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CREDIT RISK ANALYSIS &

INTERPRETATION
MODULE 4
CHAPMAN UNIVERSITY
Argyros School of Business and Economics

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
1

Framework for Analysis and Valuation

Overview of Business Activities and Financial Statements

Profitability Analysis and Interpretation

Credit Risk Analysis and Interpretation

Revenue Recognition and Operating Income

Asset Recognition and Operating Assets

Liability Recognition and Non-Owner Financing

Equity Recognition and Owner Financing

11

Forecasting Financial Statements

12

Cost of Capital and Valuation Basics

13

Cash Flow Based Valuation

14

Operating Income Based Valuation

15

Market Based Valuation

Focus

Exam

ANALYSIS:
Understanding and Evaluating
Financial Statements:

MID-TERM #1

Helps us answer:
1. Where does the firm
operate?
2. Where is the firm currently?

VALUATION:
Building Forecasting Models and
Determining Value:
Helps us answer:
1. Where is the firm going?
2. What is the firm worth?

MID-TERM #2

FINAL EXAM

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
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 customers existing and ongoing
creditworthiness

Credit limit assigned

Bank Loans

Structured to meet specific client needs

Revolving credit line

Financing feature where a bank is interposed between two parties

Term loans

Available credit to be used as needed

Letters of credit

Available on demand
Floating interest rate

Lines of credit

Balanced with myriad of rules and regulations by bank regulators

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 nonpayment


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

Buyer power

A factor if suppliers have strong bargaining power and can demand higher prices
and early payments

Threat of substitution

Can be a credit risk if customers have the ability to have stronger price concessions

Supplier power

Involves the companys competitive position and the effect on its financial results

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 Depots net operating profit after taxes (NOPAT):
= $5,839 [$1,935 + ($566 x 36.7%)] = $3,696
Operating
income

Tax
expense

Interest expense
plus other
non-operating
expenses

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 companys 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
Times interest
=
earned

Earnings before interest and taxes


Interest expense

Reflects the operating income available to pay


interest expense
Assumes only interest must be paid because the
principal will be refinanced

Coverage Analysis
EBITDA Coverage Ratio
EBITDA coverage =
Earnings before tax + Interest expense, net + Depreciation + Amortization
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 companys ability to pay interest out of
current profits

Home Depot Coverage Ratios

Coverage Analysis
Cash from Operations to Total Debt
Measures a companys ability to generate additional
cash to cover debt payments as they come due.
Cash from
operations to
total debt

Cash from operations


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
Free operating
cash flow to
total debt

Cash from operations - CAPEX


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 Depots Liquidity Ratios

Solvency Ratios
Solvency refers to a companys 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 companys 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
Liabilities to Equity
for Selected
Industries

Solvency Analysis
Total liabilities
Liabilities-to-equity ratio=
Stockholders equity

Conveys how reliant a company is on creditor


financing compared with equity financing
Does not distinguish between current and long-term
debt

Solvency Analysis
Total debt-to-equity =
Long-term debt including current portion + Short-term debt
Stockholders equity

Assumes that current operating liabilities will be


repaid from current assets (self-liquidating)

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


Credit
Limits

Take into consideration the maximum


amount a company may be loaned at a
point in time
Limits are set based on the lenders
experience with similar borrower, and by
firm-specific analysis
Limits set by trade creditors

Low limits for new customers


Higher limits for established
customers

Loss Given Default Factors


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

Loss Given Default Factors


Repayment
Terms

Longer
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

Greater
Chance of
Default

Greater
= Credit Risk =

Higher Cost
of Debt
Financing

Loss Given Default


Covenants

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

IV. Credit Ratings

Are opinions of an entitys credit worthiness


Capture the entitys 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
Poors and Moodys 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
Treasury and Corporate
10-Year Bond Yields

Risk increases the


cost of debt which is
linked directly to the
companys credit rating

Credit Rating Models

Agencies have access to information not available to


lenders
Models have three types of inputs

Macroeconomic statistics

Industry data

Monitored by economists
Through frameworks such as Porters 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