©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

©Cambridge Business Publishers, 2013 Module 4: Credit Risk Analysis and Interpretation

©Cambridge Business Publishers, 2013 Market for Credit Composed of Composed of Demand for credit Demand for credit By most companies for operating, investing, and financing activities By most companies for operating, investing, and financing activities Supply of credit Supply of credit Offered by Offered by Creditors, banks, public debt investors, private lenders 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, 2013 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, 2013 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, 2013 Financing Activities ■ Occurs less frequent 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, 2013 Supply of Credit There are many sources of credit to meet companies’ demand which include: Publicly- traded debt Publicly- traded debt Non-bank financing Non-bank financing Bank loans Trade credit Lease financing Lease financing

©Cambridge Business Publishers, 2013 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, 2013 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, 2013 More Bank Loans ■ Term loans ■ Usually set in borrowing amount (principal) with periodic payments ■ Usually based on market interest rates that are set for the duration of the borrowing ■ Mortgages ■ Debt instruments based on collateral, typically, real estate holdings

©Cambridge Business Publishers, 2013 Nonbank Private Financing ■ Private (nonbank) sources of financing ■ Used when bank financing is limited or unavailable ■ Usually results from private lenders such as private equity firms that have experience in an industry

©Cambridge Business Publishers, 2013 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, 2013 Publicly Traded Debt ■ Debt capital raised through public markets ■ Commercial paper ■ Short term borrowing facility 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, 2013 Credit Risk Analysis Process ■ Purpose is to quantify potential credit losses so lending decisions are made with full information ■ Consists of two components Primarily a debtor’s ability to pay down the debt Chance of Default × Loss given default If defaulted, how big will the loss be? Expected credit loss =

©Cambridge Business Publishers, 2013 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 information ■ Can refine risk analysis across industries ■ Have best, most current information

©Cambridge Business Publishers, 2013 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, 2013 Credit Analysis – Step 1 Step 1: Assess 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 flows needs ■ Fund temporary or ongoing operating losses ■ Major capital expenditures or acquisitions ■ Reconfigure capital structure

©Cambridge Business Publishers, 2013 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 have stronger price concessions ■ Supplier power ■ A factor if suppliers have strong bargaining power and can demand higher prices and early payments

©Cambridge Business Publishers, 2013 Credit Analysis – Step 2 continued Step 2: Assess macroeconomic environment and industry conditions ■ Threat of substitution ■ Occurs when a company has limitations on products such as to inhibit price increases or pass costs to customers ■ Threat of entry ■ Occurs with new market entrants increase competition ■ Company could be subject to aggressive tactics where the new entrants try to win over clients

©Cambridge Business Publishers, 2013 Credit Analysis – Step 3 Step 3:Perform financial analysis Step 3: Perform financial analysis ■ Includes focusing on performing analysis of the financial statements ■ 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, 2013 Profitability Analysis Step 3:Performfinancial analysis - continued Step 3: Perform financial analysis - continued ■ Considers items that surround profitability using return on net operating assets (RNOA) ■ Net operating profit margin (NOPM) ■ Net operating asset turnover (NOAT) ■ Adjusted to better reflect a company’s economic profitability ■ Excludes items that will not persist such as one- time charges

©Cambridge Business Publishers, 2013 Profitability Analysis Example Home Depot’s net operating profit after taxes (NOPAT): = $5,839 – [$1,935 + ($566 x 36.7%)] = $3,696 Interest expense plus other non-operating expenses Interest expense plus other non-operating expenses Statutory tax rate Operating income Tax expense

©Cambridge Business Publishers, 2013 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, 2013 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, 2013 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 Earnings before interest and taxes Times interest earned= Interest expense

©Cambridge Business Publishers, 2013 ■ ■ 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 Earnings before tax + Interest expense, net + Depreciation + Amortization EBITDA coverage = Interest expense Coverage Analysis EBITDA Coverage Ratio

©Cambridge Business Publishers, 2013 Home Depot Coverage Ratios

©Cambridge Business Publishers, 2013 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. Cash from operations Cash from operations to total debt = Short-term debt + Long-term debt

©Cambridge Business Publishers, 2013 Coverage Analysis Free Operating Cash Flow to Total Debt Considers excess operating cash flow after cash is spent on capital expenditures Cash from operations - CAPEX Free operating cash flow to total debt = Short-term debt + Long-term debt

©Cambridge Business Publishers, 2013 Home Depot Cash Flow Ratios

©Cambridge Business Publishers, 2013 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. 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. Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

©Cambridge Business Publishers, 2013 Current Ratio ■Current assetsare those assets that a company expects to convert into cash within the next operating cycle, which is typically a year. ■Current assets are those assets that a company expects to convert into cash within the next operating cycle, which is typically a year. ■Current liabilitiesare those liabilities that come due within the next year. ■Current liabilities are 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 capitalor simply working capital. ■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, 2013 Quick Ratio Thequick ratiofocuses on quick assets. The quick ratio focuses on quick assets. Quick assets include cash, marketable securities, and accounts receivable; they exclude inventories and prepaid assets. Quick assets include cash, marketable securities, and accounts receivable; they exclude inventories and prepaid assets.

©Cambridge Business Publishers, 2013 Home Depot’s Liquidity Ratios

©Cambridge Business Publishers, 2013 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:

©Cambridge Business Publishers, 2013 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 Median Ratio of Liabilities to Equity for Selected Industries

©Cambridge Business Publishers, 2013 Solvency Analysis ■ Conveys how reliant a company is on creditor financing compared with equity financing ■ Does not distinguish between current and long- term debt Liabilities-to-equity ratio= Total liabilities Stockholders’ equity

©Cambridge Business Publishers, 2013 Solvency Analysis Assumes that current operating liabilities will be repaid from current assets (self-liquidating) Total debt-to-equity = Long-term debt including current portion + Short-term debt Stockholders’ equity

©Cambridge Business Publishers, 2013 Home Depot Solvency Ratios

©Cambridge Business Publishers, 2013 Perform Prospective Analysis – Step 4 Step 4: Forecast future results ■ 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 ■ Perform sensitivity analysis

©Cambridge Business Publishers, 2013 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, 2013 Minimization of Potential Loss Structure credit terms for loans in advance Structure credit terms for loans in advance Credit limits Credit limits Collateral Collateral Repayment terms Repayment terms Covenants Covenants Trade-off exists between being too strict where the terms cause the borrower to default, and not being strict enough causing the borrower to default Trade-off exists between being too strict where the terms cause the borrower to default, and not being strict enough causing the borrower to default

©Cambridge Business Publishers, 2013 Loss Given Default Factors ■ Take into consideration the maximum amount a company may be loaned at a point in time ■ Limits are set based on the lender’s experience with similar borrower, and by firm-specific analysis ■ Limits set by trade creditors ■ Low limits for new customers ■ Higher limits for established customers Credit Limits Credit Limits

©Cambridge Business Publishers, 2013 Loss Given Default Factors ■ 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 Collateral

©Cambridge Business Publishers, 2013 Loss Given Default Factors ■ 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 Higher Cost of Debt Financing Greater Credit Risk Greater Chance of Default = == Repayment Terms

©Cambridge Business Publishers, 2013 Loss Given Default ■ Are terms and conditions of a loan designed to limit the loss given default ■ Three common types ■ Covenants that require the borrower to take certain actions, such as submitting financial statements to the lender ■ Covenants that restrict the borrower from taking certain actions, such as preventing mergers ■ Covenants that require the borrower to maintain specific financial conditions, including certain ratios and minimum equity Covenants

©Cambridge Business Publishers, 2013 Credit Ratings ■ Are 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 ■ Provide ratings on both debt issues and issuers ■ Consider macroeconomic, industry, and firm- specific information ■ Assess chance of default and ultimate payment in the event of default

©Cambridge Business Publishers, 2013 Credit Ratings by Agencies Long-term issue rating scales used by Standard and Poor’s and Moody’s Investor Services

©Cambridge Business Publishers, 2013 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 Risk increases the cost of debt which is linked directly to the company’s credit rating Treasury and Corporate 10-Year Bond Yields

©Cambridge Business Publishers, 2013 Credit Rating Models ■ Agencies have access to information not available to lenders ■ Models have three types of inputs ■ Macroeconomic statistics ■ Monitored by economists ■ Industry data ■ Through frameworks such as Porter’s Five Forces and SWOT analysis ■ Company specific information ■ Financial ratios for companies compared to median averages for various risk classes

©Cambridge Business Publishers, 2013 How Credit Ratings Are Determined ■ Macroeconomic events are monitored ■ Industry level data is analyzed ■ Financial statement data is gathered and analyzed ■ Firm-specific qualitative information is gathered, including on-site visits ■ 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, 2013 Ratio Values for Different Risk Classes of Corporate Debt

©Cambridge Business Publishers, 2013 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 8 of 130 agencies as NRSROs

©Cambridge Business Publishers, 2013 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 AssetsTotal Liabilities x Sales Total Assets

©Cambridge Business Publishers, 2013 Z-Score Interpretation ■ ■ Shown to reasonably accurately predict bankruptcy for up to two years ■ ■ 95% accuracy in year 1 ■ ■ 72% accurate in year 2 Z-Scores and Their Interpretation

©Cambridge Business Publishers, 2013 Application of Z-Score Use Home Depot’s financial statement information for year ending January 30, Current assets$13,479Shares outstanding, in millions1,623 Current liabilities 10,122 × Share price $36.70 Working capital (SC)$3,357Market value of equity (MVE)$59,564 Total assets (TA)$40,125Total liabilities (TL)$21,236 Retained earnings (RE)$14,995Sales$67,997 EBIT$5,839 WC/TA × 1.2 = RE/TA × 1.4 = EBIT/TA × 3.3 = MVE/TL × 0.6 = Sales/TA × 0.99 = Z-Score4.464 Greater than 3.00 Home Depot is healthy and there is low bankruptcy potential in the short term.

©Cambridge Business Publishers, 2013 Bankruptcy Prediction Errors Two types of errors from a Z-Score A false negative or a situation where the company is healthy but the Z-Score predicts bankruptcy A false positive or a situation where the company is projected to go bankrupt yet the company remains intact Type I Error Type II Error

©Cambridge Business Publishers, 2013 Factors of S&P Credit Risk Business risk Industry characteristics Management Financial risk Profitability Competitive position Financial characteristics Financial policy Capital structure Cash flow protection Financial flexibility

©Cambridge Business Publishers, 2013 Moody’s Four Factor Analysis Factor 1 Size, Scale & Diversification RevenueDiversity Concentration by top customer segment Factor 2 Product Portfolio and Profitability R&D percent of salesEBIT marginROA

©Cambridge Business Publishers, 2013 Moody’s Four Factor Analysis Factor 3 Financial Strength CFO/DebtFCF/DebtEBIT/Interest expense Factor 4 Financial Policies Reliance on acquisitions, share buybacks, and dividends Debt/Book Capitalization Debt/EBITDA

©Cambridge Business Publishers, 2013 End Module 4