Financial Statement Analysis & Valuation Third Edition

1. Financial Statement Analysis & Valuation Third Edition Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAnally Sommers Zhang

2. Module 4: Credit Risk Analysis and Interpretation

3. Market for Credit • Composed of • Demand for credit • By most companies for operating, investing, and financing activities • Supply of credit • Offered by • Creditors, banks, public debt investors, private lenders Maximum return of a debt investor is determined by the interest rate set in the loan and the prevailing market rate of interest.

4. Credit Demand for Operating Activities • Credit terms • Dictated by past experience with a company • Routine, low risk needs created by • Cyclical operating cash needs such as materials or labor • Advance seasonal purchases • Higher risk credit • When used to cover operating losses A willing creditor could make the difference between bankruptcy and continued operations for a company.

5. Investing Activities • Require large amounts of cash for investments such as new equipment or mergers • Needs can vary in timing and amount • Long-term debt routinely used for start-up and growth • Predictable capital expenditure patterns often held by mature firms

6. Financing Activities • Occurs less frequent than operating and investing activities • Common situations • A bank loan or bond comes due and a company does not have the necessary funds on hand • Funds to pay dividends or repurchase stock are borrowed • Evergreen debt • When a company consistently pays off debt by taking on more debt

7. Supply of Credit There are many sources of credit to meet companies’ demand which include: Non-bank financing Bank loans Trade credit Publicly- traded debt Lease financing

8. Trade Credit • Routine credit from suppliers • Most often non-interest bearing • Suppliers often tailor contractual terms to particular customer’s existing and ongoing creditworthiness • Credit limit assigned

9. Bank Loans • Structured to meet specific client needs • Balanced with myriad of rules and regulations by bank regulators • Revolving credit line • Available on demand • Floating interest rate • Lines of credit • Available credit to be used as needed • Letters of credit • Financing feature where a bank is interposed between two parties

10. More Bank Loans • Term loans • Usually set in borrowing amount (principal) with periodic payments • Usually based on market interest rates that are set for the duration of the borrowing • Mortgages • Debt instruments based on collateral, typically, real estate holdings

11. Nonbank Private Financing • Private (nonbank) sources of financing • Used when bank financing is limited or unavailable • Usually results from private lenders such as private equity firms that have experience in an industry

12. Lease Financing • Typically used for the acquisition of capital equipment • Typical items • Machinery • Computer equipment • Vehicles • Leasing firm structures lease • Considers collateral • Credit risk of the lessee

13. Publicly Traded Debt • Debt capital raised through public markets • Commercial paper • Short term borrowing facility under SEC regulations which cannot exceed 270 days • Bonds or debentures • Public borrowings for longer durations regulated by the SEC • Principal borrowed is paid back on a fixed term with semi-annual or annual interest payments

14. Credit Risk Analysis Process • Purpose is to quantify potential credit losses so lending decisions are made with full information • Consists of two components Expected credit loss = Chance of Default × Loss given default Primarily a debtor’s ability to pay down the debt If defaulted, how big will the loss be?

15. Credit Raters • Credit rating agencies assess credit risk • Differ from other lenders • Have no direct financial involvement with companies whose credit they are rating • Have access to more, better information • Can refine risk analysis across industries • Have best, most current information

16. Credit Analysis • Purpose is to quantify the risk of loss from non-payment • Involves several steps Step 1:Assess nature and purpose of the loan Step 2: Assess macroeconomic environment and industry conditions Step 3: Perform financial analysis Step 4: Perform prospective analysis

17. Credit Analysis – Step 1 Step 1: Assess nature and purpose of the loan • Must determine why the loan is necessary • Nature and purpose of the loan affect its riskiness • Possible loan uses • Cyclical cash flows needs • Fund temporary or ongoing operating losses • Major capital expenditures or acquisitions • Reconfigure capital structure

18. Credit Analysis – Step 2 Step 2: Assess macroeconomic environment and industry conditions • Industry competition • Involves the company’s competitive position and the effect on its financial results • Buyer power • Can be a credit risk if customers have the ability to have stronger price concessions • Supplier power • A factor if suppliers have strong bargaining power and can demand higher prices and early payments

19. Credit Analysis – Step 2 continued Step 2: Assess macroeconomic environment and industry conditions • Threat of substitution • Occurs when a company has limitations on products such as to inhibit price increases or pass costs to customers • Threat of entry • Occurs with new market entrants increase competition • Company could be subject to aggressive tactics where the new entrants try to win over clients

20. Credit Analysis – Step 3 Step 3:Perform financial analysis • Includes focusing on performing analysis of the financial statements • Adjustments to financial statements made to provide more accurate ratios and forecasts • Excludes one-time events that will not persist • Includes all operating assets and liabilities • Considers items that may distort operations

21. Profitability Analysis Step 3:Performfinancial analysis - continued • Considers items that surround profitability using return on net operating assets (RNOA) • Net operating profit margin (NOPM) • Net operating asset turnover (NOAT) • Adjusted to better reflect a company’s economic profitability • Excludes items that will not persist such as one-time charges

22. Profitability Analysis Example = $5,839 – [$1,935 + ($566x 36.7%)] = $3,696 Home Depot’s net operating profit after taxes (NOPAT): Interest expense plus other non-operating expenses Operating income Statutory tax rate Tax expense

23. Profitability Related To Credit Risk • Repayment of debt more likely when profit is higher • Helpful to examine return on equity and return on debt plus equity

24. Coverage Analysis • Considers a company’s ability to generate additional cash to cover principal and interest payments when due • Called ‘flow’ ratios • Because they consist of cash flow and income statement data • Include four ratios • Times interest earned • EBITDA coverage ratio • Cash from operations to total debt • Free operating cash flow to total debt

25. Coverage AnalysisTimes Interest Earned Ratio • Reflects the operating income available to pay interest expense • Assumes only interest must be paid because the principal will be refinanced Times interest earned Earnings before interest and taxes = Interest expense

26. Coverage AnalysisEBITDA Coverage Ratio EBITDA coverage = • EBITDA is a non-GAAP performance metric • More widely used than the Times interest earned ratio because depreciation does not require a cash outflow • Always higher than times interest earned ratio • Measures company’s ability to pay interest out of current profits Earnings before tax + Interest expense, net + Depreciation + Amortization Interest expense

27. Home Depot Coverage Ratios

28. Coverage Analysis Cash from Operations to Total Debt Cash from operations to total debt Measures a company’s ability to generate additional cash to cover debt payments as they come due. = Cash from operations Short-term debt + Long-term debt

29. Coverage Analysis Free Operating Cash Flow to Total Debt Free operating cash flow to total debt Considers excess operating cash flow after cash is spent on capital expenditures = Cash from operations - CAPEX Short-term debt + Long-term debt

30. Home Depot Cash Flow Ratios

31. Liquidity and Solvency Measures • Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice. • Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

32. Current Ratio • Current assetsare those assets that a company expects to convert into cash within the next operating cycle, which is typically a year. • Current liabilitiesare those liabilities that come due within the next year. • An excess of current assets over current liabilities (Current assets Current liabilities), is known as net working capitalor simply working capital.

33. Quick Ratio • Thequick ratiofocuses on quick assets. • Quick assets include cash, marketable securities, and accounts receivable; they exclude inventories and prepaid assets.

34. Home Depot’s Liquidity Ratios

35. Solvency Ratios • Solvency refers to a company’s ability to meet its debt obligations. • Solvency is crucial since an insolvent company is a failed company. • Two common solvency ratios:

36. Solvency Analysis • Assesses a company’s ability to meet its long-term obligations • Less costly source of financing • Carries default risk • General approach to solvency is to assess the level of debt relative to equity Median Ratio of Liabilities to Equity for Selected Industries

37. Solvency Analysis Total liabilitiesStockholders’ equity • Conveys how reliant a company is on creditor financing compared with equity financing • Does not distinguish between current and long-term debt Liabilities-to-equity ratio=

38. Solvency Analysis Assumes that current operating liabilities will be repaid from current assets (self-liquidating) Total debt-to-equity = Long-term debt including current portion + Short-term debt Stockholders’ equity

39. Home Depot Solvency Ratios

40. Perform Prospective Analysis – Step 4 Step 4: Forecast future results • Based on adjusted past performance • Should adjust the capital structure to reflect anticipated future debt retirements as they come due over the forecast horizon • Compute ratios based on the forecast • Evaluate changes and trends • Perform sensitivity analysis

41. Loss Given Default • Consists of factors that affect the amount that could be lost if the company defaulted on its obligations • Defaults include • Failure to make payments • Violation of loan covenants • Creditors loss is dependent on priority of the claim compared with all other existing claims • Determined by laws and private contracts

42. Minimization of Potential Loss • Structure credit terms for loans in advance • Credit limits • Collateral • Repayment terms • Covenants • Trade-off exists between being too strict where the terms cause the borrower to default, and not being strict enough causing the borrower to default

43. Loss Given Default Factors Credit Limits • Take into consideration the maximum amount a company may be loaned at a point in time • Limits are set based on the lender’s experience with similar borrower, and by firm-specific analysis • Limits set by trade creditors • Low limits for new customers • Higher limits for established customers

44. Loss Given Default Factors Collateral • Collateral is property pledged by the borrower to guarantee repayment • Personal property, and • Real property, such as real estate mortgages • Best collateral is high-grade property such as securities with an active market • Value is known • Liquidation is straight-forward

45. Loss Given Default Factors Repayment Terms • Term of loan is the length of time the creditor has to repay the debt • Early payment discounts often offered • Influenced by the nature of loan • Ensures that the life of the asset matches or exceeds the amount of time allowed to pay back the debt Higher Cost of Debt Financing Greater Chance of Default Longer Terms Greater Credit Risk = = =

46. Loss Given Default Covenants • Are terms and conditions of a loan designed to limit the loss given default • Three common types • Covenants that require the borrower to take certain actions, such as submitting financial statements to the lender • Covenants that restrict the borrower from taking certain actions, such as preventing mergers • Covenants that require the borrower to maintain specific financial conditions, including certain ratios and minimum equity

47. Credit Ratings • Are opinions of an entity’s credit worthiness • Capture the entity’s ability to meet its financial commitments as they come due • Credit analysts at rating agencies • Provide ratings on both debt issues and issuers • Consider macroeconomic, industry, and firm-specific information • Assess chance of default and ultimate payment in the event of default

48. Credit Ratings by Agencies Long-term issue rating scales used by Standard and Poor’s and Moody’s Investor Services

49. Why Companies Care About Their Credit Ratings • Credit ratings affect the cost of debt • Increases interest expense • May limit new investment projects • Can restrict growth • Certain investors will not invest in their debt if considered non-investment grade Treasury and Corporate 10-Year Bond Yields Risk increases the cost of debt which is linked directly to the company’s credit rating

50. Credit Rating Models • Agencies have access to information not available to lenders • Models have three types of inputs • Macroeconomic statistics • Monitored by economists • Industry data • Through frameworks such as Porter’s Five Forces and SWOT analysis • Company specific information • Financial ratios for companies compared to median averages for various risk classes