module 4 conceptual
Lenders distinguish between cyclical cash needs and cash needed to fund operating losses because the second type of cash is riskier. It is typical for firms such as retailers to experience cyclical cash flows during the year as they gear up for busy season (October - December for many retailers). This happens in the ordinary course of business. In contrast, operating losses are not routine and can signal ongoing liquidity problems, or at worst, bankruptcy.
Companies often borrow money to fund operating activities. Why do lenders distinguish between cyclical cash needs and cash needed to fund operating losses?
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 effectively replace the borrowing companies' credit ratings with the bank's credit rating and guarantee the return of borrowed funds. While 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
Distinguish between a line of credit and a letter of credit. Why do companies obtain lines of credit
The Altman bankruptcy model attempts to assess a firm's potential for bankruptcy based on measures of its financial health. The measures are financial ratios that assess the company's liquidity (working capital/total assets), its short and long-term profitability (EBIT/total assets and retained earnings/total assets, respectively), its proclivity to seek debt versus equity financing (market value of equity/total liabilities), and its assets' efficiency in producing sales (sales/total assets).
Explain in general terms the Altman bankruptcy prediction model. What do each of the five model variables measure
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
Explain the concepts of liquidity and solvency. Why is performance on these two dimensions crucial to company survival? How does coverage analysis differ from measures of liquidity and solvency
i. 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. ii. Lines of credit are similar to revolving credit. They 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. iii. Letters of credit are 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. iv. Perhaps the most prevalent source of bank funding is term loans. These often involve a principal amount as well as a stipulated interest rate to be charged for borrowing the money. v. Banks may extend mortgages on real property to companies for 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
Identify and explain at least three means that banks have to extend credit to companies.
i. Suppliers extend non-interest-bearing trade credit to regular customers. ii. Financial institutions, such as banks, extend many forms of credit to industrial firms, including lines of credit, letters of credit, revolving credit, term loans and mortgages. iii. Private financing can be obtained from nonbank entities such as venture capitalists who may be more willing to take on riskier loans because they have contextual expertise or deeper industry knowledge. iv. Lease financing is another form of "borrowing," wherein firms may reap the benefits of fixed assets without an initial cash outlay to purchase the equipment outright. v. Publicly traded debt markets provide a cost-efficient manner to raise capital over the short term with commercial paper, or the long term with bond issuances
Identify parties that routinely supply credit to companies
i. Assess the nature and purpose of the loan. Is the loan needed? What was the purpose of the loan needed? ii. Assess the macroeconomic environment and industry conditions. Is the industry competitive? Are its consumers/suppliers powerful? How does the condition of the global economy impact this business? Is the market perfectly competitive with many substitutes? iii. 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 shortterm liquidity, long-term solvency, and interest coverage ratios. iv. Perform prospective analysis. This analysis considers that the company's current financial position; ratios may not predict the future. It is future ability to generate cash and repay obligations that determines the chance of default.
What are the four steps to assess the chance of default for a company?
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. Indeed, many investment firms will not invest in companies given a poor classification by credit rating agencies.
What is credit rating? Why do companies care about their credit ratings
Credit risk encapsulates the chance of loss resulting from a creditor's default (either interest or principal). Assessing credit risk via a credit 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). For example, a lender would be more likely to impose greater restrictions and a higher rate of interest for entities that posed a larger credit risk than those with lower credit risk ratings. The "junk bonds" of the 80s yielded high returns for the very reason these loans posed high credit risks
What is credit risk? What is the main purpose of performing a credit analysis
(1.) chance of default, and (2.) the magnitude of loss given a default.
What two factors determine a company's level of credit risk? Explain what each factor tries to measure.
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. Operating leases are an example of a financing vehicle with stipulated payment terms. Understanding the implications of operating leases may not be possible from a cursory glance at the financial statements. Before and after the new lease standard, analysts use footnote information to calculate credit risk as accurately as possible.
Why are missing or understated liabilities especially critical for credit analysis?
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. Loan covenants tied to financial ratios also aid creditors by providing evidence of deteriorating conditions within the firm. Three types of common covenants: 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 do lenders impose debt covenants on borrowers? Explain the three types of debt covenants
Creditors 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. Real and personal property is usually the basis of collateral for a real estate mortgage, or, in some cases, marketable securities, accounts receivable, and inventory
Why do lenders require collateral? What are some common types of collateral?
