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Basics of Credit Analysis ????????

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Title: Basics of Credit Analysis ????????


1
Basics of Credit Analysis ????????
Alexandru Cebotari
2
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 (????)
3
  • 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
  • ??????????????????,??????????????????????????

4
Profitability, Growth, Risk ????,???,??
Product-Market Strategies ????
Financial-Market Strategies ????
Operating Decisions ????
Financing Decisions ????
Dividend Decisions ????
Investment and Asset Management
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 ??????
5
  • 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
  • (1) ??????,????????????????????????
  • (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
  • (2)??????,?????????????????????????
    ?
  • The field of finance identifies two types of
    risks
  • ???????
  • (1) credit risk, a firms ability to make
    payments on interest and principle payments, and
  • (1) ????,?????????????
  • (2) bankruptcy risk, the likelihood that a firm
    will be liquidated
  • (2) ????,???????????

6
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 ????????
7
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)
  • ??????????????????,?????????(???????1.0)
  • 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)
  • ??????????,??????????????????,????????(??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)
  • ????????????????????????????????(???????????40)
  • Short-term liquidity problems also arise from
    longer-term solvency difficulties!
  • ??????????????????

8
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 ?????????????,???????????????????????????
9
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)
  • ??????????????????????(??????2?????)
  • 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?)
  • ????/?????????????????????(??????1,?????)

10
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 companys 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. ????????????????
11
Models of Bankruptcy Prediction
12
??????
  • ????????
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  • 2)???????
  • 3)???????
  • 4)???????
  • ?????
  • 1)?????
  • 2)??????
  • 3)??????
  • 4)??????
  • ???????
  • 1)????????
  • 2)????????
  • 3)???????
  • 4)??????????
  • ??????????
  • 1)??????
  • 2)????????
  • 3)????????
  • ???????????
  • 1)???????
  • 2)?????????
  • 3)?????????
  • ?????
  • 1)?????
  • 2)???????
  • 3)?????
  • 4)???????
  • 5)???????
  • 6)???????
  • 7)??????
  • 8)??????
  • 9)???? (??/??????)
  • 10) ???? (?????/??????)
  • 11)???????
  • (?????-????)/??????

???????????????????????????????????????
?????????-??????????????-??-??-????????????
13
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)

14
Multivariate Bankruptcy Prediction Models ???????
  • Altmans Z-Score(Altmans Z-????)

15
Multivariate Bankruptcy Prediction Models ???????
  • 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.
  • ?????Excel????Z-score?????????????NORMSDIST(1-Z-
    score)?Altman?????Z-score??????,??????????
  • The principle strengths of MDA are as follows
  • ??????????
  • It incorporates multiple financial ratios
  • ??????????
  • It provides the appropriate coefficients for
    combining the independent variables
  • ??????????????
  • It is easy to apply once the initial model has
    been developed.
  • ?????????????????

16
  • Each ratio captures a different dimension of
    profitability or risk
  • ???????????????
  • Net 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.

17
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) ?? ln
(???/??????????) TLTA Total Liabilities/Total
Assets TLTA???/??? WCTA
(CA-CL)/Total Assets
WCTA(????-????)/??? CLCA Current
Liabilities/Current Assets CLCA
????/???? NITA Net Income/Total Assets
NITA???/??? FUTL Funds (Working
Capital) from Operations/Total Liabilities
FUTL????/??? INTWO one if Net Income (NI) was
negative in the last two years and zero
otherwise INTWO???????0,???1????0 OENEG one
if owners equity is negative and zero
otherwise OENEG?????????0,???1????0 CHIN NI
(this year) NI (last year)/NI (this year)
NI (last year) CHIN (?????-?????)/(??????????
)
18
Earnings Manipulation ????
  • Beneish developed a probit model to identify the
    financial characteristics of firms likely to
    engage in earnings manipulation
  • Beneish?????????????????????????
  • 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
  • Excel??NORMSDIST???????Y?????????

19
Beneishs eight factors and the rationale for
their inclusion are as follows Beneishs?????????
??
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??????1?????????????????
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????????????
20
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.
  • ?????????????????,????????????????????????????????
    ?????

21
Rate of Return on Assets ?????
22
Average Median ROA, Profit Margin for ROA, and
Assets Turnover for 23 industries for 1990 to 2004
23
1999??2004?23????????,??????????? (??)
  • Airlines ???
  • Industrial equipment ??
  • Transportation equipment ???
  • Restaurants ???
  • Wholesalers-Non Durables ??-?????
  • Wholesalers-Durables??-?????
  • Retailing-General Merchandise ???-????
  • Retailing-Apparel???-??
  • Grocery store ???
  • Utilites ??
  • OilGas extraction ????
  • Hotels ??
  • Petropleum ??
  • Paper ???
  • Printing and publishing ?????
  • Personal service ???
  • Amusements ???
  • Lumber ???
  • Food products ???
  • Agricultural ??
  • Health service ?????
  • Metals ???
  • Communications ???

24
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 ????
???
????
????
?????
25
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 ???????
26
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 ?????????????
27
Return on Common Shareholders Equity
(ROCE) ????????
Return on Assets ?????
Return to Creditors ??????
Return to Preferred Shareholders ????????
Return to Common Shareholders ????????
??????????????????????????
????????????????/???
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