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afm 212 > week 3 | market for credit & credit analysis > Flashcards

week 3 | market for credit & credit analysis Flashcards

1
Q

what is the process of credit analysis & what does it involve

A

Process of evaluating the ability & willingness of a borrower (corporation, gov’t, individual) to meet their financial obligations, typically in the form of loans or bonds

Involves detailed assessment of the credit risk associated w/ lending money or extending credit to a borrower

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2
Q

primary purpose of credit analysis

A

Primary purpose: to determine the likelihood that a borrower will repay their debt on time & in full

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3
Q

what is credit risk

A

Credit risk → risk that a borrower will fail to meet financial obligations as come due, leading to a loss for lenders/investors

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4
Q

3

A
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5
Q

supplier of credit

A

Internal corporate credit terms
Bank’s in-house credit analysis teams
Credit rating agencies
- S&P
- Moody’s
- Fitch
Fixed-income research firms
Consulting firms

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6
Q

Demand for Credit: Operating Activities

A
  • Companies have cyclical operating cash needs
    • Manufactures need cash for materials or labour
    • Advance seasonal purchases
  • Cash needed for operating activities is not uniformly “low risk”
    • Cash needed to cover operating losses might not be temporary
  • A willing lender could make the difference b/w bankruptcy & continued operations for a company
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7
Q

Demand for Credit: Investing Activities

A

Companies require large amounts of cash for investing activities → purchase of property, plant & equipment or for corporate acquisitions
- New PP&E (CAPEX)
- Intangible assets
- Mergers & acquisition
- LBO (Leverage buyout)

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8
Q

Demand for Credit: Financing Activities

A

Companies occasionally need credit for financing activities
- A bank loan or bond matures
- Rolling loans
- Funds to repurchase stock

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9
Q

Supple of Credit: Trade Credit

A
  • Trade (supplier) credit is routine & non-interest bearing
  • Suppliers’ credit terms specify
    • Amount & timing of any early payment discounts
    • Maximum credit limit
    • Payment terms
    • Other restrictions or specifications
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10
Q

Supple of Credit: Bank Loans

A

Bank structure financing to meet specific client needs
- Revolving credit line (revolvers)
- Line of credit (back-up credit facilities)
- Term loans (“bank loans”)
- Mortgages

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11
Q

Revolving credit line

A

Cash available for seasonal shortfalls
Bank commits to a credit line maximum, balance repaid later in the year
Low fees on unused balance, high fees on used balance

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12
Q

Line of credit

A

Bank provides a guaranty that funds will be available when needed

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13
Q

Term loans

A

Fund PP&E (collateral)
Loan duration matches useful life of PP&E

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14
Q

Mortgage

A

Real estate transactions
Lender takes property as security

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15
Q

Supple of Credit: Other Forms of Financing

A
  • lease financing
  • publicly traded debt
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16
Q

lease financing

A

Leasing firms finance CAPEX
Leasing companies → publicly traded

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17
Q

publicly traded debt

A

Cost efficient way to raise large amounts of funding
Regulated by SEC
Commercial paper → matures w/in 270 days
Bonds & Debentures → longer terms, trade on major exchanges
Rated for credit quality

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18
Q

Credit Risk Analysis Process

A

Purpose is to quantify potential credit losses so lending decisions are made with full info

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19
Q

expected credit loss is the product of which 2 factors?

A

change of default (debtor’s ability to repay debt) * loss given default (size of loss if debtor defaults)

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20
Q

what is the purpose of knowing the chance of default?

A

Purpose is to quantify the risk of loss from non-payment

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21
Q

what does chance of default depend on?

A

Chance of default depends on company’s ability to repay its obligations → depends on future cash flow & profitability

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22
Q

4 steps to determine chance of default

A
  1. evaluate the nature & purpose of the loan
  2. assess macroeconomic environment & industry conditions
  3. perform financial analysis
  4. perform prospective analysis
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23
Q

what is the EDF model & who was it developed by?

A

Expected Default Frequency Model
- Estimates the profitability of a firm defaulting within a specified time horizon (~ one year)
- Developed by Moody’s Analytics → widely used in credit risk assessment by large financial institutions

24
Q

key components of EDF model

A
  • Market Value of Assets (V): estimated using the market value of equity & book value of liabilities
  • Default Point (D): threshold where liabilities > assets (calculated as short-term + half of long-term liabilities)
  • Distance to Default (DD): measure of how far the firm’s asset value is from the default point
25
Q

distance to default (dd) formula

A

dd = (market value of firms’ asset - default point) / volatility of firm’s asset value

26
Q

Relationship b/w DD to Probability of Default (Expected Default Frequency) [reverse s shape curve]

A

AA higher DD (right side) corresponds to a lower EDF probability → lower likelihood of default
A lower DD (left side) corresponds to a higher EDF probability → higher likelihood of default
When DD = 0 → probability of default is 50%

27
Q

how does stock price decrease affect firms DD & EDF

A

Decrease market & asset value
Likelihood of default goes up

28
Q

how does firm paying down long term debt using cash affect firms DD & EDF

A

Go down! No debt!
Market value of asset → go down

29
Q

what is Loss Given Default (LGD)

A

The amount that could be lost if the company defaulted on its obligations
- Potential loss 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

30
Q

what does default mean?

A

failure to make payments & violation of loan covenants

31
Q

how to minimize potential loss (LGD factors)

A

Credit limits
Collateral
Repayment terms
Covenants

32
Q

Summary of Liquidity Order in US Bankruptcy (in order)

A
  1. Administrative costs (legal fees, court costs, trustee fees)
  2. Secured creditors (w/ claims backed by collateral)
  3. Priority unsecured creditors (wages, benefits, & taxes)
  4. Unsecured creditors (bondholder, suppliers, customers etc)
  5. Subordinated debt holders
  6. Preferred shareholders
  7. Common shareholders
33
Q

week-related financial information adjustment

A
  • Retailers typically have a 53rd week every 4-5 years
  • Must make all affected IS numbers
    • Adjust sales & expense that vary proportionately w/ sales (COS & SG&A)
      • Multiply by 52/53
    • Do not adjust other expenses measured annually (interest, depreciation, & gains/losses)
    • Adjust tax expense proportionately based on effective tax rates (tax expense/pre-tax income)
34
Q

2 coverage ratios

A

times interest earned & ebitda coverage ratio

34
Q

what is coverage analysis

A

Considers a company’s ability to generate additional cash to cover principal & interest payments when due
- Called “flow” ratios → consist of CF & IS data

34
Q

times interest earned formula

A

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

35
Q

EBITDA coverage formula

A

[earnings before interest & tax (EBIT) + depreciation + amortization] / interest expense, gross

35
Q

define times interest earned

A

Reflects the operating income available to pay interest expense
Assumes only interest must be paid → principal will be refinanced
How many times the company can cover its interest expense

36
Q

define EBITDA coverage

A

Measures company’s ability to pay interest out of current profits
Non-GAAP performance metric
More widely used than TIE → depreciation & amortization doesn’t require cash outflow
Always higher than TIE

37
Q

cash flow ratios

A

Cash from operations to total debt & Free operating CF to total debt

38
Q

Cash from operations to total debt definition & formula

A

Measures the ability to generate addition cash to cover debt payments as come due

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

39
Q

Free OCF to total debt definition & formula

A

Considers excess operating cash flow after cash is spent on capital expenditures

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

40
Q

define liquidity ratio & list 2

A

Cash availability → how much cash a company has & how much it can generate on short notice

current ratio & quick ratio

41
Q

current ratio formula

A

= current assets / current liabilities

42
Q

quick ratio formula

A

= (cash + marketable securities + AR) / current liabilities

43
Q

define solvency ratio & list 2

A

Company’s ability to meet its debt obligations
Solvency is crucial → an insolvent company is a failed company

liabilities-to-equity ratio & total debt to equity

44
Q

liabilities-to-equity definition & formula

A

= total liabilities / stockholders’ equity

how reliant a company is on creditor financing compared w/ equity financing

45
Q

total debt to equity definition & formula

A

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

distinguishes b/w operating creditors & debt obligations

46
Q

what does credit rating analysts at agencies consider?

A

Consider macroeconomic, industry, & firm-specific information
Assess chance of default & ultimate payment in the event of default
Provide ratings on both debt issues & issuers
Predict loan default w/ fair degree of accuracy

47
Q

S&P credit rating methodology: business risk

A

Country risk
Industry risk
Competitive position
Profitability/Peer group comparisons

48
Q

S&P credit rating methodology: financial risk

A

Accounting
Financial governance & policies/risk tolerance
Cash flow adequacy
Capital structure/asset protection
Liquidity/short-term factors

49
Q

Credit Rating Agency Reform Act

A
  • Signed into law in 2006
  • Establishes a registration system for credit rating agencies
  • Separation of rating activities from other business activities (consulting)
  • Improved transparency → mandate disclosure of rating methodologies, performance track records & conflict of interest
  • Created list of Nationally Recognized Statistical Ratings Organizations (NRSRO)
  • SEC has designated only 9 of nearly 100 agencies as NRSROs
50
Q

Rating of Issuers vs Rating of Issue

A

The issuer’s credit rating addresses the issuer’s overall creditworthiness & usually applies to senior unsecured debt

Issue rating refers to specific financial obligations & considers ranking in the capital structure (secured or subordinated)

However, cross-default provisions → refers to events of default → non-payment of interest on one bond triggering default on all outstanding debt, may often suggest the same default probability for all issues

51
Q

Bankruptcy Prediction Indicators

A

Assess a company’s bankruptcy risk at a point of time
Altman’s Z Model used to predict bankruptcy risk

52
Q

Z-Score Interpretation

A

Shown to reasonably predict bankruptcy accurately for up to 2 years
95% accuracy in Year 1
72% accuracy in Year 2

53
Q
A

afm 212 (6 decks)

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