AFM 212 Week 3 Credit Analysis PDF

AFM 212 Week 3 Credit Analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Revision of Tesla Example professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 3.1 Market for credit and credi...

AFM 212 Week 3 Credit Analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Revision of Tesla Example professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 3.1 Market for credit and credit analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE What is credit Analysis § Credit analysis is the process of evaluating the ability and willingness of a borrower, such as a corporation, government, or individual, to meet their financial obligations, typically in the form of loans or bonds. It involves a detailed assessment of the credit risk associated with lending money or extending credit to a borrower. § The primary purpose of credit analysis is to determine the likelihood that a borrower will repay their debt on time and in full. § Credit risk is the risk that a borrower will fail to meet their financial obligations as they come due, leading to a loss for the lender or investors. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Demand and Supply of Credit Analysis Demand Supplier § Banks § Internal corporate credit teams § Bond Investors § Bank’s in-house credit analysis teams § Corporates § Credit rating agencies § Suppliers § S&P § Customers § Moody’s § Individuals § Fitch § Fixed income research firms § Consulting firms professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Demand for Credit: Operating Activities § Companies have cyclical operating cash needs § Manufactures need cash for materials or labor § Advance seasonal purchases § Cash needed for operating activities is not uniformly “low risk” § Cash needed to cover operating losses might not be temporary § A willing lender could make the difference between bankruptcy and continued operations for a company 6 © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Demand for Credit: Investing Activities § Companies require large amounts of cash for investing activities such as the purchase of property, plant and equipment or for corporate acquisitions § New PP&E (CAPEX) § Intangible assets § Mergers & acquisitions § LBO- Leverage Buy Out 7 © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Demand for Credit: Financing Activities § Companies occasionally need credit for financing activities § A bank loan or bond matures § Funds to repurchase stock 8 © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Supply of Credit: Trade Credit § Trade (supplier) credit is routine and non-interest bearing § Suppliers’ credit terms specify § The amount and timing of any early payment discounts § The maximum credit limit § Payment terms § Other restrictions or specifications § Recall “ 2/10 Net 30”? 9 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Supply of Credit: Bank Loans § Banks structure financing to meet specific client needs § Revolving credit line (revolvers) § Cash available for seasonal shortfalls § Bank commits to a credit line maximum, balance repaid later in the year § Low fees on unused balance, high fees on used balance § Lines of credit (back-up credit facilities) § Bank provides a guaranty that funds will be available when needed § Term loans (“bank loans) § Typically used to fund PP&E which serves as collateral § Loan duration matches useful life of PP&E § Mortgages § Typically used for real estate transactions § Lender takes property as security 10 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Supply of Credit: Other Forms of Financing § Lease financing § Leasing firms finance CAPEX § Leasing companies are often publicly traded § Publicly traded debt § Cost efficient way to raise large amounts of funding § Regulated by the SEC § Commercial paper – matures within 270 days § Bonds and debentures – longer term, trade on the major exchanges § Rated for credit quality 11 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 3.2 credit risk analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 13 Credit Risk Analysis Process § Purpose of credit risk analysis is to quantify potential credit losses so lending decisions are made with full information. § Expected credit loss is the product of two factors: Debtor’s ability Size of loss if to repay the debt debtor defaults professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 14 Chance of Default § Purpose is to quantify the risk of loss from non-payment. § Chance of default depends on the company’s ability to repay its obligations and this depends on future cash flow and profitability. § Involves several steps: § Step 1 Evaluate the nature and purpose of the loan § Step 2 Assess macroeconomic environment and industry conditions § Step 3 Perform financial analysis § Step 4 Perform prospective analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 15 Step 1 Evaluate 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 flow needs § Major capital expenditures or acquisitions § Fund temporary or ongoing operating losses § Reconfigure capital structure professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 16 Step 2 Assess Macroeconomics Environment and Industry Conditions § Industry competition―Competition and rivalry raise the cost of doing business § Bargaining power of buyers―Buyers with strong bargaining power can extract price concessions § Bargaining power of suppliers―Suppliers with strong bargaining power can demand higher prices § Threat of substitution―As the number of product substitutes increases, sellers have less power to raise prices and/or pass on costs to buyers § Threat of entry―New market entrants increase competition and companies must develop new technologies and human capital to create barriers to entry and economies of scale professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 17 Step 3 Analyze Financial Ratios § Financial ratios play a key role in credit-risk analysis. There is no general agreement about the best set of ratios to use to assess credit risk. § Also there is not one “correct” way to calculate specific ratios. § For our purposes, we compute three classes of credit-risk ratios: § Profitability and Coverage § Liquidity § Solvency/Leverage professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 18 Step 4 Perform Prospective Analysis § To evaluate creditworthiness, creditors must forecast the borrower’s cash flows to estimate its ability to repay its obligations. § Projected cash flows are especially critical because a company must have sufficient cash in the future to: 1. Repay debts as they mature 2. Service those debts along the way § Must first project (forecast) financial statements § Then we can use forecasted numbers to compute future ratios (profitability, liquidity, and solvency) and coverage ratios and evaluate changes or trends. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Introduction to the EDF Model What is the EDF Model? The EDF model estimates the probability of a firm defaulting within a specified time horizon, typically one year. Developed by Moody's Analytics, it is widely used in credit risk assessment by large financial institutions. Key Components: Market Value of Assets (V): Estimated using the market value of equity and book value of liabilities. Default Point (D): Threshold where liabilities exceed assets, typically calculated as short-term liabilities plus half of long-term liabilities. Distance to Default (DD): Measure of how far the firm's asset value is from the default point. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Moody’s KMV Expected Default Frequency Model Distance to ( Market Value of Firms’ Asset – Default point) Default (DD) = Volatility of the firm’s asset Value professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Relationship Between Distance to Default to Probability of Default ( Expected Default Frequency) Map DD to Expected Default Frequency AA higher DD (to the right on the graph) corresponds to a lower EDF probability, indicating a lower likelihood of default. A lower DD (to the left on the graph) corresponds to a higher EDF probability, indicating a higher likelihood of default. When DD = 0, the probability of default is 50%. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Question: How following scenarios affect firms Distance to Default and EDF: Stock Price Decrease Stock Price decrease and increase dramatically within a short period Firm pay down long term debt using cash Firm refinance short term debt with long term debt Time Horizon change from 1 year to 2 years professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 23 Loss Given Default (LGD) § LGD―the amount that could be lost if the company defaulted on its obligations § Defaults include failure to make payments and violation of loan covenants. § Potential loss depends on priority of the claim compared with all other existing claims. § Companies must repay senior claims first. § U.S. Bankruptcy Code specifies the priority of other claims. § To minimize potential loss, lenders structure credit terms including: § Credit limits § Collateral § Repayment terms § Covenants professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 24 Summary of Liquidity Order in U.S. Bankruptcy: 1.Administrative costs (legal fees, court costs, trustee fees) 2.Secured creditors (with claims backed by collateral) 3.Priority unsecured creditors (wages, benefits, and taxes) 4.Unsecured creditors (bondholders, suppliers, Customer etc.) 5.Subordinated debt holders 6.Preferred shareholders 7.Common shareholders professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 25 Loss Given Default Factors Credit Limits § Credit limits represent the maximum that a creditor will allow a customer to owe at any point in time. § Limits are based on the lender’s experience with similar borrowers and by firm-specific analysis. § Trade creditors § Set low limits for new customers and higher limits for established customers. § Bankruptcy laws protect ordinary trade creditors: goods shipped to a customer within 20 days before the bankruptcy have higher priority for payment. § Banks § Set credit limits on revolving credit. § Specify that if a borrower’s credit rating falls, credit limit may be reduced. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 26 Loss Given Default Factors Collateral § Collateral is property pledged by the borrower to guarantee repayment, most often real estate. § A full credit analysis should include an assessment of the number of existing liens on the collateral. § Bankruptcy laws protect ordinary trade creditors―seller can reclaim goods shipped within 45 days before bankruptcy to settle an unpaid balance. § Collateral will limit the amount of the loss but amounts owing in excess of the fair-value of the collateral will be lost. § Given a default, the time and costs incurred to gain control of and liquidate collateral can be substantial. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Poll Question § Between unsecured loan and secured loan ( loan with collateral), which one usually have higher interest rate? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 28 Loss Given Default Factors Repayment Terms § Term of loan is the length of time the creditor has to repay the debt. § Early payment discounts often offered by trade creditors. § To assess LGD must consider whether the economic life of the asset matches or exceeds the loan term. Greater Greater Higher cost Longer chance of credit of debt terms default risk financing professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 29 Loss Given Default Factors Covenants § Covenants are loan terms and conditions designed to limit the loss given default. § Three common types of covenants: § Positive/Affirmative covenants: Those that require the borrower to take certain actions, such as submitting financial statements to the lender. § Negative/Restrictive Covenants: Those that restrict the borrower from taking certain actions, such as preventing mergers or other major investments. § Financial Covenants: Those requiring the borrower maintain specific financial conditions, including certain ratios and minimum equity. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Typical Financial Covenants examples professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Typical negative Covenants professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 3.3 Credit risk measures professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 33 Adjusting Financial Information § Analysts scrutinize current and prior years’ financial statements to ensure they accurately reflect the company’s financial condition and operating performance. § General-purpose GAAP financial statements prepared in conformity with do not always accurately reflect our estimate of the “true” financial condition and operating performance. § Before we begin the analysis process, we make appropriate adjustments. § For example, we adjust Home Depot’s February 2019 income statement to “undo” the effects of a 53rd week in their fiscal year. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 34 Adjusting Financial Information Home Depot professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 35 Analyst Adjustments 4.1 § Retailers’ typically have a 53rd week every 4-5 years. § We must adjust all affected income statement numbers. § Adjust sales and expenses that vary proportionately with sales (such as cost of sales and SG&A) by multiplying by 52/53 § We do not adjust other expenses that are measured annually (such as interest, depreciation, and gains or losses) § We adjust tax expense proportionately based on effective tax rates (Tax expense / Pretax income) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 36 Analyst Adjustments 4.1 § For Target Corp, trends in total revenue and cost of sales are more obvious when we use adjusted numbers. § Unadjusted numbers: § Adjusted numbers: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 37 Coverage Analysis § Considers a company’s 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. § There are MANY coverage ratios including: § Times interest earned § EBITDA coverage ratio § Cash from operations to total debt § Free operating cash flow to total debt professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 38 Times Interest Earned Ratio § Reflects the operating income available to pay interest expense § Assumes only interest must be paid because the principal will be refinanced § For Home Depot: Home Depot can cover its interest expense 14.5 times over. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 39 Analyst Adjustments 4.2 § Credit analysts adjust or reformulate companies’ financial statements prior to ratio analysis. § Moody’s adjusts a number of items and these are typical for credit analysts. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 40 EBITDA Coverage Ratio § EBITDA is a non-GAAP performance metric. § More widely used than the times interest earned ratio because depreciation and amortization do not require a cash outflow. § Always higher than times interest earned ratio. § Measures company’s ability to pay interest out of current profits. § For Home Depot: Depreciation and amortization from the statement of cash flows. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 41 Income Coverage Ratios Home Depot professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 42 Coverage Analysis Based on Cash Flow § Cash from operations to total debt measures the ability to generate additional cash to cover debt payments as they come due. § Free operating cash flow to total debt considers excess operating cash flow after cash is spent on capital expenditures. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 43 Cash Flow Coverage Ratios Home Depot professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 44 Liquidity Ratios Liquidity refers to cash availability―how much cash a company has, and how much it can generate on short notice. Assets a company expects to convert into cash within a year. Liabilities that come due within a year. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 45 Liquidity Ratios Home Depot professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 46 Solvency Ratios Solvency refers to a company’s ability to meet its debt obligations. § Solvency is crucial―an insolvent company is a failed company § Two common solvency ratios: How reliant a company is on creditor financing compared with equity financing Distinguishes between operating creditors and debt obligations professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 47 Solvency Analysis § Solvency varies by industry and depends on the relative stability of cash flows. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 3.4 Credit rating process professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 49 Credit Ratings § A credit rating is an opinion of an entity’s creditworthiness, captured in alpha-numeric scales. Investment Grade Non-investment Grade professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 50 Credit Rating Analysis § Credit analysts at rating agencies: § Consider macroeconomic, industry, and firm-specific information § Assess chance of default and ultimate payment in the event of default § Provide ratings on both debt issues and issuers § Predict loan default with fair degree of accuracy professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 51 Credit Rating Process § Every agency has a unique approach. § Moody’s process involves the following 9 steps: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers S&P Global Ratings: General Approach 52 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers S&P Global Ratings: Financial Risk S&P determines financial risk using cash flow and leverage ratios similar to those in the textbook: 53 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE S&P Credit rating methodology (1) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE S&P Credit rating methodology (2) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE S&P Global Ratings: Verizon Composite Rating S&P composite rating for Verizon: bbb+ 56 © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE S&P Credit rating methodology (3) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Question § If an issuer have an FFO/DEBT ratio of 25%, Debt/EBITDA 2.5X, Debt to Capital 30%. The business risk profile is considered as strong. What is the base-line credit rating for the issuer (Anchor)? § What might the final Credit rating be? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 59 Ratio Values for Different Risk Classes of Corporate Debt § Debt is increasingly more risky as we move from the first row to the last. § For the most part, ratios weaken from row to row. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 60 Credit Rating Agency Reform Act § Signed into law in 2006 § Establishes a registration system for credit rating agencies § Separation of rating activities from other business activities such as consulting. § Improved transparency, such as mandate disclosure of rating methodologies, performance track records and conflict of interest § Created list of Nationally Recognized Statistical Ratings Organizations (NRSRO) § SEC has designated only 9 of nearly 100 agencies as NRSROs: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 61 Rating of Issuers vs Rating of Issue § The issuer’s credit rating addresses the issuer’s overall creditworthiness and usually applies to senior unsecured debt. § Issue rating refers to specific financial obligations and considers ranking in the capital structure such as secured or subordinated. § However, cross-default provisions, which refer to events of default such as nonpayment of interest on one bond triggering default on all outstanding debt, may often suggest the same default probability for all issues. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 3.5. Bankruptcy predication models professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 63 Bankruptcy Prediction Indicators § Assess a company’s bankruptcy risk at a point of time. § Altman’s Z model used to predict bankruptcy risk Working Capital Retained Earnings Z-Score = 1.2 x + 1.4 x Total Assets Total Assets Market Value of EBIT + 3.3 x + 0.6 x Equity Total Assets Total Liabilities Sales + 0.99 x Total Assets professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 64 Z-Score Interpretation § Shown to reasonably predict bankruptcy accurately for up to two years § 95% accuracy in Year 1 § 72% accuracy in Year 2 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Poll question: § When calculating Altman Z score, should we use average amount or year-end amount for Market value of Equity? How about other balance sheet items? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 66 Application of Z-Score Home Depot’s financial statement information for year ending February 3, 2019. Z-Score > 3.00 HD is healthy. Low risk of bankruptcy in the short term. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE