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.

Supply of Credit

There are many sources of credit to meet companies’ demand which include:

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

Home Depot Coverage Ratios

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

Home Depot Cash Flow Ratios

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.

Home Depot’s Liquidity Ratios

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

Home Depot Solvency Ratios

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

Ratio Values for Different Risk Classes

of Corporate Debt

Problems

1-13, 17, 27, 31