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Credit Analysis

Chapter 10

Learning Objectives
• Understand debt instruments, accounting disclosures and claim status • Understand interest rates and risk considerations • Understand bond ratings • Perform credit analysis

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Nature of Debt Instruments
• Creditors receive interest and principal payments they have been promised • Creditors do not share in the profits of the firm • Credit-granting decisions are based on financial statement analysis and commercial credit ratings
– Including off-balance-sheet financing
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Liquidity-availability of company’s resources to meet short term obligations

• Short term liquidity risk is affected by timing of cash flows and outflows along with prospects of future performance.

• Does current ratio : Measure and predict the pattern of future cash inflows and outflows Measure the adequacy of future cash inflows and outflows NO .

Solvency • Refers to a company’s long run financial viability and its ability to cover long term obligations • Solvency analysis involves capital structure analysis and earnings stability .

e.Debt Covenants • Protect lender/bond investor by restricting certain activities (i.. dividend payments) • Intended to provide an early warning system for loans that may be in danger • May result in higher bond rating and lower interest rate 7 .

basis for interest payments • Issued in $1. 20-.000 increments • 10-.Bonds • Indenture is the bond document • Principal (par or face value) is the amount to be repaid. 30-year maturities • Coupon or stated rate is the interest rate • Secured or unsecured (debenture) 8 .

junior 9 .Bonds • Sinking fund – used to pay off the loan • Puttable or redeemable at the purchaser’s option – Callable – at the issuer’s option • Convertible – into another security • Senior vs.

Bond Selling price • Present value of principal and interest payments • Par. at face value • Discount – Stated rate < investor’s required rate of return • Premium – Stated rate > investor’s required rate of return 10 .

Interest rates • Market rate = Risk free rate + Risk premium • Risk free rate ƒ(inflation rate and investor’s desired ―real‖ return) • Risk premium – additional return. compensation for uncertainty 11 .

Bond investment risks • Default risk – issuer unable to make payments • Interest rate risk – potential variation in market rates • Reinvestment rate risk – investor’s ability to reinvest coupon payments at the same rate • Call risk – possibility that issuer will redeem the bond • Purchasing power risk – yield < inflation • Currency risk – for foreign bonds 12 .

000 bond – 4% semiannual interest payment – 5% prevailing market rate 13 .000. $10.Accounting for Debt Instruments • • • • • Original cost/consideration received Minus principal payments Plus discount amortization Less premium amortization Example: – 5-year.

173 – Represents additional interest • Initially report: Bond par value Unamortized discount Bond Carrying value $10.227.694 – Present value of principal.827 – Present value of interest.Bond example • Issue price = $9. $3.133 • Discount = $772.000.139. $6.173) $ 9.227.000 (772.088.827 14 .

068 474.405 82.827 61.052 78.218 64.645.595 9.684 578.353.000 400.762 95.173 9.000 400.569 9.227.068 507.492.461 646.675 86.703 495.000 400.000 400.421.000 400.948 9.637 9.353 354.325 9.000 400.567.391 464.270 486.000 400.461 467.622 478.Bond example Interest Period At issue 1 2 3 4 5 6 7 8 9 10 Payment 400.782 9.270 272.363 71.431 74.703 95.238 9.321 9.353 482.000 Expense 461.622 432.059 90.941 9.000.384 490.000 400.238 Discount Carrying Unamortized Amortization value balance 772.679 67.391 710.000 15 .684 471.000 400.289.814.384 185.727.238 0 10.904.

020 16 .440.412.081 – Present value of principal.Bond example • Market interest drops to 3% • Issue price = $ 10.853.020 $10.000 853.020 – Represents a reduction in interest • Initially report: Bond par value Unamortized premium Bond Carrying value $10.020 – Present value of interest.853.939 • Premium = $853. $3.000. $7.

282.853.000 400.000 Expense 325.309) (541.028) (81.020) (74.191.719 10.748) (457.740 302.691 316.913 Discount Unamortized Amortization balance (853.941) (623.000 400.097.486 305.347) (94.260) (97.028 10.409) (778.969 10.000 400.087 10.611 10.642) (701.710) (88.000 17 .252 313.000 400.059 318.087) (97.861) (91.000 400.087) (0) Carrying value 10.151 308.514) (191.000 400.710 10.849) (282.000 400.358 321.000.971 10.969) (78.861 10.611) (76.701.719) (83.591 323.541.020 10.778.623.347 10.261) (371.457.371.000 400.000 400.971) (86.Bond example Interest Period At issue 1 2 3 4 5 6 7 8 9 10 Payment 400.739 311.

. Treating a bond as an amortized asset is an accounting method in the handling of bonds. intangible asset.Amortization of bonds • Amortization is an accounting method that gradually and systematically reduces the cost value of a limited life. Amortizing allows bond issuers to treat the bond discount as an asset over the life of the bond (until the bond's maturity).

000 bond with a stated interest rate of 9% per annum (9% per year).000 x 9% x 6/12).500 ($100. 2016. a corporation has prepared a $100. The bond's interest payment dates are June 30 and December 31 of each year.Example • To illustrate the premium on bonds payable. The bond is dated as of January 1. . 2012 and has a maturity date of December 31. This means that the corporation will be required to make semiannual interest payments of $4. let's assume that in early December 2011.

• Let's assume that just prior to selling the bond on January 1. Rather than changing the bond's stated interest rate to 8%. Since this 9% bond will be sold when the market interest rate is 8%. the corporation will receive more than the bond’s face value. . 2012. the market interest rate for this bond drops to 8%. the corporation proceeds to issue the 9% bond on January 1.

100.• Let’s assume that this 9% bond being issued in an 8% market will sell for $104. The corporation’s journal entry to record the issuance of the bond on January 1.FV=100.PMT=4500. 2012 Cash 104.100 Bonds Payable 100.100 .000 Premium on Bonds Payable 4. I/Y=4%.000 • Jan. 2012 will be: • Financial calculator: N=10. 1.

In other words.• The account Premium on Bonds Payable is a liability account that will always appear on the balance sheet with the account Bonds Payable. if the bonds are a long term liability. both Bonds Payable and Premium on Bonds Payable will be reported on the balance sheet as long term liabilities. The combination of these two accounts is known as the carrying value of the bonds .

the bond premium of $4. Each accounting period during the life of the bond there needs to be a credit to Interest Expense and a debit to Premium on Bonds Payable. the balance in the account Premium on Bonds Payable must be reduced to $0.Amortization of bond premium • Over the life of the bond. Therefore.100 must be reduced to $0 during the bond’s 5-year life. • The bond premium of $4. 2012 to $100. the bond’s book value will be decreasing from $104. Reducing the bond premium in a logical and systematic manner is referred to amortization.100 was received by the corporation because its interest payments to the bondholders will be greater than the amount demanded by the market interest rates. the amortization of the bond premium will involve the account Interest Expense. 2016.100 on January 1. . In our example. By reducing the bond premium to $0.000 when the bonds mature on December 31.

it will receive less than $100. or discount.000 bond with an interest rate of 9%. Just prior to issuing the bond.Amortization of bond discount • Let’s assume that the corporation prepares a $100. When a bond is sold for less than its face amount. . bond discount. it is said to have been sold at a discount. If the corporation goes forward and sells its 9% bond in the 10% market. The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount. The difference is known by the terms discount on bonds payable.000. a financial crisis occurs and the market interest rate for this type of bond increases to 10%.

2012.139 on January 1. 2012Cash 96.P 3. 1.861 Bonds Payable 100. The corporation's journal entry to record the sale of the bond will be: • Jan.• To illustrate the accounting for bonds payable issued at a discount.000 . let’s assume that the 9% bond is sold in the 10% market for $96.139 Discount on B.

The combination or net of these two accounts is known as the book value or the carrying value of the bonds. . Discount on Bonds Payable will always appear on the balance sheet with the account Bonds Payable.• The account Discount on Bonds Payable (or Bond Discount or Unamortized Bond Discount) is a contra liability account since it will have a debit balance. both Bonds Payable and Discount on Bonds Payable will be reported on the balance sheet as long term liabilities. In other words. if the bond is a long term liability.

• . the straight-line amortization would be $772. In this example. When the same amount of bond discount is recorded each year.861 divided by the 5-year life of the bond).Amortizing bond discount • The discount of $3.20 ($3.861 is treated as an additional interest expense over the life of the bonds. it is referred to as straight-line amortization.

3‖ scores • Fitch (AAA to D) 28 .2.Credit rating • Rely on qualitative and quantitative analyses • Standard & Poor’s (AAA to D) – Intermediate ―+/-‖ scores • Moody’s (Aaa to C) – Intermediate ―1.

5. 8. EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt % Free operating cash flow/Total debt % Return on capital % Operating income/Sales Long-term debt/Capital Total debt/Capital 29 .Standard & Poor’s rating method 1. 2. 4. 6. 7. 3.

Financial distress • Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans. • Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets. 30 . • Financial distress can be predicted.

Prediction of financial distress Univariate models • Beaver (1966) relied on • • • • • • Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio No-credit (defensive) interval 31 .

71 (below the 2.99 nonbankrupt benchmark) 32 .88 • Motorola = 1.Prediction of financial distress Multivariate models • Altman Z-score – – – – (Current assets – current liabilities)/total assets Retained earnings/Total assets EBIT/Total assets Preferred and common stock market value/Book value of liabilities – Sales/Total assets • Nokia = 9.

394 9. LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Notes payable and current portion of long-term debt Accounts payable Accrued liabilities Total current liabilities Long-term debt Long-term deferred income taxes Other Liabilities Company-obligated.Motorola Liabilities December 31.192 485 33 .293 1..374 16.504 1.492 6.152 485 6.391 3.698 8.372 1..257 4.434 6. preferred securities… 2001 2000 870 2.

Note 3 Long-term debt December 31.5% senior notes due 2007 (debt portion of equity security 6.5% debentures due 2028 8.0% notes due 2011 7.22% debentures due 2097 Other long-term debt Less: current maturities Long-term debt 2001 825 79 498 18 398 1.5% notes due 2008 5.4% debentures due 2031 5.5% debentures due 2025 6.75% debentures due 2006 7.293 34 .301 -8 4.515 -143 8.8% debentures due 2008 7.625% debentures due 2010 8.200 200 323 1.190 598 398 440 3 227 419 8.Motorola.6% notes due 2007 6.75% debentures due 2004 Zero coupon notes due 2009 (puttable in 2004) 6.372 2000 — 77 498 17 398 — 300 — 199 323 1. Puttable Reset Securities due 2011 (puttable annually beginning 2003) Zero coupon notes due 2013 (puttable in 2003 and 2008) 6.5% debentures due 2025 (puttable in 2005) 6.189 — 398 440 200 226 36 4.399 300 1.

70% 4.80% Add: Current maturities Notes payable and current portion of long-term debt Weighted average interest rates on short-term borrowings Commercial paper Other short-term debt 35 .40% 5.00% 2000 139 6. Note 3 Short-term debt Notes to banks Commercial paper Other short-term debt December 31.Motorola.383 8 6. 2001 189 514 24 727 143 870 4.244 — 6.391 6.

future minimum lease obligations. at 7%.Motorola. Note 8 Off-balance-sheet financing ―At December 31. beyond—$90 million. is $484 million •Inclusion of these items increases debt by 5% 36 . 2001. 2003— $117 million. 2005—$76 million. for the next five years and beyond are as follows: 2002—$150 million. 2006— $63 million. 2004—$97 million.‖ •The present value of these payments. net of minimum sublease rentals.

814 Accrued expenses 3.184 1.566 8. IAS (EURm) December 31.477 2. 2001 2000 Minority interests 196 177 Long-term liabilities Long-term interest-bearing liabilities 207 173 Deferred tax liabilities 177 69 Other long-term liabilities 76 69 460 311 Current liabilities Short-term borrowings 831 1.594 37 .Nokia Liabilities Nokia Consolidated Balance Sheet.804 9.074 2.069 Current portion of long-term debt 0 47 Accounts payable 3.860 Provisions 2.

Nokia debt note detail By lender: (EURm) Bonds Financial institutions Pension loans Other long-term finance loans Other long-term liabilities By maturity dates: 2002 2003 2004 2005 2006 Thereafter 0 89 103 0 0 91 283 38 31-Dec-01 90 76 25 16 76 283 Repayment date > 5 years 0 0 15 0 76 91 31-Dec-00 138 62 12 8 69 289 .

Nokia debt note detail Operating lease payments Payments due Amount PV factor 2002 254 € 0.8163 2005 165 € 0.9346 2003 213 € 0.6663 Total estimated liability PV 237 € 186 € 145 € 126 € 116 € 183 € 993 € 39 .8734 2004 178 € 0.7130 Beyond 274 € 0.7629 2006 162 € 0.

273) (6.041) 978 5.920 (1.312) Capital expenditures Working capital change Free operating cash flow (1.Elements of Free Operating Cash Flow 2001 EBITDA Nokia (EURm) Motorola ($m) 5.106) 40 .527 (6.735 (4.321) 1.983 (2.039) Non-cash items Fund from operations 248 5.

29 (0.085 0.27) 0.04 0.40) (0.238 0.97 0.018 0.22) 2.58) 0.59 2.44 37.066 0.04 4.63 5.91 49.31 0.97 (6.68 (0.26) 8.116 0.427 41 .56) (0.Debt Analysis Ratios EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt Free operating cash flow/Total debt Return on end of year capital Operating income/Sales Long-term debt/Capital Total debt/Capital Nokia 2001 2000 37.094 0.160 0.443 0.195 0.11 31.115 Motorola 2001 2000 (10.50 0.06 4.421 0.

As noncontrolling interest does not meet FASB definition for Liabilities and are not part of Equity.Additional considerations • Mezzanine items-Auction Preferred Shares (in mutual funds) or noncontrolling interest in subsidiaries. – Could be debt or equity • Off-balance-sheet liabilities – Operating leases – Contingent liabilities – Environmental liabilities 42 .

interest. risk and covenants • Bonds – Discount and premium • Risk analysis • Financial statement presentation • Financial statement analysis 43 .Summary • Debt.