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LECTURE 9CREDIT ANALYSIS AND DISTRESS

PREDICTION

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Credit risk and bankruptcy risk Credit analysis

◦ Sources of debt financing◦ The C’s of credit risk analysis

Debt and credit ratings Financial distress prediction

◦ Models of bankruptcy prediction

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Credit risk relates to a firm’s ability to make interest and principal payments on borrowings

Bankruptcy risk relates to the likelihood that a firm will file for bankruptcy

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Credit analysis is the evaluation of a firm creditworthiness from the perspective of holder or potential holder of its debt.

Credit analysis involves predicting the likelihood a firm will face financial distress

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Commercial banks Other financial institutions Commercial paper market Unsecured debt market Suppliers

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Circumstances leading to need for the loan◦ Purpose of the loan affects the riskiness and

the likelihood of repayment. Credit history Cash flows

◦ Examining borrower’s ability to generate cash flows to pay interest and principal

Analyzing statement of cash flowsCash flow financial ratiosProjected financial statements

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Collateral◦ Availability and value of collateral for a loan

(marketable securities, accounts receivable, inventories, PPE)

Capacity for debt◦ Assessing a firm’s capacity to assume

additional debt by using:Debt ratiosInterest coverage ratio

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Contingencies ◦ Identifying any uncertainties that may negatively

impact the firm in the futurePending litigationGuarantee commitmentOther commitmentsDependence on key employees, contracts, suppliers...

Character of management◦ Managers who have substantial portion of

personal wealth invested in the firm are likely to operate the firm profitably and avoid defaulting on debt.

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Communication◦ Effective communication with lenders on an

ongoing basis to provide sufficient and updated information for credit analysis

Conditions: debt covenants◦ Covenants are the restrictions used to

safeguard the creditors investments

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A credit rating is an assessment of the credit worthiness of a borrower to be used by those who does not maintain a close relationship with the borrower.

A debt rating is essentially the same since it refers to the credit standing of the debt securities issued by the borrower

Firms with high debt ratings generally have stronger financial ratios than those firms with a lower credit rating

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Criteria determining a specific rating involve both quantitative and qualitative factors◦ Asset protection◦ Financial resources◦ Earning power◦ Management◦ Debt provisions◦ Other: Company size, market share, industry

position, cyclical influences, and economic conditions

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Rating Grades Standard & Poor’s Moody’s

Highest grade AAA AaaHigh grade AA AaUpper medium A ALower medium BBB BaaMarginally speculative BB BaHighly speculative B B, CaaDefault D Ca, C

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Example firms and debt ratings◦ AAA: Toyota, Pfizer◦ AA: Wal-mart, Citigroup, P&G, HSBC◦ A: HP, Kellog, Kraft Food, Boeing, Cocacola◦ BBB: May Dept Store, Time Warner, Viacom◦ BB: General Motor, Hilton◦ B: Goodyear, Ford Motor

(Source: Fitch ratings, yahoo finance website)

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Assessing the probability that a firm will face financial distress and file for bankruptcy

There are a number of indicators and information sources of financial distress, the most common are◦ Cash flows◦ Corporate strategy◦ Financial statements◦ External variables

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Univariate bankruptcy prediction models Multivariate bankruptcy prediction models

◦ Altman Z-score

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Use a single variable to predict financial distress In a study by Beaver, 29 financial ratios are

examined and the followings have the best discriminating power:◦ Net Income before Depreciation, Depletion and

Amortization/Total liabilities◦ Net Income/Total assets◦ Total Debt/Total assets◦ Net working capital/Total assets◦ Current assets/Current liabilities◦ Cash Marketable securities Accounts Receivable/Operating

Expenses excl. Depreciation and Amortization

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The multivariable approach uses numerous independent variables to discriminate between 2 discrete groups of the dependent variable: bankrupt and non-bankrupt

Altman’s Z score predictive model is described by:Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5

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assets Total

SalesX

sliabilitie of Book value

equity of ueMarket valX

assets Total

taxesandinterest before EarningsX

assets Total

Earnings RetainedX

assets Total

Capital WorkingX

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4

3

2

1

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The higher the Z-score, the greater chances of survival

Studies showed that◦ Z>3: likely to survive◦ Z<1.8: likely to fail◦ Z score between 1.8 and 3: grey area

Z-score is a relative rather than an absolute measurement

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No guarantee that model includes all relevant discriminating ratios

Cut off points are selected subjectively Depends on quality of ratio information Assumes financial ratios of two groups

(bankrupt and non-bankrupt) are normally distributed

Requires Variance and covariance matrix of explanatory variables is the same for both groups

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Investment factors◦ Relative liquidity of a firm’s assets◦ Rate of asset turnover

Financing factors◦ Relative proportion of debt in the capital structure◦ Relative proportion of short term debt in capital

structure Operating factors

◦ Relative level of profitability◦ Variability of operations

Other possible explanatory variables◦ Size, growth, qualified audit opinion

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Problem 5-15 Problem 5-16 Problem 5-17

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