credit analysis ratios

8/3/2019 Credit Analysis Ratios

1/24

Basics of Credit Analysis

Alexandru Cebotari


2/24

Sources and Types of Risks

Management Competence

Strategic Direction

Lawsuits

Firm-Specific

Technology

Competition

Availability of Raw Materials and Labor

Unionization

Industry

Recession

Inflation or Deflation

Interest Rate Changes

Demographic Changes

Political Changes

Domestic

Exchange Rate Changes

Host Government Regulations

Political Unrest

Expropriation of Assets

International

Type or NatureSource


3/24

A firm should continually monitor each of these and other type ofrisks

A loan officers task is to understand how a firm monitors its risks

Analysis of the financial consequences of these elements of risk

using financial statements is an important tool

Various financial reporting standards require firms to discuss innotes to financial statements how important elements of risk affect a

particular firm and the actions it takes to manage its risks

In addition to using information about risk disclosed in the notes to

financial statements, loan officers typically assess the dimensions of

risk using ratios of various items in the financial statements


4/24

Profitability, Growth, Risk

Product-Market Strategies Financial-Market Strategies

OperatingDecisions

Investment and

AssetManagement

Decisions

FinancingDecisions

DividendDecisions

ManagingRevenue &

Expenses

ManagingWorking Capital

& Fixed Assets

ManagingLiabilities and

Equity

ManagingDividend Payout

Profit MarginRatios

Efficiency RatiosCapital Structure

RatiosPayout Ratios


5/24

Most financial statement-based risk analysis focuses on a comparisonof the supply of cash and demand for cash

Risk analysis using financial statement data typically examines

(1) short-term liquidity risk, the near term ability to generate cash to

service working capital needs and debt service requirements, and

(2) long-term solvency risk, the longer-term ability to generate cash

internally or from external sources to satisfy plant capacity and debtrepayment needs

The field of finance identifies two types of risks:

(1) credit risk, a firms ability to make payments on interest and

principle payments, and

(2) bankruptcy risk, the likelihood that a firm will be liquidated


6/24

Framework for Financial Statement Analysis ofRisk

Debt ServiceRequirements

Borrowing CapacityFinancing

Long-Term SolvencyRisk

Plant CapacityRequirements

Sales of ExistingPlant Assets or

InvestmentsInvesting

Short-Term LiquidityRisk

Working CapitalRequirements

Profitability ofGoods and Services

SoldOperations

Financial StatementAnalysis Performed

Need to Use CashAbility to Generate

CashActivity


7/24

Analysis of Short-Term Liquidity Risk

The analysis of short-term liquidity risk requires an understanding ofthe operating cycle of a firm!

Current Ratio: mainly used to give an idea about the companysability to pay back its short-term liabilities and a sense of theefficiency of the firms operating cycle and its ability to turn itsproducts into cash (ratio 1.0 preferred)

Quick Ratio: known as acid test, measures the firms ability to payoff its short-term debt from current liquid assets; draws a morerealistic picture (trend towards 0.5)

Operating Cash Flow Ratio: using cash flow as opposed toaccounting items provides a better indication of liquidity

(40%ntypical of a healthy firm)

Short-term liquidity problems also arise from longer-term solvencydifficulties!


8/24

A more rigorous measure ofshort-term liquidity.Indicates the ability of theentity to meet unexpecteddemands from liquid currentasses

Current Assets less inventory / Currentliabilities

Quick Ratio

A measure of short-termliquidity. Indicates theability of entity to meet itsshort-term debts from itscurrent assets

Current Assets / Current liabilitiesCurrent Ratio

Measures a company's ability to

pay its short term liabilities.Indicates whether thecompany has generatedenough cash over the year topay off short term liabilitiesas at the year end

Cash Flows from Operations/AverageCurrent Liabilities

Operating Cash Flow Ratio

MeasurementsFormulaFinancial Ratio


9/24

Analysis of Long-Term Solvency Risk

Increasing the proportion of debt in the financial structureintensifies the risk that the firm cannot pay interest and repaythe principle on the amount borrowed

Analysis of long-term solvency risk must begin with ananalysis of short-term liquidity risk

Firms must survive in the short-term if they are to survive inthe long-term!

Interest Coverage Ratio: gives a sense of how far earningscan fall before a firm will start defaulting on its payments (riskyif 2.0)

Long-Term Debt to Long-Term Capital Ratio: way of lookingat the debt structure and determine what portion of totalcapitalization is comprised of long-term debt (what if 1?)


10/24

Measures percentage of assetsprovided by shareholders

and the extent of usinggearing

Total assets / Total shareholders equityCapitalization ratio

Measures the ability of theentity to meet its interestpayments out of current

profits.

Operating profit before income tax +Interest expense / Interest expense +

Interest capitalizedTimes interest earned

The debt-to-capital ratio givesusers an idea of a

company's financialstructure, or how it is

financing its operations,along with some insight

into its financial strength.

Total Debt/(Total Shareholders Equity +Total Debt)

Debt to Capital Ratio

Measures percentage of assetsprovided by creditors and

extent of using gearingTotal Liabilities / Total assetsDebt ratio



11/24

Models of Bankruptcy Prediction


12/24

The six ratios with the best discriminating power (and the nature of therisk each ratio measures) were as follows:

Net Income plus Depreciation, Depletion, and Amortization/TotalLiabilities (long-term solvency risk)

Net Income/Total Assets (profitability)

Total Debt/total Assets (long-term solvency risk)

Net Working Capital/Total Assets (short-term liquidity risk)

Current Assets/Current Liabilities (short-term liquidity risk)

Cash, Marketable Securities, Accounts Receivable/OperatingExpenses excluding Depreciation, Depletion and Amortization(short-term liquidity risk)

Univariate Analysis


13/24

MultivariateBankruptcy Prediction ModelsAltmans Z-Score:

AssetsTotal

Sales

sLiabilitieofValueBook

EquityofValueMarket

AssetsTotal

TaxesandInterestBeforeEarning

AssetsTotal

Earningstained

AssetsTotal

CapitalWorkingNetscoreZ

0.1

6.03.3

Re4.12.1

We can convert the Z-score into a probability of bankruptcyusing the normal density function within Excel. The formulais: =NORMSDIST(1-Z score). Altman developed this model

so that higher positive Z-scores mean lower probability ofbankruptcy.

The principle strengths of MDA are as follows:

It incorporates multiple financial ratios;

It provides the appropriate coefficients fro combining the


14/24

Each ratio captures a different dimension of profitability or risk:

Met Working Capital/Total Assets: the proportion of total assets comprisingrelatively liquid net current assets (current assets minus current liabilities). It

is a measure of short-term liquidity risk.

Retained Earnings/Total Assets: accumulated profitability.

EBIT/Total Assets: this ratio measures current profitability.

Market Value of Equity/Book Value of Liabilities: this is a form of debt/equityratio, but it incorporates the markets assessment of the value of the firmsshareholders equity. This ratio measures long-term solvency risk and themarkets overall assessment of the profitability and risk of the firm.

Sales/Total Assets: this ratio is similar to the total assets turnover ratio andindicates the ability of a firm to use assets to generate sales.

In applying this model, Altman found that Z-scores of less than 1.81indicated a high probability of bankruptcy, while Z-scores higher than 3.00indicates a low probability of bankruptcy. Scores between 1.81 and 3.00were in the gray area.


15/24

Logit Analysis

Probability of Bankruptcy of a Firm:

yep

1

1

y = -1.320.407*SIZE + 6.03*TLTA1.43*WCTA +

0.0757*CLCA

2.37*NITA

1.83*FUTL + 0.285*INTWO

1.72*OENEG0.521*CHIN,

SIZE = ln (Total Assets/GNP Deflator)

TLTA = Total Liabilities/Total Assets

WCTA = (CA-CL)/Total Assets

CLCA = Current Liabilities/Current Assets

NITA = Net Income/Total Assets

FUTL = Funds (Working Capital) from Operations/Total Liabilities

INTWO = one if Net Income (NI) was negative in the last two years and zero otherwise

OENEG = one if owners equity is negative and zero otherwise


16/24

Earnings Manipulation

Beneish developed a probit model to identify the financialcharacteristics of firms likely to engage in earningsmanipulation

)(*670.4

)(*327.0)(*172.0)(*115.0)(*892.0)(*404.0)(*528.0)(*920.0840.4

TATA

LVGISAIDEPISGIAQIGMIDSRIy

Probit converts y into a probability using standardized normaldistribution. The command NORMSDIST within Excel, whenapplied to a particular value of y, converts it to the appropriateprobability value


17/24

Beneishs eight factors and the rationale for their inclusion are asfollows:

Indicates the volume of earnings resulting fromaccruals instead of from cash flows

Total Accruals to Total Assets (TATA)

Increase in the proportion of debt might entail aviolation of debt covenants

Leverage Index (LVGI)

1 indicates increased marketing expenditures andexpected increased sales

Selling and Administrative Expense Index (SAI)

Slowing of the rate of depreciation and therebyincreasing earnings

Depreciation Index (DEPI)

The need for low-cost external financing mightmotivate sales manipulation

Sales Growth Index (SGI)

An increase in the proportion indicates an increasedefforts to defer costs

Asset Quality Index (AQI)

Firms with weaker profitability a more likely toengage in earnings manipulation

Gross Margin Index (GMI)

A large increase in accounts receivables as apercentage of sales might indicate an overstatement ofaccounts receivables and sales to boost earnings

Days Sales in Receivables Index (DSRI)

RationaleIndex


18/24

Profitability Analysis

The analysis of profitability addresses two broad questions:

How much risk economic and strategic factors pose for theoperations of a firm, its profitability and long-term solvency ?

We use the Rate of Return on Assets (ROA) to answer thisquestion.

Can the firm generate the expected return on the capital

invested by the lenders and shareholders withoutcompromising the future of the firm? That is, how much ofROA is left to shareholders (owners) after subtracting theamounts owed to lenders.


19/24

Rate of Return on Assets

AssetsTotalAverage

EarningsinInterestMinorityRateTaxExpenseInterestIncomeNetROA

)1(*

TurAssetsROAforinMofitROA argPr

Sales

EarningsinInterestMinorityRateTaxExpenseInterestIncomeNet

ROAforinMofit

)1(*

argPr

AssetsTotalAverage

SalesTurnoverAsset


20/24

Average Median ROA, Profit Margin for ROA, and AssetsTurnover for 23 industries for 1990 to 2004


21/24

Economic Factors Affecting the ProfitMargin/Assets Turnover Mix

Assets

Turnover

Pure

CompetitionLowC

BothOligopolyMediumB

Profit

Margin

for ROA

MonopolyHighA

Strategic

FocusCompetition

CapitalIntensity

Area inExhibit


22/24

Profitability Ratios

Measures net profitability ofeach dollar of sales

Operating profit after income tax / NetSales Revenue

Profit Margin

Profitability of trading andmark-up

Gross Profit / Net SalesGross Profit Margin

Measures rate of return earnedon assets provided by owners

Operating profit & extraordinary itemsafter income tax minus Preferencedividends / Average ordinaryshareholders equity

Return on ordinaryshareholders equity

Measures rate of return earnedthrough operating total assetsprovided by both creditors andowners

Operating profit before income tax +interest expense/ Average total assets

Return on Total Assets



23/24

Total Assets Turnover

Measure the efficiency of theusage of fixed assets in

generating salesNet Sales / Fixed AssetsTurnover of Fixed Assets

Measures the effectiveness of anentity in using its assets

during the period.Net sales revenue / Average total assetsTotal Asset turnover ratio

Indicates the liquidity ofinventory. Measures the

number of times inventorywas sold on the average

during the period

Cost of goods sold / Average inventorybalance

Inventory turnover

Measures the effectiveness ofcollections; used to evaluatewhether receivables balanceis excessive

Net sales revenue / Average receivablesbalance

Receivables turnover



24/24

Return on Common Shareholders Equity (ROCE)

Returnon Assets

Return toCreditors

Return to

PreferredShareholde

rs

Return to

CommonShareholde

rs

FinancialTurnoverAssetsROCEforinMofitROCE argPr

EquityrsShareholdeCommonAverage

rsShareholdeCommontoIncomeNetROCE

'

Sales

rsShareholdeCommontoIncomeNetROCEforinMofit argPr

AssetsTotalAverage

SalesTurnoverAssets

EquityrsShareholdeCommonAverage

AssetsTotalAverageLaverageFinancial

'

credit analysis ratios

Documents