Chapter 19Chapter 19

The Analysis

of

Credit Risk

The Analysis of Credit RiskThe Analysis of Credit Risk

What you will learn from this chapterWhat 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

Default Risk and Default PremiumsDefault 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

The Suppliers of CreditThe 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.

Ratio Analysis for Default EvaluationRatio Analysis for Default Evaluation

Steps:

1. Reformulate financial statements

2. Calculate ratios

Reformulating the Balance Sheet Reformulating the Balance Sheet for Credit Analysisfor 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.

Off-Balance-Sheet FinancingOff-Balance-Sheet Financing

Off-balance-sheet financing transactions are arrangements to finance assets and create obligations that do not appear on thebalance 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

Reformulated Income Statements Reformulated Income Statements and Cash Flow Statementsand Cash Flow Statements

Income Statement:

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

Ratio Analysis: Short-Term Liquidity Ratio Analysis: Short-Term Liquidity RatiosRatios

• Liquidity Stock Measures

• Liquidity Flow Measures

sLiabilitieCurrent

sInvestment term-ShortCashRatio Cash

sLiabilitieCurrent

sReceivablesInvestment term-ShortCashRatioTest Acidor Quick

sLiabilitieCurrent

AssetsCurrent RatioCurrent

esExpenditur Capital

Operations from Flow CashUnleveredesExpenditur Capital toFlow Cash

365esExpenditur Capital

sReceivable sInvestment term-ShortCashInterval Defensive

sLiabilitieCurrent

Operations from FlowCash Ratio FlowCash

Ratio Analysis: Long-term Solvency Ratio Analysis: Long-term Solvency RatiosRatios

• Solvency Stock Measures

• Solvency Flow Measures

EqutiyDebt term-Long

Debt term-LongRatio Debt termLong

Equity Total

Debt TotalEquity toDebt

Equity TotalsLiabilitie Assets Total

term-LongCurrentDebt TotalAssets Total Debt to

Debt Total

Operations from FlowCash UnleveredDebt toCFO

Basis Cash

Charges Fixed

Charges Fixed Operations from FlowCash UnleveredCoverage Charge Fixed

Charges Fixed

Charges FixedIncome OperatingCoverage Charge Fixed

Basis CashInterestCash Net

Operations from Flow Cash UnleveredCoverageInterest

EarnedInterest Times

ExpenseInterest Net

Income OperatingCoverage Interest

Ratio Analysis: Operating RatiosRatio 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

Forecasting and Credit RiskForecasting 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

Forecasting Default with Credit Forecasting Default with Credit ScoringScoring

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

Multiple Discriminate AnalysisMultiple Discriminate Analysis (Z-scoring) (Z-scoring)

Original Altman Model:

Assets Total

Sales1.0

sLiabilitie of ValueBook

Equity of ValueMarket 0.6

Assets Total

Taxes andInterest Before Earnings3.3

Assets Total

Earnings Retained1.4

Assets Total

Capital Working1.2scoreZ

Logit Scoring ModelLogit Scoring Model

Original Ohlson Model:

incomesnet years'prior andcurrent of valuesabsolute of Sum

IncomeNet in Change521.0

assets totalexceednot do sliabilitie totalif Zero

assets totalexceed sliabilitie totalif One72.1

years last two for the negativenot wasincomenet if Zero

years last two for the negative wasincomenet if One285.0

sLiabilitie Total

Operations from Flow Capital Working83.1

Assets Total

IncomeNet 37.2

AssetsCurrent

sLiabilitieCurrent 0757.0

Assets Total

Capital Working43.1

Assets Total

sLiabilitie Total03.6Size407.032.1y

2.718282ely approximat is e wheree1

1Bankruptcy ofy Probabilit

y-

Credit Scoring: Prediction Error Credit Scoring: Prediction Error AnalysisAnalysis

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

Full Information Forecasting: Using Pro Full Information Forecasting: Using Pro Forma Analysis for Default ForecastingForma Analysis for Default Forecasting

PPE Inc.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 1: Sales (growth = 5% per year) 124.90 131.15 137.70 144.59 151.82 159.41 Core operating income (PM = 7.85%) 9.80 10.29 10.81 11.35 11.92 12.51 Financial income (expense) (0.70) (0.77) (0.57) (0.35) (0.10) 0.18 Net income 9.10 9.52 10.24 11.00 11.82 12.69 Net operating assets (ATO = 1.762) 74.42 78.15 82.05 86.16 90.46 94.99 Net financial assets (7.70) (5.71) (3.47) (0.97) 1.81 4.91 Common equity 66.72 72.44 78.58 85.19 92.27 99.90 Free cash flow 5.28 6.57 6.90 7.25 7.61 7.99 Dividend 5.28 3.81 4.10 4.40 4.73 5.08 Cash Available for Debt Service 0.0 2.76 2.80 2.85 2.88 2.91 ______________________________________________ Debt to Total Assets 10.3% 7.3% 4.3% 1.1% 2.0% 5.2% Debt to Equity 11.5% 7.9% 4.4% 1.1% 2.0% 4.9% Interest Coverage 14.0 13.4 19.0 32.4 19.2 Fixed Charge Coverage 4.7 4.9 5.0 5.1 RNOA 14.0% 13.8% 13.8% 13.8% 13.8% 13.8% ROCE 14.5% 14.3% 14.1% 14.0% 13.9% 13.8% Debt Service Requirement 0.0 0.0 0.0 0.0 0.0 0.0 _____________________________________________________________________________________________

Using Pro Forma Analysis for Default Using Pro Forma Analysis for Default ForecastingForecasting

Scenario 2: Sales (decline= 5% per year) 124.90 118.66 112.72 107.09 101.73 96.65 Core operating income (PM = 1%) 9.80 1.19 1.13 1.07 1.02 0.97 Financial income (expense) (0.70) (0.77) (0.69) (0.60) (0.52) (0.42) Net Income 9.10 0.42 0.44 0.47 0.50 0.55 Net operating assets 74.42 74.00 73.60 73.20 72.80 72.40 Net financial assets (7.70) (6.86) (6.02) (5.15) (4.25) Default Common equity 66.72 67.14 67.58 68.05 68.55 Default Free cash flow 5.28 1.61 1.53 1.47 1.42 1.37 Dividend 5.28 0.0 0.0 0.0 0.0 0.0 Cash Available for Debt Service 0.0 1.61 1.53 1.47 1.42 1.37 ______________________________________________ Debt to Total Assets 10.3% 9.3% 8.2% 7.0% 5.8% Debt to Equity 11.5% 10.2% 8.9% 7.6% 6.2% Interest Coverage 14.0 1.5 1.6 1.8 2.0 Fixed Charge Coverage 1.7 1.7 1.7 1.7 RNOA 14.0% 1.6% 1.5% 1.5% 1.4% 1.3% ROCE 14.5% 0.6% 0.7% 0.9% Debt Service Requirement 0.0 0.0 0.0 0.0 4.25 Default _____________________________________________________________________________________________

PPE Inc.

Default PointsDefault Points

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

Payments Lease

Payments PrincipalNet Required

Payments Dividend Preferred andInterest RequiredtRequiremen ServiceDebt

DividendsNet -NOA-OI

DividendsNet - FlowCash FreeServiceDebt for AvailableCash

Value-at-Risk Profiles for Default Value-at-Risk Profiles for Default ForecastingForecasting

Steps:

1. Generate profiles of cash available for debt service for a full set of scenarios from pro forma analysis

2. Establish the debt service requirement

3. Identify the default point where cash available for debt service is below the debt service requirement, and so identify the default scenarios

4. Assess the probability of the set of default scenarios occurring

Value-at-Risk ProfileValue-at-Risk Profile

Liquidity Planning and Financial Liquidity Planning and Financial StrategyStrategy

• 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