Topic V:

Credit Risk Analysis

ACCT201 Corporate Reporting & Financial Analysis

Dr. ZANG Yoonseok

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Reading materials

Revsine et al. Chapters 5 & 6

Corporate Rating Criteria by S&P
Available on course website

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 Part I:
Introduction to Credit Risk Analysis

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What is credit risk?

Credit risk is the risk that a company will default on its debt
obligations when they fall due.
Definition of default:
Non-payment of interest and/or principal on debt obligations when due.
Restructuring of existing debt on terms that are less favorable to
bondholders/creditors than those covenanted.
Either inability or unwillingness to repay would constitute default.
Default on a specific debt almost always triggers default on all other debt
Cross default.

Credit risk is measured as the probability of default.

Default will directly trigger bankruptcy

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International credit rating agencies

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Credit rating scales

Investment Grade Ratings Non-investment Grade Ratings

Moodys Standard & Poors Moodys Standard & Poors
Aaa AAA Ba1 BB+
Aa1 AA+ Ba2 BB
Aa2 AA Ba3 BB-
Aa3 AA- B1 B+
A1 A+ B2 B
A2 A B3 B-
A3 A- Caa1 CCC+
Baa1 BBB+ Caa2 CCC
Baa2 BBB Caa3 CCC-
Baa3 BBB- Ca CC
C C
Which provides higher yield/return: - SD (selective default)
investment grade or non-investment grade???
- D (payment default)
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Historical corporate default rates

Sources: Standard & Poors Corporate Rating Criteria

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 Part II: Introduction to S&P Credit
Rating Criteria

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Overview of CRA

Business risk
Country risk
Industry factors
Competitive position/Strategy
Management evaluation
Profitability/Peer group comparisons
Financial risk
Governance/Risk tolerance/Financial policies
Accounting
Cash flow adequacy
Capital structure/Asset protection
Liquidity/Short-term factors

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Accounting analysis

Accounting analysis is evaluating the extent to which a

companys accounting numbers reflect economic reality.
It is important for effective financial analysis because the quality of
financial analysis depends on the quality of the underlying accounting
information.

Process of accounting analysis

1. Identify key accounting policies (which are disclosed in notes)
2. Assess accounting flexibility
3. Evaluate accounting strategy
4. Evaluate the quality of disclosure
5. Identify potential red flags
6. Undo accounting distortions
E.g., adjustment of accounting treatment to industry norms, removal of one-
time items, conversion of operating leases to capital leases, etc.

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Assess accounting flexibility

If managers have little flexibility in choosing accounting policies and

estimates, accounting data are likely to be less informative for
understanding the firms economics.
It explains why most FRSs allow accounting flexibility
Some examples of accounting flexibility
Depreciation/amortization policy (straight-line, accelerated, etc)
Estimation of useful life and residual value
Classification of minority passive investments
Inventory cost flow assumption (FIFO, average, etc)
Accounting for fixed assets (cost vs. fair value)
Equity vs. fair value option
Equity vs. proportionate consolidation

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Evaluate accounting strategy

However, when managers have accounting flexibility, they

can use it to manage earnings, esp., in following cases.
Is the firm close to violating bond covenants?
Are the managers having difficulty meeting targets?
Is the firm going to issue additional capital or debt?

Potential indicators of earnings management

Has the firm changed any of its policies or estimates? What is the
justification? What is the impact of these changes?
How do the firms accounting policies compare to the norms in the
industry? If they are different from industry norm, why?

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Evaluate quality of disclosure

Does the firm provide adequate disclosures to assess the firms business
strategy and firm performance? (Operating & Financial Review or
Management Discussion & Analysis)
Do the notes to the financial statements adequately explain the key
accounting policies and assumptions?
Does the firm provide additional non-financial information (e.g., order
backlog, expansion plan, major customers)?
How is the quality of segment disclosure? (e.g., Starhub vs. Singtel)
How forthcoming is the management with respect to bad news?
How good is the firms investor relations program?

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Warning signs Revenue recognition

Examples of aggressive revenue recognition

Recording next period revenues in the current period (premature revenue)
Bill and hold transactions (recording sales before title has passed to the
customer)
Lower credit standards to attract sales
Understate allowance for sales returns
How to tell?
Revenue = Cash collected + AR Unearned Revenue
Large increases in accounts receivable
If ratio of revenues to cash collected increases dramatically, could be questionable
Days A/R outstanding (DARO) = 365 * Average AR / Revenues
If DARO increases, may indicate problems
Large decreases in unearned revenue
Decreases in allowance for sales returns/revenue.

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Warning signs Expenses and others

Manipulating depreciation expenses through choice of salvage value, estimated life

or depreciation method
Depreciation ratios = Depreciation expense / Gross PPE
if the ratio varies dramatically, could indicate problems.
Changes in inventory cost flow assumption and days in inventory held
Days inventory held = 365 * Average Inventory / COGS
Increases could mean problems with inventory management or demand.
Improper expense capitalization such as unusual growth in noncurrent assets
Compare noncurrent asset growth to sales growth
Bad debt expense and allowance for doubtful accounts (ADA)
Bad debt expense/revenue; ADA/AR - decrease may indicate problems
Warranty expense
Warranty expense/revenue - decrease may indicate problems

Off-balance sheet arrangements

Excessive use of operating lease need to convert operating leases to capital leases
SPE
Guarantees and litigation

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Warning signs - Comparatives

Different growth rates of CFO and earnings

CFO comes from earnings, so should be consistent in long-term
Divergence of growth may indicate irregularities
Abnormal sales growth vs economy, industry or peers
It may be due to superior management
But it may be also due to earnings manipulation
Abnormal gross margin and operating margin vs peers
Same as the above argument
Abnormal inventory growth compared to sales growth
Inventory management problem
Potential obsolete inventory
Inappropriate overstatement of inventory to increase gross and net profits

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Undo accounting distortions

S&P Corporate Reporting Criteria lists 22 accounting distortions which need

to be adjusted
Financial ratios based on adjusted accounting data make more sense.
Capitalized interest (to be covered in Topic 7)
Interest expense: add the amount of capitalized interest
Fixed assets: reduce by the amount of capitalized interest
CFO: decrease by the amount of capitalized interest (CFI: increase by the same
amount)
Guarantees and litigation (to be covered in Topic 6)
Debt: add the amount of guarantees and litigation (off-balance-sheet obligations)
Equity: subtract the amount of guarantees and litigation
Nonrecurring or transitory activities (exclude from I/S for forecasting)
Operating leases (to be covered in Topic 6)
I expect you to adjust the above four accounting distortions in your project

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 Part III: Key Financial Ratio

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Online learning for EPTL

To prepare for situations where face-to-face lesson is impossible due to

unforeseen emergency events (such as extreme haze and wide spread of Zika
virus),
All SMU instructors are required to conduct one lesson online per term as a part of EPTL
(Emergency Preparedness for Teaching and Learning).
Thus, Parts III and IV lesson will be conducted online.
For remaining slides,
Watch two video clips (total 20 mins) at:
https://vlearn.smu.edu.sg/ess/echo/presentation/7665f841-d559-4fb3-84e8-4d485a42718d and
https://vlearn.smu.edu.sg/ess/echo/presentation/8e3f7636-d4ef-4c50-9824-598fe4cddb2c
Take a related quiz (Ratio Analyses) in Assessment-Quizzes at SMU Elearn by 11pm, Feb 28
(Tue).
Note that you dont need to memorize ratio formula for final exam.
If tested, ratio definitions will be provided in the exam.

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Financial ratios and credit analysis

Ratio analysis is a simple and useful method to evaluate various

aspects of a companys operating and financial performance.
By comparisons with other firms in the same industry or comparisons over time,
Ratios serve as indicators or clues regarding noteworthy conditions of a firms
profitability, liquidity, solvency, etc.
It is an integral analysis for lenders to make informed decisions.

Financial ratios play two roles in credit analysis:

They help quantify the borrowers credit risk before the loan is granted.
Once granted, they serve as an early warning device for increased credit risk (e.g.,
financial ratio covenants).

Three groups of ratios are often calculated for credit analysis.

Profitability, short-term liquidity, and long-term solvency.

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Profitability (Profit margin)

EBITDA
EBITDA M argin (%)
Total Sales

EBIT
EBIT (Operating Income) M argin (%)
Total Sales

EBITDA = Earnings before interest, tax, depreciation & amortization.

EBIT = Earnings before interest and tax, typically equivalent to operating income.

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Profitability (Return on capital)
NOPAT
Return on Assets (ROA) (%)
Average Total Assets

NPAT after M inority Interests & Preferred Dividends

Return on Equity (ROE) (%)
Average of Total Equity Preferred Stock M inority Interests

NOPAT = Net Operating Profit after Tax.

NPAT = Net Profit after Tax.

NOPAT = NPAT + [Interest x (1 Tax rate)]

Various ways to derive tax rate:

Tax rate disclosed in annual report.
Use effective tax rate from Income Statement (Tax expense divided by Pre-tax profit).
Use statutory tax rate (rate applicable under prevailing tax laws).

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DuPont decomposition of ROE
NPAT
Return on Equity
Total Equity

NPAT Sales Total Assets

Sales Total Assets Total Equity

NPAT Sales Total Liabilitie s Total Equity

Sales Total Assets Total Equity

NPAT
Sales

Sales
Total Assets

Total Liabilitie s
Total Equity
1
Net Profit M argin Asset Turnover Gearing 1

ROA can be also decomposed into net operating margin Asset turnover

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Short-term liquidity ratios

Current assets
Current ratio =
Current liabilities
Liquidity
ratios Cash + Marketable securities + Receivables
Quick ratio =
Current liabilities
Short-term
liquidity Net credit sales
Accounts receivable turnover =
Average accounts receivable

Activity Cost of goods sold

Inventory turnover =
ratios Average inventory

Inventory purchases
Accounts payable turnover =
Average accounts payable

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 Activity ratios

Cost of Sales
Inventory turnover (x) Activity ratios indicate how
Average Inventory
efficient the company is in
365 days
Days inventory held utilizing (turning over) its
Inventory Turnover
operating assets:
1. Inventory.
Total Credit Sales
Accounts receivable turnover (x)
Average accounts receivable 2. A/c receivable.
365 days
Days receivable outstanding* 3. A/c payable.
A/c receivable turnover

Total inventory purchases Average asset balance

Accounts payable turnover (x) = (Beginning-of-year
Average accounts payable
365 days
balance + End-of-year
Days payable outstanding balance).
A/c payable turnover

*Sometimes also known as days sales outstanding (DSO).

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Operating & cash conversion cycle

Inventory Inventory
purchased sold on Payable Receivable
on credit credit settled collected

Days inventory held Days receivable outstanding (30 days)

(15 days)

Operating cycle (45 days)

Days payable outstanding (20 days)

Cash conversion cycle (25 days)

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Operating & cash conversion cycle
example

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Long-term solvency ratios

Long-term debt
Long-term debt to assets =
Total assets
Debt ratios Long-term debt
Long-term debt to tangible assets =
Total tangible assets

Long-term
solvency
Operating incomes before taxes and interest
Interest coverage =
Interest expense
Coverage
ratios
Operating cash flow Cash flow from continuing operations
to total liabilities =
Average current liabilities + long-term debt

Cash flow from operations: always before dividends paid. Dividends paid in Singapore could be classified under
operating activities. Then dividend payment should be added back.

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Working capital

Working capital = Current assets Current liabilities

Firm has to manage its working capital so as to maximize its objectives of

profitability and liquidity.
Current assets are more liquid than non-current (fixed) assets but the former
yield lower return on investment.
Cash is generally most liquid (relative to other assets) but yields the lowest
return.
Costs of holding cash
Lower return
Agency problems, managers may abuse excess cash holdings and result in value
destroying
Motives of holding cash
For day-to-day operations Transactions motive.
As a precaution against unexpected contingencies Precautionary motive.
To take advantage of unexpected opportunities Speculative motive.

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Cash and dividend at Microsoft

Cash Holding and Dividend Payment in Microsoft

Cash
$60.59 bil.
80

70

60 Div
$36.97 bil.
50

40

30

20

10

0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

2005
2006
Cash/TA Dividend/TA

Source: COMPUSTAT

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 Part IV: Bankruptcy Prediction

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Bankruptcy prediction Altmans z-
score

Altman (1968) developed the z-score model to predict corporate

bankruptcy using five major financial ratios in a multivariate discriminant
analysis framework:

Model results:
z > 2.99 implies low bankruptcy risk.
z < 1.81 implies high bankruptcy risk.
z between 1.81 and 2.99 has less predictive power.

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Altmans z-score application

--END OF TOPIC--
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