CHAPMAN UNIVERSITY Argyros School of Business and Economics
CREDIT RISK ANALYSIS &
INTERPRETATION
MODULE 4
Questions
How would you decide if you would
lend to a company or not?
How would you determine if they were
well positioned to pay you back?
How would you protect yourself as the
lender?
Course Roadmap
Module Topic Focus Exam
1 Framework for Analysis and Valuation ANALYSIS:
Understanding and Evaluating
Financial Statements:
Helps us answer:
1. Where does the firm
operate?
2. Where is the firm currently?
MID-TERM #1
2 Overview of Business Activities and Financial Statements
3 Profitability Analysis and Interpretation
4 Credit Risk Analysis and Interpretation
5 Revenue Recognition and Operating Income MID-TERM #2
6 Asset Recognition and Operating Assets
7 Liability Recognition and Non-Owner Financing
8 Equity Recognition and Owner Financing
11 Forecasting Financial Statements VALUATION:
Building Forecasting Models and
Determining Value:
Helps us answer:
1. Where is the firm going?
2. What is the firm worth?
FINAL EXAM
12 Cost of Capital and Valuation Basics
13 Cash Flow Based Valuation
14 Operating Income Based Valuation
15 Market Based Valuation
I. Market for Credit
Composed of
Demand for credit
By most companies for operating, investing, and
financing activities
Supply of credit
Offered by
Creditors, banks, public debt investors, private
lenders
Maximum return of a debt investor is
determined by the interest rate set in the loan
Maximum return of a debt investor is
determined by the interest rate set in the loan
and the prevailing market rate of interest.
Trade Credit
■ Routine credit from suppliers
■ Most often non-interest bearing
■ Suppliers often tailor contractual terms to particular customer’s existing and ongoing creditworthiness
■ Credit limit assigned
Bank Loans
■ Structured to meet specific client needs ■ Balanced with myriad of rules and regulations by bank regulators
■ Revolving credit line ■ Available on demand ■ Floating interest rate
■ Lines of credit ■ Available credit to be used as needed
■ Letters of credit ■ Financing feature where a bank is interposed between two parties
■ Term loans ■ Usually set in borrowing amount (principal) with periodic payments ■ Usually based on market interest rates that are set for the duration of the borrowing
■ Mortgages ■ Debt instruments based on collateral, typically, real estate holdings
Nonbank Private Financing
■ Private (nonbank) sources of financing
■ Used when bank financing is limited or unavailable
■ Usually results from private lenders such as private equity firms that have experience in an industry
Lease Financing
■ Typically used for the acquisition of capital equipment
■ Typical items
■ Machinery
■ Computer equipment
■ Vehicles
■ Leasing firm structures lease
■ Considers collateral
■ Credit risk of the lessee
Publicly Traded Debt
■ Debt capital raised through public markets ■ Commercial paper
■ Short term borrowing facility under SEC
regulations which cannot exceed 270 days
■ Bonds or debentures
■ Public borrowings for longer durations regulated
by the SEC
■ Principal borrowed is paid back on a fixed term
with semi-annual or annual interest payments
II. Credit Analysis
■ Purpose is to quantify the risk of loss from non-payment
■ Involves several steps
Step 1: Assess nature and purpose of the
loan
Step 2: Assess macroeconomic environment and industry conditions
Step 3: Perform financial analysis
Step 4: Perform prospective analysis
Credit Analysis – Step 1
Step 1: Assess 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 flows needs
■ Fund temporary or ongoing operating losses
■ Major capital expenditures or acquisitions
■ Reconfigure capital structure
Credit Analysis – Step 2
Step 2: Assess macroeconomic environment and industry
conditions ■ Industry competition
■ Involves the company’s competitive position and the effect on its financial results
■ Buyer power
■ Can be a credit risk if customers have the ability to have stronger price concessions
■ Supplier power
■ A factor if suppliers have strong bargaining power and can demand higher prices
and early payments
■ Threat of substitution
■ Occurs when a company has limitations on products such as to inhibit price increases or pass costs to customers
■ Threat of entry
■ Occurs with new market entrants increase competition
■ Company could be subject to aggressive tactics where the new entrants try to win over clients
Credit Analysis – Step 3
Step 3: Perform financial analysis
■ Includes focusing on performing analysis of the financial statements
■ Adjustments to financial statements made to provide more accurate ratios and forecasts
■ Excludes one-time events that will not persist
■ Includes all operating assets and liabilities
■ Considers items that may distort operations
■ Considers items that surround profitability using return on net operating assets (RNOA)
■ Net operating profit margin (NOPM)
■ Net operating asset turnover (NOAT)
Profitability Analysis Example Home Depot’s net operating profit after taxes (NOPAT):
= $5,839 – [$1,935 + ($566 x 36.7%)] = $3,696
Interest expense Interest expense
plus other
non-operating
expenses
Statutory Statutory
tax rate
Operating Operating
income Tax
Tax
expense
Profitability Related To Credit Risk
■ Repayment of debt more likely when profit is higher
■ Helpful to examine return on equity and return on
debt plus equity
Coverage Analysis
■ Considers a company’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
■ Include four ratios
■ Times interest earned
■ EBITDA coverage ratio
■ Cash from operations to total debt
■ Free operating cash flow to total debt
Coverage Analysis
Times Interest Earned Ratio
■ Reflects the operating income available to pay interest expense
■ Assumes only interest must be paid because the principal will be refinanced
Earnings before interest and taxes Times interest
earned =
Interest expense
■ EBITDA is a non-GAAP performance metric
■ More widely used than the Times interest earned ratio because depreciation does not require a cash outflow
■ Always higher than times interest earned ratio
■ Measures company’s ability to pay interest out of current profits
Earnings before tax + Interest expense, net + Depreciation + Amortization
EBITDA coverage =
Interest expense
Coverage Analysis
EBITDA Coverage Ratio
Coverage Analysis
Cash from Operations to Total Debt
Measures a company’s ability to generate additional cash to cover debt payments as they come due.
Cash from operations Cash from
operations to
total debt
= Short-term debt + Long-term debt
Coverage Analysis
Free Operating Cash Flow to Total Debt
Considers excess operating cash flow after cash is spent on capital expenditures
Cash from operations - CAPEX Free operating
cash flow to
total debt
= Short-term debt + Long-term debt
Liquidity and Solvency Measures
Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice.
Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.
Current Ratio
■ Current assets are those assets that a company expects to convert into cash within the next operating cycle, which is typically a year.
■ Current liabilities are those liabilities that come due within the next year.
■ An excess of current assets over current liabilities (Current assets Current liabilities), is known as net working capital or simply working capital.
Quick Ratio
The quick ratio focuses on quick assets.
Quick assets include cash, marketable securities,
and accounts receivable; they exclude inventories
and prepaid assets.
Solvency Ratios
■ Solvency refers to a company’s ability to meet
its debt obligations.
■ Solvency is crucial since an insolvent company
is a failed company.
■ Two common solvency ratios:
Solvency Analysis
■ Assesses a company’s ability to meet its long-term obligations
■ Less costly source of financing
■ Carries default risk
■ General approach to solvency is to assess the level of debt relative to equity
Median Ratio of Median Ratio of
Liabilities to Equity
for Selected
Industries
Solvency Analysis
■ Conveys how reliant a company is on creditor financing compared with equity financing
■ Does not distinguish between current and long-term debt
Liabilities-to-equity ratio= Total liabilities
Stockholders’ equity
Solvency Analysis
Assumes that current operating liabilities will be repaid from current assets (self-liquidating)
Total debt-to-equity =
Long-term debt including current portion + Short-term debt
Stockholders’ equity
Perform Prospective Analysis – Step 4
Step 4: Forecast future results
■ Based on adjusted past performance
■ Should adjust the capital structure to reflect anticipated future debt retirements as they come due over the forecast horizon
■ Compute ratios based on the forecast
■ Evaluate changes and trends
■ Perform sensitivity analysis
III. Minimization of Potential Loss
Structure credit terms for loans in advance
Credit limits
Collateral
Repayment terms
Covenants
Trade-off exists between being too strict where the
terms cause the borrower to default, and not being
strict enough causing the borrower to default
Loss Given Default Factors
■ Take into consideration the maximum amount a company may be loaned at a point in time
■ Limits are set based on the lender’s experience with similar borrower, and by firm-specific analysis
■ Limits set by trade creditors
■ Low limits for new customers
■ Higher limits for established customers
Credit Credit
Limits
Loss Given Default Factors
■ Collateral is property pledged by the
borrower to guarantee repayment
■ Personal property, and
■ Real property, such as real estate
mortgages
■ Best collateral is high-grade property
such as securities with an active market
■ Value is known
■ Liquidation is straight-forward
Collateral Collateral
Loss Given Default Factors
■ Term of loan is the length of time the creditor has to repay the debt
■ Early payment discounts often offered
■ Influenced by the nature of loan
■ Ensures that the life of the asset matches or exceeds the amount of time allowed to pay back the debt
Longer
Longer
Terms
Higher Cost Higher Cost
of Debt
Financing
Greater
Credit Risk
Greater
Credit Risk
Greater
Chance of
Greater
Chance of
Default = = =
Repayment Repayment
Terms
Loss Given Default
■ Are terms and conditions of a loan designed to limit the loss given default
■ Three common types
■ Covenants that require the borrower to take certain actions, such as submitting financial statements to the lender
■ Covenants that restrict the borrower from taking certain actions, such as preventing mergers
■ Covenants that require the borrower to maintain specific financial conditions, including certain ratios and minimum equity
Covenants Covenants
IV. Credit Ratings
■ Are opinions of an entity’s credit worthiness
■ Capture the entity’s ability to meet its financial commitments as they come due
■ Credit analysts at rating agencies
■ Provide ratings on both debt issues and issuers
■ Consider macroeconomic, industry, and firm-specific information
■ Assess chance of default and ultimate payment in the event of default
Credit Ratings by Agencies
Long-term issue rating scales used by Standard and Poor’s and Moody’s Investor Services
Why Companies Care About
Their Credit Ratings ■ Credit ratings affect the cost of debt
■ Increases interest expense
■ May limit new investment projects
■ Can restrict growth
■ Certain investors will not invest in their debt if
considered non-investment grade
Risk increases the
cost of debt which is
linked directly to the
company’s credit rating
Treasury and Corporate
10-Year Bond Yields
Treasury and Corporate
10-Year Bond Yields
Credit Rating Models
■ Agencies have access to information not available to lenders
■ Models have three types of inputs
■ Macroeconomic statistics
■ Monitored by economists
■ Industry data
■ Through frameworks such as Porter’s Five Forces and SWOT analysis
■ Company specific information
■ Financial ratios for companies compared to median averages for various risk classes
How Credit Ratings Are Determined
■ Macroeconomic events are monitored
■ Industry level data is analyzed
■ Financial statement data is gathered and analyzed
■ Firm-specific qualitative information is gathered, including on-site visits
■ Findings are presented to a rating committee for review
■ Ratings committee assigns a rating
■ Rating agency informs the issuer of the rating