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 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
Activity
Ability to
Generate Cash
Need to Use
Cash
Financial Statement
Analysis Performed
Operations
Profitability of
Goods and
Services Sold
Working Capital
Requirements
Short-Term Liquidity
Risk
Investing
Sales of Existing
Plant Assets or
Investments
Plant Capacity
Requirements
Long-Term Solvency
Risk
Financing
Borrowing
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 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!


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 Ratio
Current 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 Ratio
Total 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 earned
Operating 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 Models
Altmans Z-Score:
(

+
(

+
(

+
(

+
(

=
Assets Total
Sales
s Liabilitie of Value Book
Equity of Value Market
Assets Total
Taxes and Interest Bef ore 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:

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
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 f or in M of it
+ +
=
=
) 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
Area in
Exhibit
Capital
Intensity
Competition
Strategic
Focus
A High Monopoly
Profit
Margin
for ROA
B Medium Oligopoly Both
C Low
Pure
Competition
Assets
Turnover
Profitability Ratios
Financial Ratio Formula Measurements
Return on Total Assets
Operating 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 Sales
Profitability of trading and
mark-up
Profit Margin
Operating profit after income tax /
Net Sales Revenue
Measures net profitability of
each dollar of sales
Total Assets Turnover
Financial Ratio Formula Measurements
Receivables turnover
Net sales revenue / Average receivables
balance
Measures the effectiveness of
collections; used to
evaluate whether
receivables balance is
excessive
Inventory turnover
Cost 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 assets
Measures the effectiveness of
an entity in using its
assets during the period.
Turnover of Fixed Assets Net Sales / Fixed Assets
Measure 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
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
'
=