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Basics of Credit Analysis

Alexandru Cebotari

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Sources and Types of Risks

Source Type or Nature

International Exchange Rate Changes

Host Government Regulations

Political Unrest

Expropriation of Assets

Domestic Recession

Inflation or Deflation

Interest Rate Changes

Demographic Changes

Political Changes

Industry Technology

Competition

Availability of Raw Materials and Labor

Unionization

Firm-Specific Management Competence

Strategic Direction

Lawsuits

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A firm should continually monitor each of these and other

type of risks

A loan officers task is to understand how a firm monitors its

risks

Analysis of the financial consequences of these elements of

risk using financial statements is an important tool

Various financial reporting standards require firms to discuss

in notes to financial statements how important elements of risk

affect a particular firm and the actions it takes to manage its

risks

In addition to using information about risk disclosed in the

notes to financial statements, loan officers typically assess the

dimensions of risk using ratios of various items in the financial

statements

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Profitability, Growth, Risk

Product-Market Strategies Financial-Market Strategies

OperatingDecisions

Investment and

AssetManagement

Decisions

FinancingDecisions

DividendDecisions

Managing

Revenue &

Expenses

Managing

Working Capital

& Fixed Assets

Managing

Liabilities and

Equity

Managing

Dividend Payout

Profit Margin

Ratios

Efficiency

Ratios

Capital

Structure RatiosPayout Ratios

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Most financial statement-based risk analysis focuses on a

comparison of the supply of cash and demand for cash

Risk analysis using financial statement data typically examines

(1) short-term liquidity risk, the near term ability to

generate cash to service working capital needs and debt service

requirements, and

(2) long-term solvency risk, the longer-term ability togenerate cash internally or from external sources to satisfy plant

capacity and debt repayment needs

The field of finance identifies two types of risks:

(1) credit risk, a firms ability to make payments oninterest and principle payments, and

(2) bankruptcy risk, the likelihood that a firm will be

liquidated

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Framework for Financial Statement Analysis of

Risk

ActivityAbility to

Generate Cash

Need to Use

Cash

Financial Statement

Analysis Performed

Operations

Profitability of

Goods and

Services Sold

Working CapitalRequirements

Short-Term LiquidityRisk

Investing

Sales of Existing

Plant Assets or

Investments

Plant Capacity

Requirements

Long-Term SolvencyRisk

FinancingBorrowing

Capacity

Debt Service

Requirements

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Analysis of Short-Term Liquidity Risk

The analysis of short-term liquidity risk requires an understanding ofthe operating cycle of a firm!

Current Ratio: mainly used to give an idea about the companysability to pay back its short-term liabilities and a sense of theefficiency of the firms operating cycle and its ability to turn itsproducts into cash (ratio 1.0 preferred)

Quick Ratio: known as acid test, measures the firms ability to payoff its short-term debt from current liquid assets; draws a morerealistic picture (trend towards 0.5)

Operating Cash Flow Ratio: using cash flow as opposed toaccounting items provides a better indication of liquidity

(40%ntypical of a healthy firm)

Short-term liquidity problems also arise from longer-term solvencydifficulties!

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Financial Ratio Formula Measurements

Current Ratio Current Assets / Current liabilities

A measure of short-term

liquidity. Indicates the

ability of entity to meet its

short-term debts from its

current assets

Quick RatioCurrent Assets less inventory / Current

liabilities

A more rigorous measure of

short-term liquidity.Indicates the ability of the

entity to meet unexpected

demands from liquid

current asses

Operating Cash Flow

Ratio

Cash Flows from Operations/Average

Current Liabilities

Measures a company's ability

to pay its short term

liabilities. Indicateswhether the company has

generated enough cash

over the year to pay off

short term liabilities as at

the year end

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Analysis of Long-Term Solvency Risk

Increasing the proportion of debt in the financial structureintensifies the risk that the firm cannot pay interest and repaythe principle on the amount borrowed

Analysis of long-term solvency risk must begin with ananalysis of short-term liquidity risk

Firms must survive in the short-term if they are to survive inthe long-term!

Interest Coverage Ratio: gives a sense of how far earningscan fall before a firm will start defaulting on its payments (riskyif 2.0)

Long-Term Debt to Long-Term Capital Ratio: way of lookingat the debt structure and determine what portion of totalcapitalization is comprised of long-term debt (what if 1?)

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Financial Ratio Formula Measurements

Debt ratio Total Liabilities / Total assets

Measures percentage of

assets provided bycreditors and extent of

using gearing

Capitalization ratio Total assets / Total shareholders equity

Measures percentage of

assets provided by

shareholders and the

extent of using gearing

Debt to Capital RatioTotal Debt/(Total Shareholders Equity +

Total Debt)

The debt-to-capital ratio gives

users an idea of a

company's financial

structure, or how it is

financing its operations,

along with some insight

into its financial strength.

Times interest earned

Operating profit before income tax +

Interest expense / Interest expense

+ Interest capitalized

Measures the ability of the

entity to meet its interest

payments out of current

profits.

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Models of Bankruptcy Prediction

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The six ratios with the best discriminating power (and the nature of therisk each ratio measures) were as follows:

Net Income plus Depreciation, Depletion, and Amortization/TotalLiabilities (long-term solvency risk)

Net Income/Total Assets (profitability)

Total Debt/total Assets (long-term solvency risk)

Net Working Capital/Total Assets (short-term liquidity risk)

Current Assets/Current Liabilities (short-term liquidity risk)

Cash, Marketable Securities, Accounts Receivable/OperatingExpenses excluding Depreciation, Depletion and Amortization(short-term liquidity risk)

Univariate Analysis

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MultivariateBankruptcy Prediction ModelsAltmans Z-Score:

AssetsTotal

Sales

sLiabilitieofValueBook

EquityofValueMarket

AssetsTotal

TaxesandInterestBeforeEarning

AssetsTotal

Earningstained

AssetsTotal

CapitalWorkingNetscoreZ

0.1

6.03.3

Re4.12.1

We can convert the Z-score into a probability of bankruptcy using the

normal density function within Excel. The formula is: =NORMSDIST(1-Z

score). Altman developed this model so that higher positive Z-scores mean

lower probability of bankruptcy.

The principle strengths of MDA are as follows:

It incorporates multiple financial ratios;

It provides the appropriate coefficients fro combining the independent

variables;

It is easy to apply once the initial model has been developed.

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Each ratio captures a different dimension of profitability or risk:

Met Working Capital/Total Assets: the proportion of total assets comprisingrelatively liquid net current assets (current assets minus current liabilities). It

is a measure of short-term liquidity risk.

Retained Earnings/Total Assets: accumulated profitability.

EBIT/Total Assets: this ratio measures current profitability.

Market Value of Equity/Book Value of Liabilities: this is a form of debt/equityratio, but it incorporates the markets assessment of the value of the firmsshareholders equity. This ratio measures long-term solvency risk and themarkets overall assessment of the profitability and risk of the firm.

Sales/Total Assets: this ratio is similar to the total assets turnover ratio andindicates the ability of a firm to use assets to generate sales.

In applying this model, Altman found that Z-scores of less than 1.81indicated a high probability of bankruptcy, while Z-scores higher than 3.00indicates a low probability of bankruptcy. Scores between 1.81 and 3.00were in the gray area.

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Logit Analysis

Probability of Bankruptcy of a Firm:

yep

1

1

y = -1.32 0.407*SIZE + 6.03*TLTA 1.43*WCTA + 0.0757*CLCA

2.37*NITA 1.83*FUTL + 0.285*INTWO 1.72*OENEG 0.521*CHIN,

SIZE = ln (Total Assets/GNP Deflator)

TLTA = Total Liabilities/Total Assets

WCTA = (CA-CL)/Total Assets

CLCA = Current Liabilities/Current Assets

NITA = Net Income/Total Assets

FUTL = Funds (Working Capital) from Operations/Total Liabilities

INTWO = one if Net Income (NI) was negative in the last two years and zero otherwise

OENEG = one if owners equity is negative and zero otherwise

CHIN = [NI (this year) NI (last year)]/[|NI (this year)| + |NI (last year)|]

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Earnings Manipulation

Beneish developed a probit model to identify the financial

characteristics of firms likely to engage in earnings

manipulation

)(*670.4

)(*327.0)(*172.0)(*115.0)(*892.0)(*404.0)(*528.0)(*920.0840.4

TATA

LVGISAIDEPISGIAQIGMIDSRIy

Probit converts y into a probability using standardized normaldistribution. The command NORMSDIST within Excel, when

applied to a particular value of y, converts it to the appropriate

probability value

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Beneishs eight factors and the rationale for their inclusion are as

follows:

Index Rationale

Days Sales in Receivables Index (DSRI) A large increase in accounts receivables as a

percentage of sales might indicate an

overstatement of accounts receivables and sales

to boost earnings

Gross Margin Index (GMI) Firms with weaker profitability a more likely to

engage in earnings manipulation

Asset Quality Index (AQI) An increase in the proportion indicates an

increased efforts to defer costs

Sales Growth Index (SGI) The need for low-cost external financing might

motivate sales manipulation

Depreciation Index (DEPI) Slowing of the rate of depreciation and thereby

increasing earnings

Selling and Administrative Expense Index (SAI) 1 indicates increased marketing expenditures

and expected increased sales

Leverage Index (LVGI) Increase in the proportion of debt might entail a

violation of debt covenants

Total Accruals to Total Assets (TATA) Indicates the volume of earnings resulting from

accruals instead of from cash flows

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Profitability Analysis

The analysis of profitability addresses two broad questions:

How much risk economic and strategic factors pose for the

operations of a firm, its profitability and long-term solvency ?

We use the Rate of Return on Assets (ROA) to answer thisquestion.

Can the firm generate the expected return on the capital

invested by the lenders and shareholders withoutcompromising the future of the firm? That is, how much of

ROA is left to shareholders (owners) after subtracting the

amounts owed to lenders.

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Rate of Return on Assets

AssetsTotalAverage

EarningsinInterestMinorityRateTaxExpenseInterestIncomeNetROA

)1(*

TurnoverAssetsROAforinMofitROA argPr

Sales

EarningsinInterestMinorityRateTaxExpenseInterestIncomeNet

ROAforinMofit

)1(*

argPr

AssetsTotalAverage

SalesTurnoverAsset

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Average Median ROA, Profit Margin for ROA, and Assets

Turnover for 23 industries for 1990 to 2004

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Economic Factors Affecting the Profit

Margin/Assets Turnover Mix

Area in

Exhibit

Capital

IntensityCompetition

Strategic

Focus

A High Monopoly

Profit

Margin

for ROA

B Medium Oligopoly Both

C LowPure

Competition

Assets

Turnover

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Profitability Ratios

Financial Ratio Formula Measurements

Return on Total Assets

Operating profit before income tax +

interest expense/ Average total

assets

Measures rate of return

earned through operating

total assets provided by

both creditors and owners

Return on ordinary

shareholders equity

Operating profit & extraordinary items

after income tax minus Preference

dividends / Average ordinary

shareholders equity

Measures rate of return

earned on assets provided

by owners

Gross Profit Margin Gross Profit / Net SalesProfitability of trading and

mark-up

Profit MarginOperating profit after income tax /

Net Sales Revenue

Measures net profitability of

each dollar of sales

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Total Assets Turnover

Financial Ratio Formula Measurements

Receivables turnoverNet sales revenue / Average receivables

balance

Measures the effectiveness of

collections; used to

evaluate whether

receivables balance is

excessive

Inventory turnoverCost of goods sold / Average inventory

balance

Indicates the liquidity of

inventory. Measures the

number of times inventory

was sold on the average

during the period

Total Asset turnover ratio Net sales revenue / Average total assets

Measures the effectiveness of

an entity in using its

assets during the period.

Turnover of Fixed Assets Net Sales / Fixed Assets

Measure the efficiency of the

usage of fixed assets in

generating sales

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Return on Common Shareholders Equity (ROCE)

Return on

AssetsReturn to

Creditors

Return toPreferred

Shareholders

Return toCommon

Shareholders

LeverageFinancialTurnoverAssetsROCEforinMofitROCE argPr

EquityrsShareholdeCommonAverage

rsShareholdeCommontoIncomeNetROCE

'

Sales

rsShareholdeCommontoIncomeNetROCEforinMofit argPr

AssetsTotalAverage

SalesTurnoverAssets

EquityrsShareholdeCommonAverage

AssetsTotalAverageLaverageFinancial

'