AFM 212 (6 decks)

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