Chapter 4: Credit Risk Analysis and Interpretation

Revolving credit lines

offer a flexible credit source by allowing the borrower to take money as needed and replace it as able. Usually, these terms are tied to floating interest rates in order to reduce the interest-rate risk of the bank.

Lines of credit

- Similar to revolving credit - Are typically negotiated with a bank or consortium of banks to provide short-run liquidity. - However, the amount of funding is stipulated and interest is charged on both the used and unused portions of the credit line.

Letters of credit

- Used to substitute the credit rating of a company with the bank's credit rating, effectively making the bank the mediator between two parties of a transaction that guarantees the return of funds and assuages the risk of default.

4 steps in assessing the chance of default for a company:

1. Assess the nature and purpose of the loan. 2. Assess the macroeconomic environment and industry conditions. 3. Perform financial analysis being sure to adjust financial statements for more accurate ratios and forecasts of a company's ability to timely meet payments. This includes analyzing the firm's short-term liquidity, long-term solvency, and interest coverage ratios. 4. Perform prospective analysis. This analysis considers that the company's current financial position and ratios may not predict the future. And its future ability to generate cash and repay obligations that determines chance of default.

Means that banks have to extend credit to companies

1. Revolving Credit Lines 2. Lines of Credit 3. Letters of Credit 4. Term loans 5. Mortgages

Three parties that routinely supply credit to companies

1. Suppliers extend non-interest-bearing trade credit to regular customers. 2. Financial institutions - Banks, (lines of credit, letters of credit, revolving credit, term loans and mortgages) 3. Private financing - venture capitalists 4. Lease financing - wherein firms may reap the benefits of fixed assets without an initial cash outlay to purchase the equipment outright. 5. Publicly traded debt markets

Main purpose for creating a credit risk analysis

Allows suppliers of credit to determine 1) whether they wish to extend credit to a particular entity, and if so, 2) what the credit terms should be (e.g. interest rate, covenants, and other contractual restrictions).

Why do lenders distinguish between cyclical cash needs and cash needed to fund operaitng​ losses?

Because cash needed to fund operating losses is riskier. It's typical for firms such as retailers to experience cyclical cash flows during the year as they gear up for busy season. In contrast, operating losses are not routine and can signal ongoing liquidity problems, or at worst, bankruptcy

Why do lenders impose debt covenants on borrowers? Explain three types

Covenants represent terms or conditions placed on the borrower to limit the loss given default by protecting cash flows the company will have to repay the loan. - Also aid creditors by providing evidence of deteriorating conditions within the firm. Three types: those that require borrowers to take certain actions, those that restrict the borrower from taking certain actions, and those that require the borrower to maintain certain financial conditions.

Why are missing or understated liabilities especially critical for credit analysis?

Credit analysis attempts to discern whether a company will be able to pay back its obligations. Because various methods exist for companies to obtain "off-balance- sheet" financing, it is imperative to adjust the financials for any obligations not listed on the balance sheet because these are real economic obligations that must be honored and may have senior claim in certain situations. (ex. Operating leases)

What is credit rating? Why do companies care about their credit rating

Credit ratings are the opinions of an entity's creditworthiness provided by independent firms that professionally analyze and rate the credit risk of a company. Credit ratings impact the cost of debt and consequentially the credit terms (higher cost of debt implies higher interest rates attached to term loans). Credit ratings may also trigger a "non-investment grade" classification that may limit the company from issuing in certain debt markets.

Distinguish between a line of credit and letter of credit

Lines of credit are made available to a borrowing company over a period of time as a form of backup financing. In this arrangement, banks charge interest on both the used and unused portions of the credit line. Letters of credit replace the borrowing companies' credit ratings with the bank's credit rating and guarantee the return of borrowed funds. Letters of credit are typically used in international transactions to reduce credit risk, lines of credit are more typically used as a source of financing to avoid default in the short run for domestic obligations.

Mortgages

Involve agreed-upon interest payments. - The mortgage holder becomes the entitled owner and may foreclose on the mortgage in the case of default, lowering the credit risk.

Why do lenders require collateral? What are some common types of collateral

Lenders take collateral in order to increase the likelihood of recouping their loss in the case of default. The pledged asset can be used to repay the debt. Common types of collateral - Real and personal property, marketable securities, accounts receivable, and inventory.

Liquidity vs Solvency

Liquidity - refers to cash availability --> how much cash the company has and how quickly it can generate more on short notice Solvency - refers to a company's ability to meet its financial obligations over the short and long run. Both measures provide perspective on companies' credit risks and thus measure the likelihood of default or potential bankruptcy. Coverage analysis differs from typical measures of liquidity and solvency because it uses flow variables (from the income statement and cash flow statement) to calculate how likely it is that the company will be able to make principal and interest payments.

Term loans

Most prevalent source of bank funding - Often involve a principal amount as well as a stipulated interest rate to be charged for borrowing the money.

What two factors determine a company's level of credit risk? Explain what each factor tries to measure.

Two factors that impact credit risk: 1. Chance for default - measures the probability that a company will not generate cash flows great enough to meet its obligations. 2. The magnitude of loss given a default - measures the likelihood of receiving compensation when the company defaults

Explain how a company's need of cash for investing activities differs over that company's life cycle. Suggest 3 reasons a company would borrow cash for financing activities.

Younger firms face high start-up costs: economies of scale dictate large costs at the outset of business. Moreover, the set of positive net present value projects for young firms is typically greater and more diverse than that of a mature company. Mature companies exhibit more stable outlays of cash for both ongoing projects and capital outlays to replace deteriorating or obsolescent fixed assets. 1. Firms may use cash borrowings to repay other maturing debt securities 2. Pay dividends 3. Repurchase stock.

Credit risk

the chance of loss resulting from a creditor's default (either interest or principal).