Credit Risk Analsis for financial Valuation.

Fourth Edition
Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang
©Cambridge Business Publishers, 2015
MODULE 4
Credit Risk Analysis
and Interpretation

©Cambridge Business Publishers, 2015 2
Learning Objective 1
Understand the demand for and
supply of credit.

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 and the
prevailing market rate of interest.

Credit Demand for Operating Activities
 Credit terms
 Dictated by past experience with a company
 Routine, low risk needs created by
 Cyclical operating cash needs such as materials or
labor
 Advance seasonal purchases
 Higher risk credit
 When used to cover operating losses
A willing creditor could make the difference between
bankruptcy and continued operations for a company.

Credit Demand for Investing Activities
 Require large amounts of cash for investments
such as new equipment or mergers
 Needs can vary in timing and amount
 Long-term debt routinely used for start-up and
growth
 Predictable capital expenditure patterns often
held by mature firms

Credit Demand for Financing Activities
 Occurs less frequently than operating and
investing activities
 Common situations
 A bank loan or bond comes due and a company does
not have the necessary funds on hand
 Funds to pay dividends or repurchase stock are
borrowed
 Evergreen debt
 When a company consistently pays off debt by taking
on more debt

Supply of Credit
There are many sources of credit to meet
companies’ demand which include:
7
Non-bank
financing
Bank
loans
Trade
credit
Publicly-
traded
debt
Lease
financing

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

More Bank Loans
 Term loans
 A set loan amount (principal) with specified
periodic payments
 Interest rates are either fixed or floating for the
duration of the loan
 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.
 Results from private lenders such as private equity
firms that have experience in industry
 Private lenders creatively structure loan repayment
and may act as a management consultant

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 resource 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

Explain the credit risk analysis process.

Credit Risk Analysis Process
 Purpose is to quantify potential credit losses
so lending decisions are made with full
information
 Consists of two components
Debtor’s ability
to repay debt
Expected credit loss =
Chance of default x Loss given default
Size of loss if
debtor defaults

Credit Raters
 Credit rating agencies assess credit risk
 Differ from other lenders
 Have no direct financial involvement with
companies whose credit they are rating
 Have access to more, better, and most current
information
 Can refine risk analysis across industries

Perform a credit analysis and
compute and interpret
measures of credit risk.

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 flow needs
 Fund temporary or ongoing operating losses
 Major capital expenditures or acquisitions
 Reconfigure capital structure

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 demand
price concessions
 Supplier power
 A factor if suppliers have strong bargaining power and can
demand higher prices and early payments

Step 2: Assess macroeconomic environment and
industry conditions (continued)
 Threat of substitution
 Occurs when a company has limitations on products such as
the inability to increase prices or pass costs on to customers
 Threat of entry
 Occurs when new market entrants increase competition
 Company could be subject to aggressive tactics where the
new entrants try to win over clients

Step 3: Perform financial analysis
 Includes analysis of the financial statements through
ratio calculations
 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

Step 3: Perform financial analysis (continued)
 Profitability analysis
 Considers items that surround profitability using return on
net operating assets (RNOA)
 Net operating profit margin (NOPM)
 Net operating asset turnover (NOAT)
 Excludes items that will not persist such as one-time
charges for a more accurate picture of the firm’s future
profitability

Profitability Analysis Example
Home Depot’s net operating profit after taxes (NOPAT)
= $7,620 – [$2,635 + ($534 x 37%)] = $4,787
24
Operating
income
Tax
expense
Interest and
other, net
Statutory
tax rate

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

Coverage Analysis
EBITDA Ratio
 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

Home Depot Coverage Ratios
29

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.
30

Coverage Analysis
Free Operating Cash Flow to Total Debt
Considers excess operating cash flow after cash is
spent on capital expenditures.
31

Home Depot Cash Flow Ratios
32

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 – those assets that a company expects
to convert into cash within the next operating cycle,
which is typically a year
 Current liabilities – 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.

Home Depot’s Liquidity Ratios
36

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:
 Liabilities-to-equity ratio
 Total debt-to-equity

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

Solvency Analysis
 Conveys how reliant a company is on creditor
financing compared with equity financing
 Does not distinguish between current and long-
term debt

Solvency Analysis
Assumes that current operating liabilities will be
repaid from current assets (self-liquidating).
40

Home Depot Solvency Ratios
41

Step 4: Perform prospective analysis
 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

Loss Given Default
 Consists of factors that affect the amount that
could be lost if the company defaulted on its
obligations
 Defaults include
 Failure to make payments
 Violation of loan covenants
 Creditors loss is dependent on priority of the
claim compared with all other existing claims
 Determined by laws and private contracts

Minimization of Potential Loss
 Structure credit terms for loans in advance
 Trade-off exists if the lender is too strict with
the loan terms causing the borrower to default
Credit Limit
Maximum allowed to
owe at one time
Collateral
Property pledged to
guarantee payment
Repayment Term
Length of time to
repay debt obligation
Covenants
Terms and conditions
to limit lender loss

Loss Given Default Factors
Credit Limits
 The maximum amount a company may be loaned
at a point in time
 Limits are set based on the lender’s experience
with similar borrowers, and by firm-specific
analysis
 Trade creditors
 Low limits for new customers
 Higher limits for established customers
 Banks
 Credit limits on revolving credit
 If credit rating falls, credit limit may be reduced

Collateral
 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

Repayment Terms
 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
terms
Greater
chance of
default
Greater
credit
risk
Higher cost
of debt
financing

Covenants
 Are terms and conditions of a loan designed to
limit the loss given default
 Three common types of covenants
 Those that require the borrower to take certain
actions, such as submitting financial statements to
the lender
 Those that restrict the borrower from taking certain
actions, such as preventing mergers
 Those requiring the borrower maintain specific
financial conditions, including certain ratios and
minimum equity

Describe the credit rating process
and explain why companies are
interested in their credit ratings.

Credit Ratings
 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:
 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

Credit Ratings by Agencies
Long-term issue rating scales used by Standard and
Poor’s and Moody’s Investor Services
51

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

How Risk is Linked to Credit Ratings
Risk increases the cost of debt which is linked
directly to the company’s credit rating.
53

Bond Rating Distribution
 Evidence suggests companies try to maintain
investment grade bond ratings
 Ratings AAA through BBB- account for 55% of all
corporate issuers

How Credit Ratings are Determined
 Analysts gather and analyze inputs:
 Macroeconomic events
 Industry level data
 Company specific information
 Financial statement data
 Qualitative information
 Findings are presented to a rating committee for
review
 Ratings committee assigns a rating
 Rating agency informs the issuer of the rating

Ratio Values for Different Risk Classes
of Corporate Debt
56

Credit Rating Agency Reform Act
 Signed into law in 2006
 Establishes a registration system for credit
rating agencies
 Allows agencies with three years of experience
to register with the SEC
 Considered nationally recognized statistical ratings
organizations (NRSRO)
 SEC has designated only 10 of nearly 100
agencies as NRSROs

Explain bankruptcy prediction models,
and compute and interpret measures
of bankruptcy risk.

Bankruptcy Prediction Indicators
 Assess a company’s bankruptcy risk
 Altman model used to predict bankruptcy risk
Z-Score = 1.2 x
Working Capital
+ 1.4 x
Retained Earnings
Total Assets Total Assets
+ 3.3 x
EBIT
+ 0.6 x
Market Value of
Equity
Total Assets Total Liabilities
+ 0.99 x
Sales
Total Assets

Z-Score Interpretation
 Shown to reasonably predict bankruptcy
accurately for up to two years
 95% accuracy in Year 1
 72% accuracy in Year 2
Z-Scores and Their Interpretation

Application of Z-Score
Use Home Depot’s financial statement information
for year ending February 3, 2013.
61
Greater than 3.00
Home Depot is healthy
and there is low
bankruptcy potential
in the short term.

Bankruptcy Prediction Errors
Two types of errors from a Z-Score
Type I Error: A false negative or a situation where the
Z-Score indicates a company is healthy but
goes bankrupt
Type II Error: A false positive or a situation where the
company is projected to go bankrupt, yet
the company remains solvent

Factors of S&P Credit Risk
(Appendix 4)
63
Business
Risk
Business
Risk Industry
Characteristics
Capital
Structure
Management
Financial
Policy
Financial
Risk
Profitability
Competitive
Position
Financial
Flexibility

Moody’s Four Factor Analysis
(Appendix 4)
64
Business
Risk
Product Portfolio
and
Profitability
Size, Scale
and
Diversification
Financial Policies
Financial Strength

Credit Risk Analsis for financial Valuation.

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