Credit Analysis

Chapter 10

Learning Objectives
Understand debt instruments, accounting disclosures and claim status Understand interest rates and risk considerations Understand bond ratings Perform credit analysis

Nature of Debt Instruments

Creditors receive interest and principal payments they have been promised Creditors do not share in the profits of the firm Credit-granting decisions are based on financial statement analysis and commercial credit ratings
Including off-balance-sheet financing
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Liquidity-availability of companys resources to meet short term obligations

Short term liquidity risk is affected by timing of cash flows and outflows along with prospects of future performance.

 Does current ratio : Measure and predict the pattern of future cash inflows and outflows Measure the adequacy of future cash inflows and outflows NO

Solvency
Refers to a companys long run financial viability and its ability to cover long term obligations Solvency analysis involves capital structure analysis and earnings stability

Debt Covenants
Protect lender/bond investor by restricting certain activities (i.e., dividend payments) Intended to provide an early warning system for loans that may be in danger May result in higher bond rating and lower interest rate

Bonds
Indenture is the bond document Principal (par or face value) is the amount to be repaid, basis for interest payments Issued in $1,000 increments 10-, 20-, 30-year maturities Coupon or stated rate is the interest rate Secured or unsecured (debenture)
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Bonds
Sinking fund used to pay off the loan Puttable or redeemable at the purchasers option
Callable at the issuers option

Convertible into another security Senior vs. junior

Bond Selling price

Present value of principal and interest payments Par, at face value Discount
Stated rate < investors required rate of return

Premium
Stated rate > investors required rate of return
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Interest rates
Market rate = Risk free rate + Risk premium Risk free rate (inflation rate and investors desired real return) Risk premium additional return, compensation for uncertainty

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Bond investment risks

Default risk issuer unable to make payments Interest rate risk potential variation in market rates Reinvestment rate risk investors ability to reinvest coupon payments at the same rate Call risk possibility that issuer will redeem the bond Purchasing power risk yield < inflation Currency risk for foreign bonds
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Accounting for Debt Instruments

Original cost/consideration received Minus principal payments Plus discount amortization Less premium amortization Example:
5-year, $10,000,000 bond 4% semiannual interest payment 5% prevailing market rate
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Bond example
Issue price = $9,227,827
Present value of interest, $3,088,694 Present value of principal, $6,139,133

Discount = $772,173
Represents additional interest

Initially report: Bond par value Unamortized discount Bond Carrying value

$10,000,000 (772,173) $ 9,227,827

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Bond example
Interest Period At issue 1 2 3 4 5 6 7 8 9 10 Payment 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 Expense 461,391 464,461 467,684 471,068 474,622 478,353 482,270 486,384 490,703 495,238 Discount Carrying Unamortized Amortization value balance 772,173 9,227,827 61,391 710,782 9,289,218 64,461 646,321 9,353,679 67,684 578,637 9,421,363 71,068 507,569 9,492,431 74,622 432,948 9,567,052 78,353 354,595 9,645,405 82,270 272,325 9,727,675 86,384 185,941 9,814,059 90,703 95,238 9,904,762 95,238 0 10,000,000

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Bond example
Market interest drops to 3% Issue price = $ 10,853,020
Present value of interest, $3,412,081 Present value of principal, $7,440,939

Premium = $853,020
Represents a reduction in interest

Initially report: Bond par value Unamortized premium Bond Carrying value

$10,000,000 853,020 $10,853,020

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Bond example
Interest Period At issue 1 2 3 4 5 6 7 8 9 10 Payment 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000 Expense 325,591 323,358 321,059 318,691 316,252 313,739 311,151 308,486 305,740 302,913 Discount Unamortized Amortization balance (853,020) (74,409) (778,611) (76,642) (701,969) (78,941) (623,028) (81,309) (541,719) (83,748) (457,971) (86,261) (371,710) (88,849) (282,861) (91,514) (191,347) (94,260) (97,087) (97,087) (0) Carrying value 10,853,020 10,778,611 10,701,969 10,623,028 10,541,719 10,457,971 10,371,710 10,282,861 10,191,347 10,097,087 10,000,000
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Amortization of bonds
Amortization is an accounting method that gradually and systematically reduces the cost value of a limited life, intangible asset. Treating a bond as an amortized asset is an accounting method in the handling of bonds. Amortizing allows bond issuers to treat the bond discount as an asset over the life of the bond (until the bond's maturity).

Example
To illustrate the premium on bonds payable, let's assume that in early December 2011, a corporation has prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year). The bond is dated as of January 1, 2012 and has a maturity date of December 31, 2016. The bond's interest payment dates are June 30 and December 31 of each year. This means that the corporation will be required to make semiannual interest payments of $4,500 ($100,000 x 9% x 6/12).

 Let's assume that just prior to selling the bond on January 1, the market interest rate for this bond drops to 8%. Rather than changing the bond's stated interest rate to 8%, the corporation proceeds to issue the 9% bond on January 1, 2012. Since this 9% bond will be sold when the market interest rate is 8%, the corporation will receive more than the bonds face value.

 Lets assume that this 9% bond being issued in an 8% market will sell for $104,100. The corporations journal entry to record the issuance of the bond on January 1, 2012 will be: Financial calculator: N=10, I/Y=4%,PMT=4500,FV=100,000 Jan. 1, 2012 Cash 104,100 Bonds Payable 100,000

Premium on Bonds Payable 4,100

 The account Premium on Bonds Payable is a liability account that will always appear on the balance sheet with the account Bonds Payable. In other words, if the bonds are a long term liability, both Bonds Payable and Premium on Bonds Payable will be reported on the balance sheet as long term liabilities. The combination of these two accounts is known as the carrying value of the bonds

Amortization of bond premium

Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0. In our example, the bond premium of $4,100 must be reduced to $0 during the bonds 5-year life. By reducing the bond premium to $0, the bonds book value will be decreasing from $104,100 on January 1, 2012 to $100,000 when the bonds mature on December 31, 2016. Reducing the bond premium in a logical and systematic manner is referred to amortization. The bond premium of $4,100 was received by the corporation because its interest payments to the bondholders will be greater than the amount demanded by the market interest rates. Therefore, the amortization of the bond premium will involve the account Interest Expense. Each accounting period during the life of the bond there needs to be a credit to Interest Expense and a debit to Premium on Bonds Payable.

Amortization of bond discount

Lets assume that the corporation prepares a $100,000 bond with an interest rate of 9%. Just prior to issuing the bond, a financial crisis occurs and the market interest rate for this type of bond increases to 10%. If the corporation goes forward and sells its 9% bond in the 10% market, it will receive less than $100,000. When a bond is sold for less than its face amount, it is said to have been sold at a discount. The discount is the difference between the amount received (excluding accrued interest) and the bonds face amount. The difference is known by the terms discount on bonds payable, bond discount, or discount.

 To illustrate the accounting for bonds payable issued at a discount, lets assume that the 9% bond is sold in the 10% market for $96,139 on January 1, 2012. The corporation's journal entry to record the sale of the bond will be: Jan. 1, 2012Cash 96,139
Discount on B.P 3,861 Bonds Payable 100,000

 The account Discount on Bonds Payable (or Bond Discount or Unamortized Bond Discount) is a contra liability account since it will have a debit balance. Discount on Bonds Payable will always appear on the balance sheet with the account Bonds Payable. In other words, if the bond is a long term liability, both Bonds Payable and Discount on Bonds Payable will be reported on the balance sheet as long term liabilities. The combination or net of these two accounts is known as the book value or the carrying value of the bonds.

Amortizing bond discount

The discount of $3,861 is treated as an additional interest expense over the life of the bonds. When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization. In this example, the straight-line amortization would be $772.20 ($3,861 divided by the 5-year life of the bond).

Credit rating
Rely on qualitative and quantitative analyses Standard & Poors (AAA to D)
Intermediate +/- scores

Moodys (Aaa to C)
Intermediate 1,2,3 scores

Fitch (AAA to D)

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Standard & Poors rating method

1. 2. 3. 4. 5. 6. 7. 8. EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt % Free operating cash flow/Total debt % Return on capital % Operating income/Sales Long-term debt/Capital Total debt/Capital
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Financial distress
Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans. Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets. Financial distress can be predicted.
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Prediction of financial distress

Univariate models
Beaver (1966) relied on
Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio No-credit (defensive) interval

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Prediction of financial distress

Multivariate models
Altman Z-score
(Current assets current liabilities)/total assets Retained earnings/Total assets EBIT/Total assets Preferred and common stock market value/Book value of liabilities Sales/Total assets

Nokia = 9.88 Motorola = 1.71 (below the 2.99 nonbankrupt benchmark)

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Motorola Liabilities
December 31, LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Notes payable and current portion of long-term debt Accounts payable Accrued liabilities Total current liabilities Long-term debt Long-term deferred income taxes Other Liabilities Company-obligated... preferred securities 2001 2000 870 2,434 6,394 9,698 8,372 1,152 485 6,391 3,492 6,374 16,257 4,293 1,504 1,192 485

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Motorola, Note 3
Long-term debt December 31, Puttable Reset Securities due 2011 (puttable annually beginning 2003) Zero coupon notes due 2013 (puttable in 2003 and 2008) 6.75% debentures due 2004 Zero coupon notes due 2009 (puttable in 2004) 6.5% debentures due 2025 (puttable in 2005) 6.75% debentures due 2006 7.6% notes due 2007 6.5% senior notes due 2007 (debt portion of equity security 6.5% notes due 2008 5.8% debentures due 2008 7.625% debentures due 2010 8.0% notes due 2011 7.5% debentures due 2025 6.5% debentures due 2028 8.4% debentures due 2031 5.22% debentures due 2097 Other long-term debt Less: current maturities Long-term debt 2001 825 79 498 18 398 1,399 300 1,200 200 323 1,190 598 398 440 3 227 419 8,515 -143 8,372 2000 77 498 17 398 300 199 323 1,189 398 440 200 226 36 4,301 -8 4,293
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Motorola, Note 3
Short-term debt Notes to banks Commercial paper Other short-term debt December 31, 2001 189 514 24 727 143 870 4.70% 4.00% 2000 139 6,244 6,383 8 6,391 6.40% 5.80%

Add: Current maturities Notes payable and current portion of long-term debt Weighted average interest rates on short-term borrowings Commercial paper Other short-term debt

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Motorola, Note 8 Off-balance-sheet financing

At December 31, 2001, future minimum lease obligations, net of minimum sublease rentals, for the next five years and beyond are as follows: 2002$150 million; 2003 $117 million; 2004$97 million; 2005$76 million; 2006 $63 million; beyond$90 million. The present value of these payments, at 7%, is $484 million Inclusion of these items increases debt by 5%

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Nokia Liabilities
Nokia Consolidated Balance Sheet, IAS (EURm) December 31, 2001 2000 Minority interests 196 177 Long-term liabilities Long-term interest-bearing liabilities 207 173 Deferred tax liabilities 177 69 Other long-term liabilities 76 69 460 311 Current liabilities Short-term borrowings 831 1,069 Current portion of long-term debt 0 47 Accounts payable 3,074 2,814 Accrued expenses 3,477 2,860 Provisions 2,184 1,804 9,566 8,594

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Nokia debt note detail

By lender: (EURm) Bonds Financial institutions Pension loans Other long-term finance loans Other long-term liabilities By maturity dates: 2002 2003 2004 2005 2006 Thereafter 0 89 103 0 0 91 283
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31-Dec-01 90 76 25 16 76 283

Repayment date > 5 years 0 0 15 0 76 91

31-Dec-00 138 62 12 8 69 289

Nokia debt note detail

Operating lease payments
Payments due Amount PV factor 2002 254 0.9346 2003 213 0.8734 2004 178 0.8163 2005 165 0.7629 2006 162 0.7130 Beyond 274 0.6663 Total estimated liability PV 237 186 145 126 116 183 993

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Elements of Free Operating Cash Flow

2001 EBITDA Nokia (EURm) Motorola ($m) 5,735 (4,039)

Non-cash items
Fund from operations

248
5,983

(2,273)
(6,312)

Capital expenditures
Working capital change Free operating cash flow

(1,041)
978 5,920

(1,321)
1,527 (6,106)
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Debt Analysis Ratios

EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt Free operating cash flow/Total debt Return on end of year capital Operating income/Sales Long-term debt/Capital Total debt/Capital Nokia 2001 2000 37.11 31.91 49.44 37.06 4.63 5.04 4.59 2.97 0.31 0.50 0.160 0.195 0.085 0.066 0.094 0.115 Motorola 2001 2000 (10.22) 2.97 (6.26) 8.68 (0.58) 0.29 (0.56) (0.40) (0.27) 0.04 0.018 0.116 0.421 0.238 0.443 0.427

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Additional considerations
Mezzanine items-Auction Preferred Shares (in mutual funds) or noncontrolling interest in subsidiaries. As noncontrolling interest does not meet FASB definition for Liabilities and are not part of Equity.
Could be debt or equity

Off-balance-sheet liabilities
Operating leases Contingent liabilities Environmental liabilities
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Summary
Debt, interest, risk and covenants Bonds
Discount and premium

Risk analysis Financial statement presentation Financial statement analysis

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