Credit Risk Analysis and Interpretation Module 4 Credit Risk Analysis and Interpretation © Cambridge Business Publishers, 2018

Describe the demand for and supply of credit. 1 Describe the demand for and supply of credit. © Cambridge Business Publishers, 2018

Market for Credit Composed of: Demand for credit Supply of credit By most companies for operating, investing, and financing activities Supply of credit Offered by creditors, banks, public debt investors, private lenders Maximum return of a debt investor is determined by the interest rate set in the loan and the prevailing market rate of interest. © Cambridge Business Publishers, 2018

Credit Demand for Operating Activities Credit terms Dictated by past experience with a company Routine, low risk needs created by Cyclical operating cash needs such as materials or labor Advance seasonal purchases Higher risk credit When used to cover operating losses A willing creditor could make the difference between bankruptcy and continued operations for a company. © Cambridge Business Publishers, 2018

Credit Demand for Investing Activities Require large amounts of cash for investments such as new equipment or mergers Needs can vary in timing and amount Long-term debt routinely used for start-up and growth Predictable capital expenditure patterns often held by mature firms © Cambridge Business Publishers, 2018

Credit Demand for 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 are borrowed Evergreen debt When a company consistently pays off debt by taking on more debt © Cambridge Business Publishers, 2018

Supply of Credit There are many sources of credit to meet companies’ demand which include: Non-bank financing Trade credit Lease financing Bank loans Publicly-traded debt © Cambridge Business Publishers, 2018

Trade Credit Routine credit from suppliers Most often non-interest bearing Suppliers often tailor contractual terms to particular customer’s existing and ongoing creditworthiness Credit limit assigned © Cambridge Business Publishers, 2018

Bank Loans Structured to meet specific client needs Balanced with myriad of rules and regulations by bank regulators Revolving credit line Available on demand Floating interest rate Lines of credit Available credit to be used as needed Letters of credit Financing feature where a bank is interposed between two parties © Cambridge Business Publishers, 2018

More Bank Loans Term loans Mortgages A set loan amount (principal) with specified periodic payments Interest rates are either fixed or floating for the duration of the loan Mortgages Debt instruments based on collateral, typically, real estate holdings © Cambridge Business Publishers, 2018

Nonbank Private Financing Private (nonbank) sources of financing used when bank financing is limited or unavailable Results from private lenders such as private equity firms that have experience in industry Private lenders creatively structure loan repayment and may act as a management consultant © Cambridge Business Publishers, 2018

Lease Financing Typically used for the acquisition of capital equipment. Typical items Machinery Computer equipment Vehicles Leasing firm structures lease Considers collateral Credit risk of the lessee © Cambridge Business Publishers, 2018

Publicly Traded Debt Debt capital raised through public markets. Commercial paper Short-term borrowing resource under SEC regulations which cannot exceed 270 days 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, 2018

Explain the credit risk analysis process. 2 Explain the credit risk analysis process. © Cambridge Business Publishers, 2018

Credit Risk Analysis Process Purpose is to quantify potential credit losses so lending decisions are made with full information Consists of two components Expected credit loss = Chance of default x Loss given default Debtor’s ability to repay debt Size of loss if debtor defaults © Cambridge Business Publishers, 2018

Credit Analysis Purpose is to quantify the risk of loss from non- payment Involves several steps Step 1: Assess 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, 2018

Credit Analysis—Step 1 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 Fund temporary or ongoing operating losses Major capital expenditures or acquisitions Reconfigure capital structure © Cambridge Business Publishers, 2018

Credit Analysis—Step 2 Step 2: Assess macroeconomic environment and industry conditions Industry competition Involves the company’s competitive position and the effect on its financial results Buyer power Can be a credit risk if customers have the ability to demand price concessions Supplier power A factor if suppliers have strong bargaining power and can demand higher prices and early payments © Cambridge Business Publishers, 2018

Credit Analysis—Step 2 continued Step 2: Assess macroeconomic environment and industry conditions (continued) Threat of substitution Occurs when a company has limitations on product such as the inability to increase prices or pass costs on to customers Threat of entry Occurs when new market entrants increase competition Company could be subject to aggressive tactics where the new entrants try to win over clients © Cambridge Business Publishers, 2018

Credit Analysis—Step 3 Step 3: Analyze financial ratios Includes analysis of the financial statements through ratio calculations Adjustments to financial statements made to provide more accurate ratios and forecasts Excludes one-time events that will not persist Includes all operating assets and liabilities Considers items that may distort operations © Cambridge Business Publishers, 2018

Credit Analysis—Step 3 continued Step 3: Analyze financial ratios (continued) Profitability analysis Considers items that surround profitability using return on net operating assets (RNOA) Net operating profit margin (NOPM) Net operating asset turnover (NOAT) Excludes items that will not persist such as one-time charges for a more accurate picture of the firm’s future profitability © Cambridge Business Publishers, 2018

Credit Analysis—Step 4 Step 4: Perform prospective analysis Based on adjusted past performance Should adjust the capital structure to reflect anticipated future debt retirements as they come due over the forecast horizon Compute ratios based on the forecast Evaluate changes and trends © Cambridge Business Publishers, 2018

Loss Given Default Consists of factors that affect the amount that could be lost if the company defaulted on its obligations Defaults include Failure to make payments Violation of loan covenants Creditors loss is dependent on priority of the claim compared with all other existing claims Determined by laws and private contracts © Cambridge Business Publishers, 2018

Minimization of Potential Loss Structure credit terms for loans in advance Trade-off exists if the lender is too strict with the loan terms causing the borrower to default Credit Limit Maximum allowed to owe at one time Collateral Property pledged to guarantee payment Repayment Term Length of time to repay debt obligation Covenants Terms and conditions to limit lender loss © Cambridge Business Publishers, 2018

Loss Given Default Factors Credit Limits The maximum amount a company may be loaned at a point in time Limits are set based on the lender’s experience with similar borrowers, and by firm-specific analysis Trade creditors Low limits for new customers Higher limits for established customers Banks Credit limits on revolving credit If credit rating falls, credit limit may be reduced © Cambridge Business Publishers, 2018

Loss Given Default Factors Collateral Collateral is property pledged by the borrower to guarantee repayment Personal property, and Real property, such as real estate mortgages Best collateral is high-grade property such as securities with an active market Value is known Liquidation is straight-forward © Cambridge Business Publishers, 2018

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 Influenced by the nature of loan Ensures that the life of the asset matches or exceeds the amount of time allowed to pay back the debt Longer terms Greater chance of default Greater credit risk Higher cost of debt financing © Cambridge Business Publishers, 2018

Loss Given Default Factors Covenants Are terms and conditions of a loan 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 Those requiring the borrower maintain specific financial conditions, including certain ratios and minimum equity © Cambridge Business Publishers, 2018

3 Compute and interpret credit risk measures. © Cambridge Business Publishers, 2018

Profitability Analysis Example Home Depot’s net operating profit after taxes (NOPAT) = $11,774 – [$4,012 + ($753 x 37%)] = $7,483 Operating income Tax expense Interest and other, net Statutory tax rate © Cambridge Business Publishers, 2018

Profitability Related to Credit Risk Repayment of debt more likely when profit is higher Helpful to examine return on equity and return on debt plus equity © Cambridge Business Publishers, 2018

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 Include four ratios Times interest earned EBITDA coverage ratio Cash from operations to total debt Free operating cash flow to total debt © Cambridge Business Publishers, 2018

Coverage Analysis 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 © Cambridge Business Publishers, 2018

Coverage Analysis EBITDA Ratio EBITDA is a non-GAAP performance metric More widely used than the times interest earned ratio because depreciation does not require a cash outflow Always higher than times interest earned ratio Measures company’s ability to pay interest out of current profits © Cambridge Business Publishers, 2018

Home Depot Coverage Ratios © Cambridge Business Publishers, 2018

Coverage Analysis Cash from Operations to Total Debt Measures a company’s ability to generate additional cash to cover debt payments as they come due. © Cambridge Business Publishers, 2018

Coverage Analysis Free Operating Cash Flow to Total Debt Considers excess operating cash flow after cash is spent on capital expenditures. © Cambridge Business Publishers, 2018

Home Depot Cash Flow Ratios © Cambridge Business Publishers, 2018

Liquidity and Solvency Measures Liquidity refers to cash How much we have How much is expected, and How much can be raised on short notice Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors. © Cambridge Business Publishers, 2018

Current Ratio Current assets—those assets that a company expects to convert into cash within the next operating cycle, which is typically a year Current liabilities—those liabilities that come due within the next year An excess of current assets over current liabilities (Current assets / Current liabilities), is known as net working capital or simply working capital © Cambridge Business Publishers, 2018

Quick Ratio The Quick ratio focuses on quick assets. Quick assets include cash, marketable securities, and accounts receivable; they exclude inventories and prepaid assets. © Cambridge Business Publishers, 2018

Home Depot’s Liquidity Ratios © Cambridge Business Publishers, 2018

Solvency Ratios Solvency refers to a company’s ability to meet its debt obligations. Solvency is crucial since an insolvent company is a failed company. Two common solvency ratios: Liabilities-to-equity ratio Total debt-to-equity © Cambridge Business Publishers, 2018

Solvency Analysis Assesses a company’s ability to meet its long-term obligations Less costly source of financing Carries default risk General approach to solvency is to assess the level of debt relative to equity © Cambridge Business Publishers, 2018

Solvency Analysis Conveys how reliant a company is on creditor financing compared with equity financing Does not distinguish between current and long-term debt © Cambridge Business Publishers, 2018

Solvency Analysis Assumes that current operating liabilities will be repaid from current assets (self-liquidating). © Cambridge Business Publishers, 2018

Home Depot Solvency Ratios © Cambridge Business Publishers, 2018

Explain credit ratings and describe the credit rating process. 4 Explain credit ratings and describe the credit rating process. © Cambridge Business Publishers, 2018

Credit Raters Credit rating agencies assess credit risk Differ from other lenders Have no direct financial involvement with companies whose credit they are rating Have access to more, better, and most current information Can refine risk analysis across industries © Cambridge Business Publishers, 2018

Credit Ratings Opinions of an entity’s credit worthiness Capture the entity’s ability to meet its financial commitments as they come due 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 © Cambridge Business Publishers, 2018

Credit Ratings by Agencies Long-term issue rating scales used by Standard and Poor’s and Moody’s Investor Services © Cambridge Business Publishers, 2018

Why Companies Care About Their Credit Ratings Credit ratings affect the cost of debt Increases interest expense May limit new investment projects Can restrict growth Certain investors will not invest in their debt if considered non-investment grade © Cambridge Business Publishers, 2018

How Risk is Linked to Credit Ratings Risk increases the cost of debt which is linked directly to the company’s credit rating. © Cambridge Business Publishers, 2018

Bond Rating Distribution Evidence suggests companies try to maintain investment grade bond ratings Ratings AAA through BBB- account for 55% of all corporate issuers © Cambridge Business Publishers, 2018

How Credit Ratings are Determined Analysts gather and analyze inputs: Macroeconomic events Industry level data Company specific information Financial statement data Qualitative information Findings are presented to a rating committee for review Ratings committee assigns a rating Rating agency informs the issuer of the rating © Cambridge Business Publishers, 2018

Ratio Values for Different Risk Classes of Corporate Debt © Cambridge Business Publishers, 2018

Credit Rating Agency Reform Act Signed into law in 2006 Establishes a registration system for credit rating agencies Allows agencies with three years of experience to register with the SEC Considered nationally recognized statistical ratings organizations (NRSRO) SEC has designated only 10 of nearly 100 agencies as NRSROs © Cambridge Business Publishers, 2018

Apply bankruptcy prediction models to evaluate bankruptcy risk. 5 Apply bankruptcy prediction models to evaluate bankruptcy risk. © Cambridge Business Publishers, 2018

Bankruptcy Prediction Indicators Assess a company’s bankruptcy risk Altman model used to predict bankruptcy risk Z-Score = 1.2 x Working Capital + 1.4 x Retained Earnings Total Assets 3.3 x EBIT 0.6 x Market Value of Equity Total Liabilities 0.99 x Sales © Cambridge Business Publishers, 2018

Z-Score Interpretation Shown to reasonably predict bankruptcy accurately for up to two years 95% accuracy in Year 1 72% accuracy in Year 2 Z-Scores and Their Interpretation © Cambridge Business Publishers, 2018

Application of Z-Score Use Home Depot’s financial statement information for year ending February 3, 2013. Greater than 3.00 Home Depot is healthy and there is low bankruptcy potential in the short term. © Cambridge Business Publishers, 2018

Bankruptcy Prediction Errors Two types of errors from a Z-Score: Type I Error: A false negative or a situation where the Z-Score indicates a company is healthy but goes bankrupt Type II Error: A false positive or a situation where the company is projected to go bankrupt, yet the company remains solvent © Cambridge Business Publishers, 2018

Credit Risk Analysis at Two Major NRSROs Appendix 4 Credit Risk Analysis at Two Major NRSROs © Cambridge Business Publishers, 2018

Factors of S&P Credit Risk Business Risk Profitability Business Risk Industry Characteristics Capital Structure Competitive Position Financial Risk Financial Policy Management Financial Flexibility © Cambridge Business Publishers, 2018

Moody’s Four Factor Analysis Size, Scale and Diversification Financial Strength Business Risk Product Portfolio and Profitability Financial Policies © Cambridge Business Publishers, 2018