Week 3 - Credit Analysis Flashcards
What is credit analysis
Credit analysis is the process of evaluating the ability and willingness of a
borrower, such as a corporation, government, or individual, to meet their
financial obligations, typically in the form of loans or bonds. It involves a detailed
assessment of the credit risk associated with lending money or extending credit to
a borrower
Who demands credit analysis
Banks, bond investors, corporates (suppliers and customers), individuals
who supplies credit analysis
internal corporate credit terms, bank’s in house credit analysis, credit rating agencies (S&P, Moody’s, Fitch), fixed income research firms, consulting firms
Demand for credit operating activities
- companies need money for cyclical cash needs
- cash for operating activities is usually low risk
- a willing lender could make the difference between bankruptcy and continued operations
demand for credit: investing activities
Companies require large amounts of cash for investing activities such as the
purchase of property, plant and equipment or for corporate acquisitions
Demand for credit: financing activities
Companies occasionally need credit for financing activities
- bank loan or bond matures
- repurchase stock
supply of credit: trade credit
Trade credit is non-interest bearing and routine
specify: amount of early payment discounts, credit limit, payment terms, other specifications
Supply of credit: bank loans
Revolving credit line (revolvers)
- cash for seasonal shortfalls
- bank commits to a credit line max to be repaid later
- low fees on unused balance, high fees on used balance
Lines of credit (back-up facilities)
- bank provides guaranty that the funds are available
Term Loans (bank loans)
- usually to fund PPE which is collateral
- loan duration matches useful life of PPE
Mortgages
- typically used for real estate
- lender takes property as security
Supply of Credit: other forms of financing
lease financing
- finance CAPEX
- often publicly traded
Publicly traded debt
- cost efficient to raise large amounts of funding
- registered by SEC
- rated for credit quality
1. commercial paper - matures within 270 days
2. bonds and debentures - longer term, trade on exchanges
how to calculate expected credit loss
= chance of default * loss given default
what is chance of default
Chance of default depends on the company’s ability to repay
its obligations and this depends on future cash flow and
profitability.
what are the 4 steps to evaluate the chance of default
- evaluate nature and purpose (cyclical cash flow, CAPEX, fund operating losses, etc.)
- assess macroeconomic enironment (industry competition, barganing power of buyers, bargaining power of suppliers, threat of substitution, threat of entry)
- analyze financial ratios
- perform prospective analysis (forecast financial statements and compute future ratios, assess ability to repay debt)
what is EDF model?
Expected Default Frequency
The EDF model estimates the probability of a firm defaulting within a specified
time horizon, typically one year.
what are the key concepts of the EDF model
Market Value of Assets (V): Estimated using the market value of equity and
book value of liabilities.
Default Point (D): Threshold where liabilities exceed assets, typically
calculated as short-term liabilities plus half of long-term liabilities.
Distance to Default (DD): Measure of how far the firm’s asset value is from the default point.
= (market value of asset - default point) / volatility of asset value
What is the relationship between the distance to default and probability of default (EDF)
high DD = lower EDF = less likely to default
lower DD = higher EDF = higher likelihood of default
DD = 0 = probability of default is 50%
What is Loss Given Default (LGD)
the amount that could be lost if the company defaulted on its obligations
how do you minimize loss given default
structure credit terms:
- credit limits: max amount to owe at a time
- collateral: property pledged to guarantee repayment
- repayment terms: length of time offered and any early payment discounts
- covenants: conditions that must be met
Bankruptcy liquidity order
- administrative costs
- secured creditors
- priority unsecured creditors
- unsecured creditors
- subordinated debt holders
- preferred shareholders
- common shareholders
what are the types of covenants
Positive/Affirmative covenants: Those that require the borrower to take certain actions, such as submitting financial statements to the lender.
Negative/Restrictive Covenants: Those that restrict the borrower from taking certain actions, such as preventing mergers or other major
investments.
Financial Covenants: Those requiring the borrower maintain specific financial conditions, including certain ratios and minimum equity.
How do you adjust for a 53rd week
multiply expenses by 52/53
note: don’t adjust for annual expenses (depreciation, interest, gains or losses)
tax is adjusted by:
tax expense / pretax income
what is coverage analysis and what are the coverage ratios
Considers a company’s ability to generate additional cash to
cover principal and interest payments when due
ratios:
- times to interest earned
- EBITDA coverage
- cash form operations to total debt
- free operating cash flow to total debt
Times Interest Earned Ratio
= EBIT / gross interest expense
Reflects the operating income available to pay interest expense
EBITDA coverage ratio
= (EBIT + Depreciation + Amortization) / gross interest expense
Always higher than times interest earned ratio
cash from operations to total debt
= cash from operations / (short term debt + long term debt)
free operating cash flow to total debt
= (cash from operations - CAPEX) / (short term debt + long term debt)
what are liquidity ratios
Liquidity refers to cash availability―how much cash a
company has, and how much it can generate on short notice
ratios:
- current ratio
- quick ratio
current ratio
= current assets / current liabilities
quick ratio
= (cash + marketable securities + AR) / current liabilities
what are solvency ratios
Solvency refers to a company’s ability to meet its debt
obligations
Solvency varies by industry and depends on the relative
stability of cash flows
ratios:
- liabilities to equity
- total debt to equity
liabilities to equity ratio
= total liabilities / stockholder’s equity
total debt to equity
= (long term + short term debt) / stockholder’s equity
What is Moody’s 9 step approach to credit ratings
- rating application
- analytical team assigned
- collection of information
- interaction with issuer
- analysis
- rating committee
- rating notifications
- rating dissemination
- surveillance
what are the core ratios in S&P global ratings
FFO/ debt
debt/EBITDA
what are the supplementary ratios in S&P global ratings
= CFO/debt
=FDCF/debt
=DCF/debt
=(FFO + cash interest paid)/cash interest paid
=EBITDA/interest expense
what are the profitability ratios of S&P global ratings
=EBIT/revenues
=EBITDA/revenues
=EBIT/average capital
what is the credit rating agency reform act
- establishes a registration system for credit rating agencies
- separation of rating activities from other business activities (ex. consulting)
- improved transparency (such as disclosure, performance track records, and conflict of interest)
- created Nationally Recognized Statistical Ratings Organization (NRSRO)
rating of issuers vs rating of issue
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.
what is the Z-model used for
to predict bankruptcy risk
Z-score interpretation
Z-score > 3 : healthy
2.99 > Z-score > 1.8 : grey area caution
Z-score < 1.8 : financial distress
