Basics of Credit Analysis

Alexandru Cebotari

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

• 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

Profitability, Growth, Risk

Product-Market Strategies Financial-Market Strategies

Operating Decisions

Investment and Asset

Management Decisions

Financing Decisions

Dividend 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

• 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

(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

• The field of finance identifies two types of risks:

(1) credit risk, a firm’s ability to make payments on interest and principle payments, and

(2) bankruptcy risk, the likelihood that a firm will be liquidated

Framework for Financial Statement Analysis of Risk

ActivityAbility to

Generate CashNeed to Use

CashFinancial Statement Analysis Performed

OperationsProfitability of

Goods and Services Sold

Working Capital Requirements

Short-Term Liquidity Risk

InvestingSales of Existing Plant Assets or

Investments

Plant Capacity Requirements

Long-Term Solvency Risk

FinancingBorrowing Capacity

Debt Service Requirements

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 company’s ability to pay back its short-term liabilities and a sense of the efficiency of the firm’s operating cycle and its ability to turn its products into cash (ratio ≥ 1.0 preferred)

• Quick Ratio: known as acid test, measures the firm’s ability to pay off its short-term debt from current liquid assets; draws a more realistic picture (trend towards 0.5)

• Operating Cash Flow Ratio: using cash flow as opposed to accounting items provides a better indication of liquidity (40%ntypical of a healthy firm)

• Short-term liquidity problems also arise from longer-term solvency difficulties!

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 RatioCurrent 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

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)

• 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?)

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 RatioTotal Debt/(Total Shareholders’ Equity +

Total Debt)

The debt-to-capital ratio gives users an idea of a

company's financial structure, or how it is

financing its operations, along with some insight

into its financial strength.

Times interest earnedOperating 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.

Models of Bankruptcy Prediction

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)

Univariate Analysis

Multivariate Bankruptcy Prediction ModelsAltman’s Z-Score:

AssetsTotal

Sales

sLiabilitieofValueBook

EquityofValueMarket

AssetsTotal

TaxesandInterestBeforeEarning

AssetsTotal

Earningstained

AssetsTotal

CapitalWorkingNetscoreZ

0.1

6.03.3

Re4.12.1

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.

The principle strengths of MDA are as follows:• It incorporates multiple financial ratios;• It provides the appropriate coefficients fro combining the independent variables;• It is easy to apply once the initial model has been developed.

Each ratio captures a different dimension of profitability or risk:

• Met 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 market’s assessment of the value of the firm’s shareholders’ equity. This ratio measures long-term solvency risk and the market’s 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.

Logit AnalysisProbability of Bankruptcy of a Firm:

yep

1

1

y = -1.32 – 0.407*SIZE + 6.03*TLTA – 1.43*WCTA + 0.0757*CLCA – 2.37*NITA – 1.83*FUTL + 0.285*INTWO – 1.72*OENEG – 0.521*CHIN,

SIZE = ln (Total Assets/GNP Deflator)

TLTA = Total Liabilities/Total Assets

WCTA = (CA-CL)/Total Assets

CLCA = Current Liabilities/Current Assets

NITA = Net Income/Total Assets

FUTL = Funds (Working Capital) from Operations/Total Liabilities

INTWO = one if Net Income (NI) was negative in the last two years and zero otherwise

OENEG = one if owners’ equity is negative and zero otherwise

CHIN = [NI (this year) – NI (last year)]/[|NI (this year)| + |NI (last year)|]

Earnings Manipulation

• Beneish developed a probit model to identify the financial characteristics of firms likely to engage in earnings manipulation

)(*670.4

)(*327.0)(*172.0)(*115.0)(*892.0

)(*404.0)(*528.0)(*920.0840.4

TATA

LVGISAIDEPISGI

AQIGMIDSRIy

• 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

Beneish’s eight factors and the rationale for their inclusion are as follows:

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

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

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.

Rate of Return on Assets

AssetsTotalAverage

EarningsinInterestMinorityRateTaxExpenseInterestIncomeNetROA

)1(*

TurnoverAssetsROAforinMofitROA argPr

Sales

EarningsinInterestMinorityRateTaxExpenseInterestIncomeNet

ROAforinMofit

)1(*

argPr

AssetsTotalAverage

SalesTurnoverAsset

Average Median ROA, Profit Margin for ROA, and Assets Turnover for 23 industries for 1990 to 2004

Economic Factors Affecting the Profit Margin/Assets Turnover Mix

Area in Exhibit

Capital Intensity

CompetitionStrategic

Focus

A High Monopoly

Profit

Margin

for ROA

B Medium Oligopoly Both

C LowPure

Competition

Assets

Turnover

Profitability Ratios

Financial Ratio Formula Measurements

Return on Total AssetsOperating 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 SalesProfitability of trading and mark-up

Profit MarginOperating profit after income tax / Net Sales Revenue

Measures net profitability of each dollar of sales

Total Assets Turnover

Financial Ratio Formula Measurements

Receivables turnoverNet sales revenue / Average receivables

balance

Measures the effectiveness of collections; used to evaluate whether receivables balance is excessive

Inventory turnoverCost 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 assetsMeasures the effectiveness of

an entity in using its assets during the period.

Turnover of Fixed Assets Net Sales / Fixed AssetsMeasure the efficiency of the

usage of fixed assets in generating sales

Return on Common Shareholders’ Equity (ROCE)

Return on Assets

Return to Creditors

Return to Preferred

Shareholders

Return to Common

Shareholders

LeverageFinancialTurnoverAssetsROCEforinMofitROCE argPr

EquityrsShareholdeCommonAverage

rsShareholdeCommontoIncomeNetROCE

'

Sales

rsShareholdeCommontoIncomeNetROCEforinMofit argPr

AssetsTotalAverage

SalesTurnoverAssets

EquityrsShareholdeCommonAverage

AssetsTotalAverageLaverageFinancial

'