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LECTURE 9

CREDIT ANALYSIS AND DISTRESS


PREDICTION

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Credit risk and bankruptcy risk


Credit analysis

Sources of debt financing


The Cs of credit risk analysis

Debt and credit ratings


Financial distress prediction

Models of bankruptcy prediction

Credit risk relates to a firms ability to


make interest and principal payments on
borrowings
Bankruptcy risk relates to the likelihood
that a firm will file for bankruptcy

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

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

Circumstances leading to need for the


loan

Purpose of the loan affects the riskiness and


the likelihood of repayment.

Credit history
Cash flows

Examining borrowers ability to generate cash


flows to pay interest and principal
Analyzing statement of cash flows
Cash flow financial ratios
Projected financial statements

Collateral

Availability and value of collateral for a loan


(marketable securities, accounts receivable,
inventories, PPE)

Capacity for debt

Assessing a firms capacity to assume


additional debt by using:
Debt ratios
Interest coverage ratio

Contingencies

Identifying any uncertainties that may negatively


impact the firm in the future
Pending litigation
Guarantee commitment
Other commitments
Dependence 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.

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

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
Moodys

Standard & Poors

Highest grade
AAA
High grade
AA
Upper medium
A
Lower medium
BBB
Marginally speculative BB
Highly speculative
B
Default
D

Aaa
Aa
A
Baa
Ba
B, Caa
Ca, C

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Example firms and debt ratings

AAA: Toyota, Pfizer


Wal-mart, Citigroup, P&G, HSBC
AA:
HP, Kellog, Kraft Food, Boeing,
A:
Cocacola
BBB: May Dept Store, Time Warner, Viacom
General Motor, Hilton
BB:
Goodyear, Ford Motor
B:
(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
Altmans Z score predictive model is
described by:
Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5

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Working Capital
Total assets
Retained Earnings

X2
Total assets
Earnings before interest and taxes

X3
Total assets
Market value of equity

X4
Book value of liabilities
Sales

X5
Total assets
X1

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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 firms 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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