week 3 (mod 4) credit analysis Flashcards
what is credit analysis?
- process of evaluating the ability and willingness of a borrower (corp, gov, ind) to meet their financial obligations, typically in the form of loans or bonds
- involves a detailed assessment of the credit risk associated with lending money or extending credit to a borrower
what is the primary purpose of credit analysis
determine likelihood of a borrower to repay their debt on time and in full
what is credit risk?
the risk that a borrower will fail to meet their financial obligations as they come due, leading to a loss for lenders or investors
what is the demand and supply of credit analysis?
DEMAND
banks
bond investors
corporates (suppliers, customers)
individuals
SUPPLIER
internal corporate credit teams
bank’s in house credit analysis teams
credit rating agencies (s&p, moody’s, fitch)
fixed income research firms
consulting firms
what is demand for credit in terms of operating activities?
- companies have cyclical operating cash needs
- manufacturers need money for materials/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 between bankruptcy and cont. operations for a company
what is demand for credit in terms of investing activities?
- companies req large amnts of cash for investing activities (ex. purchase of property, plant and equipment or for corp acquisitions)
- new pp&e (capex)
- intangible assets
- mergers & acquisitions
- lbo - leverage buy out
what is demand for credit in terms of financing activities?
- comps occasionally need credit for financing activities
- bank loan/bond matures
- funds to repurchase stock
what is supply of credit in terms of trade credit?
- trade (supplier) credit is routine and non interest bearing
- suppliers’ credit terms specify:
- the amnt and timing of any early payment discounts
- the max credit limit
- payment terms
- other restrictions/specificatons
- 2/10 net 30 → buyer receives 2% discount if they pay the amount within 10 days, otherwise the payment is due within 30 days
what is supply of credit in terms of bank loans?
- banks structure financing to meet specific client needs
- revolving credit line (revolvers)
- cash available for seasonal shortfalls
- bank commits to a credit line max, balance repaid later in the year
- low fees on unused balance, high fees on used
- lines of credit (back up credit facilities)
- bank provides a guaranty that funds will be available when needed
- term loans (”bank loans”
- typically used to fund pp&e which serves as collateral
- loan duration matches useful life of pp&e
- mortgages
- typically used for real estate transactions
- lender takes property as security
what is supply of credit in terms of other forms of financing?
- lease financing
- leasing firms finance capex
- leasing comps are often publicly traded
- publicly traded debt
- cost efficient way to raise large amnts of funding
- regulated by the sec
- commercial paper - matures within 270 days
- bonds and debentures - longer term, trade on major exchanges
- rated for credit quality
what is the credit risk analysis process?
purpose: quantify potential credit losses so lending decisions are made with full information
what are the 2 factors that produce expected credit loss?
expected credit loss = chance of default * loss given default
chance of default - debtors ability to repay debt
loss given default - size of loss if debtor defaults
what is the chance of default?
- purpose: quantify the risk of loss from non payment
- depends on company’s ability to repay obligations and this depends on future cash flow and profitability
- steps:
- evaluate nature and purpose of the loan
- assess macroeconomic environment and industry conditions
- perform financial analysis
- perform prospective analysis
what are the more extensive steps of determining chance of default?
step 1: evaluate nature and purpose of the loan
must determine why the loan is necessary
nature and purpose of the loan affect its riskiness
possible loan uses:
- cyclical cash flow needs
- major capital expenditures or acquisitions
- fund temporary or ongoing operating losses
- reconfigure capital structure
step 2: assess macroeconomic env. and indus. conditions
industry competition - competition and rivalry raise cost of doing business
bargaining power of buyers - buyers with strong bp can extract price concessions
bargaining power of suppliers - suppliers with strong bp can demand higher prices
threat of substitution - as the # of substitutes increases, sellers have less power to raise prices and/or pass on costs to buyers
threat of entry - new market entrants increase competition and comps must develop new tech and human capital to create barriers to entry and economies of scale
step 3: analyze 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 not one “correct” way to calculate specific ratios
compute 3 classes of credit-risk ratios:
- profitability and coverage
- liquidity
- solvency/leverage
step 4: perform prospective analysis
to evaluate creditworthiness, creditors must forecast borrower’s cash flow to estimate ability to repay obligations
projected cash flows are esp critical because a comp must have sufficient cash in the future to:
1. repay debts as they mature
2. service those debts along the way
must first project (forecast) financial statements
then use forecasted numbers to compute future ratios (profitability, liquidity, solvency) and coverage ratios and evaluate changes/trends
what is the edf model?
- estimates probability of a firm defaulting within a specified time horizon, typically one year
- developed by moody’s, it’s widely used in credit risk assessment by large financial institutions
what are key components 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 + half of long term liabilities
- distance to default (dd): measure of how far the firm’s asset value is from default point
dd = (market value of firm’s asset - default point)/vloatility of firm’s asset value
what is the liquidity order in us bankruptcy
- admin costs (legal fees, court, trustee)
- secured creditors (with claims backed by coll)
- prioirty unsecured creditors (wages, benefits, taxes)
- unsecured creditros (bondholders, suppliers, customers)
- subordinated debt holders
- preferred shareholders
- common shareholders
what is loss given default (lgd)?
- the amount that could be lost if a comp defaulted on its obligations
- defaults: failure to make payments and violation of loan covenants
- potential loss depends on priority of the claim compared with all other existing claims
- comps must repay senior claims first
- us bankruptcy code specifies the priority of other claims
- to min potential loss, lenders structure credit terms including:
- credit limits
- collateral
- repayment terms
- covenants
what are credit limits?
- rep the max that a creditor will allow a customer to owe at any point in time
- limits are based on lender’s experience with similar borrowers and by firm specific analysis
- trade creditors
- 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
- banks
- set credit limits on revolving credit
- specify that if a borrower’s credit rating falls, credit limit may be reduced
- trade creditors
what si collateral
- property pledged by borrower to guanatee repayment, usually real estate
- limits amnt of loss but amounts owing in excess of fair vlaye of collateral will be lost
- in case of default, time and costs incurred to gain control of/liq coll can be substantial
what is term of loan
length of time creditor has to repay debt
- early payment discounts are often offered by trade creditors
- to assess lgd, consider whether econ life of asset matches/exceeds loan term
longer terms = greater chance of default = greater credit risk = higher cost of debt financing
what are covenants?
loan terms and conditions designed ot limite the loss given default
what are 3 common types of covenants
- positive/affirmative covenants:
- require borrower to take certain actions
- ex. submitting financial statements to the lender- negative/restrictive covenants:
- restrict borrower from taking certain actions
- ex. preventing mergers or other major investments, selling a certain asset
- negative/restrictive covenants:
- financial covenants
- maintain specific financial conditions
- ex. certain ratios and minimum equity
what is coverage analysis?
considers a comp’s ability to gen additional cash to cover principal and interest payments when due
why are they also referred to as “flow ratios”?
- consist of cash flow and income statement data
- ex. times interest earned, ebitda coverage, cash from operations to total debt, free operating cash flow to total debt
what is the times interest earned ratio?
times int earned = ebit/interest exp, gorss
- make sure it’s just interest expense, not net interest expense
- reflects operating income available to pay interest expense,
- make sure it’s just interest expense, not net interest expense
- assumes only interest must be paid bc the principal will be refinanced
- ratio of 2.5 and higher is good!, earns twice the amount of interest required to be paid
- anything below 1, comp isn’t generating enough income to cover interest (warning sign)
- can vary by industry more stable companies operate with a lower times interest earned, riskier comps have higher
what is coverage analysis?
comp’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.
what are examples of flow ratios?
Times interest earned
EBITDA coverage ratio
Cash from operations to total debt
Free operating cash flow to total debt
what is ebitda coverage ratio?
- is a non-gaap performance metric, (not based on accounting principles, alternative)
- more widely used than the times interest earned ratio because depreciatipn and amortization do not require a cash outflow
- always higher than times interest earned ratio
- measures company’s ability to pay interest out of current profits
- score of 3+ is good, indicates comp can pay 3 times more than the interest to pay
- below 1 is not a good score, cannot cover interest, 1-3 is grey zone, it’s okay but in the case of an emergency they will struggle
what is cash from operations to total debt
cash from operations to tot debt = cash from op / (short term debt + lt debt)
- EBITDA is a non-GAAP performance metric.
- Always higher than times interest earned ratio.
- measures ability to generate additional cash to cover debt payments as they come due
what is free operating cash flow to total debt
focf to td = (cash from op - capex)/(short term debt + lt debt)
- considers excess operating cash flow after cash is spent on capital expenditures
- provide reserve to keep equipment/pp&e maintained or to purchase new
- anything above 15% is good
- if a comp is investing a lot in their company, their ratio is gonna be lower
- greater flexibility and LOWER credit risk, appealing to creditors
what is liquidity?
cash availability - how much cash a comp has and how much it can gen on short notice
wwhat are 2 examples of liquidity ratios?
current ratio = current assets/curr liab
quick ratio = (cash + marketable securities + a/r)/curr liabilities
(quick ratio is just curr ratio but no inven)
- current ratio of 1.5-2 is generally healthy, but it really depends on comp and also industry
- quick ratio isn’t involving inventory, will be lower than current
- anything around 1.5 is good for most comps
- what is solvency?
- comp’s ability to meet its debt obligations
- crucial, an insolvent comp is a failed comp
what are 2 examples of solvency ratios?
liabilities to equity ratio = tot liab/stockholders’ equity
total debt to equity ratio = (lt debt including current port. + short term debt)/stockholders equity
- debt to equity ratio below 2 is good, 1-2 is generally acceptable
- the lower the better
how does solvency analysis work?
Solvency varies by industry and depends on the relative stability of cash flows.
what is a credit rating?
A credit rating is an opinion of an entity’s creditworthiness, captured in alpha-numeric scales.
investment grade
s&p -> BBB- to AAA
moody’s -> Baa3 to Aaa
fitch’s -> BBB- to AAA
what do credit analysts at rating agencies do?
Credit analysts at rating agencies:
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
what is moody’s rating process?
- rating application
- analytical team assigned
- collection of info
- interaction with issuer
- analysis
- rating committee
- rating notification
- rating dissemination
- surveillance
how does s&p evaluate financial risk?
core ratios - ffo/debt and debt/ebitda
supplementary ratios - cfo/debt, focf/debt, dcf/debt, (ffo + cash int paid)/ cash int paid, ebitda/int exp
profitability ratios - ebit/revenue, ebitda/revenues, ebit/avg cap
what is s&p’s credit rating methodology?
business risk:
- country risk
- indus risk
- competitive position
- profiyability/peer group comparisons
financial risk
- accunting
- fin governance and policies/risk tolerance
- cash flow adequacy
- capital structure/asset protectipon
- liquidity/short term factors
what is the difference between rating of issuers vs rating of issue
- issuers rating addresses issuer’s creditworthiness and usually appliers to senior unsecured debt
- issue rating referes to specific financial obligatons and considers ranking in capital structure (secured/subordinated)
what score on altman’s z score model indicates not likely to go bankrupt and likely to go banktrupt?
greater than 3, good
less than 1.8, bad
