1. Chapter 19
The Analysis of
Credit Risk

2. The Analysis of Credit Risk

3. What you will learn from this chapter
How default risk determines the price of credit (the cost of debt capital)
What determines default risk
How default risk is analyzed
How credit scoring models work
The difference between Type I and Type II errors is predicting defaults
How pro forma analysis aids in assessing default risk
How value-at-risk analysis is used to assess default risk
How financial planning works

4. Default Risk and Default Premiums
Required Return on Debt = Risk-free Rate + Default Premium
The default premium is determined by the risk that the debtor could default
Similar terms:
Required return on debt
Cost of debt
Price of credit

5. The Suppliers of Credit
Public debt market investors who include (long-term) bondholders and (short-term) commercial paper holders.
Commercial banks that make loans to firms.
Other financial institutions such as insurance companies, finance houses and leasing firms make loans, much like banks, but usually with specific assets serving as collateral.
Suppliers to the firm who grant (usually short- term) credit upon delivery of goods and services.

6. Ratio Analysis for Default Evaluation
Steps:
Reformulate financial statements
Calculate ratios

7. Reformulating the Balance Sheet for Credit Analysis
The key idea in the reformulation of the balance sheet is to order assets by liquidity and liabilities by maturity. Annotate as you reformulate.
Issues:
Detail on different classes of debt and their varying maturities is available in the debt footnotes; this detail can be brought on to the face of reformulated statements.
Debt of unconsolidated subsidiaries (where the parent owns less that 50%, but has effective obligations) should be recognized.
Long-term marketable securities are sometimes available for sale in the short-term if a need for cash arises.
Long-term debt (of similar maturity) can be presented on a net basis.
Remove deferred tax liabilities that are unlikely to reverse from liabilities to shareholders’ equity.
Add the LIFO reserve to inventory and to shareholder’s equity to convert LIFO to a FIFO basis.
Off-balance-sheet debt should be recognized on the face of the statement.
Contingent liabilities that can be estimated should be included in the reformulated statements.
The risk in derivatives and other financial instruments should be noted.

8. Off-Balance-Sheet Financing
Off-balance-sheet financing transactions are arrangements to
finance assets and create obligations that do not appear on the
balance sheet.
Examples:
Operating leases
Agreements and commitments:
third-party agreements
through-put agreements
take-or-pay agreements
repurchase agreements
sales of receivables with recourse
Special purpose entities not consolidated
Unfunded pension liabilities not booked
Guarantees of third-party or related-party debt
Positions in derivatives off balance sheet

9. Reformulated Income Statements and Cash Flow Statements
Distinguish income from operations that “covers” net financial expense
The reformulation follows that for profitability analysis
in Chapter 9
Cash Flow Statement:
Distinguish (unlevered) cash flow from operations that can be used to make payments on debt
The reformulation follows that in Chapter 10

10. Ratio Analysis: Short-Term Liquidity Ratios
Liquidity Stock Measures
Liquidity Flow Measures

11. Ratio Analysis: Long-term Solvency Ratios
Solvency Stock Measures
Solvency Flow Measures

12. Ratio Analysis: Operating Ratios
Poor profitability increases the likelihood of default.
So the profitability analysis of Chapter 11 and the risk analysis of Chapter 18 are inputs into credit analysis. Watch particularly for declines in
RNOA
Operating profit margins
Sales growth

13. Forecasting and Credit Risk
The Prelude:
Know the business
Appreciate the “moral hazard” problem of debt
Understand the financing strategy
Understand the current financing arrangements
Understand the quality of the firm’s accounting
Understand the auditor’s opinion, particularly any qualification to the opinion

14. Forecasting Default with Credit Scoring
Credit scores combine a number of indicators into one score that estimates the probability of default.
Credit Scoring Methods:
Multiple Discriminate Analysis (MDA)
Logit Analysis

15. Multiple Discriminate Analysis (Z-scoring)
Original Altman Model:

16. Logit Scoring Model
Original Ohlson Model:

17. Credit Scoring: Prediction Error Analysis
Type I error: Classifying a firm as not likely to default when it actually does default
Type II error: Classifying a firm as likely to default when it does not default
Trade off Type I and Type II errors: choose a cut- off score that minimizes the cost of errors

18. Full Information Forecasting: Using Pro Forma Analysis for Default Forecasting
PPE Inc.

19. Using Pro Forma Analysis for Default Forecasting
PPE Inc.

20. Default Points
Default occurs when cash available for debt service is less than the debt service requirement.

21. Value-at-Risk Profiles for Default Forecasting
Steps:
Generate profiles of cash available for debt service for a full set of scenarios from pro forma analysis
Establish the debt service requirement
Identify the default point where cash available for debt service is below the debt service requirement, and so identify the default scenarios
Assess the probability of the set of default scenarios occurring

22. Value-at-Risk Profile

23. Liquidity Planning and Financial Strategy
A default strategy is a strategy to avoid default
Pro forma analysis of default points can be used as a planning tool to avoid default
Modify plans to increase liquidity in
order to avoid default and build those plans
into the financial strategy pro forma