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ASSET VALUATION

I
...
General Principles of Credit Analysis

LECTURE PLAN BASED ON LAST YEAR’S
BOOKS
Wk No
...
Default risk: Borrower does not repay
obligation (assessed by credit rating)
2
...
Downgrade risk: Issue downgraded by
rating agencies; bond value falls and/or
bond underperforms benchmark

5

FOUR “CS” OF CREDIT ANALYSIS

1
...


Capacity to pay: Ability to generate
cash or liquidate assets to repay
obligations

3
...
Collateral: Assets offered as security
and the quality/quantity of unpledged
assets controlled by the issuer

CREDIT ANALYSIS IN PRACTICE: AN EXAMPLE
▪

Factors analysts at Moody’s examine:
▪

Management quality

▪

Industry trends

▪

Regulatory environment

▪

Operating and competitive position

▪

Financial position and liquidity
sources
7

▪

Company structure

CAPACITY TO REPAY: CREDIT ANALYSIS
WITH RATIOS
▪ Profitability ratios: Measure ability to
generate earnings to pay interest and
principal
▪

DuPont framework
▪

return on stockholders’ equity

▪

return on total assets

▪

profit margin

▪

asset turnover

CAPACITY TO REPAY: CREDIT ANALYSIS
WITH RATIOS
▪

Short-term solvency ratios: Measures
the adequacy of liquid assets to meet
short-term obligations
current assets
current ratio 
current liabilities

 current assets  inventories 
acid test ratio 
current liabilities

▪

CAPACITY TO REPAY: CREDIT ANALYSIS
WITH RATIOS
Capitalization (financial leverage)
ratios: Measure use of debt in capital
structure
LT debt-to-cap ratio
LT debt

LT debt  minority interest  SH's equity
Total debt-to-cap ratio
current liabilities  LT debt

current liabilities  LT debt 
minority interest  SH's equity

CREDIT ANALYSIS WITH RATIOS
▪ Coverage ratios: Measure firm’s ability to
repay its debt out of operating cash flow
EBIT coverage ratio 

EBIT
annual interest expense

EBITDA coverage ratio 

EBITDA
annual interest expense

CREDIT ANALYSIS WITH RATIOS
▪ Does ABC deserve to be upgraded from
BBB to A rating?
Current ratio
Guidelines for
A-rated issues
ABC Inc
...
00 to 1
...
35 to 0
...
00 to 4
...
10

0
...
20

CREDIT ANALYSIS WITH RATIOS

▪ Yes—liquidity is within the range, leverage is
better (lower), and coverage is higher
Current ratio

EBIT / Interest
Expense

1
...
20

0
...
45

3
...
00

1
...
30

4
...


In “A” range

Better than “A”

Better than “A”

CASH FLOW ANALYSIS: S&P FRAMEWORK

Net income
+
Depreciation
+/─ Other noncash items
Funds from operations
─
Increase in NWC
Operating cash flow
─
Capital expenditures
Free operating cash flow
─
Cash dividends
Discretionary cash flow

14

CASH FLOW ANALYSIS: S&P
FRAMEWORK
▪

Funds from operations/Total debt ratio
▪

▪

Used for companies with good credit rating

Free operating CFs/total debt ratio
▪

Used for companies with short term solvency
issues

15

CHARACTER OF CORPORATION: CORPORATE
GOVERNANCE & BOND RATINGS
Bhojraj & Sengupta (2003) – studied 1,001 industrial
bonds for the period 1991-1996 and argue that strong
governance leads to superior bond rating and lower
bond yields
...



16

CHARACTER OF CORPORATION:
CORPORATE GOVERNANCE
•

•

•

•

Corporate Governance deals with the rights and
obligations of directors, board members and
shareholders
...


Managers will follow their own objectives i
...
increasing
their
...

 Shareholders need to ensure that their own wealth is
maximised
...

 Managers accept low risk, short payback investment
projects
...

 Management gets reward for ‘below average’
performance
...
Floating rate: Makes scenario analysis under different
rates necessary
2
...
Seniority: Bank debt is repaid first in bankruptcy
Point: High-yield issuers are frequently structured as
holding companies
▪ Parent borrows, passes funds to subs
▪

Problem: This requires analysis of subs

ASSET-BACKED SECURITIES CREDIT ANALYSIS
Analysis by rating agencies
1
...
Seller/servicer quality: Higher
quality means higher rating, all else
equal
3
...
Issuer’s debt structure (debt per capita)
2
...
Local tax and intergovernmental revenue
availability (tax collection rates)
4
...
Project revenue: Amount, reliability (limits
of basic security)
2
...
Other covenants

SOVEREIGN BOND CREDIT ANALYSIS
▪

▪

Point: Two ratings assigned to each national
government
...
Political stability

2
...
Fiscal policy

5
...
Debt service track record

SOVEREIGN BOND CREDIT ANALYSIS
▪

Rating #2: Foreign currency debt ratings
1
...
External balance sheet
-Net public debt
-Total net external debt
-Net external liabilities

CREDIT SCORING MODEL
Multiple Discriminant Analysis (MDA)
 Z-Score Model – Altman
 Z= 1
...
4 (RE/TA) + 3
...
6 (MVE/TL) + 1
...
81 – problems
 If Z > 3 – healthy firm




Score interpretations may vary for different
industries, company sizes etc







WC: Working capital
TA: Total assets
RE: Retained earnings
MVE: Market value of equity
TL: Total liabilities

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THE BIG PICTURE
Type of Credit

Key Factors

Corporate

Base case: Capacity to repay, CF analysis,
corp

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