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
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