MOUNTAIN MENTORS ASSOCIATES

Corporate Credit Analysis

 

Arnold Ziegel

Mountain Mentors Associates

 

I. Introduction – The Goals and Nature of Credit Analysis

​

 

January, 2008

 

© 2008 Arnold Ziegel

Mountain Mentors Associates

 

 

 

1. Introduction – The Goals and Nature of Credit Analysis

 

Credit analysis is an art, not a science.  The goal of credit analysis is to make a judgment about an obligor’s ability and willingness to pay back what it owes, when it is owed.  These obligations would include short and long term loans, trade payables, letters of credit and all types of derivatives contracts. 

 

The fundamental question that a credit analyst needs to answer is:  “what is the degree of risk that an obligor will have sufficient cash to pay back an obligation on a timely basis?”  If the obligation is short term, and the obligor has a lot of liquidity, the answer is probably easy to determine.    If the time frame is longer, the answer is not so easy.  The credit analyst must assess a lot of factors that will impact the obligor’s ability to pay in the future, including the willingness to pay.  If a confident conclusion cannot be reached, the transaction will be rejected, or structured to reduce the risks, usually through the taking of collateral or security.

 

Financial analysis is the starting point of credit analysis.  Historic trends must be examined relative to the current financial position (balance sheet and capital structure) and operating performance.  These trends serve as the basis for judging the degree to which forecasts for future operating results and financial position are reasonable.

 

Determining what is “reasonable” leads to the “art” of credit analysis.  Judgments must be made about the forecasts of performance relative to history, management capability, competitors’ performance and competitive pressure, and the macro-economic environment.  Judgments must also be made about the strength or weakness of the obligor’s current and future financial position.

 

In traditional credit training, the process of credit analysis is framed by three simple questions:

 

Who’s the borrower?

What’s the purpose of the loan (obligation)?

How and when will it be paid back?

 

The analysis to be done to answer these questions can be addressed in another traditional way, referred to as the four “C’s” of credit – capacity, capital, condition and character. 

 

Capacity is the ability to generate enough cash to repay all obligations, when due.   Assessing this is the goal of credit analysis.

 

Capital is required during periods of weak cash flow generation for a company to sustain itself.  If there isn’t sufficient cash flow from operations to meet obligations, then assets may have to be sold to produce cash. 

 

Condition refers to the macro economic and competitive environment which will impact an obligor’s future performance and its ability to generate cash. 

 

Character is not only the willingness to repay an obligation, and live up to its terms, but also honesty relative to the risk of fraud.   It might also refer to the competence of the obligor.

 

The challenge for the credit analyst is to move from these simplistic statements to a framework for reaching an answer to this question:

“What is the degree of risk that an obligor will be able to have, or to generate,  sufficient cash to pay back the obligation on a timely basis?” 

 

This question is fundamental to the analysis of all types of corporate / commercial obligations – bank loans (long and short), trade credit (supplier credit), trading obligations (foreign exchange and derivatives), and rated (public) obligations from short term commercial paper through long term debt (senior and/or subordinated bonds), and subordinated forms of equity such as preferred stock.

 

Of course, the answer can range from “zero risk” to “a lot of risk”.  The goal of credit analysis is to establish where an obligor, and specific obligations, fits into this range.  In modern bank risk management, this is analogous to determining a “risk rating”.  It is also analogous to a public debt rating established by Moody’s or Standard and Poor’s.

 

Almost all forms of debt have an obligation to pay interest on a periodic basis.  Some very short term debt instruments have interest paid at maturity.  The greatest risk posed by debt is not the interest payments, but the principal payments.

 

Short term debt is commonly thought of as debt that matures in less than one year.  In reality, its maturity is usually much less than one year.  Debt in the form of credit from trade suppliers is usually due in 30 to 90 days from delivery.  Short term bank debt can be payable “on demand”, but more often than not will have notes that mature in 30 to 90 days.  For large companies with access to the public commercial paper market (CP), the maturities are usually less than 30 days.  Short term debt is often “rolled over” or extended.  But if the holder of the debt demands payment, this will come from a company’s liquidity.  Either from cash on hand, or the natural cash generated from the collection of accounts receivable or the liquidation of inventory.

 

Long term debt is usually in the form of bank term loans or publicly or privately placed long term notes or bonds.  This debt may be amortizing (period payments of principal) or be due in a lump sum at maturity.  Most bank terms loans require periodic principal payments.  Public and privately placed notes and bonds often have a single payment due at maturity.  Repayment of long term debt comes from annual cash flow generation or refinancing.  But, refinancing of long term debt will occur only if the lender is confident that the borrow has the ability to generate cash flow to repay it, or the ability to sell large amounts of assets to repay.

 

 

The degree of risk associated with a company’s cash flow is often referred to as the volatility of its cash flow.   High risk is due to highly volatile cash flow.  Low risk is a function of very low volatility of cash flow. 

 

For example, the cash flow volatility produced by an office building that is leased entirely to a highly rated corporation for a very long term, with the tenant paying all operating costs and maintenance will be very low.  The credit risk of a mortgage loan made to finance this building would have risk characteristics very similar to that of the long term corporate tenant.

 

On the other hand, the risk of a mortgage loan for the same building, but with no major long term tenant, might be very high.  To make a judgment about this, the credit analyst would have to do extensive research about current and historic rental rates, occupancy rates, the existence of competitive buildings and plans for new ones, and the macro-economic outlook for the demand for office space in the location.  An appraisal would be obtained to establish an independent view of the building’s value, but this should not be the only basis for establishing the degree of risk of the potential loan.

 

Highly risky (volatile) future cash flow doesn’t mean that a particular loan or obligation has to be risky.  A good lending officer or risk manager can structure a loan to remove some of the risk.  For a general corporate loan, the analysis can focus on a “second way out”.  If the borrower can’t generate sufficient cash to repay an obligation, it can hopefully raise cash in a second way – usually through the sale or liquidation of an asset.  This can be a variety of assets available to the obligor, or a specific asset that might be identified and secured. 

 

An obligation can be structured such that the risk of the specific obligation is actually lower than the overall risk of the obligor.  Collateral (security) is used to accomplish this.  Some very secure loans are made to bankrupt companies!  As one old saying goes, “it is possible to turn a sow’s ear into a silk purse!”  Where this is done, the risk rating of the specific obligation could be much better than the risk rating of the bankrupt company!  The probability of the secured obligation being repaid on time could be very high, due to the nature of the collateral.  On the other hand, the ability to forecast the repayment of unsecured obligations to a bankrupt company would be very difficult.

 

The credit crisis that began in 2007 was a result of the flawed assessment of collateral used to reduce risk.  The “CDO’s” (collateralized debt obligations) were secured by home mortgages in The United States.  The credit quality of the individual obligors was relatively low (maybe very low), but each loan was secured by a residence.  There seemed to be a very low risk that losses in a “pool” of mortgages (the CDO) would exceed a certain level.  The crisis occurred because default rates turned out to be much higher than anticipated, the value of the collateral (the mortgages on homes) turned out to be less than the amount of the mortgage loans, and the actual losses in these pools of mortgages far exceeded what was forecast.  The credit analysts for many of these CDO’s did a poor job of forecasting cash flow of the individual borrowers, as well as the value of the underlying collateral.

 

 

Summary of the Introduction

 

The fundamental question of credit analysis is:  “what is the degree of risk that an obligor will have sufficient cash to pay back an obligation on a timely basis?”  The “art” of credit analysis is an understanding about how to convert historic financial and operating performance and financial condition into a judgment about an obligor’s willingness and ability to repay an obligation in the future.  The traditional four “C’s” of credit analysis still provide a valid, if simplistic, framework for this process – assessing Capital, Capacity, Conditions, and Character.

 

Financial analysis is the starting point of all “securities” analysis – equity securities and debt (credit) securities or obligations.  An equity analyst will use financial analysis tools to estimate the value of a company’s equity, usually in the form of the market value of its publicly held stock, or the market value of the firm if the analyst is working for a private equity fund.  A credit analyst will use financial analysis to try to establish the degree to which an obligor can fulfill the terms of its debt obligations – short term and long term.  This is analogous to the estimation of the value of these obligations.  Unlike equity, the value of a debt obligation at its maturity date should be the same as when it was issued.  There is no specific maturity date of equity, which is the key difference between debt and equity.  Both equity analysis and credit analysis require the use of significant judgment to assess future performance.

 

The remainder of this chapter will describe how companies utilize different sources of funding to finance their assets.  This is the “capital structure” of a company. 

 

An appropriate capital structure is one that provides adequate returns to the equity investors, while not incurring so much debt that the risk of bankruptcy becomes very high.  A good credit analyst will always be assessing the quality of an obligor’s capital structure, and the degree of risk that it creates for the various suppliers of capital.  A company’s capital structure should be designed to match financial risk with the nature of its business risk.  A company with very low business risk can safely assume a lot of balance sheet (financial) risk in the form of leverage (debt).  A company with very high business risk will not survive for long if it also assumes a great deal of financial risk (leverage).

 

The remaining chapters of this course cover more specific aspects of credit analysis, including:

 

• Fundamentals of financial analysis

 

• Principles of Credit and Credit Analysis

 

• Debt Capacity and Cash Flow Analysis

 

• Cash Flow Forecasting

 

• Credit facility structure

 

• Modern risk management in commercial banks

 

​​