week 3 | market for credit & credit analysis Flashcards
what is the process of credit analysis & what does it involve
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
primary purpose of credit analysis
Primary purpose: to determine the likelihood that a borrower will repay their debt on time & in full
what is credit risk
Credit risk → risk that a borrower will fail to meet financial obligations as come due, leading to a loss for lenders/investors
3
supplier of credit
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
Demand for Credit: Operating Activities
- 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
Demand for Credit: Investing Activities
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)
Demand for Credit: Financing Activities
Companies occasionally need credit for financing activities
- A bank loan or bond matures
- Rolling loans
- Funds to repurchase stock
Supple of Credit: Trade Credit
- 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
Supple of Credit: Bank Loans
Bank structure financing to meet specific client needs
- Revolving credit line (revolvers)
- Line of credit (back-up credit facilities)
- Term loans (“bank loans”)
- Mortgages
Revolving credit line
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
Line of credit
Bank provides a guaranty that funds will be available when needed
Term loans
Fund PP&E (collateral)
Loan duration matches useful life of PP&E
Mortgage
Real estate transactions
Lender takes property as security
Supple of Credit: Other Forms of Financing
- lease financing
- publicly traded debt
lease financing
Leasing firms finance CAPEX
Leasing companies → publicly traded
publicly traded debt
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
Credit Risk Analysis Process
Purpose is to quantify potential credit losses so lending decisions are made with full info
expected credit loss is the product of which 2 factors?
change of default (debtor’s ability to repay debt) * loss given default (size of loss if debtor defaults)
what is the purpose of knowing the chance of default?
Purpose is to quantify the risk of loss from non-payment
what does chance of default depend on?
Chance of default depends on company’s ability to repay its obligations → depends on future cash flow & profitability
4 steps to determine chance of default
- evaluate the nature & purpose of the loan
- assess macroeconomic environment & industry conditions
- perform financial analysis
- perform prospective analysis
what is the EDF model & who was it developed by?
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
key components of EDF model
- 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
distance to default (dd) formula
dd = (market value of firms’ asset - default point) / volatility of firm’s asset value
Relationship b/w DD to Probability of Default (Expected Default Frequency) [reverse s shape curve]
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%
how does stock price decrease affect firms DD & EDF
Decrease market & asset value
Likelihood of default goes up
how does firm paying down long term debt using cash affect firms DD & EDF
Go down! No debt!
Market value of asset → go down
what is Loss Given Default (LGD)
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
what does default mean?
failure to make payments & violation of loan covenants
how to minimize potential loss (LGD factors)
Credit limits
Collateral
Repayment terms
Covenants
Summary of Liquidity Order in US Bankruptcy (in order)
- Administrative costs (legal fees, court costs, trustee fees)
- Secured creditors (w/ claims backed by collateral)
- Priority unsecured creditors (wages, benefits, & taxes)
- Unsecured creditors (bondholder, suppliers, customers etc)
- Subordinated debt holders
- Preferred shareholders
- Common shareholders
week-related financial information adjustment
- 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)
- Adjust sales & expense that vary proportionately w/ sales (COS & SG&A)
2 coverage ratios
times interest earned & ebitda coverage ratio
what is coverage analysis
Considers a company’s ability to generate additional cash to cover principal & interest payments when due
- Called “flow” ratios → consist of CF & IS data
times interest earned formula
earnings before interest & tax (EBIT) / interest expense, gross
EBITDA coverage formula
[earnings before interest & tax (EBIT) + depreciation + amortization] / interest expense, gross
define times interest earned
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
define EBITDA coverage
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
cash flow ratios
Cash from operations to total debt & Free operating CF to total debt
Cash from operations to total debt definition & formula
Measures the ability to generate addition cash to cover debt payments as come due
= cash from operations / (short term debt + long term debt)
Free OCF to total debt definition & formula
Considers excess operating cash flow after cash is spent on capital expenditures
= (cash from operations - CAPEX) / (short term debt + long term debt)
define liquidity ratio & list 2
Cash availability → how much cash a company has & how much it can generate on short notice
current ratio & quick ratio
current ratio formula
= current assets / current liabilities
quick ratio formula
= (cash + marketable securities + AR) / current liabilities
define solvency ratio & list 2
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
liabilities-to-equity definition & formula
= total liabilities / stockholders’ equity
how reliant a company is on creditor financing compared w/ equity financing
total debt to equity definition & formula
= (long term debt including current portion + short term debt) / stockholders’ equity
distinguishes b/w operating creditors & debt obligations
what does credit rating analysts at agencies consider?
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
S&P credit rating methodology: business risk
Country risk
Industry risk
Competitive position
Profitability/Peer group comparisons
S&P credit rating methodology: financial risk
Accounting
Financial governance & policies/risk tolerance
Cash flow adequacy
Capital structure/asset protection
Liquidity/short-term factors
Credit Rating Agency Reform Act
- 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
Rating of Issuers vs Rating of Issue
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
Bankruptcy Prediction Indicators
Assess a company’s bankruptcy risk at a point of time
Altman’s Z Model used to predict bankruptcy risk
Z-Score Interpretation
Shown to reasonably predict bankruptcy accurately for up to 2 years
95% accuracy in Year 1
72% accuracy in Year 2
