The Analysis

1
Chapter 19

• The Analysis
• of
• Credit Risk

2
The Analysis of Credit Risk
3
What you will learn from this chapter

• How default risk determines the price of credit
  (the cost of debt capital)
• What determines default risk
• How default risk is analyzed
• How credit scoring models work
• The difference between Type I and Type II errors
  is predicting defaults
• How pro forma analysis aids in assessing default
  risk
• How value-at-risk analysis is used to assess
  default risk
• How financial planning works

4
Default Risk and Default Premiums

• Required Return on Debt Risk-free Rate
  Default Premium
• The default premium is determined by the risk
  that the debtor could default
• Similar terms
• Required return on debt
• Cost of debt
• Price of credit

5
The Suppliers of Credit

• Public debt market investors who include
  (long-term) bondholders and (short-term)
  commercial paper holders.
• Commercial banks that make loans to firms.
• Other financial institutions such as insurance
  companies, finance houses and leasing firms
  make loans, much like banks, but usually with
  specific assets serving as collateral.
• Suppliers to the firm who grant (usually
  short- term) credit upon delivery of goods and
  services.

6
Ratio Analysis for Default Evaluation

• Steps
• Reformulate financial statements
• Calculate ratios

7
Reformulating the Balance Sheet for Credit
Analysis

• The key idea in the reformulation of the balance
  sheet is to order assets by liquidity and
  liabilities by maturity. Annotate as you
  reformulate.
• Issues
• Detail on different classes of debt and their
  varying maturities is available in the debt
  footnotes this detail can be brought on to the
  face of reformulated statements.
• Debt of unconsolidated subsidiaries (where the
  parent owns less that 50, but has effective
  obligations) should be recognized.
• Long-term marketable securities are sometimes
  available for sale in the short-term if a need
  for cash arises.
• Long-term debt (of similar maturity) can be
  presented on a net basis.
• Remove deferred tax liabilities that are
  unlikely to reverse from liabilities to
  shareholders equity.
• Add the LIFO reserve to inventory and to
  shareholders equity to convert LIFO to a FIFO
  basis.
• Off-balance-sheet debt should be recognized on
  the face of the statement.
• Contingent liabilities that can be estimated
  should be included in the reformulated
  statements.
• The risk in derivatives and other financial
  instruments should be noted.

8
Off-Balance-Sheet Financing

• Off-balance-sheet financing transactions are
  arrangements to
• finance assets and create obligations that do not
  appear on the
• balance sheet.
• Examples
• Operating leases
• Agreements and commitments
• third-party agreements
• through-put agreements
• take-or-pay agreements
• repurchase agreements
• sales of receivables with recourse
• Special purpose entities not consolidated
• Unfunded pension liabilities not booked

9
Reformulated Income Statements and Cash Flow
Statements
Income Statement Distinguish income from
operations that covers net financial
expense The reformulation follows that for
profitability analysis in Chapter 9
Cash Flow Statement Distingui
sh (unlevered) cash flow from operations that
can be used to make payments on debt The
reformulation follows that in Chapter 10
10
Ratio Analysis Short-Term Liquidity Ratios

• Liquidity Stock Measures
• Liquidity Flow Measures

11
Ratio Analysis Long-term Solvency Ratios

• Solvency Stock Measures
• Solvency Flow Measures

12
Ratio Analysis Operating Ratios

• Poor profitability increases the likelihood of
  default.
• So the profitability analysis of Chapter 11 and
  the risk analysis of Chapter 18 are inputs into
  credit analysis. Watch particularly for declines
  in
• RNOA
• Operating profit margins
• Sales growth

13
Forecasting and Credit Risk

• The Prelude
• Know the business
• Appreciate the moral hazard problem of debt
• Understand the financing strategy
• Understand the current financing arrangements
• Understand the quality of the firms
  accounting
• Understand the auditors opinion, particularly
  any qualification to the opinion

14
Forecasting Default with Credit Scoring

• Credit scores combine a number of indicators into
  one score that estimates the probability of
  default.
• Credit Scoring Methods
• Multiple Discriminate Analysis (MDA)
• Logit Analysis

15
Multiple Discriminate Analysis (Z-scoring)
Original Altman Model
16
Logit Scoring Model
Original Ohlson Model
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Credit Scoring Prediction Error Analysis
Type I error Classifying a firm as not likely
to default when it actually does default Type
II error Classifying a firm as likely to
default when it does not default Trade off
Type I and Type II errors choose a cut- off
score that minimizes the cost of errors
18
Full Information Forecasting Using Pro Forma
Analysis for Default Forecasting

• PPE Inc.

19
Using Pro Forma Analysis for Default Forecasting
PPE Inc.
20
Default Points

• Default occurs when cash available for debt
  service is less than the debt service
  requirement.

21
Value-at-Risk Profiles for Default Forecasting

• Steps
• Generate profiles of cash available for debt
  service for a full set of scenarios from pro
  forma analysis
• Establish the debt service requirement
• Identify the default point where cash available
  for debt service is below the debt service
  requirement, and so identify the default
  scenarios
• Assess the probability of the set of default
  scenarios occurring

22
Value-at-Risk Profile
23
Liquidity Planning and Financial Strategy

• A default strategy is a strategy to avoid
  default
• Pro forma analysis of default points can be
  used as a planning tool to avoid default
• Modify plans to increase liquidity in
• order to avoid default and build those
  plans
• into the financial strategy pro forma