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A Framework for Business Analysis and Valuation Using Financial Statements

Topic 9 – Credit Analysis

Processes/Methods of Credit Analysis

Grant

Credit?

Credit Analysis

Process

Debt Ratings

Distress

Predictors

Business Analyses

• The better a firm’s future business prospects, the lower the risk to the creditor

Credit Analysis Process (steps) Step 1: Analyse the potential borrower's financial status

Step 2: Consider the purpose for extending credit

Step 3: Nature of credit

Step 4: Term and ability to repay

Step 5: Security

Step 6: Loan covenants

Step 7: Pricing

Credit Analysis Process (step 1) Step 1: Analyse the company's financial status

- Links to previous analyses (e.g. strategy, accounting, financial analysis)

Credit Analysis Process (step 2) Step 2: Consider the purpose for extending credit

- The purpose of credit may effect the financing decision (e.g. – re-financing vs purchase new equipment)

Credit Analysis Process (step 3) Step 3: Nature of credit

- Open-end (e.g. – line of credit) vs Closed-end (e.g. – mortgage)

Credit Analysis Process (step 4) Step 4: Term and ability to repay

- How long? And, in the future do we expect that the borrower can pay?

Credit Analysis Process (step 5) Step 5: Security

Where required, is the security adequate? How much will be lent against the security?

Credit Analysis Process (step 6) Step 6: Loan covenants

- Essentially restrictions placed against the borrower

Credit Analysis Process (steps) Step 7: Pricing

- What (interest rate) to charge?

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Credit Analysis (information)

Debt ratings provide important information to investors.

• The meaning of debt ratings:

– Rating systems grade the relative riskiness of debt (e.g. AAA to C [S&P and Moody’s] plus speculative)

– Debt ratings influence the yield that debt instruments must pay for investors to buy them.

Credit Analysis (information)

Credit Analysis (methods/tools) • Models for distress prediction

– Several models have been developed over the years

– One of the more popular and robust is the Altman’s Z-score model:

• Debt of distressed companies present investment opportunities because they trade at steep discounts.

Credit Analysis (methods/tools) • Simple example

– X1 = -0.2, X2 = 0.3, X3 = 0.15, X4 = 2.5 and X5 = 0.6

– Z = (1.2 x -0.2) + (1.4 x 0.3) + (3.3 x 0.15) + (0.6 x 2.5) + (1.0 x 0.6)

– Z = 2.78 (conclusion – no material distress predicted)

Credit Market (Suppliers)

Listed Debt

Markets

Commercial

Banks

Other Financial

Institutions Credit

Market

Trade Creditors

Suppliers of Credit • Commercial banks: May have better knowledge of a firm, but are constrained

in the amount of risk they can assume.

• Other financial institutions: For example, savings and loans, insurance companies, and investment bankers.

• Public debt markets: Requires that a firm have the size, financial strength and credibility to bypass the banking sector.

• Trade creditors: Suppliers typically extend very short term financing to buyers.

Credit Mix

• Entities may use multiple suppliers of credit

• Legal environments (e.g. – bankruptcy) can affect the type of borrowing