CH.10 CREDIT ANALYSIS AND DISTRESS PREDICTION

Credit Analysis Is the evaluation of a firm from the perspective of a holder or potential holders of its debt. Key element: the prediction of the likelihood a firm will face financial distress

The Market for Credit Suppliers for credit: Commercial banks Other financial institutions Public debt markets Sellers who provide financing

The Credit Analysis Process Step 1: Consider the nature and the purpose of the loan Step 2: Consider the type of loan and available security Open line credit Revolving line of credit Working capital loan Term loan Mortgage loan Lease financing

The Credit Analysis Process Step 2 (Cont’d): Security Receivables Inventory Machinery and equipment Real estate

The Credit Analysis Process Step 3: Analyze the potential borrower’s financial status The emphasis is on the firm’s ability to service the debt at the scheduled rate Key question is how likely it is that cash flows will be sufficient to repay the loan Step 4: Utilize forecasts to assess payment prospects

The Credit Analysis Process Step 5: Assemble the detailed loan structure, including loan covenants Writing loan covenants: specify mutual expectations of the borrower and lender by specifying actions the borrower will and will not take

The Credit Analysis Process Step 5 (Cont’d): Loan pricing: assuring that the yield on the loan is sufficient to cover (1) the lender’s cost of borrowed funds: (2) the lender’s costs of administering and servicing the loan; (3) a premium for exposure to default risk; and (4) at least a normal return on the equity capital necessary to support the lending operation

Financial Statement Analysis and Public Debt Debt rating Factors that drive debt ratings: profitability, leverage, firm size

Prediction of distress and turnaround Factors most useful in predicting bankruptcy year in advance: profitability, volatility, financial leverage Altman Z-Score model