Chapters 10 and 12

Credit Analysis and Distress Prediction Corporate

Financing Policies

November 14, 2007

Today’s Topics

 Credit Analysis
 Debt Rating Process
 Distress Prediction
 Corporate Financing Policies
Credit Analysis
What risks should a credit analyst care
about?
 Credit Risk - concerns the firms’ ability to
continue to make interest and principal payments
on borrowings

 Bankruptcy risk - concerns the firms’ ability to

remain a going concern and avoid eventual
liquidation
Who cares about Creditworthiness?
Credit Markets
 How (other than through equity) does a firm finance its
asset needs?

How Who Credit Analysis

Buy on credit Supplier Supplier’s policies/ratings

Take out a loan Bank Bank Criterion

Sell Commercial Public Market Rating Agencies and

paper Fixed Inc. Analysts
Sell Bonds Public Market Rating Agencies and
Fixed Inc. Analysts
Credit Process
 Determine the purpose of loan
 Assess Creditworthiness
 Determine Structure of Debt
 Term, security, covenants, etc.
 Determine Cost of Debt
 Risk v. Reward
 Finalize loan
 Monitor
Assessing Creditworthiness

 Fundamental Analysis
 Strategy Analysis
 Accounting Analysis
 Financial Statement Analysis
 Assessment of management

 Forecasts and Sensitivity Analysis

Financial Analysis
 Focus in credit analysis is on ability to repay
debts
 Liquidity Ratios – ability of the firm to pay bills
due in the next year with current assets or cash
flow that will be generated in the next year
 Solvency Ratios - profit or cash flow relative to
debt service and other requirements
 Historical and forecasted
Financial Analysis -Liquidity Ratios

 Liquidity ratios can be viewed from two

perspectives
 As efficiency ratios that assess the company’s
optimal working capital management (turnover
ratios)
 As ratios that assess the ability of the company to
survive (i.e. pay its bills) in the coming period or
periods
Liquidity Ratios

 Liquidity Ratios
 Current Ratio
 Quick Ratio
 Cash Ratio
 Operating Cash Flow Ratio
Short-term liquidity risk

 Interpreting current ratio (and other similar

liquidity ratios):
 What do these ratios intend to capture? What is the implicit
assumption?

 What is the benchmark for these ratios? How high is high?

 How to use these ratios?

Ratios to measure long-term solvency
risk
 Solvency (or leverage) ratios provide us with
information about
 The extent to which the firm’s assets are financed by
borrowed money
 The extent to which the borrowed money has required
interest payments
Ratios to measure long-term solvency
risk
 Long-term debt to total capitalization
 Debt to equity
 Liabilities to assets
 Interest coverage (EBIT /Interest Expense)
 Operating cash flow to total liabilities
Long-term solvency risk
 What will solvency ratios NOT tell you?
Liquidity and Solvency Ratios

 Use these ratios judiciously. Interpret them in

the context of your specific case, and in
conjunction with other relevant information.
Forecasts
 Forward looking view of ability to repay
 Sensitivity/Scenario Analysis
 Assess Cash Flow – is it adequate to allow
repayment?
 CF from Operations/Average CL
 CF from Operations/Average Total Liabilities
 CF from Operations/Average Cap. Exp.
 Capacity for Debt
 Debt Ratios
 Interest Coverage
Determine Loan Type and Structure

 Loan Type and Term

 Open line of credit
 Revolving line of credit
 Working Capital loan
 Term loan
 Mortgage
 Security - receivables, inventory, equipment and
machinery, land
 Pricing
 Covenants
Pricing

 Key variable is level of risk involved

 Term
 Security
 Creditworthiness
 Often stated as percent above prime or
LIBOR (London Interbank Offered Rate)
Covenants
 Means of protection and monitoring for lender
 Financial covenants targeted to identified
risks
 Minimum net worth
 Minimum coverage
 Minimum liquidity
 Limits on relative liabilities or spending
Debt Rating Process
Debt Ratings
 Public markets need means to assess and monitor
credit risk
 Two major rating agencies: Moody’s and Standard
and Poor’s
 plus Fitch, smaller agency
 Ratings Process
 Fundamental Analysis
 Detailed forecasts 3-5 years
 Detailed review of risks and mitigation strategies
 Application of models
Ratings Models
 Proprietary Models used by agencies and firms
 Researchers have estimated models
 Key Characteristics
 Size

 Subordination status of debt

 Leverage

 Systematic risk

 Profitability

 Unsystematic risk

 Riskiness of profit stream

 Interest coverage
Ratings Parameters
Median Financial Ratios by Rating Category:90-03
S&P Moody’s Total ROA Debt/ Interest
Revenue Assets Coverage
AAA Aaa 28.8b 9.4% 24.2% 23.72
AA Aa 12.5b 6.7% 27.4% 12.41
A A 8.3b 4.7% 30.5% 9.83
BBB Baa 4.6b 2.7% 33.3% 6.80
BB Ba 2.2b 1.6% 43.4% 5.61
B B 1.0b -3.2% 61.5% 2.24
Ratings and Yields
 Yields will reflect ratings and particular
characteristics of bonds
 Significant difference between investment
grade (BBB and above) and non investment
grade
 Secondary markets will reflect ratings and
circumstance changes occurring after
issuance
Distress Prediction
 Bankruptcy Risk Analysis

 Can we predict future bankruptcy?

 Not exactly, but developing a reasonable
methodology.
 Various algorithms have been devised to
predict bankruptcy probability using firm’s
financial ratios
 Z-score is one of the most widely used
Bankruptcy risk
 Z-score’s basic idea:
 For each bankrupt firm, find a similar sized non-
bankrupt firm in the same industry.
 Perform a Multiple Discriminate Analysis (MDA)
between the bankrupt group and the non-
bankrupt group.
 Identify the ratios/variables that differ the most
between the groups. These ratios/variables are
the one that have the most discriminating power
for bankruptcy.
Bankruptcy risk
 Altman’s Z-score for manufacturing firms:
 Z= 1.2 X Working capital / total assets
+ 1.4 X Retained earnings / total assets
+ 3.3 X EBIT / total assets
+ 0.6 X Market value of equity / BV of debt
+ 1.0 X Sales / total assets
 Predict: bankrupt if Z<1.81; non-bankrupt if Z>2.99; in
between is the “zone of ignorance.”
 These factors meant to capture firms’ liquidity,
profitability, solvency, and activity ratios.
 Worldcom’s Z-Score

Input Financial Ratio 1999 2000 2001

X1 (1.2) Working capital/Total Assets -0.09 -0.08 0
X2 (1.4) RE/Total Assets -0.02 0.03 0.04
X3 (3.3) EBIT/Total Assets .09 .08 .02
X4 (0.6) Market Value/Total Liab. 3.7 1.2 .50
X5 (1.0) Sales/Total Assets .51 .42 0.3
Z-Score 2.5 1.4 .85
 Bankruptcy Risk Analysis
 Problems with Z-Scores
 Fitting one model to unique situations
 area between 1.81 and 3.00 is grey
 Not all firms report required data
 Best use of Z-Scores
 Gauge of relative financial health
 If trouble indicated, conduct more detailed
analysis
Corporate Financing Policies

 Capital Structure
 Optimal mix of debt and equity

 Dividend Policy
 Whether to pay and what amount
Debt Policy

 What are debt/equity ratios today?

 Total ST & LT debt / common equity

 S&P 500 - 1.73

 DJIA - 1.75
 Nasdaq - .33

 What accounts for the difference?

Explanations for Differences in
Capital Structure
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

Financial Risk - Risk to shareholders resulting from

the use of debt.

Financial Leverage - Increase in the variability of

shareholder returns that comes from the use of
debt.
Trade-off Theory of Capital Structure
 When choosing capital structure, the firm chooses
the debt level that maximizes the market value of
the firm

 The important point is that there is a tradeoff with

increased leverage: firm value increases due to the
interest tax shield but decreases due to financial
distress cost.
Trade-off Theory of Capital
Structure
 Shareholders benefit when the firm obtains
funds from borrowing and invests the money in
assets that generate a higher return than the
after-tax cost of borrowing
 ROE > ROA when ROA>rd
 Financial leverage can increase the return to
shareholders
Trade-off Theory of Capital
Structure
 But increasing levels of debt increases financial
leverage and increases credit and bankruptcy
risk and the chance that the company will
become insolvent
What else might determine CS?

Some empirical observations:

 Avoidance of equity issuance - most

companies do not use seasoned equity
offerings outside of M&A
 Peer similarity - Most companies tend to end
up looking like peer industry members
What else might determine CS?

 Accounting performance - Better accounting

performance and more tangible assets result in
more debt
 Uncertainty - Firms with more volatile underlying
real assets tend to have less debt (i.e. growth
firms)
 Active Market timing - Firms experiencing
increasing stock prices tend to issue more debt
and more equity
Dividend Policy

 The decision to pay out earnings versus

retaining and reinvesting them. Includes
these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
 Dividend Payout Ratios for
Selected Industries

Industry Payout ratio

Banking 38.29
Computer Software Services 13.70
Drug 38.06
Electric Utilities 67.09
Semiconductors 24.91
Steel 51.96
Tobacco 55.00
Water utilities 67.35

What explains differences?

Setting Dividend Policy

 Forecast capital needs over a

planning horizon, often 5 years.
 Set a target capital structure.
 Estimate annual equity needs.
 Generally, some dividend growth rate
emerges. Maintain target growth
rate if possible, varying capital
structure somewhat if necessary.
Stock Repurchases

Repurchases: Buying own stock back

from stockholders.
 As an alternative to distributing cash as
dividends.
 To dispose of one-time cash from an
asset sale.
 To make a large capital structure
change.
Advantages and Disadvantages of
Repurchases
 Advantages
 Stockholders have choice
 Single event vs. recurring dividend
 Flexibility to use repurchased stock
 Capital gain treatment vs. dividend
 Seen as positive signal—mgmt. thinks stock is
undervalued.
 Disadvantages
 Seen as negative – no better alternative use of cash
 IRS could challenge as avoidance of tax on dividends
Summary
 Credit analysis

 Public debt markets and rating process

 Distress Prediction

 Corporate Financing Policies