Basics of Credit Analysis

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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
Investment and Asset Management Decisions
Operating Decisions
Financing Decisions
Dividend Decisions
Managing Revenue Expenses
Managing Working Capital Fixed Assets
Managing Liabilities and Equity
Managing Dividend Payout
Profit Margin Ratios
Efficiency Ratios
Capital Structure Ratios
Payout 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 to generate 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 on interest 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
Activity Ability to Generate Cash Need to Use Cash Financial Statement Analysis Performed
Operations Profitability of Goods and Services Sold Working Capital Requirements Short-Term Liquidity Risk
Investing Sales of Existing Plant Assets or Investments Plant Capacity Requirements Long-Term Solvency Risk
Financing Borrowing Capacity Debt Service Requirements Long-Term Solvency Risk
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Analysis of Short-Term Liquidity Risk

• The analysis of short-term liquidity risk
  requires an understanding of the operating cycle
  of a firm!
• Current Ratio mainly used to give an idea about
  the companys ability to pay back its short-term
  liabilities and a sense of the efficiency of the
  firms operating cycle and its ability to turn
  its products into cash (ratio 1.0 preferred)
• Quick Ratio known as acid test, measures the
  firms ability to pay off its short-term debt
  from current liquid assets draws a more
  realistic picture (trend towards 0.5)
• Operating Cash Flow Ratio using cash flow as
  opposed to accounting items provides a better
  indication of liquidity (40ntypical of a healthy
  firm)
• Short-term liquidity problems also arise from
  longer-term solvency difficulties!

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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 Ratio Current 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. Indicates whether 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 structure intensifies the risk that the
  firm cannot pay interest and repay the principle
  on the amount borrowed
• Analysis of long-term solvency risk must begin
  with an analysis of short-term liquidity risk
• Firms must survive in the short-term if they are
  to survive in the long-term!
• Interest Coverage Ratio gives a sense of how far
  earnings can fall before a firm will start
  defaulting on its payments (risky if 2.0)
• Long-Term Debt to Long-Term Capital Ratio way of
  looking at the debt structure and determine what
  portion of total capitalization 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 by creditors 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 Ratio Total 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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Univariate Analysis

• The six ratios with the best discriminating power
  (and the nature of the risk each ratio measures)
  were as follows
• Net Income plus Depreciation, Depletion, and
  Amortization/Total Liabilities (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/Operating Expenses excluding
  Depreciation, Depletion and Amortization
  (short-term liquidity risk)

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Multivariate Bankruptcy Prediction Models

• Altmans Z-Score

• 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 comprising relatively 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/equity ratio, but it
  incorporates the markets assessment of the value
  of the firms shareholders equity. This ratio
  measures long-term solvency risk and the markets
  overall assessment of the profitability and risk
  of the firm.
• Sales/Total Assets this ratio is similar to the
  total assets turnover ratio and indicates the
  ability of a firm to use assets to generate
  sales.
• In applying this model, Altman found that
  Z-scores of less than 1.81 indicated a high
  probability of bankruptcy, while Z-scores higher
  than 3.00 indicates a low probability of
  bankruptcy. Scores between 1.81 and 3.00 were in
  the gray area.

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Logit Analysis

• Probability of Bankruptcy of a Firm

y -1.32 0.407SIZE 6.03TLTA 1.43WCTA
0.0757CLCA 2.37NITA 1.83FUTL 0.285INTWO
1.72OENEG 0.521CHIN, 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

• Probit converts y into a probability using
  standardized normal distribution. 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 this question.
• Can the firm generate the expected return on the
  capital invested by the lenders and shareholders
  without compromising 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
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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 Intensity Competition Strategic Focus
A High Monopoly Profit Margin for ROA
B Medium Oligopoly Both
C Low Pure 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 Sales Profitability of trading and mark-up
Profit Margin Operating 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 turnover Net sales revenue / Average receivables balance Measures the effectiveness of collections used to evaluate whether receivables balance is excessive
Inventory turnover Cost 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 Assets
Return to Creditors
Return to Preferred Shareholders
Return to Common Shareholders