Chapters 10 and 12

Credit Analysis and Distress Prediction Corporate Financing Policies

November 14, 2007

Today’s Topics

Credit Analysis Debt Rating Process Distress Prediction Corporate Financing Policies

Credit Analysis

What risks should a credit analyst care about?

Credit Risk - concerns the firms’ ability to continue to make interest and principal payments on borrowings

Bankruptcy risk - concerns the firms’ ability to remain a going concern and avoid eventual liquidation

Who cares about Creditworthiness?

Credit Markets How (other than through equity) does a firm finance its

asset needs?

How Who Credit Analysis

Buy on credit Supplier Supplier’s policies/ratings

Take out a loan Bank Bank Criterion

Sell Commercial paper

Public Market Rating Agencies and Fixed Inc. Analysts

Sell Bonds Public Market Rating Agencies and Fixed Inc. Analysts

Credit Process

Determine the purpose of loan Assess Creditworthiness Determine Structure of Debt

Term, security, covenants, etc. Determine Cost of Debt

Risk v. Reward Finalize loan Monitor

Assessing Creditworthiness

Fundamental Analysis Strategy Analysis Accounting Analysis Financial Statement Analysis Assessment of management

Forecasts and Sensitivity Analysis

Financial Analysis

Focus in credit analysis is on ability to repay debts 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

Solvency Ratios - profit or cash flow relative to debt service and other requirements

Historical and forecasted

Financial Analysis -Liquidity Ratios Liquidity ratios can be viewed from two

perspectives As efficiency ratios that assess the company’s

optimal working capital management (turnover ratios)

As ratios that assess the ability of the company to survive (i.e. pay its bills) in the coming period or periods

Liquidity Ratios

Liquidity Ratios Current Ratio Quick Ratio Cash Ratio Operating Cash Flow Ratio

Short-term liquidity risk

Interpreting current ratio (and other similar liquidity ratios): What do these ratios intend to capture? What is the implicit

assumption?

What is the benchmark for these ratios? How high is high?

How to use these ratios?

Ratios to measure long-term solvency risk Solvency (or leverage) ratios provide us with

information about The extent to which the firm’s assets are financed by

borrowed money The extent to which the borrowed money has required

interest payments

Ratios to measure long-term solvency risk Long-term debt to total capitalization Debt to equity Liabilities to assets Interest coverage (EBIT /Interest Expense) Operating cash flow to total liabilities

Long-term solvency risk

What will solvency ratios NOT tell you?

Liquidity and Solvency Ratios

Use these ratios judiciously. Interpret them in the context of your specific case, and in conjunction with other relevant information.

Forecasts

Forward looking view of ability to repay Sensitivity/Scenario Analysis

Assess Cash Flow – is it adequate to allow repayment? CF from Operations/Average CL CF from Operations/Average Total Liabilities CF from Operations/Average Cap. Exp.

Capacity for Debt Debt Ratios Interest Coverage

Determine Loan Type and Structure Loan Type and Term

Open line of credit Revolving line of credit Working Capital loan Term loan Mortgage

Security - receivables, inventory, equipment and machinery, land

Pricing Covenants

Pricing

Key variable is level of risk involved Term Security Creditworthiness

Often stated as percent above prime or LIBOR (London Interbank Offered Rate)

Covenants

Means of protection and monitoring for lender Financial covenants targeted to identified

risks Minimum net worth Minimum coverage Minimum liquidity Limits on relative liabilities or spending

Debt Rating Process

Debt Ratings

Public markets need means to assess and monitor credit risk

Two major rating agencies: Moody’s and Standard and Poor’s plus Fitch, smaller agency

Ratings Process Fundamental Analysis Detailed forecasts 3-5 years Detailed review of risks and mitigation strategies Application of models

Ratings Models

Proprietary Models used by agencies and firms Researchers have estimated models Key Characteristics

Size Subordination status of debt Leverage Systematic risk Profitability Unsystematic risk Riskiness of profit stream Interest coverage

Ratings ParametersMedian Financial Ratios by Rating Category:90-

03 S&P Moody’s Total

Revenue

ROA Debt/

Assets

Interest

Coverage

AAA Aaa 28.8b 9.4% 24.2% 23.72

AA Aa 12.5b 6.7% 27.4% 12.41

A A 8.3b 4.7% 30.5% 9.83

BBB Baa 4.6b 2.7% 33.3% 6.80

BB Ba 2.2b 1.6% 43.4% 5.61

B B 1.0b -3.2% 61.5% 2.24

Ratings and Yields

Yields will reflect ratings and particular characteristics of bonds

Significant difference between investment grade (BBB and above) and non investment grade

Secondary markets will reflect ratings and circumstance changes occurring after issuance

Distress Prediction

Bankruptcy Risk Analysis

Can we predict future bankruptcy? Not exactly, but developing a reasonable

methodology. Various algorithms have been devised to

predict bankruptcy probability using firm’s financial ratios Z-score is one of the most widely used

Bankruptcy risk

Z-score’s basic idea: For each bankrupt firm, find a similar sized non-

bankrupt firm in the same industry. Perform a Multiple Discriminate Analysis (MDA)

between the bankrupt group and the non-bankrupt group.

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.

Bankruptcy risk

Altman’s Z-score for manufacturing firms: Z= 1.2 X Working capital / total assets

+ 1.4 X Retained earnings / total assets+ 3.3 X EBIT / total assets+ 0.6 X Market value of equity / BV of debt+ 1.0 X Sales / total assets

Predict: bankrupt if Z<1.81; non-bankrupt if Z>2.99; in between is the “zone of ignorance.”

These factors meant to capture firms’ liquidity, profitability, solvency, and activity ratios.

Worldcom’s Z-Score

Input Financial Ratio 1999 2000 2001

X1 (1.2) Working capital/Total Assets -0.09 -0.08 0

X2 (1.4) RE/Total Assets -0.02 0.03 0.04

X3 (3.3) EBIT/Total Assets .09 .08 .02

X4 (0.6) Market Value/Total Liab. 3.7 1.2 .50

X5 (1.0) Sales/Total Assets .51 .42 0.3

Z-Score 2.5 1.4 .85

Bankruptcy Risk Analysis

Problems with Z-Scores Fitting one model to unique situations area between 1.81 and 3.00 is grey Not all firms report required data

Best use of Z-Scores Gauge of relative financial health If trouble indicated, conduct more detailed

analysis

Corporate Financing Policies

Capital Structure Optimal mix of debt and equity

Dividend Policy Whether to pay and what amount

Debt Policy

What are debt/equity ratios today? Total ST & LT debt / common equity

S&P 500 - 1.73 DJIA - 1.75 Nasdaq - .33

What accounts for the difference?

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Explanations for Differences in Capital Structure

Trade-off Theory of Capital Structure When choosing capital structure, the firm chooses

the debt level that maximizes the market value of the firm

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.

Trade-off Theory of Capital Structure 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

ROE > ROA when ROA>rd

Financial leverage can increase the return to shareholders

Trade-off Theory of Capital Structure But increasing levels of debt increases financial

leverage and increases credit and bankruptcy risk and the chance that the company will become insolvent

What else might determine CS?Some empirical observations:

Avoidance of equity issuance - most companies do not use seasoned equity offerings outside of M&A

Peer similarity - Most companies tend to end up looking like peer industry members

What else might determine CS? Accounting performance - Better accounting

performance and more tangible assets result in more debt

Uncertainty - Firms with more volatile underlying real assets tend to have less debt (i.e. growth firms)

Active Market timing - Firms experiencing increasing stock prices tend to issue more debt and more equity

The decision to pay out earnings versus retaining and reinvesting them. Includes these elements:

1. High or low payout?

2. Stable or irregular dividends?

3. How frequent?

4. Do we announce the policy?

Dividend Policy

Dividend Payout Ratios forSelected Industries

Industry Payout ratioBanking 38.29Computer Software Services 13.70Drug 38.06Electric Utilities 67.09Semiconductors 24.91Steel 51.96Tobacco 55.00Water utilities 67.35

What explains differences?

Setting Dividend Policy

Forecast capital needs over a planning horizon, often 5 years.

Set a target capital structure. Estimate annual equity needs. Generally, some dividend growth rate

emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

Stock Repurchases

As an alternative to distributing cash as dividends.

To dispose of one-time cash from an asset sale.

To make a large capital structure change.

Repurchases: Buying own stock back from stockholders.

Advantages and Disadvantages of Repurchases Advantages

Stockholders have choice Single event vs. recurring dividend Flexibility to use repurchased stock Capital gain treatment vs. dividend Seen as positive signal—mgmt. thinks stock is

undervalued. Disadvantages

Seen as negative – no better alternative use of cash IRS could challenge as avoidance of tax on dividends

Summary

Credit analysis

Public debt markets and rating process

Distress Prediction

Corporate Financing Policies