Basics of Credit Analysis

Alexandru Cebotari
 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
• 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
 Profitability, Growth, Risk

Product-Market Strategies Financial-Market Strategies

Investment and
Operating Asset Financing Dividend
Decisions Management Decisions Decisions
Decisions

Managing Managing Managing

Managing
Revenue & Working Capital Liabilities and
Dividend Payout
Expenses & Fixed Assets Equity

Profit Margin Efficiency Capital

Payout Ratios
Ratios Ratios Structure Ratios
• 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 to
generate 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 firm’s ability to make payments on
interest and principle payments, and
(2) bankruptcy risk, the likelihood that a firm will be
liquidated
 Framework for Financial Statement Analysis of
Risk

Ability to Need to Use Financial Statement

Activity
Generate Cash Cash Analysis Performed

Profitability of
Working Capital Short-Term Liquidity
Operations Goods and
Requirements Risk
Services Sold

Sales of Existing
Plant Capacity
Investing Plant Assets or
Requirements
Investments
Long-Term Solvency
Risk
Borrowing Debt Service
Financing
Capacity Requirements
 Analysis of Short-Term Liquidity Risk
• The analysis of short-term liquidity risk requires an understanding of
the operating cycle of a firm!
• Current Ratio: mainly used to give an idea about the company’s
ability to pay back its short-term liabilities and a sense of the
efficiency of the firm’s operating cycle and its ability to turn its
products into cash (ratio ≥ 1.0 preferred)
• Quick Ratio: known as acid test, measures the firm’s ability to pay off
its short-term debt from current liquid assets; draws a more realistic
picture (trend towards 0.5)
• Operating Cash Flow Ratio: using cash flow as opposed to
accounting items provides a better indication of liquidity (40%ntypical
of a healthy firm)

• Short-term liquidity problems also arise from longer-term solvency

difficulties!
Financial Ratio Formula Measurements

A measure of short-term
liquidity. Indicates the
Current Ratio Current Assets / Current liabilities ability of entity to meet its
short-term debts from its
current assets

A more rigorous measure of

short-term liquidity.
Current Assets less inventory / Current Indicates the ability of the
Quick Ratio
liabilities entity to meet
unexpected demands
from liquid current asses
Measures a company's ability
to pay its short term
liabilities. Indicates
Operating Cash Flow Cash Flows from Operations/Average whether the company
Ratio Current Liabilities has generated enough
cash over the year to pay
off short term liabilities as
at the year end
 Analysis of Long-Term Solvency Risk
• Increasing the proportion of debt in the financial structure
intensifies the risk that the firm cannot pay interest and repay
the principle on the amount borrowed
• Analysis of long-term solvency risk must begin with an
analysis of short-term liquidity risk
• Firms must survive in the short-term if they are to survive in
the long-term!
• Interest Coverage Ratio: gives a sense of how far earnings
can fall before a firm will start defaulting on its payments (risky
if ≤ 2.0)
• Long-Term Debt to Long-Term Capital Ratio: way of looking at
the debt structure and determine what portion of total
capitalization is comprised of long-term debt (what if ≥ 1?)
Financial Ratio Formula Measurements

Measures percentage of
assets provided by
Debt ratio Total Liabilities / Total assets
creditors and extent of
using gearing
Measures percentage of
assets provided by
Capitalization ratio Total assets / Total shareholders’ equity
shareholders and the
extent of using gearing
The debt-to-capital ratio gives
users an idea of a
company's financial
Total Debt/(Total Shareholders’ Equity + structure, or how it is
Debt to Capital Ratio
Total Debt) financing its operations,
along with some insight

into its financial strength.

Measures the ability of the

Operating profit before income tax +
entity to meet its interest
Times interest earned Interest expense / Interest expense
payments out of current
+ Interest capitalized
profits.
Models of Bankruptcy Prediction
 Univariate Analysis
The six ratios with the best discriminating power (and the nature of the risk
each ratio measures) were as follows:

• Net Income plus Depreciation, Depletion, and Amortization/Total Liabilities

(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/Operating Expenses

excluding Depreciation, Depletion and Amortization (short-term liquidity risk)
 Multivariate Bankruptcy Prediction Models
Altman’s Z-Score:
 Net Working Capital   Re tained Earnings 
Z  score  1.2    1.4  
 Total Assets   Total Assets 
 Earning Before Interest and Taxes   Market Value of Equity 
 3.3   0. 6  
 Total Assets   Book Value of Liabilitie s 
 Sales 
 1.0  
 Total Assets 

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.
Each ratio captures a different dimension of profitability or risk:

• Met Working Capital/Total Assets: the proportion of total assets comprising relatively 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/equity ratio, but it
incorporates the market’s assessment of the value of the firm’s shareholders’ equity. This
ratio measures long-term solvency risk and the market’s overall assessment of the
profitability and risk of the firm.

• Sales/Total Assets: this ratio is similar to the total assets turnover ratio and indicates the
ability of a firm to use assets to generate sales.

In applying this model, Altman found that Z-scores of less than 1.81 indicated a high
probability of bankruptcy, while Z-scores higher than 3.00 indicates a low probability of
bankruptcy. Scores between 1.81 and 3.00 were in the gray area.
 Logit Analysis
Probability of Bankruptcy of a Firm:
1
p
1  ey
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)|]
 Earnings Manipulation

• Beneish developed a probit model to identify the financial

characteristics of firms likely to engage in earnings
manipulation

y  4.840  0.920 * ( DSRI )  0.528 * (GMI )  0.404 * ( AQI ) 

0.892 * ( SGI )  0.115 * ( DEPI )  0.172 * ( SAI )  0.327 * ( LVGI )
 4.670 * (TATA )

• Probit converts y into a probability using standardized normal

distribution. The command NORMSDIST within Excel, when
applied to a particular value of y, converts it to the appropriate
probability value
Beneish’s eight factors and the rationale for their inclusion are as
follows:
Index
Days Sales in Receivables Index (DSRI)
Gross Margin Index (GMI)
Asset Quality Index (AQI)
Sales Growth Index (SGI)
Depreciation Index (DEPI)
Selling and Administrative Expense Index (SAI)
Leverage Index (LVGI)
Total Accruals to Total Assets (TATA)
Rationale
A large increase in accounts receivables as a
percentage of sales might indicate an
overstatement of accounts receivables and sales
to boost earnings
Firms with weaker profitability a more likely to
engage in earnings manipulation
An increase in the proportion indicates an
increased efforts to defer costs
The need for low-cost external financing might
motivate sales manipulation
Slowing of the rate of depreciation and thereby
increasing earnings
≥ 1 indicates increased marketing expenditures
and expected increased sales
Increase in the proportion of debt might entail a
violation of debt covenants
Indicates the volume of earnings resulting from
accruals instead of from cash flows
 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 this
question.

• Can the firm generate the expected return on the capital

invested by the lenders and shareholders without
compromising the future of the firm? That is, how much of
ROA is left to shareholders (owners) after subtracting the
amounts owed to lenders.
 Rate of Return on Assets

Net Income  Interest Expense* (1  Tax Rate)  Minority Interest in Earnings

ROA 
Average Total Assets

ROA  Pr ofit M arg in for ROA  Assets Turnover

Pr ofit M arg in for ROA 

Net Income  Interest Expense * (1  Tax Rate)  Minority Interest in Earnings

Sales

Sales
Asset Turnover 
Average Total Assets
Average Median ROA, Profit Margin for ROA, and Assets
Turnover for 23 industries for 1990 to 2004
Economic Factors Affecting the Profit
Margin/Assets Turnover Mix

Area in Capital Strategic

Competition
Exhibit Intensity Focus

Profit
A High Monopoly Margin
for ROA

B Medium Oligopoly Both

Pure Assets
C Low
Competition Turnover
Profitability Ratios

Financial Ratio Formula Measurements

Measures rate of return

Operating profit before income tax +
earned through operating
Return on Total Assets interest expense/ Average total
total assets provided by
assets
both creditors and owners

Operating profit & extraordinary

Measures rate of return
Return on ordinary items after income tax minus
earned on assets provided
shareholders’ equity Preference dividends /  Average
by owners
ordinary shareholders’ equity

Profitability of trading and

Gross Profit Margin Gross Profit / Net Sales
mark-up

Operating profit after income tax / Measures net profitability of

Profit Margin
Net Sales Revenue each dollar of sales
Total Assets Turnover
Financial Ratio Formula Measurements

Measures the effectiveness of

collections; used to
Net sales revenue / Average receivables
Receivables turnover evaluate whether
balance
receivables balance is
excessive
Indicates the liquidity of
inventory. Measures the
Cost of goods sold / Average inventory
Inventory turnover number of times
balance
inventory was sold on the
average during the period
Measures the effectiveness of
Total Asset turnover ratio Net sales revenue / Average total assets an entity in using its
assets during the period.
Measure the efficiency of the
Turnover of Fixed Assets Net Sales / Fixed Assets usage of fixed assets in
generating sales
Return on Common Shareholders’ Equity (ROCE)

Return on Return to Return to

Return to
Assets Preferred Common
Creditors
Shareholders Shareholders

ROCE  Pr ofit M arg in for ROCE  Assets Turnover  Financial Leverage

Net Income to Common Shareholders

ROCE 
Average Common Shareholders' Equity

Net Income to Common Shareholders

Pr ofit M arg in for ROCE 
Sales
Sales
Assets Turnover 
Average Total Assets

Average Total Assets

Financial Laverage 
Average Common Shareholde rs' Equity