Basics of Credit Analysis

Alexandru Cebotari
Sources and Types of Risks
Management Competence
Strategic Direction
Lawsuits
Firm-Specific
Technology
Competition
Availability of Raw Materials and Labor
Unionization
Industry
Recession
Inflation or Deflation
Interest Rate Changes
Demographic Changes
Political Changes
Domestic
Exchange Rate Changes
Host Government Regulations
Political Unrest
Expropriation of Assets
International
Type or Nature Source
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 firms 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
Debt Service
Requirements
Borrowing Capacity Financing
Long-Term Solvency
Risk
Plant Capacity
Requirements
Sales of Existing
Plant Assets or
Investments
Investing
Short-Term Liquidity
Risk
Working Capital
Requirements
Profitability of
Goods and Services
Sold
Operations
Financial Statement
Analysis Performed
Need to Use Cash
Ability to Generate
Cash
Activity
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 companys
ability to pay back its short-term liabilities and a sense of the
efficiency of the firms operating cycle and its ability to turn its
products into cash (ratio 1.0 preferred)
Quick Ratio: known as acid test, measures the firms 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!


A more rigorous measure of
short-term liquidity.
Indicates the ability of the
entity to meet unexpected
demands from liquid current
asses
Current Assets less inventory / Current
liabilities
Quick Ratio
A measure of short-term
liquidity. Indicates the
ability of entity to meet its
short-term debts from its
current assets
Current Assets / Current liabilities Current Ratio
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
Cash Flows from Operations/Average
Current Liabilities
Operating Cash Flow Ratio
Measurements Formula Financial Ratio
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?)
Measures percentage of assets
provided by shareholders
and the extent of using
gearing
Total assets / Total shareholders equity Capitalization ratio
Measures the ability of the
entity to meet its interest
payments out of current
profits.
Operating profit before income tax +
Interest expense / Interest expense +
Interest capitalized
Times interest earned
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.
Total Debt/(Total Shareholders Equity +
Total Debt)
Debt to Capital Ratio
Measures percentage of assets
provided by creditors and
extent of using gearing
Total Liabilities / Total assets Debt ratio
Measurements Formula Financial Ratio
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 Models
Altmans Z-Score:
(

+
(

+
(

+
(

+
(

=
Assets Total
Sales
s Liabilitie of Value Book
Equity of Value Market
Assets Total
Taxes and Interest Before Earning
Assets Total
Earnings tained
Assets Total
Capital Working Net
score Z
0 . 1
6 . 0 3 . 3
Re
4 . 1 2 . 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 markets assessment of the value of the firms
shareholders equity. This ratio measures long-term solvency risk and the
markets 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 Analysis
Probability of Bankruptcy of a Firm:


y
e
p

+
=
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 . 0 840 . 4
TATA
LVGI SAI DEPI SGI
AQI GMI DSRI y
+
+
+ + + + =
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
Beneishs eight factors and the rationale for their inclusion are as
follows:

Indicates the volume of earnings resulting from
accruals instead of from cash flows
Total Accruals to Total Assets (TATA)
Increase in the proportion of debt might entail a
violation of debt covenants
Leverage Index (LVGI)
1 indicates increased marketing expenditures and
expected increased sales
Selling and Administrative Expense Index (SAI)
Slowing of the rate of depreciation and thereby
increasing earnings
Depreciation Index (DEPI)
The need for low-cost external financing might
motivate sales manipulation
Sales Growth Index (SGI)
An increase in the proportion indicates an increased
efforts to defer costs
Asset Quality Index (AQI)
Firms with weaker profitability a more likely to
engage in earnings manipulation
Gross Margin Index (GMI)
A large increase in accounts receivables as a
percentage of sales might indicate an overstatement of
accounts receivables and sales to boost earnings
Days Sales in Receivables Index (DSRI)
Rationale Index
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
Assets Total Average
Earnings in Interest Minority Rate Tax Expense Interest Income Net
ROA
+ +
=
) 1 ( *
Turnover Assets ROA for in M ofit ROA = arg Pr
Sales
Earnings in Interest Minority Rate Tax Expense Interest Income Net
ROA for in M ofit
+ +
=
=
) 1 ( *
arg Pr
Assets Total Average
Sales
Turnover Asset =
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
Assets
Turnover
Pure
Competition
Low C
Both Oligopoly Medium B
Profit
Margin
for ROA
Monopoly High A
Strategic
Focus
Competition
Capital
Intensity
Area in
Exhibit
Profitability Ratios
Measures net profitability of
each dollar of sales
Operating profit after income tax / Net
Sales Revenue
Profit Margin
Profitability of trading and
mark-up
Gross Profit / Net Sales Gross Profit Margin
Measures rate of return earned
on assets provided by owners
Operating profit & extraordinary items
after income tax minus Preference
dividends / Average ordinary
shareholders equity
Return on ordinary
shareholders equity
Measures rate of return earned
through operating total assets
provided by both creditors and
owners
Operating profit before income tax +
interest expense/ Average total assets
Return on Total Assets
Measurements Formula Financial Ratio
Total Assets Turnover
Measure the efficiency of the
usage of fixed assets in
generating sales
Net Sales / Fixed Assets Turnover of Fixed Assets
Measures the effectiveness of an
entity in using its assets
during the period.
Net sales revenue / Average total assets Total Asset turnover ratio
Indicates the liquidity of
inventory. Measures the
number of times inventory
was sold on the average
during the period
Cost of goods sold / Average inventory
balance
Inventory turnover
Measures the effectiveness of
collections; used to evaluate
whether receivables balance
is excessive
Net sales revenue / Average receivables
balance
Receivables turnover
Measurements Formula Financial Ratio
Return on Common Shareholders Equity (ROCE)
Return
on Assets
Return to
Creditors
Return to
Preferred
Shareholde
rs
Return to
Common
Shareholde
rs
Leverage Financial Turnover Assets ROCE for in M ofit ROCE =arg Pr
Equity rs Shareholde Common Average
rs Shareholde Common to Income Net
ROCE
'
=
Sales
rs Shareholde Common to Income Net
ROCE for in M ofit = arg Pr
Assets Total Average
Sales
Turnover Assets =
Equity rs Shareholde Common Average
Assets Total Average
Laverage Financial
'
=