Chapters 10 and 12 Credit Analysis and Distress Prediction ...


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  • Chapters 10 and 12 Credit Analysis and Distress Prediction ...

    1. 1. Chapters 10 and 12 Credit Analysis and Distress Prediction Corporate Financing Policies November 14, 2007
    2. 2. Today’s Topics <ul><li>Credit Analysis </li></ul><ul><li>Debt Rating Process </li></ul><ul><li>Distress Prediction </li></ul><ul><li>Corporate Financing Policies </li></ul>
    3. 3. Credit Analysis
    4. 4. What risks should a credit analyst care about? <ul><li>Credit Risk - concerns the firms’ ability to continue to make interest and principal payments on borrowings </li></ul><ul><li>Bankruptcy risk - concerns the firms’ ability to remain a going concern and avoid eventual liquidation </li></ul>
    5. 5. Who cares about Creditworthiness?
    6. 6. Credit Markets <ul><li>How (other than through equity) does a firm finance its asset needs? </li></ul>Rating Agencies and Fixed Inc. Analysts Public Market Sell Bonds Rating Agencies and Fixed Inc. Analysts Public Market Sell Commercial paper Bank Criterion Bank Take out a loan Supplier’s policies/ratings Supplier Buy on credit Credit Analysis Who How
    7. 7. Credit Process <ul><li>Determine the purpose of loan </li></ul><ul><li>Assess Creditworthiness </li></ul><ul><li>Determine Structure of Debt </li></ul><ul><ul><li>Term, security, covenants, etc. </li></ul></ul><ul><li>Determine Cost of Debt </li></ul><ul><ul><li>Risk v. Reward </li></ul></ul><ul><li>Finalize loan </li></ul><ul><li>Monitor </li></ul>
    8. 8. Assessing Creditworthiness <ul><li>Fundamental Analysis </li></ul><ul><ul><li>Strategy Analysis </li></ul></ul><ul><ul><li>Accounting Analysis </li></ul></ul><ul><ul><li>Financial Statement Analysis </li></ul></ul><ul><ul><li>Assessment of management </li></ul></ul><ul><li>Forecasts and Sensitivity Analysis </li></ul>
    9. 9. Financial Analysis <ul><li>Focus in credit analysis is on ability to repay debts </li></ul><ul><ul><li>Liquidity Ratios – ability of the firm to pay bills due in the next year with current assets or cash flow that will be generated in the next year </li></ul></ul><ul><ul><li>Solvency Ratios - profit or cash flow relative to debt service and other requirements </li></ul></ul><ul><li>Historical and forecasted </li></ul>
    10. 10. Financial Analysis -Liquidity Ratios <ul><li>Liquidity ratios can be viewed from two perspectives </li></ul><ul><ul><li>As efficiency ratios that assess the company’s optimal working capital management (turnover ratios) </li></ul></ul><ul><ul><li>As ratios that assess the ability of the company to survive (i.e. pay its bills) in the coming period or periods </li></ul></ul>
    11. 11. Liquidity Ratios <ul><li>Liquidity Ratios </li></ul><ul><ul><li>Current Ratio </li></ul></ul><ul><ul><li>Quick Ratio </li></ul></ul><ul><ul><li>Cash Ratio </li></ul></ul><ul><ul><li>Operating Cash Flow Ratio </li></ul></ul>
    12. 12. Short-term liquidity risk <ul><li>Interpreting current ratio (and other similar liquidity ratios): </li></ul><ul><ul><li>What do these ratios intend to capture? What is the implicit assumption? </li></ul></ul><ul><ul><li>What is the benchmark for these ratios? How high is high? </li></ul></ul><ul><ul><li>How to use these ratios? </li></ul></ul>
    13. 13. Ratios to measure long-term solvency risk <ul><li>Solvency (or leverage) ratios provide us with information about </li></ul><ul><ul><li>The extent to which the firm’s assets are financed by borrowed money </li></ul></ul><ul><ul><li>The extent to which the borrowed money has required interest payments </li></ul></ul>
    14. 14. Ratios to measure long-term solvency risk <ul><li>Long-term debt to total capitalization </li></ul><ul><li>Debt to equity </li></ul><ul><li>Liabilities to assets </li></ul><ul><li>Interest coverage (EBIT /Interest Expense) </li></ul><ul><li>Operating cash flow to total liabilities </li></ul>
    15. 15. Long-term solvency risk <ul><li>What will solvency ratios NOT tell you? </li></ul>
    16. 16. Liquidity and Solvency Ratios <ul><li>Use these ratios judiciously. Interpret them in the context of your specific case, and in conjunction with other relevant information. </li></ul>
    17. 17. Forecasts <ul><li>Forward looking view of ability to repay </li></ul><ul><ul><li>Sensitivity/Scenario Analysis </li></ul></ul><ul><li>Assess Cash Flow – is it adequate to allow repayment? </li></ul><ul><ul><li>CF from Operations/Average CL </li></ul></ul><ul><ul><li>CF from Operations/Average Total Liabilities </li></ul></ul><ul><ul><li>CF from Operations/Average Cap. Exp. </li></ul></ul><ul><li>Capacity for Debt </li></ul><ul><ul><li>Debt Ratios </li></ul></ul><ul><ul><li>Interest Coverage </li></ul></ul>
    18. 18. Determine Loan Type and Structure <ul><li>Loan Type and Term </li></ul><ul><ul><li>Open line of credit </li></ul></ul><ul><ul><li>Revolving line of credit </li></ul></ul><ul><ul><li>Working Capital loan </li></ul></ul><ul><ul><li>Term loan </li></ul></ul><ul><ul><li>Mortgage </li></ul></ul><ul><li>Security - receivables, inventory, equipment and machinery, land </li></ul><ul><li>Pricing </li></ul><ul><li>Covenants </li></ul>
    19. 19. Pricing <ul><li>Key variable is level of risk involved </li></ul><ul><ul><li>Term </li></ul></ul><ul><ul><li>Security </li></ul></ul><ul><ul><li>Creditworthiness </li></ul></ul><ul><li>Often stated as percent above prime or LIBOR (London Interbank Offered Rate) </li></ul>
    20. 20. Covenants <ul><li>Means of protection and monitoring for lender </li></ul><ul><li>Financial covenants targeted to identified risks </li></ul><ul><ul><li>Minimum net worth </li></ul></ul><ul><ul><li>Minimum coverage </li></ul></ul><ul><ul><li>Minimum liquidity </li></ul></ul><ul><ul><li>Limits on relative liabilities or spending </li></ul></ul>
    21. 21. Debt Rating Process
    22. 22. Debt Ratings <ul><li>Public markets need means to assess and monitor credit risk </li></ul><ul><li>Two major rating agencies: Moody’s and Standard and Poor’s </li></ul><ul><ul><li>plus Fitch, smaller agency </li></ul></ul><ul><li>Ratings Process </li></ul><ul><ul><li>Fundamental Analysis </li></ul></ul><ul><ul><li>Detailed forecasts 3-5 years </li></ul></ul><ul><ul><li>Detailed review of risks and mitigation strategies </li></ul></ul><ul><ul><li>Application of models </li></ul></ul>
    23. 23. Ratings Models <ul><li>Proprietary Models used by agencies and firms </li></ul><ul><li>Researchers have estimated models </li></ul><ul><li>Key Characteristics </li></ul><ul><ul><li>Size </li></ul></ul><ul><ul><li>Subordination status of debt </li></ul></ul><ul><ul><li>Leverage </li></ul></ul><ul><ul><li>Systematic risk </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Unsystematic risk </li></ul></ul><ul><ul><li>Riskiness of profit stream </li></ul></ul><ul><ul><li>Interest coverage </li></ul></ul>
    24. 24. Ratings Parameters Median Financial Ratios by Rating Category:90-03 2.24 61.5% -3.2% 1.0b B B 5.61 43.4% 1.6% 2.2b Ba BB 6.80 33.3% 2.7% 4.6b Baa BBB 9.83 30.5% 4.7% 8.3b A A 12.41 27.4% 6.7% 12.5b Aa AA 23.72 24.2% 9.4% 28.8b Aaa AAA Interest Coverage Debt/ Assets ROA Total Revenue Moody’s S&P
    25. 25. Ratings and Yields <ul><li>Yields will reflect ratings and particular characteristics of bonds </li></ul><ul><li>Significant difference between investment grade (BBB and above) and non investment grade </li></ul><ul><li>Secondary markets will reflect ratings and circumstance changes occurring after issuance </li></ul>
    26. 26. Distress Prediction
    27. 27. Bankruptcy Risk Analysis <ul><li>Can we predict future bankruptcy? </li></ul><ul><ul><li>Not exactly, but developing a reasonable methodology. </li></ul></ul><ul><li>Various algorithms have been devised to predict bankruptcy probability using firm’s financial ratios </li></ul><ul><ul><li>Z-score is one of the most widely used </li></ul></ul>
    28. 28. Bankruptcy risk <ul><li>Z-score’s basic idea: </li></ul><ul><ul><li>For each bankrupt firm, find a similar sized non-bankrupt firm in the same industry. </li></ul></ul><ul><ul><li>Perform a Multiple Discriminate Analysis (MDA) between the bankrupt group and the non-bankrupt group. </li></ul></ul><ul><ul><li>Identify the ratios/variables that differ the most between the groups. These ratios/variables are the one that have the most discriminating power for bankruptcy. </li></ul></ul>
    29. 29. Bankruptcy risk <ul><li>Altman’s Z-score for manufacturing firms: </li></ul><ul><ul><li>Z= 1.2 X Working capital / total assets </li></ul></ul><ul><ul><li> + 1.4 X Retained earnings / total assets </li></ul></ul><ul><ul><li>+ 3.3 X EBIT / total assets </li></ul></ul><ul><ul><li>+ 0.6 X Market value of equity / BV of debt </li></ul></ul><ul><ul><li>+ 1.0 X Sales / total assets </li></ul></ul><ul><ul><li>Predict: bankrupt if Z<1.81; non-bankrupt if Z>2.99; in between is the “zone of ignorance.” </li></ul></ul><ul><li>These factors meant to capture firms’ liquidity , profitability , solvency , and activity ratios. </li></ul>
    30. 30. Worldcom’s Z-Score .85 1.4 2.5 Z-Score 0.3 .42 .51 Sales/Total Assets X5 (1.0) .50 1.2 3.7 Market Value/Total Liab. X4 (0.6) .02 .08 .09 EBIT/Total Assets X3 (3.3) 0.04 0.03 -0.02 RE/Total Assets X2 (1.4) 0 -0.08 -0.09 Working capital/Total Assets X1 (1.2) 2001 2000 1999 Financial Ratio Input
    31. 31. Bankruptcy Risk Analysis <ul><li>Problems with Z-Scores </li></ul><ul><ul><li>Fitting one model to unique situations </li></ul></ul><ul><ul><li>area between 1.81 and 3.00 is grey </li></ul></ul><ul><ul><li>Not all firms report required data </li></ul></ul><ul><li>Best use of Z-Scores </li></ul><ul><ul><li>Gauge of relative financial health </li></ul></ul><ul><ul><li>If trouble indicated, conduct more detailed analysis </li></ul></ul>
    32. 32. Corporate Financing Policies <ul><li>Capital Structure </li></ul><ul><ul><li>Optimal mix of debt and equity </li></ul></ul><ul><li>Dividend Policy </li></ul><ul><ul><li>Whether to pay and what amount </li></ul></ul>
    33. 33. Debt Policy <ul><li>What are debt/equity ratios today? </li></ul><ul><ul><li>Total ST & LT debt / common equity </li></ul></ul><ul><li>S&P 500 - 1.73 </li></ul><ul><li>DJIA - 1.75 </li></ul><ul><li>Nasdaq - .33 </li></ul><ul><li>What accounts for the difference? </li></ul>
    34. 34. <ul><li>Interest Tax Shield - Tax savings resulting from deductibility of interest payments. </li></ul><ul><li>Financial Risk - Risk to shareholders resulting from the use of debt. </li></ul><ul><li>Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. </li></ul>Explanations for Differences in Capital Structure
    35. 35. Trade-off Theory of Capital Structure <ul><li>When choosing capital structure, the firm chooses the debt level that maximizes the market value of the firm </li></ul><ul><li>The important point is that there is a tradeoff with increased leverage: firm value increases due to the interest tax shield but decreases due to financial distress cost. </li></ul>
    36. 36. Trade-off Theory of Capital Structure <ul><li>Shareholders benefit when the firm obtains funds from borrowing and invests the money in assets that generate a higher return than the after-tax cost of borrowing </li></ul><ul><li>ROE > ROA when ROA>r d </li></ul><ul><li>Financial leverage can increase the return to shareholders </li></ul>
    37. 37. Trade-off Theory of Capital Structure <ul><li>But increasing levels of debt increases financial leverage and increases credit and bankruptcy risk and the chance that the company will become insolvent </li></ul>
    38. 38. What else might determine CS? <ul><li>Some empirical observations: </li></ul><ul><li>Avoidance of equity issuance - most companies do not use seasoned equity offerings outside of M&A </li></ul><ul><li>Peer similarity - Most companies tend to end up looking like peer industry members </li></ul>
    39. 39. What else might determine CS? <ul><li>Accounting performance - Better accounting performance and more tangible assets result in more debt </li></ul><ul><li>Uncertainty - Firms with more volatile underlying real assets tend to have less debt (i.e. growth firms) </li></ul><ul><li>Active Market timing - Firms experiencing increasing stock prices tend to issue more debt and more equity </li></ul>
    40. 40. <ul><li>The decision to pay out earnings versus retaining and reinvesting them. Includes these elements: </li></ul><ul><ul><li>1. High or low payout? </li></ul></ul><ul><ul><li>2. Stable or irregular dividends? </li></ul></ul><ul><ul><li>3. How frequent? </li></ul></ul><ul><ul><li>4. Do we announce the policy? </li></ul></ul>Dividend Policy
    41. 41. Dividend Payout Ratios for Selected Industries Industry Payout ratio Banking 38.29 Computer Software Services 13.70 Drug 38.06 Electric Utilities 67.09 Semiconductors 24.91 Steel 51.96 Tobacco 55.00 Water utilities 67.35 What explains differences?
    42. 42. Setting Dividend Policy <ul><li>Forecast capital needs over a planning horizon, often 5 years. </li></ul><ul><li>Set a target capital structure. </li></ul><ul><li>Estimate annual equity needs. </li></ul><ul><li>Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary. </li></ul>
    43. 43. Stock Repurchases <ul><li>As an alternative to distributing cash as dividends. </li></ul><ul><li>To dispose of one-time cash from an asset sale. </li></ul><ul><li>To make a large capital structure change. </li></ul>Repurchases: Buying own stock back from stockholders.
    44. 44. Advantages and Disadvantages of Repurchases <ul><li>Advantages </li></ul><ul><ul><li>Stockholders have choice </li></ul></ul><ul><ul><li>Single event vs. recurring dividend </li></ul></ul><ul><ul><li>Flexibility to use repurchased stock </li></ul></ul><ul><ul><li>Capital gain treatment vs. dividend </li></ul></ul><ul><ul><li>Seen as positive signal—mgmt. thinks stock is undervalued. </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Seen as negative – no better alternative use of cash </li></ul></ul><ul><ul><li>IRS could challenge as avoidance of tax on dividends </li></ul></ul>
    45. 45. Summary <ul><li>Credit analysis </li></ul><ul><li>Public debt markets and rating process </li></ul><ul><li>Distress Prediction </li></ul><ul><li>Corporate Financing Policies </li></ul>