Financial Statement Analysis

Credit and Risk Analysis

Instructor: M. Jibran Sheikh Email: jibransheikh@comsats.edu.pk

Credit and Risk Analysis

Credit analysis is the financial analysis used to determine the creditworthiness of an issuer from the perspective of a holder or potential holder of its debt i.e. an evaluation of the firms ability to service and repay its debt. Creditors use this information to evaluate the profitability and safety of their loans to the firm. Equity investors are concerned with the firms credit risk since defaults and bankruptcy may cost them some or all of their investment.
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Suppliers of Credit
Commercial Banks
- Good knowledge of existing clients reduces the perceived riskiness - Ongoing credit risk can be monitored more closely

Other financial institutions

- Along with banks, other institutions offer asset-based lending (secured financing of specific assets) - Life Insurance companies with obligations of a long term match with long term investments such as long term bonds or loans.

Public debt markets

- Companies can issue debt direct to the market in the form of commercial paper or bonds. Such debt issues are given a debt rating by one of the major rating agencies. Changes in the rating can cause a change in the price of the security.

Sellers who provide financing

- Many manufactures sell their products on 30 to 60 days credit, interest free and on an unsecured basis. Some will extend this to longer periods.
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Debt Ratings
A debt rating is an indicator of the likelihood of timely repayment of principal and interest by a borrower The more likely the borrower will repay both the principal and interest, in accordance with the time schedule in the borrowing agreement, the higher will be the rating assigned to the debt security.

Rating of Debt Securities

Ratings are sought by companies from agencies when they issue new debt. - Company pays fee and agency issues rating after the agency has examined the creditworthiness of the company - The agency will examine the companys operations and personnel, its financial statements, and its pro-forma projections as well as other relevant financial and non-financial information. Actual ratings themselves are shrouded in mystery. How each rating agency arrives at its rating and the criteria used are not disclosed. The rating agencies go to great lengths to discourage speculation that the rating process is mechanical and based on some mathematical formula. Agencies stress that ratings are based on the judgement of their analysts who arrive at their rating after assimilating quantitative as well as qualitative data available to them.

Function of Debt Ratings

Superior information source on the ability of companies, councils, or even governments to make timely repayment of principal and interest on borrowings. Low-cost source of credit information. Source of legal insurance for an investment trustee. Source of additional certification of the financial and other representations of management. Monitor the actions of management. Facilitate a public policy that restricts speculative investments by institutions such as banks, insurance companies, and pension funds. The social costs can be high when such institutions become bankrupt.

Analysing Credit Risk

The factors that an analyst should examine:- Circumstances leading to the need for the loan - Cash flows
Indicators of potential cash flow problems - Growth in debtors or stock in excess of growth in sales - Increases in creditors in excess of increases in stock - Persistent -ve cash flows from operations, either due to losses or increases in net working capital - Capex greatly in excess of CFO - A substantial shift from long-term to short-term borrowing. - Reduction or elimination of dividend payments

- Collateral (i.e. security)

Need to consider availability and value of security for a loan

- Capacity for Debt

Lenders want to ensure that a margin of safety exists. (Consider capital & income gearing ratios)

- Contingencies - Character of management - Conditions

Lenders can place restrictions or constraints.

Quantitative Models of Debt Ratings

If the goal of a mathematical model is simply to duplicate the rating agencies classification, why bother? Some debt offerings are not rated Ratings are not continually revised Model can be used to: - monitor the debt after the original rating is made - forecast ratings change The variables in a predictive model can give insight into factors that determine the perceived riskiness of debt
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Models
Models developed to predict ratings assigned to debt securities generally follow the Altman model (discriminant analysis). More recently researchers have applied logit and probit analysis. Main problem is selecting the set of independent variables. Ratings firms do not disclose the process used to confer ratings. Ideally there should be some economic rationale for the variables included in the model.

Distress Prediction
A survey was conducted by Berry, Citron, & Jarvis (1987) involving 254 Branch Managers or their equivalent. Participants were asked to rate the frequency of use of the following when deciding whether to grant a loan:
Actual Frequency of use Bankers records of prior loans Audited accounts Interviews with company personnel Interim reports Visit to company premises Always Often Rarely Never 4 1 3 18 19
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84 83 79 59 28

12 16 18 23 53

Univariate Models
Number of individual financial and other ratios examined in distress prediction studies in the last 20 years is well over 100. Beaver (1966) compared patterns of 29 ratios in the 5 years preceding bankruptcy. The purpose was to see which ratios could forecast bankruptcy and how many years in advance the forecast could be made.

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Multivariate models
Altmans multivariate model (1968; original model)

Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E - Altman noted that "any firm with a Z score below 1.8 is considered to be a prime candidate for bankruptcy, the lower the score, the higher the failure probability.
Taffler (1982; UK study) - EBIT/Total Assets - Total Liabilities/Net Capital Employed - Quick Assets/Total assets - Working Capital/ Net worth - Cost of sales/Stock A more refined bankruptcy prediction model, the ZETA was developed by Altman et al. (1977) but the parameters and the design of the model remain proprietary.

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Corporate Bond Ratings

Variables found to be significant in predicting the rating of corporate bonds include: - Total assets - Total debt - Long term debt/total invested capital - Short term debt/ total invested capital - Current ratio - Fixed charge coverage ratio - 5-Year cash flow/5-year(Capex+stock change+ordinary dividends)
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Example of Ratings Definitions Of Long-term Government Debt

Highest Quality ... AAA Very Good Quality ... AA Good Quality ... A Medium Quality ... BBB Lower Medium Quality ... BB Poor Quality ... B Speculative Quality ... C Default ... D (per Canadian Bond Rating Service)

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Moody's Investors Service

Aaa Judged to be the best quality, carrying the smallest degree of investment risk. U.S. Government and Agency Securities have Aaa ratings. Aa Judged to be of high quality by all standards. Together with the Aaa group, they are known as high-grade bonds. A Possess many favourable investment attributes and are considered as high,medium-grade obligations. Baa Considered medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Ba Judged to have speculative elements (i.e., their future cannot be considered well assured). B Generally lack characteristics of a desirable investment. Caa Poor standing; may be in default.

NR Not Rated.
Note: Moody's applies numerical modifiers (1, 2, and 3) in each rating classification from Aa through Baa in its corporate bond rating system. The modifier 1 indicates that the security ranks in the higher end of its category; 2 indicates a mid-range ranking; and 3 indicates a low ranking.

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Default rates of corporate bonds 1971 - 1997 by Standard and Poor's rating at date of issue
Percentage defaulting within:

Rating at time of issue

AAA AA A BBB BB B CCC

1 Year after issue

0.0 0.0 0.0 0.0 0.4 1.5 2.3

5 Years after issue

0.1 0.7 0.2 1.6 8.3 22.0 35.4

10 Years after issue

0.1 0.7 0.6 2.8 16.4 33.0 47.5

Default rates of corporate bonds 1971 - 1997 by Standard and Poor's rating at date of issue

Source: R.A. Waldman, E.I. Altman and A.R. Ginsberg, Defaults and Returns on High Yield Bonds: Analysis through 1997 Saloman Smith Barney, New York 1998
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The Independent April 22, 2008

BAA FLYING SOLO; The airports operator says it is now tackling problems at Heathrow, but restructuring plans are unlikely to head off monopoly complaints from competition watchdogs today. By Danny Fortson;
After the announcement of the latest delay to (..) refinancing - to the third quarter of this year - Standard & Poor's, the credit rating agency, last week downgraded the bonds of BAA and ADIL, the investment vehicle set up by Ferrovial to buy the company, to BBB-, just one grade above "junk". In its report last week, the agency warned that if the commission forces an asset sale, it would probably cut it again. Relegating the rating to "junk" could wreck the refinancing deal altogether or force its bankers at RBS and Citi-group to restructure the offering, which proposes to use BAA's regulated airports as collateral for new bonds. "Our concern is that [an airport disposal] could derail BAA's strategy and timeline, as it is impossible to predict market willingness to go ahead with a refinancing before BAA's future is certain," S&P said. "We will closely scrutinise progress on the refinancing and, if there is any risk of further delay to its execution, we will likely lower the bond ratings further." It is not an academic point. Last year, the gross interest payments for BAA and ADIL were 964m - more than the 956m it generated in earnings from all of its airports together. Getting the refinancing done is crucial as it would provide immediate relief from those onerous rates.
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Business & Money March 30, 2008

Share-shy investors pay for dealing with the devil they didn't know; Outside view

Investor distaste for equities helped fuel the extraordinary surge in the structured credit markets. The question now is whether the responses of investors and policymakers to the current downturn will prompt a longer-term switch back to equities.
However, little attention has been paid to the point that the demand for these new instruments was fuelled by investors' reluctance to buy equities after their earlier bust. The search was on for alternatives that would preserve capital while delivering robust returns. This is not to say shares did not do well out of the generalised boom in asset markets that began in 2003. But the surge in stock prices was underpinned by an extraordinary surge in corporate profits, which meant equity valuations remained moderate. Meanwhile, investors satisfied their appetite for more returns by buying increasingly complex structured credit instruments that compensated for falling yields by employing ever more leverage and taking on more credit risk. The snag was that investors and, worse still, many of the issuers, were not aware of just how much risk was involved. While the combination of investor over-optimism, excessive leverage and lax credit has been a recipe for market crises in the past, the complexity, opacity and scale of the structured credit markets have made this crisis especially shocking and unpredictable. That commentators can question the fate of the $45 trillion credit default swap market, one which barely existed a decade ago, gives some idea of the extent of the uncertainty. Meanwhile, with the ratings agencies tarnished, investors will develop other sources of credit analysis. They will also be looking for banks originating credit securities to retain more exposure, so they have "more skin in the game".
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