CHAPTER 10

CREDIT ANALYSIS AND DISTRESS PREDICTION

Rizki Nur Sa’diyah 041711333143
Dina Indriana 042024253016
Darojatum Muthi’atur R 042024253030
Why Do Firms Use Debt Financing?

Interest Tax Shields

Corporations or other taxable
entities are able to deduct interest
paid on debt as an ordinary
business expense.

Management Incentive
Alignment

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Leverage imposes a discipline on
management to create value,
reducing conflicts of interest between
managers and shareholders.
Some Potential Downsides of Debt Financing
Increasing levels of debt financing may be
accompanied by higher a likelihood of
financial distress.

Financial distress has some of the

following negative consequences:
➢ Legal costs
➢ Damage to ability to raise capital
➢ cost of conflicts between creditors
and stockholders.
Median Leverage in Selected Industries
 The Market for Credit
Commercial banks
May have better knowledge
of a firm, but are constrained
in the amount of risk they
can assume.
Non-bank financial
institutions
For example, savings & loans,
insurance companies, and
investments bankers
Public debt markets
Requires that a firm have
the size, financial strength,
and credibility to bypass
the banking sector.
Sellers who provide
financing
Suppliers typically extend
very short term financing to
buyers, but may occasionally
grant a loan.
Credit Analysis Process in Private Debt Markets

1. Consider the 2. Consider the 3. Conduct a 4. Assembled the

nature and Type of Loan and Financial Detailed Loan
purpose of the Available Analysis of The Structure,
Loan Security Potential including Loan
Borrower Covenants
 Financial Statement Analysis & Public Debt
analysts and debt raters thus serve an important function
in closing the information gap between issuers and
investors.

A firm’s debt rating influences the yield that must be offered

to sell the debt instruments.

To be considered
investment grade, a firm
must achieve a rating of
BBB or higher, which is an
important threshold as
many funds are precluded
by their charters from
investing in any bonds
below that grade.
 Factors That Drive Debt Ratings
Research using quantitative models of debt ratings demonstrates that some of the
variation in ratings can be explained by selected financial statement ratios.

In each case,
profitability and leverage
play an important role in
the rating.

In each case,
profitability and leverage
play an important role in
the rating.
 Prediction of Distress and Turnaround

The prediction of distress or turnaround that

involves all of the steps of analysis :
Altman Z-score model 1. business strategy analysis,
2. accounting analysis,
3. financial analysis,
4. prospective analysis.

One study suggests that the factors most useful

(on a stand-alone basis) in predicting bankruptcy one
year in advance are the firm’s level of profitability, the
volatility of that profitability (as measured by the standard
deviation of ROE), and its leverage.

Such models have some ability to predict failing and surviving firms.

Investors in these securities can earn attractive returns if the firm recovers from its cash flow difficulties.
Credit Ratings and The Subprime Crisis

The Dodd-Frank Wall Street Reform and Consumer Protection Act was an attempt
to address through regulation some of the key causes of the financial crisis, and
included increased oversight of the ratings agencies. Among its key provisions
related to credit agencies:
• Creation of an Office of Credit Ratings at the SEC
• Increased disclosure requirements for the ratings agencies.
• Required use of independent information by the ratings agencies
• Increased limitations on activities involving potential conflict of interest
• Increased potential liability.
• Gives SEC right to deregister a ratings agency
• Increased education requirements
• Elimination of statutory and regulatory requirements for use of ratings
• Increased independence of agency boards
• New SEC mechanism to prevent “shopping for ratings”
 CHAPTER 10
CREDIT ANALYSIS
Rizki Nur Sa’diyah 041711333143
Dina Indriana 042024253016
Darojatum Muthi’atur R 042024253030
Liquidity
✔ The availability of company resources to meet short
term cash requirements.
✔ The ability to convert assets into cash or obtain cash to
meet short-trerm obligations.
Current Assets and Liabilities

Current Assets Current Liabilities

are obligations expected to
cash and other be satisfied within a
assets reasonably relatively short period of
time, usually one year.
expected to be (1) Concern:
realized in cash or 1. Contingent liabilities associated
with loan guarantees
(2) sold or 2. Future min rental payments
consumed within under noncancelable operating
lease agreement
one year 3. Contracts for construction or
acquisition of long term assets
often call for substantial progress
payments
 Working Capital

Current assets – current

liabilities

Usefulness
Investment decisions and

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recommendations, for regulatory
and policy actions
 Current Ratio
Computation:

Relevance used as a measure of liquidity, it is able to measure:

• Current liability coverage
• Buffer against losses
• Reserve of liquid funds

Limitation:
• Cant measure and predict the pattern of future cash inflows and outflows
• Cant measure the adequacy of future cash inflows to outflows
 Numerator Current Ratio
Sales is major
determinant, which Expenditure for
Has a little relation related by credit future benefits that
to existing level of policies and preserve the outlay
business activity collection methods of current funds

Cash & Cash Marketable Accounts Prepaid

Inventories
Equivalents Securities Receivable Expenses

Viewed as available Sales or expected

to discharge current sales is the major
liabilities. Much of determinant, which
the guesswork from related by the
estimating their net observation that
realizable value is sales initiate the
removed conversion of
inventories to cash.
Using Current Ratio for Analysis
Liquidity depends to a large extent on prospective cash
A flows and to a lesser extent on the level of cash and cash
equivalents

No direct relation exists between balances of working

B capital accounts and likely patterns of future cash flows.

Managerial policies regarding receivables and inventories

C are directed primarily at efficient and profitable asset
utilization and secondarily at liquidity.

2 elements must evaluate and measure before current

D ratio: quality current assets and current liabilities; turnover
rate both current assets and current liabilities
 01
Cash to current asset
ratio

Cash based ratio Measures of Liquidity

02
Cash to current
liabilities ratio
Operating Activity Analysis of Liquidity
Accounts Receivable Measures of Liquidity
Accounts Receivable Turnover

Days Sales in Receivables

Usefully compared with industry averages or with the credit terms given by
the company
Inventory Turnover Measures

Average inventory adding the beginning and

ending balances then dividing by 2. This
averaging computation can be refined by
averaging quarterly or monthly.
 Days’ Sales in Inventory

is another measure of inventory turnover useful

in assessing a company’s purchasing and
production policy.

When inventory turnover decreases over time,

or is less than the industry norm, it suggests
slow-moving inventory items attributed to
obsolescence, weak demand, or nonsalability.

Conversion period or operating cycle is measure combines the collection period

of receivables with the days to sell inventories to obtain the time interval
to convert inventories to cash.
 Liquidity of Current Liabilities
are important in computing both working capital and the current ratio for two related reasons:

Current liabilities are used in determining whether Current liabilities are deducted from current
the excess of current assets over current liabilities assets in arriving at working capital.
affords a sufficient margin of safety

A measure of the extent to which companies “lean on the trade” is the average
payable days outstanding :
 Additional Liquidity Measures
Acid-Test (Quick) Ratio

Cash Flow Measures

Financial Flexibility
is the ability of a company to take steps to counter unexpected
interruptions in the flow of funds.

Management’s Discussion and Analysis

If a material deficiency in liquidity is identified, management

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must discuss the course of action it has taken or proposes to
take to remedy the deficiency.
What-If Analysis
s is a useful technique to trace through the effects of changes in
conditions or policies on the resources of a company
 A Typical Company’s Asset Distribution
Basics of and Capital Structure
Solvency
Capital structure refers to the
sources of financing for a company.
This PowerPoint Template has clean and neutral
Covenants are often designed to : design that can be adapted to any content and
1. emphasize key measures of meets various market segments.
financial strength like the
current ratio and debt to
equity ratio,
2. prohibit the issuance of
additional debt,
3. ensure against disbursement
of company resources
through excessive dividends
or acquisitions.
Motivation for Debt Capital
Debt is a preferred external financing source for at least
two reasons:
1. Interest on most debt is fixed and, provided interest
cost is less than the return on net operating assets,
the excess return is to the benefit of equity investors.
2. Interest is a tax-deductible expense,
whereas dividends are not.

Concept of
Financial Companies Companies with
Leverage typically carry
both debt and
financial leverage
are said to be
equity financing. trading on the
equity
Adjustments to Book Values of Liabilities
Deferred Income Taxes
An important question is whether we treat deferred taxes
as a liability, as equity, or as part debt and part equity.

Operating Leases
Operating leases should be recognized on the balance sheet for
analytical purposes, increasing both fixed assets and liabilities

Off-Balance-Sheet Financing
In determining the debt for a company, analysis must be aware
that some managers attempt to understate debt.

Contingent Liabilities
such as product guarantees and warranties represent obligations
to offer future services or goods that are classified as liabilities.
Minority Interests
represent the book value of ownership interests of
minority shareholders of subsidiaries in the consolidated
group.
Capital Structure
Composition and Solvency
Common-Size Statements in Solvency Analysis

Composition analysis
➢ Performed by constructing a common-size
statements of the liabilities and equity
section of the balance sheet.
➢ Reveal relative magnitude of financing
sources.
Capital Structure
Composition and Solvency
Capital Structure Ratios

➢ Total Debt to Total Capital Ratio ➢ Long-Term Debt to Equity Capital

○ Comprehensive measure of the ○ Measures the relation of LT debt to
relation between total debt and total equity capital.
capital. ○ Commonly referred to as the debt to
○ Also called total debt ratio. equity ratio.

➢ Total Debt to Equity Capital ➢ Short-Term Debt to Total Debt

○ Indicator of enterprise reliance on
short-term financing.
○ Usually subject to frequent changes
in interest rates.
Capital Structure
Composition and Solvency
Interpretation of Capital Structure Measures

➢ Capital structure measures serve as

screening devices.

➢ Further analysis required if debt is a

significant part of capitalization.
Capital Structure
Composition and Solvency
Asset-Based Measures of Solvency

Asset composition in solvency analysis

➢ Important tool to assessing capital
structure risk exposure.
➢ Typically evaluated using common-size
statements of asset balances
Earnings Coverage
Earnings to Fixed Charges
Limitations of capital structure measures -
inability to focus on availability of cash flows
to service debt.
Roles of earnings coverage, or earnings
power, as the sources of the interest and
principal repayments.

Earnings to fixed charges ratio.

Earnings Coverage
Earnings to Fixed Charges
Earnings Coverage
Earnings to Fixed Charges
 Earnings Coverage
Times Interest Earned

Time Interest Earned Ratio

Consider interest as the only fixed
charge needing earnings coverage:

Numerator sometimes referred

to as earnings before interest
and taxes, or EBIT.

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Potentially misleading and not
as effective an analysis tool as
the earnings to fixed charges
ratio.
 Earnings Coverage
Relation of Cash Flow to Fixed Charges

Cash flow to fixed charges ratio

Computed using cash from operations
rather than earnings in the numerator
of the earnings to fixed charges ratio.

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 Earnings Coverage
Earnings Coverage of Preferred Dividends

Earnings coverage of preferred dividends ratio

➔ Computation must include in fixed charges all
expenditures taking precedence over preferred
dividends.
➔ Since preferred dividends are not tax deductible,
after-tax income must be used to cover them.
 Earnings Coverage
Interpreting Earnings Coverage

➔ Earnings coverage measures provide insight into the

ability of a company to meet its fixed charges.
➔ High correlation between earnings-coverage measures
and default rate on debt.
➔ Earnings variability and persistence is important.
➔ Use earnings before discontinued operations,
extraordinary items, and cumulative effects of
accounting changes for single year analysis - but,
include them in computing the average coverage ratio
over several years.
 Earnings Coverage
Capital Structure Risk and Return

➔ A company can increase risks (and potential returns)

of equity holders by increasing leverage.
➔ Substitution of debt for equity yields a riskier capital
structure.
➔ Relation between risk and return in capital structure
exists.
➔ Only personal analysis can reflect one’s unique risk
and return expectations.
 CASE 10 - 4A
SUBRAMANYAM
Rizki Nur Sa’diyah 041711333143
Dina Indriana 042024253016
Darojatum Muthi’atur R 042024253030
Required:
a. You arrange a visit with Altria management. Given the information you have assembled above, identify
and discuss five major industry considerations you should pursue when questioning management.
Economic cyclicality. How closely do the tobacco,
food, and beverage industries track GNP? Is tobacco
consumption more tied to sociopolitical and regulatory
factors than to economic ones? Cyclicality of an
industry is the starting point an analyst should
consider in reviewing an industry. A company's
earnings growth should be compared against the
growth trend of its industry, with significant deviations
carefully analyzed. Industries may be somewhat
dependent on general economic growth, demographic
changes, and interest rates. In general, however,
industry earnings are not perfectly correlated with any
one economic statistic. Not only are industries
sensitive to many economic variables, but often
segments within a company or industry move with
different lags in relation to the overall economy.
Growth prospects. Are the businesses that Altria is
operating within growing at a steady pace, or is growth
slipping? Will European consumption of cigarettes
begin to slow as they have in the U.S. due to more no
smoking regulations? Related to the issue of growth, is
there consolidation going on in tobacco, food or
beverages? Alternate growth scenarios have different
implications for a company. With high‑growth
industries, the need for additional capacity and related
financing is an issue. With low‑growth industries,
movements toward diversification and/or consolidation
strategies are a possibility. As a general proposition,
companies in high‑growth industries have greater
potential for credit improvement than companies
operating in lower-growth industries.
Competition. How competitive are these industries?
Are there players who are out to gain market share at
the expense of profits? Is the industry trending
toward oligopoly, which would make small
companies in the industry vulnerable to the
economies of scale the larger companies bring to
bear? Economic theory shows us how competition
within an industry relates to market structure and has
implications for pricing flexibility. An unregulated
monopoly is in position to price its goods at a level
that will maximize profits. Most industries, however,
encounter free market forces and cannot price their
goods/services without consideration of supply and
demand as well as the price charged for substitute
goods/services. Oligopolies often have a pricing
leader. Analysts must be concerned about small
companies in an industry that is trending toward
oligopoly. In such an environment, the small
company's production costs may exceed those of the
industry leaders. If a small firm is forced to follow the
pricing of the industry leaders, the firm may be driven
out of business.
Research & development. R&D activities are not large
in the tobacco, food or beverage industries, although
expenditures are directed at new product
development. In general, it is safe to characterize
these businesses as having a stable product line that
will not vary much over time. For firms relying on
such expenditures to maintain or improve market
position, it is important to assess whether the
company in question has the financial resources to
maintain a leadership position or at least expend a
sufficient amount of money to keep technologically
current.
Sources of supply. Are these businesses vulnerable
to the cost of production inputs? Or is the market
position of Altria such that it can easily pass on
higher raw material costs? Industry market
structure often has a direct impact on sources of
supply. From a competitive standpoint, the company
that controls its factors of production is in a
superior position.
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b. Additional information is collected showing median ratio values along with their bond rating category
for three financial ratios. Using this information reported in the excerpt below along with the projections
above:
(1) Calculate these same three ratios for Altria for Year 9 using:
(a) Amounts before accounting for the Kraft acquisition.
(b) Consolidated amounts after the Kraft acquisition.

1a. Ratios for Altria for Year 9 before the acquisition of Kraft are:

Pretax interest coverage = ($4,820+$500)/$500 = 10.64

LT debt as % of capitalization = $3,883/($3,883+$9,931) = 28.11%

CF as % of total debt = ($2,820+$750+$100-$125)/($3,883+$1,100) = 71.14%

1b. Ratios for Altria for Year 9 pro forma for the acquisition of Kraft are:

Pretax interest coverage = ($4,420+$1,600)/$1,600 = 3.76

LT debt as % of capitalization = $15,778/($15,778+$9,675) = 61.99%

CF as % of total debt = ($2,564+$1,235+$390-$125)/($15,778+$1,783) = 23.14%

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b. Additional information is collected showing median ratio values along with their bond rating category for three financial
ratios. Using this information reported in the excerpt below along with the projections above:
(2) Discuss and interpret the two sets of ratios from 1 compared to the median values for each bond rating category.
Determine and support your recommendation on a rating category for Altria after the Kraft acquisition.

2. Relating these ratios to the median ratios for the various bond rating categories places Altria in the position shown below:

Before Kraft Ratio Implied Rating

Pretax interest coverage..................................... 10.64 AA

Recommendation: These ratios suggest that

LT debt as % of cap.............................................. 28.11% A Altria bonds have deteriorated from a strong
A rating to a BB rating, based on the median
ratios for the various bond categories. Given
CF as % of total debt............................................ 71.14% A+/AA- that Altria is in relatively stable businesses
(food and tobacco) that tend to be much less
cyclical than the economy overall, an
After Kraft Ratio Implied Rating argument could be made that its bonds
should be rated as a strong BB or even a
BBB.
Pretax interest coverage..................................... 3.76 BBB

LT debt as % of cap.............................................. 61.99% B

CF as % of total debt............................................ 23.14% BB

Artificial Intelligent Credit Risk Prediction: An Empirical Study of Analytical
Artificial Intelligence Tools for Credit Risk Prediction in a Digital Era
Rizki Nur Sa’diyah 041711333143
Dina Indriana 042024253016
Darojatum Muthi’atur R 042024253030
 Introduction
The purpose of this paper therefore is to provide a contribution to
the improvement of individual credit decisioning.

(Brown, et.al., 2014)
which began in 2006 with sub-prime
mortgages in the United States, has
highlighted the fundamental
importance of the credit decision.
(Basel Committee, 2000)
Credit risk is the risk of default on a
debt that may arise from a
borrower’s failing to make required
payments.
(Van Thiel, et.al., 2017)
Customer experience and financial
advice are ill-defined concepts, and
lack well developed assessment
methods and metrics

On the other hand, the higher the amount that can be recovered, the lower the risk.
Formally, we can therefore express the risk as:

Credit risk = Exposure at default * Probability of Default * (1- Recovery Rate)

 Hipothesis
Observation 1: Artificial intelligent models, like random forests and
neural networks can qualify to improve credit decisioning in
different asset classes like mortgage loans and credit card loans.
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Observation 2: Artificial intelligent models, like random forests and

neural networks can qualify to improve credit decisioning by having
the ability to apply both structured and unstructured data.
 Data preparation
Empirical Collect and prepare
the daya which
Design participating banks
share anonymized
customer data
Dependent variable: The
*133,152 customers)
delinquency (default) status, as a

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mortgage or credit card account 2 samples Dutch

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greater than or equal to 90 dpd banks for mortgage
default prediction are
55.812 and 47.346.
Sample for thin file
British credit card
issuer is 6.994

Data is prepared for the

machine learning models using
complete and coherent
meaningdul features also
conducted on data definitions,
data sources and banks policy
definitions of delinquencies
 Modelling Approach
Each model is applied on the
validation sample. The
champion model within each
modeling
algorithm is identified based
on the above performance
indicators.

The best performing

50 variants within each champion models of the
modeling algorithm are tried different experiments are
and applied on the training analyzed on
sample. The similarities in features, as
modeling algorithms used well in type of model.
are Neural Net and Random
Forest.
 RESULTS
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Experiment 1: Dutch
Bank Insurance
Company
Experiment 2: Dutch
Mortgage Bank
Experiment 3: British
Credit Card Company
 ❖ Di sini, tiga eksperimen telah dilakukan untuk menguji manfaat model risiko kredit AI
untuk kemungkinan gagal bayar dalam pinjaman konsumen.
❖ Dalam semua percobaan, model kecerdasan buatan tampil lebih baik daripada model
tradisional.
❖ Model perusahaan kartu kredit Inggris dan bank asuransi, yang dapat memanfaatkan
data pembayaran, berkinerja lebih baik daripada model data hipotek saja.
❖ Pembayaran bunga dan pembayaran bulanan adalah salah satu fitur prediktif teratas
dengan bank khusus hipotek.
❖ Perusahaan asuransi bank dan kartu kredit lebih memperhatikan skor kredit dan rasio
pinjaman terhadap pendapatan yang dapat mereka akses.
❖ Peneliti melihat pemberi pinjaman yang lebih maju menciptakan fitur yang lebih cerdas
dengan menciptakan hubungan antara pendapatan dan pinjaman dan menggunakan
data media sosial (perusahaan asuransi bank).

Untuk memvalidasi pengamatan,

Results Summary and hasil dibuat sebanding antara
Observation Testing random forests dan pendekatan
logistik dengan menerapkan
dataset terstruktur tradisional
yang sama dalam percobaan dan
membandingkan metrik risiko
yang jelas.
 Discussion
As banks lend more money and new lenders pop-up, the risk of over
crediting and default increases. To reduce over-crediting, it needs better
individual risk assessments, limit setting and pricing
Millenials drive a change in customer experience expectations 🡪 from
digitalizations.
Digital lending allow lenders target their customers withappropriately
timed offers; automates complex process and reduces manual
interferences
The study employ large dataset tot test the added value of artificial
interlligent risk models for predicting mortgage and credit card
delinquency
It analyze and compare risk management practices across the banks
and compare drivers of delinquenct across institutions
 Findings
Theres substantial homogeneity across banks in traditional risk features
like payment of the interest, monthly payment, credit score and loan to
income rations
Portfolio characteristics are insufficient in identifying drivers of
delinquency
The study provides an illustration of the potential benefits that advanced
machine-learning techniques, and with that the use of unstructured data,
can bring to consumers in terms of a faster and more predictive and
prescriptive customer experience; to risk managers by transforming from
expert driven modelling into digitalization of risk management with more
advanced ways of artificial intelligent modelling and monitoring on more
internal and external data and to shareholders by lowering delinquencies
and regulators by better controlling systematic credit risk
In the study, the author develop random forest models for consumer
credit delinquency,
Limitation and Future Research
LIMITATION
• Center on the focus on two
leading European credit
markets
• The time frame of the
experiments might bring
bias
• The application of
structured data in order to
make results comparable
across models
FUTURE RESEARCH
• Perform other greogaphies
especially in developing
countries
• Repeat the experiments after
a few years to understand
the advancements in
digitalization of risk
management better
• More research with the
application of other data
groups to understand the
impact of unstructured
behavioral data on risk
scorecards
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Thank you