Chapters 10 and 12 Credit Analysis and Distress Prediction3223

Chapters 10 and 12 Credit Analysis and Distress Prediction Corporate Financing Policies

November 14, 2007

 Today’s Topics 

Credit Analysis

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Debt Rating Process

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Distress Prediction

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Corporate Financing Policies

Credit Analysis

 What risks should a credit analyst care about? 

Credit Ris ! concerns t"e #irms$ ability to contin%e to mae interest and principal payments on borro&ings

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'anr%ptcy ris ! concerns t"e #irms$ ability to remain a going concern and avoid event%al li(%idation

 Who cares about Creditworthiness?

Credit Markets 

)o& *ot"er t"an t"ro%g" e(%ity+ does a #irm #inance its asset needs

)o&

"o

Credit Analysis

'%y on credit

%pplier 

%pplier$s policies3ratings

ae o%t a loan

'an

'an Criterion

ell Commercial paper 

P%blic aret

Rating Agencies and Fi-ed .nc/ Analysts

ell 'onds

P%blic aret

Rating Agencies and Fi-ed .nc/ Analysts

Credit Process Determine t"e p%rpose o# loan   Assess Credit&ort"iness  Determine tr%ct%re o# Debt 

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Determine Cost o# Debt 

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erm, sec%rity, covenants, etc/ Ris v/ Re&ard

Finali5e loan onitor 

 Assessing Creditworthiness

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F%ndamental Analysis    

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trategy Analysis  Acco%nting Analysis Financial tatement Analysis  Assessment o# management

Forecasts and ensitivity Analysis

inancial Analysis 

Foc%s in credit analysis is on ability to repay debts 

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6i(%idity Ratios  ability o# t"e #irm to pay bills d%e in t"e ne-t year &it" c%rrent assets or cas" #lo& t"at &ill be generated in t"e ne-t year  olvency Ratios ! pro#it or cas" #lo& relative to debt service and ot"er re(%irements

)istorical and #orecasted

inancial Analysis !"i#uidity $atios 

6i(%idity ratios can be vie&ed #rom t&o perspectives 

 As e##iciency ratios t"at assess t"e company$s optimal &oring capital management *t%rnover ratios+

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 As ratios t"at assess t"e ability o# t"e company to s%rvive *i/e/ pay its bills+ in t"e coming period or periods

"i#uidity $atios 

6i(%idity Ratios 

C%rrent Ratio

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8%ic Ratio

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Cas" Ratio

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9perating Cas" Flo& Ratio

%hort!ter& li#uidity risk  

.nterpreting c%rrent ratio *and ot"er similar li(%idity ratios+: 

"at do t"ese ratios intend to capt%re "at is t"e implicit ass%mption

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"at is t"e benc"mar #or t"ese ratios )o& "ig" is "ig"

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)o& to %se t"ese ratios

$atios to &easure long!ter& sol'ency risk  

olvency *or leverage+ ratios provide %s &it" in#ormation abo%t 

"e e-tent to &"ic" t"e #irm$s assets are #inanced by borro&ed money

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"e e-tent to &"ic" t"e borro&ed money "as re(%ired interest payments

$atios to &easure long!ter& sol'ency risk  

6ong!term debt to total capitali5ation

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Debt to e(%ity

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6iabilities to assets

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.nterest coverage *;'. 3.nterest ;-pense+

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9perating cas" #lo& to total liabilities

"ong!ter& sol'ency risk 

"at &ill solvency ratios N9 tell yo%

"i#uidity and %ol'ency $atios 

ey variable is level o# ris involved 

erm

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ec%rity

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Credit&ort"iness

9#ten stated as percent above prime or 6.'9R *6ondon .nterban 9##ered Rate+

Co'enants  

eans o# protection and monitoring #or lender  Financial covenants targeted to identi#ied riss    

inim%m net &ort" inim%m coverage inim%m li(%idity 6imits on relative liabilities or spending

(ebt $ating Process

(ebt $atings 

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P%blic marets need means to assess and monitor credit ris &o ma=or rating agencies: oody$s and tandard and Poor$s 

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pl%s Fitc", smaller agency

Ratings Process F%ndamental Analysis  Detailed #orecasts ?!@ years  Detailed revie& o# riss and mitigation strategies   Application o# models 

$atings Models   

Proprietary odels %sed by agencies and #irms Researc"ers "ave estimated models >ey C"aracteristics  i5e  %bordination stat%s o# debt  6everage  ystematic ris  Pro#itability 