Credit Analysis: a complete guide

Chapter one: What is Credit analysis?

1) Examines business in context of industry
2) Analyze cash flow

1a) Pressure of competition/ risk and reward structure of industry
2a) estimate future use of cash, based on prior use of cash

In the old days (1930-1940), there was only short term lending, so bankers only focused on the B/S. Their main concern was working capital.

Problem with that main concern is what if no one wants the asset

1950s LT lending in U.S. first then overseas
Bankers moved from looking at working capital to Debt service ratio (NI/ Current debt obligation). Although it is a an improvement, it is still flawed because NI can be altered with creative accounting while Debt Oblig. must be paid in cash.
A couple decades later Cash flow became more important–
Cash Conversion cycle ratio, cash flow from operations.

We must analyze the risk associated to the company’s cash flow
Generally we look at
-Business
-Production
-Marketing
-Personnel
-Finance risk
But analyst should use their judgement on what to look for.

Also, we would do a comparative analysis of the company with its competitors in the industry
-Financial comparison
-Key Variables and elements that are important for companies in that industry and how the company rate compared to its peers
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Credit analysis Lending Stages
1. Development of new businesses
2. Process of evaluating credit
3. Pricing and structuring of the loan/ line of credit
4. Obtaining repayment
4a. Workouts
4b. Charge off- amount that is uncollectible
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Ch 2: Examining the Evidence:

Credit analysis: where to start?

The Annual report. While reading the annual report be mindful of
1. what is disclosed and not disclosed
2. whom the annual report is made for
3. Read the fine prints (very important)

The first thing you do when you look at the annual report is to read the auditor’s opinion (they only audit the 3 fin. statement and its notes)
Auditors opinion:
1. qualified opinion: info was limited in scope or hasn’t maintain GAAP
1a. ‘Subject to’: means that assets, liabilities, or ‘X’ is subject to outcome outside of company’s control
1b. ‘except for’: used when auditor has to “qualify” an opinion to change something like accounting principles
Problems with auditors
1. small auditing firms might be pressured to comply with large corporate clients
2. change in auditors might indicate dispute
3. check date to see if audit took longer than usual
3a. longer means more complex/ unusual/ disagreement

Next look at the page in the annual report that sets out the Nature of accounting principle– This section goes on to talk about accounting and things that you will come across.
Basically, there are many ways to account for things, ie: inventory LIFO and FIFO, Depreciation straight line or accelerated, different revenue recognition methods.

After knowing the auditors opinions and the accounting principles we can go to the financial statements itself and spread them..
Bankers usually take the financial statements that are presented in a variety of formats and spread these figures onto a rigid spreadsheet that is consistent every time.
–before spreading, read notes to be sure that you are classifying items correctly.

For unaudited financial statements, its hard to be confidence unless there is a physical inspection of the plant, inventory, book of account. Should ask management for basic accounting principles, esp inventory valuation and basis for recognizing rev.

During inspection
Asset (esp inventory valuation) is the hardest to inspect
Account receivable can be checked against an ageing schedule
Fixed assets: beware of revaluations, ask about depreciation
Intangibles aren’t valued in audited statements
Liabilities will be reliable.

Income statement:
Depending on the revenue recognition method used, there can be an overstatement of revenue.

Expense: not likely understate b/c of tax effect.
If overstated then lender has advantage b.c. then better CF than reported

Last note: depending on the place of business, you might want to learn about the local practices for unaudited statements b.c. sometimes that is all there is.
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Ch3. Cash Flow Analysis

We will learn how to do a ‘CF analysis’ and how to find CFO
‘CF analysis’ is basically summarizing the sources and uses of cash and being able to answer 3 questions:
1. Did the business generate positive CF after allowing for the effects of changes in the working accounts?
2. How was Capex financed?
3. What did they use debt for?

Why is CF important?
B/c you aren’t payed back based on accrual income. Also, CF provides an estimate of future CF.

Net Working Asset: comes from taking current asset less current liabilities. ***asset and liabilities must move with sales, so cash isn’t a net working asset.

NWA is important because you can utilize it to get CFO.
CFO = Net income + non cash charges – *change in NWA
*Change in NWA comes from two different time periods
Another note on NWA, make sure to pay attention to the make up of NWA aka quality.

Funds from operation is another metric and you get that by: NI + non cash expenses

The book also looked at debt, whether it is LT or ST debt, and what it is used for? In this case the company is using ST debt to finance LT Capex, which can be a problem if the company continues to grow at the same rate and constantly needs to spend the same amount on CAPEX.

Net working assets/ Sales
A higher % means you need more assets to create more sales, which is a bad thing. Another way to phrase it is that you need more working assets to create sales.
We can forecast the future NWA and CFO by calculating net working assets/ sales.

More on NWA:
If NWA increases then it would mean that there is more assets like inventory or less liabilities like account payable. But regardless of the reason, if NWA increases it is always bad from the point of view of cash.
The inverse would be a lower NWA b/c of an increase in liabilities like account payables or decrease in assets like Inventory..
NWA is all balance sheet items.

Another ratio that is similar to NWA/Sales is Cash cycle. This tells us how long it takes for cash to be turned to inventory and then back to cash.
(Inventory/COGS * 365) + (Receivables/Sales * 365) – (Payable/COGS * 365)= Cash Cycle

How to classify Non operating items:
Operating items also include current taxes.
Operating items are day to day business transactions
Non operating items are CAPEX, dividend.

Then this book goes through an example of a transaction analysis, which is basically accounting, to show you examples of operating and non operating items. Transaction Analysis is basically accounting, you are listing down all the transactions and how it affect the balance sheet. They are using alot of statements (income statement, statement of change). It is a hard topic to grasp, but from this analysis we see where cash is coming from and going. We get the change in NWA and CFO.
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Ch 4: Corporate Structure

This ch. is on the effect of corporate structure on consolidated financial statement and how to decide which subsidiary will be the borrower

Consolidated statement: all subsidiary financial statements are consolidated into one. Statement doesn’t show intercompany transactions and no legal existence, just adding all the transactions, assets, and liabilities.

Understanding a consolidated statement
1. owners equity in a consolidated statement is always that of the parent or top company
1a. you don’t add the subsidiaries OE together to get the OE in a consolidated statement
2. Assets and liabilities are from the subsidiaries actual assets and liabilities
3. The difference between OE and assets + liabilities are recorded as a gain or loss
4. Minority interest is the portion which isn’t own by the parent
5. If a company owns more than 50% then it must be consolidated.

Example if Company X have
A= 200
L=130
OE= 70
And we own 60% of Company X, then we would add the full A and L to our consolidated statement but only “.60*70” of OE and the rest will be minority interest.

More side notes on accounting principles for minority interest
1. Profits are divided equally by percentage of ownership
2. If ownership decrease to less than 50% then no longer minority interest
3. Minority interest increase when subsidiary raises new shares
4. Losses will be divided equally between the ownership and minority interest

(Accounting rule) Parent can choose not to consolidate a >50% ownership of a subsidiary, if consolidating doesn’t present a clear picture.
As an analyst, we need to determine which subsidiary we should include in our analysis

First some Jargons:
1. upstream the money: money goes from sub to parent
2. downstream the money: parent to sub
3. consolidating statement: hasn’t been consolidated
Debt Priority
As a lender, we want to lend as close to the CF as possible; could be either parent or sub.
Examples: if lend to parent, and parents default you will get their asset, if assets are xyz company then you become a shareholder of xyz company and as a shareholder, you have last priority.
-If parent has operating assets you can loan to it, but make sure all LT assets are covered by LT sources of funds (debt, OE). IF LT assets > LT sources of funds then no additional room for ST debt.
-After you figure out who to lend to (make sure you look at amount of debt to tangible net worth/ stability of CF etc), make a schedule to compare the seniority/ priority of your loan w/ existing debt
Debt ranking
1. preferred creditors: govt taxes, employee wages, liquidation exp.
2. Secured creditors
3. unsecured creditors
4. shareholders

Parents can support subsidiaries by giving them a guarantee, a comfort letter, etc. For comfort letter we need to focuson
1. why no guarantee: many reasons; multiple lenders to choose from, tax reasons, laws, prior loans, etc
2. borrowers own condition: is borrower dependent on parent? Does the parent need the subisdiary? if they do, then that is better
3. parent relationship to borrower
4. actual text of comfort letter

Also, always consider what will happen if they sub were sold w/o consulting lenders.

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Ch5: Using Financial Ratios

How to use financial ratios for credit analysis?
In credit analysis we want to unveil the financial health of a company, and so we use ratios to ask questions related to the financial health of the company. These questions are:
1. [INDUSTRY] What is the nature of the industry of the borrower?
1a. High risk/ high return industry, stable industry, dying industry
2. [COMPETITORS] How are borrowers’ sales, cost, profit, asset utilization compared to their competitors?
3. [BORROWER] Financial condition, expectation regarding CF, obligations of firm compared to size, is it solvent?

How do we answer these questions? The book jumps into ratios

Profitability Ratio: used to identify profitable industries/companies b/c w/o profits company will have less retain earnings and more debt leading to a collapse in the long run. Profitability ratios are used to assess why firms are so profitable, and if there are barriers to entry.
Flaws with profitability ratio:
1. If assets are revalued upward, then the accounting for it would be “+Assets, +Owners equity”. This will automatically decrease ROE (NI/OE).
a. we combat this by using multiple ratios and eliminating the ones that are obviously flawed.

Profitability ratio: ROE [NI/OE]

-Company need to generate enough profits to pay dividend, and still have enough money left over to grow the company.
-ROE should equal cost of equity in order for the company to break even
-Investors expect a certain return. Investors receive return from dividend and growth in dividend aka ‘D/P + g’
D/P = Dividend yield
g= growth in dividend

Now that we know how investors get their return, what % of return do they expect?
We should expect it to be the sum of risk free rate + equity risk premium. Adjust the risk premium depending on the industry and the riskiness of the company.

If the risk free rate rises too high, it’ll be tough for company to find sources of cash, because lenders will expect higher return and investors will expect a higher return (risk free rate + equity risk premium) that the company might not be able to provide.

The flaw of this ratio? ROE will automatically increase if there is an increase in leverage

Profitability ratio [EBIT/ Total Assets]

EBIT removes tax/ financing decisions and its a better gauge on firms competitive market position and efficiency of firms production

Now they go into how to construct this ratio. For EBIT
1. Include operating, investment, and equity income (no extraordinary)
2. Exclude cost of ST and LT debt aka interest
3. Capitalize any leases as assets and adjust operating income for interest element in lease payment (if possible) (*not to sure how to capitalize leases yet, and why it is important, but I think its because leases have both depreciation and interest expense, and we capitalize it so that we take away these two, and then only account for depreciation? Also capitalize it and you’ll get a higher asset #)

Leverage ratios
Leverage increase profitability b/c interest is tax deductible and cost of debt will always be cheaper than cost of equity

Leverage ratio [Debt/Equity]
There is so many ways to create this ratio. Some questions to ask:
1. Are we using all liabilities
2. Liabilities with interest?
3. Some liabilities?
4. What about deferred taxes?
5. What about equities; are we considering intangible assets or non controlling interest?

On deferred taxes
If we sum up all liabilities including deferred taxes, then we are using the liquidation approach. Because during liquidation deferred taxes also become due. Deferred taxes are usually left out of the ratio when we view business as a going concern basis. We should also look at when deferred taxes were created and when it will become due to decide what to do.

Basically the above statements are all saying in order to construct a Debt/Equity ratio, we must know why we are using this ratio. Once we know why, we can include/ exclude certain debt and equity.

Then this ratio is normally used by lenders to limit risk. Lenders usually want a ratio of equity to total asset that is inline with the inherent risk level of the asset. Assets risk level can be determine by assessing the assets ability to generate cash on a reliable basis, or the marketability of the assets.

Flaws: Book value of asset, debt can be off balance sheet. Nothing on cash flow
Pros: easy to calculate and compare with other companies

Company that is less leverage have room to maneuver

Leverage ratio [CF/Total Liabilities]

CFO should be made up of CFO and total liabilities should be all liabilities.
Book goes into examples where Y amounts of Future CF discounted back to the present is “X” PV. This PV should be what you should be willing to borrow to break even. If you borrow more than “X” PV for Y amount of future CF then you are losing money.

Now CF/total liabilities ratio share the same concept, but you don’t want to break even. You want to make money, so what is a good CF to Total liabilities ratio? It depends on the interest rate and how long you can wait for the amount to be paid back. Generally most lenders believe total liabilities shouldn’t exceed 4 times gross CF.

Leverage ratio [Debt service coverage ratio]
***not to sure if this is a leverage ratio or a coverage ratio
Basically you want to relate reported income to interest bearing debt–very popular with bond holders and agencies that rate bonds
Simplest is EBIT/Interest payment
More advance ratio would include lease payments, sinking fund payments, and all other forms of debt service required. EBIT would be swapped out for EBITDA.
This ratio is good when debt substitution is payment method for existing lenders.

Liqudity/Solvency ratios
Liquidity – nearness to cash
Solvency- ability to pay one’s debt as they fall due
There is a lot of ratios for these two. Best to know what we are measuring.
Firms can be liquid yet insolvent and vice versa.

Ratios for liquidity:
1. current ratio [current asset/current liabilities]: Simplest and most traditional way to measure liquidity but a high ratio doesn’t necessarily mean liquidity..you would need to look at the make up of CA and its liquidity. Less than 1 means firm can’t meet current oblig.
2. quick ratio [Cash+AR+marketable sec/CL] is a better ratio if there is a large amount of inventory/ work in progress (we are dropping the least liquid of current asset, which is usually inventory).

Then goes into Days of inventory/ Sales in credit/ Payable and how we should examine changes in these numbers
[Inventory*365/COGS] [AR*365/Sales] [AP*365/COGS]

The Self Financing Short Term Growth Rate
This is basically a formula that tells us how much can a company grow without taking on debt.
So we use NWA / Sales aka Cash efficiency ratio
and profit margin aka cash generating ratio.
Say Y1 sales were 3000. And Y2 sales were 5000. We can use the “NWA / Sales” ratio to figure out how much cash we would need to cover the increase in sales. Then we use gross profit to see how much additional cash we would generate. The difference needs to be covered with debt
Y1 sales = 3000
Y2 sales = 5000
profit margin = 8%
NWA/Sales= 20%
2000*0.20 = 400
5000*0.08 = 400
So no need to take on debt.
This model is limiting because of the assumptions that profit margins and NWA/sales will always stay the same.
The model can be rewritten as X = P / Q – P
X = self financing growth rate
P = profit margin
Q = NWA / Sales

Performance ratio
Each industry have their own distinct performance ratios.
Ratios concentrated on Assets:
The more significant (determine by price) the asset the more likely there will be a ratio

Finally Summary
-single ratio might distort the picture
-alterations of one ratio can affect another ie. debt affects ROE

Defintion:
Ailing- sickly; unwell

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Ch6: Financial conditions

Examine Financial statement and make assumptions on company’s financial vulnerability or flexibility
We must look and describe:
1. Major changes in company’s balance sheet since previous year
2. Consider asset quality, seniority and magnitude of liabilities, company’s ability to react to unexpected changes
3. Examine trends
4. Conclude if company has enough $$ to pay

  • Asset quality
    • Does asset generate cash on a consistent basis
    • marketable?
    • value?
    • Most dubious asset is Inventory

Inventory
We must determine the accounting principals of Inventory to understand how value is determine.
There is 3 different accounting principals that alters the value
1. is LIFO, or FIFO being used?
2. is value recorded based on market value or cost value
3. what type of inventory is it? Raw, In progress, Final product
4. Lastly, the different types of final product also complicate the value of inventory

I think this book is going on to marketability. Generally we calculate inventory turnover [COGS/Inventory] to see how fast inventory is moving and subsequently determine how sell-able the inventories are.. Side note: inventory turnover is the inverse of days sale in inventory.
Cons of using inventory turnover:
-assumes all inventory is in the form of final goods
-ending inventory is the avg inventory for the year

  • Then it continues on about all the info we want to know about inventory
    • Average inventory each day
    • Target inventory each day
    • avg age of inventory
    • if there is an inventory control system, which will minimize storage cost and while keeping inventory in stock
  • Inventory concealment
    • Inventory is a great place to conceal things
      • Some examples: if you realize your inventory is worth less than the market value, and if you don’t revalue it downward, then you are fooling the banker, who believes you have more asset than you actually have
      •  If you understate your inventory, and overstate your COGS then you might be hiding profits from tax collectors.

Working Capital: CA- CL

  • The quality of current assets that makeup working capital is important.
    • we want CA that will retain it’s value; CA associated to cash is better than inventory
    • If inventory is riskier or slower moving then as a lender we would want a higher working capital
    • For seasonal loans, the quality of working capital is more significant than profitability. Because you might be really profitable but your inventory goes out of fashion and it doesn’t sell through. So we want to know if you can absorb unexpected changes.
  • Changes in working capital
    • Analyst should assess changes in working capital
    • Working capital should be constantly increasing because of retain earnings. New equity and LT debt should also have the same affect, unless it is used to finance fixed (LT) assets
    • ST debt shouldn’t decrease working capital unless it is used to finance capex

Account receivables: quality depends on customer

  • AR more liquid than inventory b.c. nearer to the end of the Cash conversion cycle
  • Important tools
    • receivable aging schedule
    • Receivable turnovers: Sales/ Ending balance of account receivable (think we can use average if it fluctuates)
      • Days sales outstanding: Ending account receivable/ (*sales/ 365) = # of days of uncollected sales.
        • *Sales are credit.

Cash conversion cycle aka cash to cash cycle : $ days in inventory + # days sales (AR) outstanding – days payable outstanding

Quality of Fixed Assets:

  • Usually with problem loans, sale of fixed asset is the fallback option for repayment. We need to ask 3 questions to find out the quality of fixed assets
    1. How marketable is the asset? Can you sell it to any company like land? or is it specific to an industry?
    2. How will selling this asset impact the business? Will it destroy it?
    3. Are the asset already pledged as collateral? If it is, we can assume book value of those pledged assets are recorded at maximum/market value.

Liabilities

  • Look at size, seniority, contingency, relationship between cashflow and existing levels of debt, debt limit
  • Analyst should have a general idea on the coverage ratio for industry/ company
  • Stability and certainty of future cash flow are most important
  • Ratios
    • Interest coverage ratio: EBIT/ Interest expense
      • Weaknesses: based on earnings and not CF, doesn’t factor in movements in interest rate, doesn’t take into account repayment of principal or lease payment.
    • Debt coverage ratio: EBITDA + lease payments / Interest + principal + lease payments
      • eliminated some of the weaknesses seen in the interest coverage ratio but still flawed b/c we don’t look at capex or change in working capital.
    • Closes ratio to cash and cash required ratio is Total liabilities/ CF

Access to capital market

  • There are theories to what is the optimal capital structure for a firm but in reality companies might not have access to fixed rate financing, or raising equity because its too small or don’t want to lose control. So as an analyst we should look at the company from a practical point of view and 1) see if the company’s debt makes sense. 2) see if there are any adjustments to the capital structure in the near future 3) what are their options for capital; if their shareholders are happy, if their stock price is under or over value. etc
    • LT debt should be funded by LT debt

Breakup Analysis:

  • If company is forced to liquidate, which assets do we have access to?’
    • how much those assets will sell for
      • The price of assets depend on whether the liquidation process is orderly, disorderly, or disastrous. During a disastrous liquidation all asset will be on the auction block at distress price.
    • Seniority of your bank debt vs rest of company’s debt: anything senior is debt, anything junior is equity
      • not as important when the company is operating on a going concern, because the bank will need to pay all of its debt payments.
  • We are going through what is considered senior or junior to bank debt
    • Wages payable – senior
    • tax payable- senior
    • legal, and accounting fee – EQUAL seniority
    • mortgage (plant) payments – senior
    • operating leases – could be senior (if it is critical for company then it is senior)
      • lessors and mortgage lenders can sue company for losses, mortgage lenders can claim entire loss, while lessors claims are limited
    • Deferred taxes, and deferred revenue are considered debt when the company is going concern, but during liquidation we consider rev unsecure debt and taxes as an accounting liability and not a legal liability.
  • Finally we take the gross assets and subtract the senior debt and then divide it by our loan amount and we’ll get a coverage ratio.

going concern: business is operating normally

gone concern: business can no longer operation. done. finish.

Definition:

  • Dubious- doubtful
  • Substantiate: to establish by proof or competent evidence
  • preponderant: superior in weight, force, influence, numbers, etc
  • Incipient: beginning to exist or appear; in an initial stage
  • quasi: resembling, having some but not all the features of
  • markedly: strikingly noticeable
  • gross: without deductions; like expenses, taxes etc
  • precept: a commandment or direction given as a rule of action or conduct
  • axact: call for, demand

Ch 7: Evaluating Industry and Management

  • Evaluate management with performance and results
  • Business world is a continual process of creation, growth, and disappearance among business enterprises
  • Profits is one of the keys to evaluate management
  • 7 other keys to evaluate management
    • market standing: find by calculating market share
      • more market share = profitability, price leadership, economies of scale
      • hard to calculate companies with multi-products so we categorize it into 1 of 4 boxes.
        Low market share High market share
        High growth A:new product B: new product becoming successful
        Low growth C: dogs : bad products D
        • A: uses cash
        • B: products in this box requires substantial increase in NWA, and capex
        • D: these are products that are no longer experiencing growth, need less working assets, and earlier capex comes to fruition
      • Ideally companies will have enough D products to offset A&B products need for cashflow
    • Innovation: Technology, marketing, and changing customer behavior: what are the changes in the world of tech, marketing, n customers’ behavior? Is the firm keeping up?
    • Productively: Degree to which resources were used efficiently (ratios) and to the extent to which firm contribute value by putting together labor, raw materials, and capital
    • Physical and financial resources: firm must have reliable access to both raw material and capital market. Ask how company obtain resources, with what risk? And how efficient?
      • Neat example: should company depend on 1 supplier? or multiple? Can depend on one if you have leverage, like being able to integrate backwards (make the raw material itself)
      • human resource (another resource) also needs to be looked at. It is measured by: output, spirit of the organization, committment, loyalty. Can’t be assess through ratios but you can assess it by asking some key questions (see p.125-126 of book)
    • Manager performance and development
    • worker performance and attitude
    • Public responsbility: relationship between company and public, and company and government. the latter is what we are worried about, because of potential government regulation. We need to ask several questions when assessing this key. What role does govt play with the company? (questions on p 126-127)
  • INDUSTRY DYNAMIC: are forces that shape competition in an industry. Competition is the cause for profit and bankruptcy.
  • Competition in an industry is neither a matter of coincidence nor bad luck. Rather competition in an industry is rooted in its underlying economic structure and goes well beyond the behavior of current competitors
  • State of competition depends on 5 forces
    1. Barrier to entry
      1. economies of scale: you either enter huge and risk suffering large losses, or enter small and suffer from cost disadvantage
      2. product differentiation: existing firms have brand recognition, and credibility
      3. capital requirement
      4. switching cost: cost for customers to switch companies, include cost of retaining employees, keeping machines, R&D
      5. distribution channels: hard to find places to distribute your products; groceries and shelf space
      6. cost barrier independent of scale: things that primitive companies have, which becomes a cost barrier; patents, access to raw material thru favorable location, etc
      7. government regulation can give early movers even more time to lead by enforcing policies that hinder new comers.
    2. Rivalry: must try to assess the degree of rivalry; why is it competitive, how do firms compete
      1. Number and relative size of competitors: usually fragmented industry tend to have more competition
      2. Rate of industry growth: fast growth means less competition because there is no need to compete for revenue.
      3. level of fixed costs and overcapacity: high fixed cost produces pressure to fill capacity, like airplanes and passengers.
      4. degree of diversity among competitors: the more different (goals, strategies, outlook) the companies are the more competition. For instance, foreign banks didn’t have the same restrictions as domestic banks in the U.S. so competition was fierce.
    3. Substitute products: should spend some time on this, since it can cause the primary market to stop price increases, and threaten the cost structure
    4. buyer power: must identify when buyer will have power, and how it will affect the industry
      1. buyer will have power when there’s not many buyers, or one buyer equals a large portion of sales
      2. 7 other situations that will give buyers power p.132 but generally if they have options, low switching cost, if input doesn’t really matter, etc.
    5. Supplier power: must identify suppliers power and how it will affect the industry
      1. usually its the opposite of buyers power. When they have alot of customers, when there aren’t as many other options, etc.

Definition:

  • Grace: elegance or beauty of form
  • analogous: having analogy
  • analogy: similarity between like features of two things
  • primitive: the first or earliest of the kind, or in existence
  • inherent: existing in someone or something as a permanent and inseparable element, quality, or attribute
  • obsolescence: the state, process or condition or being or becoming obsolete
  • merely: only as specified and nothing more
  • postulate: to ask, demand or claim
  • inroads: an advance or penetration often at the expense of someone or something; damaging or serious encroachment
  • encroachment: to trespass upon the property, domain or right of another
  • substantial: ample or considerable amount
  • extensive: great extent; wide
  • outlay: expending or spending
  • obliged: to require or constrain as by law, command, etc
  • contend: to struggle in opposition

Ch8: Corporate Collaspe

  • We want to recognize both the symptoms and cause for a corporate collapse. There are two approaches: quantitative and qualitative
    • Altman approach (quantitative): uses a linear model to predict failure. It was intially a 5 variable model, but it soon expanded to 7 to account for bigger firms, and new GAAP rules.
      • IT looked at liquidity, profitability, leverage, solvency, and performance ratios
      • (not the actual formula, just an example of what a linear model looks like) Z = 0.012X1 +0.014X2 + 0.033X3 ~~~ and a company with a Z score below 1.8 was considered likely to fail.
        • Variable 1: ROA (EBIT/ Total assets) (2nd most important ratio)
          • *EBIT shows operating results  not distorted by financing policies or tax.
        • Variable 2: Stability of earnings – we look at earnings, within the last 10 years, to see how stable it is.
        • Variable 3: Coverage ratio: EBIT/ Total Interest payment
        • Variable 4: Cumulative profitability: retain earning/ Total assets — (most important ratio). Ratio is affected if there are back to back years of losses
        •  Variable 5: liquidity, use current ratio
        • Variable 6: Capitalization: Equity/ total capital (3rd most important)
        • Variable 7: size : measure total asset
          • When looking at these variable, pay attention to trend.
          • The larger the z score the less risky it is
      • Company can become healthier if it tries to improve the ratios in Altmans approach
    • Argenti Approach (qualitative)
      • Companies follow a certain path to failure
        • It is important to look at the qualitative, because when companies deteriorate, they will apply creative accounting to make ratios look better.
      • Believes management causes failure
        • Doesn’t or can’t react to change
        • launch big projects that does poorly
        • leverage are allowed to rise
      • There are many types of poor management that leads to failure
        • one man rule, non participation by the Board of Directors (most important task to elect CEO), top heavy, lack of depth, weak finance function, combine chairman and chief executive
      • Another factor is poor management information system
        • This is where you have a lack of information about your market, budget, cash flow, inventory, competitors, new technology etc. And due to this lack of knowledge your company fail
      • Failure to response to change is also major cause of failure
        • political
        • economic: inflation, devaluation, interest rate. All companies need to be aware of inflation. Foreign exchange rates are also important
        • society: attitude towards pollution, consumer protection, woman going to work, etc
        • technology
          • Also responding to change too soon can be fatal
      • Over trading, launching a big project & leverage are more reasons for failure
        • over-trading or trying to expand beyond one’s limits like making sales at the expense of profits; negative CFO with increase sales and low profit margin are signs of over-trading
        • launching a big project, usually a gamble, will lead to failure. These projects are usually a hail Mary for companies that are already in a bad position and is usually financed by debt.
        • Having high leverage seems to be universally evident for companies that fail. High leverage is only justifiable if future CF are highly predictable
      • Companies on the path to failure will be more likely to have symptoms of creative accounting. This is used as a smoke screen to maintain company’s credit worthiness and to confuse investors.
      • Then finally it talks about the path to failure, where young companies path to failure is their attempt to become a business.
        • Larger and more mature companies have 2 steps to decline. Usually an outside event not properly anticipated hit the company, then it either tries to gamble its way out, or another shock hits it that causes it to collapse.

Definition:

  • adhere: to stay attached
  • Matrix: something that constitutes the place or point from which something else originates, take form, or develop
  • manifest: clear or obvious to the eye; evident
  • white elephant: a possession that is useless or troublesome, esp. one that is expensive to maintain or difficult to dispose of
  • Ingenious: characterized by cleverness or originality of invention or construction
  • Latitude: freedom from narrow restrictions; freedom of action, opinion, etc.
  • water logged: so filled or flooded with water as to be heavy or unmanageable
  • plausible: credible, believable
  • dubious: doubtful
  • ailing: sickly; unwell

Chapter 9: Term Loans

  • Term loans = repayment 2 years from commitment date
  • Revolving credit becomes solid debt once borrower financial condition deteriorate
  • Good covenants doesn’t make a good loan, certainty of future CF makes a good loan
  • Term loans
    • history: back in the day loans were mostly short term and those were periodically renewed, if borrower used it to invest in fixed assets. But during the recessions lender didn’t want to renew those loans. Banks realize although theoretically short term loans were repayable on demand it isn’t. So term loans became more popular.
    •  Purposes suitable for term loans:
      • fixed asset expansion (most suitable)
      • working capital expansion (should evaluate whether it is suitable)
        • If inventory or extension of credit, then it might not be wise to lend. Since these can be symptoms of problems in the business/ industry
        • For working capital, lenders usually do a borrowing base loan, or lend 60 of inventory and 80% of eligible receivables
      • For acquisition of business; business can be going concern, or breakup situation
      • For refinancing:
        • if the reason is inadequate cash from operations then it is very risky
        • But as a lender, you must always calculate future CF and repayment possibilities and compare the situation to if you refuse refinancing.
        • You must make sure that the company will be gone concern, before you refuse to refinance. Cause you already lent the money, now you need it back.
  • Short term loans emphasize the balance sheet, current assets, working capital. While long term loans emphasize the cash flow statement. To lend LT we must determine LT risk and structure and agreement so that if risk becomes reality then loan can be renegotiated
  •  Loan agreements
    • main purpose is to provide periodic reviews and renewal of term credit
    • it also gives lender the right to terminate if borrower doesn’t payback, becomes bankrupted, accerlates other indebtedness
    • 5 main parts of a loan agreement
      1. Preamble and Description: describe lender, borrower, loan info, define terms
      2. Representation and warranties: gives you the date of agreement, the economic, financial and legal circumstances prevailing at the time of the credit decision. Most importantly it gives lender the ability to reassess if there are any unforeseen adverse changes
        1. For financials: It confirms the financial statements given to the lender is accurate and that there have not been any material adverse developments since then.
        2. For legal, it confirm that the BOD has approved the loan. That it is legally contractual/ no conflict with govt. or law. Also includes any litigation pending on the company
      3. Conditions precedent: This section talks about the legal side of things. It makes sure that the loan is approved, and any pledges are secured, etc.
      4. Covenants: the framework of the financial plan, agreed upon jointly by the borrower and the lender
        • 3 principles of convenants: limitation of other indebtedness, prohibition of more senior obligations, provision for certain minimum ratios
        • negative covenants are don’t dos like don’t pay dividend. positive covenants are dos
        • Primary covenants are categorized into 3 basic principles: limitation of other indebtedness, prohibition of secure obligations or of obligations more senior to the loan, provision for maintenance of working capital
        • Secondary covenants revolves around earnings and how excess cash are spent, ie. prohibit M&A activities, investments, limit capital expenditures
        • Tertiary covenants: maintenance of corporate existences. ie. payment of taxes when due, maintenance of adequate insurance
      5. Event of default: section set forth conditions to which lenders have right to accelerate the loans.
        • Important parts:
          • It should include steps during bankruptcy
          • If material is false or if info used to make credit approval is false
          • default covenants
      6. Misc. Section: anything not covered in previous sections
  • Cash flow projections: essential for term loan analysis.
    • We are trying to project the margin of safety or cash that is left over after the company pays off all requirements, including this loan.
    • Need assumptions: key assumptions- annual rate of sales increase. Need to assume net income margin, if NWA will continue as a constant % of sales, required capex?, any changes in tax rate?
    • Should look at exhibit 9.1
Net income after tax

add back non cash charges

minus increase in NWA

minus capex

minus dividend

minus LT debt payments

minus this specific loan


equals margin of safety
  • Continuing onward
    • Need to project CF 3 times; best, worst, and most likely scenarios and then we should compare these results and see how easy it is to raise additional debt since these periods seldom project much margin of safety
    • To double check your CF projection/ margin of safety projections
      • project the balance sheet and income statement, then calculate key ratios to see if there is anything off with our projections. If we get EBIT/ Total asset increase of say 30%, we know something is off.
        • Essentially we spread numbers for the base year first (sometimes people use an average of the last 3 years number). Along the way we are calculating certain ratios which we will use in our “projection years”
        • I can’t go into the nitty gritty because I’m not going to remember it anyways. But they do give us an list of variables, and questions that we need to answer in order to project reasonable numbers and ways to check these numbers (looking at other companies’s, in the industry, numbers)

Definition

  • Superfluous: excessive
  • conglomerate: a corporation consisting of a # of subsidiary companies or divisions in a variety of unrelated industries, usually as a result of M&A
  • prudent: wise or careful in providing for the future
  • retrieval: the chance of recovery or restoration
  • Preamble: introductory statement
  • prevailing: existing at a particular time
  • render: to cause to be or become
  • resolution: a formal expression of opinion or intention made, usually after voting by a formal organization, club or group
  • Hypothecation: to pledge to a creditor as security, w/o delivering over
  • affairs: thing; matter
  • ramification: a branch
  • ramify: to divide or spread
  • margin: is like a gap, the difference between two points

Ch 10:

 

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