Financial Statement Analysis & Valuation PDF

Financial Statement & Analysis Valuation Sixth Edition Peter D. Easton Mary Lea McAnally Gregory A. Sommers Module 4 Credit Risk Analysis and Interpretation © Cambridge Business Publishers, 2021 Learning Objective 1 Describe t...

Financial Statement & Analysis Valuation Sixth Edition Peter D. Easton Mary Lea McAnally Gregory A. Sommers Module 4 Credit Risk Analysis and Interpretation © Cambridge Business Publishers, 2021 Learning Objective 1 Describe the demand for and supply of credit. © Cambridge Business Publishers, 2021 Market for Credit  Companies demand credit for operating, investing, and financing activities.  Many parties offer credit including:  Trade creditors  Banks  Public debt investors  Private lenders  Laws of demand and supply affect the credit market. © Cambridge Business Publishers, 2021 4 Demand for Credit― Operating Activities  Operating credit demand can be a routine low risk need created by:  Cyclical operating cash needs such as materials or labor  Advance seasonal purchases  Or operating credit demand could signal higher risk  When used to cover operating losses  A willing creditor could make the difference between bankruptcy and continued operations for a company. © Cambridge Business Publishers, 2021 5 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.  Needs can vary in timing and amount.  Long-term debt routinely used for start-up and growth  Mature firms settle into predictable capital expenditure patterns and credit demands. © Cambridge Business Publishers, 2021 6 Demand for Credit― Financing Activities  Occurs less frequently than operating and investing activities.  Common situations  A bank loan or bond comes due and a company does not have the necessary funds on hand.  Funds to pay dividends or repurchase stock © Cambridge Business Publishers, 2021 7 Supply of Credit― Trade Credit  Trade credit from suppliers is routine and most often 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.  Suppliers often tailor contractual terms to particular customer’s existing and ongoing creditworthiness. © Cambridge Business Publishers, 2021 8 Supply of Credit― Bank Loans  Structured to meet specific client needs  Balanced with myriad of rules and regulations by regulators  Revolving credit line  Cash available on demand, balance fluctuates  Floating interest rate  Letters of credit  Bank is interposed between the company and its supplier  Bank provides a guaranty of payment  Term loans  A set loan amount (principal) with specified periodic payments  Interest rates are either fixed or floating for duration of the loan  Mortgages―term loan based on collateral, typically © Cambridge Business Publishers, 2021 9 Supply of Credit― Other Forms of Financing  Nonbank private financing  Used when bank financing is limited or unavailable  Provided by private lenders that have experience in industry  Lender creatively structures loan repayment and may act as a management consultant  Lease financing  Typically used for PPE acquisition  Leasing firm considers credit risk of the lessee and collateral © Cambridge Business Publishers, 2021 10 Supply of Credit― Publicly Traded Debt  Efficient way to raise funds in public markets  Regulated by the SEC even if the company’s stock does not trade publicly.  Commercial paper  Short-term borrowing, 270 days or less  Makes it exempt from SEC regulation  Bonds or debentures  Public borrowings for longer durations  Regulated by the SEC  Principal borrowed is paid back on a fixed term with semi- annual or annual interest payments. © Cambridge Business Publishers, 2021 11 Learning Objective 2 Explain the credit risk analysis process. © Cambridge Business Publishers, 2021 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  Many parties perform credit risk analysis:  Trade creditors  Financial institutions  Public debt market participants  Credit rating agencies © Cambridge Business Publishers, 2021 13 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 © Cambridge Business Publishers, 2021 14 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 © Cambridge Business Publishers, 2021 15 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 © Cambridge Business Publishers, 2021 16 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 © Cambridge Business Publishers, 2021 17 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. © Cambridge Business Publishers, 2021 18 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 © Cambridge Business Publishers, 2021 19 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. © Cambridge Business Publishers, 2021 20 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. © Cambridge Business Publishers, 2021 21 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 Higher Greater Longer chance cost of credit terms of debt risk default financing © Cambridge Business Publishers, 2021 22 Loss Given Default Factors Covenants  Covenants are loan terms and conditions designed to limit the loss given default.  Three common types of covenants:  Those that require the borrower to take certain actions, such as submitting financial statements to the lender.  Those that restrict the borrower from taking certain actions, such as preventing mergers or other major investments.  Those requiring the borrower maintain specific financial conditions, including certain ratios and minimum equity. © Cambridge Business Publishers, 2021 23 Learning Objective 3 Compute and interpret credit risk measures. © Cambridge Business Publishers, 2021 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. © Cambridge Business Publishers, 2021 25 Adjusting Financial Information Home Depot © Cambridge Business Publishers, 2021 26 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) © Cambridge Business Publishers, 2021 27 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: © Cambridge Business Publishers, 2021 28 Profitability Analysis  Profitability is related to credit risk because firms pay interest and repay their debt with cash generated from profits.  The more profitable the firm, the less likely it is to default.  We can disaggregate ROE to assess profitability: © Cambridge Business Publishers, 2021 29 Profitability Analysis Home Depot  For Home Depot using numbers reported:  Home Depot’s 2019 ROE is negative due to negative stockholders’ equity owing to large levels of treasury stock.  2017 and 2018 ROE is very high because treasury stock reduced stockholders’ equity to a small number and inflated ROE.  Adjust equity by adding back the treasury stock book value. © Cambridge Business Publishers, 2021 30 Expanded Profitability Analysis  RNOA is an aggregate measure of the return from operating activities and is a comprehensive profitability measure.  RNOA is not affected by the company’s leverage or treasury stock activity.  Home Depot: © Cambridge Business Publishers, 2021 31 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 © Cambridge Business Publishers, 2021 32 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. © Cambridge Business Publishers, 2021 33 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. © Cambridge Business Publishers, 2021 34 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. © Cambridge Business Publishers, 2021 35 Income Coverage Ratios Home Depot © Cambridge Business Publishers, 2021 36 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. © Cambridge Business Publishers, 2021 37 Cash Flow Coverage Ratios Home Depot © Cambridge Business Publishers, 2021 38 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. © Cambridge Business Publishers, 2021 39 Liquidity Ratios Home Depot © Cambridge Business Publishers, 2021 40 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 © Cambridge Business Publishers, 2021 41 Solvency Analysis  Solvency varies by industry and depends on the relative stability of cash flows. © Cambridge Business Publishers, 2021 42 Solvency Analysis Home Depot Recall that Home Depot has negative equity and in such situations ratios should be calculated on RESTATED numbers for better comparability. © Cambridge Business Publishers, 2021 43 Learning Objective 5 Apply bankruptcy prediction models to evaluate bankruptcy risk. © Cambridge Business Publishers, 2021 Bankruptcy Prediction Indicators  Assess a company’s bankruptcy risk  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 Equity + 3.3 x + 0.6 x Total Assets Total Liabilities Sales + 0.99 x Total Assets © Cambridge Business Publishers, 2021 45 Z-Score Interpretation  The first variable provides a measure of liquidity, while the second and third variables measure long- term and short-term profitability. The fourth variable captures the company's levered status, while the fifth variable reflects its total asset efficiency.  Shown to reasonably predict bankruptcy accurately for up to two years  95% accuracy in Year 1  72% accuracy in Year 2 © Cambridge Business Publishers, 2021 46 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. © Cambridge Business Publishers, 2021 47 Financial Statement & Analysis Valuation Sixth Edition Cambridge Business Publishers www.cambridgepub.com