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Rudiments of Credit Analysis

Rudiments of Credit Analysis

May 18, 2001

Credit for Bluffers – Part ICredit for Bluffers – Part I

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AgendaAgenda

What is credit risk?

What types of transactions give rise to credit risk?

Who is the credit counterparty?

How is the magnitude of credit risk determined?

Methods to assess probabilities of default of a credit counterparty

Key considerations in credit analysisGeneral

Financial statement analysis

Key considerations in determining recovery amounts

Jargon

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Credit RiskCredit Risk

In addition to the counterparty’s ability to fulfill its payment obligation, the creditor’s efforts to collect and the counterparty’s willingness to pay are important factors in credit risk.

What is it?

The risk of a financial loss that could be incurred if a counterparty fails to fulfill its obligation to deliver cash, a commodity, or another item of value pursuant to a contract.

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Types of Transactions that give rise to credit risk:Types of Transactions that give rise to credit risk:

Loans

Accounts receivable

Derivative transactions and other transactions with “cost of cover” or “make-whole” termination provisions

Other (including “equity”)

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Who is the credit counterparty? Who is the credit counterparty?

Who are the specific legal entity(ies) party to the contract?

If we are relying on a parent company for credit support, is there a guarantee so that the parent company is the effective creditor counterparty? If there is no guarantee or other credit support, we will be looking only to the legal entity that is our counterparty for payment.

What restrictions apply to the counterparty receiving cash flows that may appear on its historical or projected financial statements?

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ExampleExample

“X” Corporation

Domestic Domestic Holding Holding

CompanyCompany

International International Holding Holding

CompanyCompany

Russian Subsidiary

LibyanSubsidiary

Indonesian Subsidiary

Transmission

Subsidiary

ProductionSubsidiary

Marketing Subsidiary

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Magnitude of Credit RiskMagnitude of Credit Risk

The magnitude of credit risk, distilled to its essence, can be determined by answering the following two questions:

1. What is the probability of payment default by the creditor counterparty?

(i.e., what is the probability that the counterparty will be unable to pay its contractual obligations?)

2. Upon default, how much of the obligation owed will be recovered by the creditor?

(i.e., what assets are available to repay the creditor’s claim and to what extent must these be share with other creditors?)

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Methods to Assess Probabilities of Default of a Credit Counterparty Methods to Assess Probabilities of Default of a Credit Counterparty

Internally generated credit analysis and rating models for the credit counterparty

Debt ratings for the counterparty from rating agencies (Moody’s, Standard & Poor’s, etc.)

Public or private debt spreads for the counterparty relative to benchmark rates (US Treasuries, LIBOR, etc.)

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Key Considerations in Credit Analysis – General Key Considerations in Credit Analysis – General

General macroeconomic outlook for global and specific domestic economies

Industry macroeconomic environment

Character and quality of management

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Key Considerations in Credit Analysis – General cont’d.Key Considerations in Credit Analysis – General cont’d.

Financial flexibility What access does the counterparty have to multiple capital markets?

Does the counterparty have the ability to sell assets without materially impairing its business?

Does the counterparty have the ability to offset losses in one business unit by gains in another?

Competitive analysis Where does the counterparty fit in its industry: is it a leader, a viable competitor, or a marginal player?

Is it well-established or a new competitor and, if new, does it have any significant competitive advantages?

Does it rely on a single customer, product, or contract that may vanish or dissipate?

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Key Considerations in Credit Analysis – General cont’d.Key Considerations in Credit Analysis – General cont’d.

Operating leverage Are fixed costs high relative to revenues?

Are revenues volatile?

Is cost structure high relative to competitors?

What are the exposures to commodity prices?

Capital ExpendituresAre significant capital expenditures for replacements or repairs necessary?

Are these capital expenditures expected to generate additional revenue or merely maintain revenues?

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Key Considerations in Credit Analysis – Enterprise Risk Identification

Key Considerations in Credit Analysis – Enterprise Risk Identification

Enterprise Risk

Asset RiskAsset Risk

Demand Elasticity

Operating Costs

Capital Replacement / Repairs

Environmental / Regulatory / Legal

Commodity Commodity RiskRisk

Fixed Price

Basis

Index

Financial RiskFinancial Risk

Interest Rate

Foreign Exchange

Debt / Other Debt-like Obligations

Refinancing

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Key Considerations in Credit Analysis – Financial Statement Analysis

Key Considerations in Credit Analysis – Financial Statement Analysis

Leverage

What is the relationship of the counterparty’s debt and other debt-like obligations to the:

(1) book value or market value of its assets or net worth and

(2) operating cash flow or Earnings before Interest, Taxes, and Depreciation, Depletion, and Amortization expenses (“EBITDA”) it generates?

How much of this debt is senior to (or subordinated to) the counterparty’s obligations under our contract?

Does the counterparty have additional debt capacity?

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Key Considerations in Credit Analysis – Financial Statement Analysis cont’d.

Key Considerations in Credit Analysis – Financial Statement Analysis cont’d.

Interest or Fixed Charge Coverage

What is the relationship of cash flow available for payment of debt service (generally Earnings before Interest and Taxes (“EBIT”) or EBITDA to:

(1) Interest (both expensed and capitalized)

(2) Fixed Charges - Interest plus other interest-like financial charges (e.g, rent payments, put obligations, preferred stock dividends)

(3) Additional expected cash maintenance and normalized or maintenance capital expenditures

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Key Considerations in Credit Analysis – Financial Statement Analysis cont’d.

Key Considerations in Credit Analysis – Financial Statement Analysis cont’d.

Liquidity

How much cash and other current assets does the counterparty have on its balance sheet (particularly in relationship to its current assets)?

How much unused committed revolving credit availability does the counterparty have?

What maturing debt and debt-like obligations does the counterparty have during, and shortly after, the term of our contract?

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Key Considerations in Determining Recovery Amounts Key Considerations in Determining Recovery Amounts

Priority of claim relative to other creditors – Is our claim secured or unsecured, senior or subordinated?

Quality and liquidity of counterparty’s assets securing or available for repayment of our obligation as well as generally

Volatility of counterparty’s asset values and correlation of asset values with defaults

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JargonJargon

Basis point

Cost of cover

LIBOR

Make-whole

Negative pledge

Ratable pledge

Refinancing Risk

Subordination

Structural subordination

Treasury