credit risks
TRANSCRIPT
-
7/30/2019 Credit Risks
1/24
Basics of Credit Analysis
Alexandru Cebotari
-
7/30/2019 Credit Risks
2/24
Sources and Types of Risks
Source Type or Nature
International Exchange Rate Changes
Host Government Regulations
Political Unrest
Expropriation of Assets
Domestic Recession
Inflation or Deflation
Interest Rate Changes
Demographic Changes
Political Changes
Industry Technology
Competition
Availability of Raw Materials and Labor
Unionization
Firm-Specific Management Competence
Strategic Direction
Lawsuits
-
7/30/2019 Credit Risks
3/24
A firm should continually monitor each of these and other
type of risks
A loan officers task is to understand how a firm monitors its
risks
Analysis of the financial consequences of these elements of
risk using financial statements is an important tool
Various financial reporting standards require firms to discuss
in notes to financial statements how important elements of risk
affect a particular firm and the actions it takes to manage its
risks
In addition to using information about risk disclosed in the
notes to financial statements, loan officers typically assess the
dimensions of risk using ratios of various items in the financial
statements
-
7/30/2019 Credit Risks
4/24
Profitability, Growth, Risk
Product-Market Strategies Financial-Market Strategies
OperatingDecisions
Investment and
AssetManagement
Decisions
FinancingDecisions
DividendDecisions
Managing
Revenue &
Expenses
Managing
Working Capital
& Fixed Assets
Managing
Liabilities and
Equity
Managing
Dividend Payout
Profit Margin
Ratios
Efficiency
Ratios
Capital
Structure RatiosPayout Ratios
-
7/30/2019 Credit Risks
5/24
Most financial statement-based risk analysis focuses on a
comparison of the supply of cash and demand for cash
Risk analysis using financial statement data typically examines
(1) short-term liquidity risk, the near term ability to
generate cash to service working capital needs and debt service
requirements, and
(2) long-term solvency risk, the longer-term ability togenerate cash internally or from external sources to satisfy plant
capacity and debt repayment needs
The field of finance identifies two types of risks:
(1) credit risk, a firms ability to make payments oninterest and principle payments, and
(2) bankruptcy risk, the likelihood that a firm will be
liquidated
-
7/30/2019 Credit Risks
6/24
Framework for Financial Statement Analysis of
Risk
ActivityAbility to
Generate Cash
Need to Use
Cash
Financial Statement
Analysis Performed
Operations
Profitability of
Goods and
Services Sold
Working CapitalRequirements
Short-Term LiquidityRisk
Investing
Sales of Existing
Plant Assets or
Investments
Plant Capacity
Requirements
Long-Term SolvencyRisk
FinancingBorrowing
Capacity
Debt Service
Requirements
-
7/30/2019 Credit Risks
7/24
Analysis of Short-Term Liquidity Risk
The analysis of short-term liquidity risk requires an understanding ofthe operating cycle of a firm!
Current Ratio: mainly used to give an idea about the companysability to pay back its short-term liabilities and a sense of theefficiency of the firms operating cycle and its ability to turn itsproducts into cash (ratio 1.0 preferred)
Quick Ratio: known as acid test, measures the firms ability to payoff its short-term debt from current liquid assets; draws a morerealistic picture (trend towards 0.5)
Operating Cash Flow Ratio: using cash flow as opposed toaccounting items provides a better indication of liquidity
(40%ntypical of a healthy firm)
Short-term liquidity problems also arise from longer-term solvencydifficulties!
-
7/30/2019 Credit Risks
8/24
Financial Ratio Formula Measurements
Current Ratio Current Assets / Current liabilities
A measure of short-term
liquidity. Indicates the
ability of entity to meet its
short-term debts from its
current assets
Quick RatioCurrent Assets less inventory / Current
liabilities
A more rigorous measure of
short-term liquidity.Indicates the ability of the
entity to meet unexpected
demands from liquid
current asses
Operating Cash Flow
Ratio
Cash Flows from Operations/Average
Current Liabilities
Measures a company's ability
to pay its short term
liabilities. Indicateswhether the company has
generated enough cash
over the year to pay off
short term liabilities as at
the year end
-
7/30/2019 Credit Risks
9/24
Analysis of Long-Term Solvency Risk
Increasing the proportion of debt in the financial structureintensifies the risk that the firm cannot pay interest and repaythe principle on the amount borrowed
Analysis of long-term solvency risk must begin with ananalysis of short-term liquidity risk
Firms must survive in the short-term if they are to survive inthe long-term!
Interest Coverage Ratio: gives a sense of how far earningscan fall before a firm will start defaulting on its payments (riskyif 2.0)
Long-Term Debt to Long-Term Capital Ratio: way of lookingat the debt structure and determine what portion of totalcapitalization is comprised of long-term debt (what if 1?)
-
7/30/2019 Credit Risks
10/24
Financial Ratio Formula Measurements
Debt ratio Total Liabilities / Total assets
Measures percentage of
assets provided bycreditors and extent of
using gearing
Capitalization ratio Total assets / Total shareholders equity
Measures percentage of
assets provided by
shareholders and the
extent of using gearing
Debt to Capital RatioTotal Debt/(Total Shareholders Equity +
Total Debt)
The debt-to-capital ratio gives
users an idea of a
company's financial
structure, or how it is
financing its operations,
along with some insight
into its financial strength.
Times interest earned
Operating profit before income tax +
Interest expense / Interest expense
+ Interest capitalized
Measures the ability of the
entity to meet its interest
payments out of current
profits.
-
7/30/2019 Credit Risks
11/24
Models of Bankruptcy Prediction
-
7/30/2019 Credit Risks
12/24
The six ratios with the best discriminating power (and the nature of therisk each ratio measures) were as follows:
Net Income plus Depreciation, Depletion, and Amortization/TotalLiabilities (long-term solvency risk)
Net Income/Total Assets (profitability)
Total Debt/total Assets (long-term solvency risk)
Net Working Capital/Total Assets (short-term liquidity risk)
Current Assets/Current Liabilities (short-term liquidity risk)
Cash, Marketable Securities, Accounts Receivable/OperatingExpenses excluding Depreciation, Depletion and Amortization(short-term liquidity risk)
Univariate Analysis
-
7/30/2019 Credit Risks
13/24
MultivariateBankruptcy Prediction ModelsAltmans Z-Score:
AssetsTotal
Sales
sLiabilitieofValueBook
EquityofValueMarket
AssetsTotal
TaxesandInterestBeforeEarning
AssetsTotal
Earningstained
AssetsTotal
CapitalWorkingNetscoreZ
0.1
6.03.3
Re4.12.1
We can convert the Z-score into a probability of bankruptcy using the
normal density function within Excel. The formula is: =NORMSDIST(1-Z
score). Altman developed this model so that higher positive Z-scores mean
lower probability of bankruptcy.
The principle strengths of MDA are as follows:
It incorporates multiple financial ratios;
It provides the appropriate coefficients fro combining the independent
variables;
It is easy to apply once the initial model has been developed.
-
7/30/2019 Credit Risks
14/24
Each ratio captures a different dimension of profitability or risk:
Met Working Capital/Total Assets: the proportion of total assets comprisingrelatively liquid net current assets (current assets minus current liabilities). It
is a measure of short-term liquidity risk.
Retained Earnings/Total Assets: accumulated profitability.
EBIT/Total Assets: this ratio measures current profitability.
Market Value of Equity/Book Value of Liabilities: this is a form of debt/equityratio, but it incorporates the markets assessment of the value of the firmsshareholders equity. This ratio measures long-term solvency risk and themarkets overall assessment of the profitability and risk of the firm.
Sales/Total Assets: this ratio is similar to the total assets turnover ratio andindicates the ability of a firm to use assets to generate sales.
In applying this model, Altman found that Z-scores of less than 1.81indicated a high probability of bankruptcy, while Z-scores higher than 3.00indicates a low probability of bankruptcy. Scores between 1.81 and 3.00were in the gray area.
-
7/30/2019 Credit Risks
15/24
Logit Analysis
Probability of Bankruptcy of a Firm:
yep
1
1
y = -1.32 0.407*SIZE + 6.03*TLTA 1.43*WCTA + 0.0757*CLCA
2.37*NITA 1.83*FUTL + 0.285*INTWO 1.72*OENEG 0.521*CHIN,
SIZE = ln (Total Assets/GNP Deflator)
TLTA = Total Liabilities/Total Assets
WCTA = (CA-CL)/Total Assets
CLCA = Current Liabilities/Current Assets
NITA = Net Income/Total Assets
FUTL = Funds (Working Capital) from Operations/Total Liabilities
INTWO = one if Net Income (NI) was negative in the last two years and zero otherwise
OENEG = one if owners equity is negative and zero otherwise
CHIN = [NI (this year) NI (last year)]/[|NI (this year)| + |NI (last year)|]
-
7/30/2019 Credit Risks
16/24
Earnings Manipulation
Beneish developed a probit model to identify the financial
characteristics of firms likely to engage in earnings
manipulation
)(*670.4
)(*327.0)(*172.0)(*115.0)(*892.0)(*404.0)(*528.0)(*920.0840.4
TATA
LVGISAIDEPISGIAQIGMIDSRIy
Probit converts y into a probability using standardized normaldistribution. The command NORMSDIST within Excel, when
applied to a particular value of y, converts it to the appropriate
probability value
-
7/30/2019 Credit Risks
17/24
Beneishs eight factors and the rationale for their inclusion are as
follows:
Index Rationale
Days Sales in Receivables Index (DSRI) A large increase in accounts receivables as a
percentage of sales might indicate an
overstatement of accounts receivables and sales
to boost earnings
Gross Margin Index (GMI) Firms with weaker profitability a more likely to
engage in earnings manipulation
Asset Quality Index (AQI) An increase in the proportion indicates an
increased efforts to defer costs
Sales Growth Index (SGI) The need for low-cost external financing might
motivate sales manipulation
Depreciation Index (DEPI) Slowing of the rate of depreciation and thereby
increasing earnings
Selling and Administrative Expense Index (SAI) 1 indicates increased marketing expenditures
and expected increased sales
Leverage Index (LVGI) Increase in the proportion of debt might entail a
violation of debt covenants
Total Accruals to Total Assets (TATA) Indicates the volume of earnings resulting from
accruals instead of from cash flows
-
7/30/2019 Credit Risks
18/24
Profitability Analysis
The analysis of profitability addresses two broad questions:
How much risk economic and strategic factors pose for the
operations of a firm, its profitability and long-term solvency ?
We use the Rate of Return on Assets (ROA) to answer thisquestion.
Can the firm generate the expected return on the capital
invested by the lenders and shareholders withoutcompromising the future of the firm? That is, how much of
ROA is left to shareholders (owners) after subtracting the
amounts owed to lenders.
-
7/30/2019 Credit Risks
19/24
Rate of Return on Assets
AssetsTotalAverage
EarningsinInterestMinorityRateTaxExpenseInterestIncomeNetROA
)1(*
TurnoverAssetsROAforinMofitROA argPr
Sales
EarningsinInterestMinorityRateTaxExpenseInterestIncomeNet
ROAforinMofit
)1(*
argPr
AssetsTotalAverage
SalesTurnoverAsset
-
7/30/2019 Credit Risks
20/24
Average Median ROA, Profit Margin for ROA, and Assets
Turnover for 23 industries for 1990 to 2004
-
7/30/2019 Credit Risks
21/24
Economic Factors Affecting the Profit
Margin/Assets Turnover Mix
Area in
Exhibit
Capital
IntensityCompetition
Strategic
Focus
A High Monopoly
Profit
Margin
for ROA
B Medium Oligopoly Both
C LowPure
Competition
Assets
Turnover
-
7/30/2019 Credit Risks
22/24
Profitability Ratios
Financial Ratio Formula Measurements
Return on Total Assets
Operating profit before income tax +
interest expense/ Average total
assets
Measures rate of return
earned through operating
total assets provided by
both creditors and owners
Return on ordinary
shareholders equity
Operating profit & extraordinary items
after income tax minus Preference
dividends / Average ordinary
shareholders equity
Measures rate of return
earned on assets provided
by owners
Gross Profit Margin Gross Profit / Net SalesProfitability of trading and
mark-up
Profit MarginOperating profit after income tax /
Net Sales Revenue
Measures net profitability of
each dollar of sales
-
7/30/2019 Credit Risks
23/24
Total Assets Turnover
Financial Ratio Formula Measurements
Receivables turnoverNet sales revenue / Average receivables
balance
Measures the effectiveness of
collections; used to
evaluate whether
receivables balance is
excessive
Inventory turnoverCost of goods sold / Average inventory
balance
Indicates the liquidity of
inventory. Measures the
number of times inventory
was sold on the average
during the period
Total Asset turnover ratio Net sales revenue / Average total assets
Measures the effectiveness of
an entity in using its
assets during the period.
Turnover of Fixed Assets Net Sales / Fixed Assets
Measure the efficiency of the
usage of fixed assets in
generating sales
-
7/30/2019 Credit Risks
24/24
Return on Common Shareholders Equity (ROCE)
Return on
AssetsReturn to
Creditors
Return toPreferred
Shareholders
Return toCommon
Shareholders
LeverageFinancialTurnoverAssetsROCEforinMofitROCE argPr
EquityrsShareholdeCommonAverage
rsShareholdeCommontoIncomeNetROCE
'
Sales
rsShareholdeCommontoIncomeNetROCEforinMofit argPr
AssetsTotalAverage
SalesTurnoverAssets
EquityrsShareholdeCommonAverage
AssetsTotalAverageLaverageFinancial
'