[MUSIC] So as we have said, credit analysis,

what does that involved? And as I keep reminding ourselves and

you, I remind the stuff that we're not going to really get into the details
of, how do we analyze a balance sheet? How do we analyze working capital? How do we
analyze the cash flows and
revenue streams of a particular company? How do we analyze all
the financial ratios? What I'm trying to do here is to help
us understand, why we need to do this, why we do to do this. And so what we're
doing is I said,
that's it, we're assessing the probability
of performance. But, if we take one or
two steps back, what we're trying to understand is that can the bar
achieve a sustainable and stable financial performance from period
and period to meet all obligations. If I'm a bank or if I'm an institutional
lender or bond investors, not just I want to make sure that it is
solvent can operate on an ongoing basis smoothly and with high probability of
performance from period to period. I also want to understand to
the extent that from the performance, having done the analysis,
can it generate cash? And so a lot of our financial
analysis ultimately is an assessment. How much cash does the company
have on its balance sheet or how much cash flow can we project and
predict will come into the operations to come into cash reserves to be able to
use the principal and interest purposes. And so ultimately,
when we're talking about performance, and we're talking about making sure
that there's a high probability predictability of principal interest,
famous, ultimately is about cash, cash reserves and cash coming onto
the balance sheet or cash flow. So analysis is going to focus on
operating cash flow and cash reserves. Then, as I had said, I'm forward looking, I
want to make sure that despite, or
no matter what has happened in the past. And yes, the past has really helped you
get
a sense of how well the company is doing. I want to project and
predict how will it continue to perform or is there a continuing high probability
that will be is payouts in the future. And then ultimately having done
the analysis having come up with a rating, I can actually try to project. What is
the probability that
my loan will go into default? So I do all the analysis,
I come up with a rating and then I extra concern to say,
okay, based on that rating, what do we think, what do we think is
the probability of non-performance? Or probability of default? Now, as I said later
on, what we'll do
is we'll talk about, if there is a loss, what can we do, if there is a default, how
can we minimize loss if there's a default? So we reached the point where the
company
cannot make that principal payment when it's due and we actually give him some
time to be able to make that payment. And then at some point,
what are the steps that we take and then how could we sort of
recover parts of the loan? So part of our analysis and
looking at the structures and exposure will include that, okay. The company did go
into default, now let's make sure that we can recover
as much of our loan as possible. I make a loan for 10 million dollars,
I buy the bond for $50 million, it declares it goes into default. We go through
what we call an acceleration
that could lead to bankruptcy, but there's still a possibility and recovery. What
can we recovery? So that's my loss given default,
what is my loss given default? Now, another thing that
credit analysis helps us, because credit analysis allows us to
do a rating allows us to do a rating. We can therefore price alone,
we can price the risk. And so, so, we'll talk about
this later in terms of risk versus rewards debt investors, lenders, credit counter
parties want to be
rewarded for the risk that they take on. And so usually we think of that
in the concept of a spread, a long spread, a bond spread. And so we'll talk about
that because
we want to be rewarded for the risk. Now, normally if it's a bond or if it's
alone is going to be an interest rate, so how do we determine what
the appropriate rate is? How do we determine the appropriate
interest rates which also gives us a reward for the risk that we
are actually going to take. So analysis going to help us determine
at least at least more precisely what we think, what we deserve is the
reward for the risk that we are taking on. And so of course, analysis will
also help us determine that at some point after the loan has been booked. And if
it's a 10 year loan or five
years loan, the money is out the door. Is their credit deterioration? We continue
to do the analysis,
we do updates. And is their deterioration, is there
an increasing probability of default? And then therefore if risks
are increasing, what can we do? So the analysis will tell us
that the risk is increasing, we probably need to do something, hedge,
reduce selloff, transfer the exposure. The analysis will also help us determine
the rating but also help us determine that we might need to structure this loan
that
sets out this short term versus long term. We need to structure this such that it
is advertising in terms of principal payments, not necessarily what we call
a bullet payout or balloon payout. I make a loan for 10 millions,
I want to little portion. I want some portion of that principle to
be paid down every single year as opposed to a ten year loan on
which no principle is paid until the final expiration date and
then I get interest during that period. So the analysis is going to
help us determine the rating, which is going to help us determine
the type of structure that we think is appropriate for
a particular loan. So as we show here,
is that I have a borrower, it has obligations to pay,
obligations to perform. I have lenders and those lenders and
investors and counterparts. There are different types of products,
some of them will outline in this course, I just talked about pricing. We will talk
about what
the appropriate amount of pricing, should we have collateral,
if there is an insolvency, how is the bankruptcy judge
going to arrange for payout? So that if the total debt on
the balance sheet could be 100 million, the company has filed for bankruptcy, there
might be 50 million in
cash on the balance sheet. Well, who gets the cash, who gets parts
of the cash, what gets all of the cash? And that's what we talked about waterfall
and wrinkles and that's very important. Because oftentimes I want to make sure
that I am senior enough such that if there is an insolvency or liquidation or
bankruptcy that I'm at the top of the waterfall and not necessarily
at the bottom of the waterfall. If I agree to be at the bottom of
the waterfall, I want to get rewarded for that in terms of pricing,
in terms of the interest rate. So as we had said,
we analyze the financial condition and that's going to help us make a lot of
decisions about how we do the loan, whether we do the, and then how we
actually structure that particular loan. Now when we do credit analysis,
it's we often present an argument. It's a presentation, its rationale for why
should we do the loan and
risk managers, credit analyst. What shape should do is try
to present a very thorough, comprehensive, well
integrated financial story. So this is where we have a lot of numbers,
right? Company will have earnings, it will have cash flows that will have
blown chief assets and liabilities. It will have equity of
financial statements. I don't have an accounting report,
supplementary information, there's a lot of information and
so we digested information. But ultimately what we're trying to
do is what is the financial story? Is the company getting better,
is it deteriorating? Why is it getting better? Is it controlling costs? Is
expanding in certain
markets when cash comes in? What does it do with the cash? Does it pay down debt?
Does it prepaid that, doesn't reward
stockholders with dividends and buy back and share buybacks? Or does it reinvested?
So what we're trying to do is
that analysis is just not about sharing the numbers, or repeating,
or regurgitating numbers. Analysis is about understanding
what the story is all about. So it's not about numbers go up and down
from period to period from year to year. It's about what is in essence going
on with this particular company. So this particular company, it may not
be growing revenues could be flat, but it's cost could be declining
as a percentage of revenues. And therefore profits are increasing
not because of revenue growth, but because of improvements in cost control. All
right, earnings translate into
cash flow and that cash comes in. What is the company doing with that cash? Is it
taken on? Is it buying back stock? Is it paying dividends or
is it reinvesting? Or is it choosing if it thinks
interest rates are going to increase? Is it choosing to pay down debt? Prepaid that
if it can do so. So, analysis, as I said,
it's not just about numbers, it's also about standing back
to understand the story. What is this story and how that story is going to be
reflected
in a risk rating or a credit rating? So the analysis,
analysis should be convincing, it should be rational,
it should make sense. It should take a look and
take a peek at the past. It should be quantitative, but it also
should be qualitative and forward looking. So let's make sure that as we understand
the role of analysis, we understand that. I want to understand
the integrated financial story as opposed to movement in
numbers from year to year. Movement and numbers. I want to get the essence
of what's going on, now. As I said,
this course is not about how do we do the analysis about what I
want to see an analysis. And how important the analysis
is in helping us manage and also understand credit risk. And so usually in an
analysis,
if it's a company are borrow, what we want to see is that
what industry does it operate? What is the business model? So I have a counter
party that
counterpart, it could be an airline, it could be a high-tech company. It could be a
social media company,
can be a consumer products company, or it could be a bank. I understand the
business model. What is this business environment? How does it make money? How does
it generate operating
cash flow from period to period? What are the risks, what are the threats? What are
going to be the threats
to performance from year to year? Is that argument is is going to have
to tell the reader or the responders or the loan committee what the operating
environment is and what the threats are. Then we get into an understanding
who's running the show. Who is the management, who or what
are the expectations of equity investors? What are their business
strategies are they thinking and contemplating of expanding abroad. Getting into
other markets,
penetrating other markets? How does this company tried to
differentiate itself from some of its peers and competitors? Then, as they had
said,
we get into that financial story. That's the profits and
earnings in the operating cash flow. That's the assets and
liabilities and the working capital. The fixed assets, productivity,
cost control, pro operating profitability, returns on capital and debt to equity,
debt to Ebitda types of metrics. Now that's not covered here, but
it helps us understand how we take that information to sort of form
that integrated story. And then ultimately,
as I present this very logical argument. I can fairly smoothly come
up with conclusions and recommendations and
that all important rating. As I say, that rating is important because
they're going to help us structure. It's going to help us make a decision
about whether we should do a transaction or not. But it's also going to help us in
terms
of how do we price the credit risk? That rating is going to help
us understand what should be, what do we think is the probability of
default and how should we price that risk? Now in the long world, corporate it
could be the risk free
rate plus a credit spread library. That is the traditional form for
corporate loans pricing. Library rate plus a credit spread. Now I say this as sort
of a side library
is eventually going to go away and be replaced by another metric. But we have a
based metric in terms
of interest rate, usually the cost of funding the investment, the cost
of funding that loan plus a spread. So that's my reward. But my reward is going to
be
determined based on my analysis. So that's what that's it. When we do analysis,
we assess the creditworthiness. We want to understand the ability of the
bar to make future contractual payments. The analysis is going to look at all
the different types of activities and the operations and then come up
with these types of conclusions. And we can use that analysis
to come up with a rating and is applicable to all types of credit risk. Not just
what I have been talking about,
loan risk and bond risk but risk that come up from other types
of financial activity as well. Counter party trading cash for banks would also be
financial processing
and cash management activity. Credit risk comes up in those activities
and then I can use my analysis and rating to come up with a posture
of how I will manage that risk. Now when we think of credit risk and
also credit explosion, we say how does, how can a company or
a blade or pay us back? And so what we would do is we try to
identify what is the major source of payback and
then primary source of payback. And then what is the secondary
source of payback? Now, what we want is we want to
make sure there is a sufficient amount of primary source of payback. Traditionally
for companies that
will be operating earnings and operating cash flow. A secondary source of
payback could be a guarantor, a third party or the company has to
sell off certain investments and fix us sense to raise the cash
to be able to pay it back. Now we accept that I have alone. I will accept that as a
form of payment. But I want to see the company being
able to pay down debt to handle all of that credit exposure
from primary sources. A payback. Primary sources of payback. Now in credit
analysis,
we look at a corporate balance sheet. As I have mentioned, we're not
going to go through its in depth. I'm just trying to define what
do we tend to look at as we approach doing the analysis. And so on a corporate
balance
sheet very typically that credit risk is going to be in the form of
short term debt and long term debt. And so as an analyst or risk manager, I want to
know what is the company
doing with the proceeds of that. So what is the purpose are they taking on
short term debt to fund working capital? Are they taking a long term debt to
fund fixed assets, infrastructure, plant, property equipment. But I also want to
know sometimes
companies take on debt and they bar to be able to buy back stock and pay dividends
to expand
in foreign countries. So I want to get a sense of what are they, what are they
actually
using the funds for? And that's part of an analytical process. The different types
of debt later
we're going to summarize that and then how is that debt
going to be serviced? Of course, that's going to be related
to principal interest payments and they're going to be scheduled
over a period of time. And as I just talked about is
that I've got the debt and I've got the loan,
I've got the credit exposure. It now appears on the balance sheet. Now I want to
know what are the sources
of how they're going to come up with that payment. Again, that's hard of the credit
analysis for the analysts can identify what those primary and
secondary sources of payback will be. Also in credit analysis, debt investors
and lenders rely on cash flows and assets to ensure obligations
will be paid as scheduled. We just talked about that. So, a balance sheet. This is
my corporate balance sheets and
that's cash that's going to be used to be able to pay down principle
and interest or any type of obligation. It could be accounts payables to
suppliers, it could be accrued, expenses, could be other forms of liabilities,
could be taxes payable. So cash is going to be of course,
obviously it's going to be the primary way of paying it down, but
it's going to be also operating cash flow. That's over a period of time, more
cash will come onto the balance sheet. It can be used to pay down long term debt,
but sometimes companies will take that cash that's coming in, as I had said,
they're going to actually going to pay down, they're going to buy back equity
stock or they're going to pay dividends or they might reinvest it,
that goes to my financial story. So from quarter to quarter for
a month, a month. From year to year, what is the company actually doing
with that cash that's coming in? Credit analysis, as I said,
when we're looking at, we look at operating cash flow
that's from the performance. We also look at the debt that's
on the balance sheet and then how that operating cash flow
is going to service the debt, that operating cash flow is always
going to be used to pay suppliers and expenses are oftentimes,
the corporate, when the debt comes on, it's going to be refinanced now
as a lender and as an investor, I know that my debt is going to be
service from operating cash flow, interest payments going to come
in from operating cash flow. But I know that oftentimes what happens
is that companies don't pay down debt. They re finance it, they re finance it. And
so operating cash flow would
come in and so dept will come in. It will fund this. But then that new cash
is going to come in and to be able to service that
debt on an ongoing basis. Keep in mind also companies exist
to provide rewards to investors. And so at some point, some of that
operating cash flow is going to be made available to equity investors
in the form of activity or buyback. So when we analyze the company, we're
analyzing the financial, performance, the financial condition
coming up with a rating. But also understand that
the company also has its eye out on the expectations of
equity investors as well. Now when we talk about types
of exposure and debt funding, there's lots of different types of
products that involved credit risk. And this is just sort of a summary the
sources of debt funding, revolving credit, confirm long guidance loans, short term,
long term advertising, that's alone for which principal payments are made
regularly throughout the life of the loan. A balloon payment. That's when the
principle of payments
are not paid until expiration. They syndicated bank loan,
club loan term loan, a working capital, corporate bonds, bridge loans, subordinated
loans convertible on the type
of bond that is that at the discretion or at the option of the investor, they
can convert that into stock or equity. We have bonds with warrants and
private placements. So now we don't have time in this course
to go through each one of those types, but it shows you for all the exposure that
a company can have on its balance sheet. This, this is the lending group,
the financing group for which there is a lot of credit
exposure for large, global companies. They will have a little bit of all of
these products on the balance sheet. Now, even for small companies,
they will have, they will have sort of a,
some of these sources and revolving credit facility, working
capital facility and maybe a term loan. But so
what I'm trying to capture here is that, what are the different types of
products that have credit risk? A lot of these are loan products and
I'm focused on loans later now, other, later on, we'll talk about other
types of financial transactions for which there could be credit exposure. And so
credit analysis. This goes back to credit analysis and
we've talked about this already, or at least summarizes what's
the purpose of that debt? What are the proceeds? What is the reward for the
investor,
the pricing of that debt? What is the company's strategy
in terms of managing that debt? How has the company managed
its obligations in the past? Is the company vulnerable
to deterioration? Is the company vulnerable
to deterioration? Can the company take on
new amounts of debt? Lots of companies are saying
we're going to expand. I need to take on more debt. That's part of the analysis of
the balance
sheet and capital structure as it expands, it needs more assets, more investments.
How is it going to fund it? I need to take on more debt. Credit risk management.
Credit announcer says, can can help us
determine, can it take on more debt? The company has a billion dollars in debt. Can
it take on a billion 5 billion 7? And the analysis and ratings process will help us
determine
is there the capacity to take on debt? So as I said, for
the most part, what we do and when we manage that credit
risk is that is the risk. It is the risk of probability default, but a lot of that
is going to be
the probability of being able to come up with operating cash flow to be
able to serve service that debt. So ultimately, the corporate, if there's
loans, if there's a loan exposure, if there's a bond investment,
short term debt, long term down, it really comes down to what is the probability
that the company will have cash reserves. Or continuing operating
cash flow to meet all these obligations on an ongoing basis,
on an ongoing basis. So we're going to start summarizing here, financial analysis
that benefits and
deficiencies. Financial analysis helps us
come up with that rating. And so we can look at a company's
performance over time. We can look at it at a point in time. I can go back and look
at it, how did
that company perform in other down terms, economic slumps or the previous
recession? I can look at it in terms of
understanding its business models. I can sort of also use analysis
to project the company and also go through worst case scenarios. I can look for
anything that
doesn't look right, volatility and performance uncertainty and
performance, and then also of course, this analysis is going to help
me make my risk decision. The deficiencies, the pros and cons, the con would be is
that we're
looking at past performance. So sometimes analysts get too
bogged down in what happened 5 or 6 years ago, and
we need to be more forward looking. Analysis of old information helps,
but we've gotta make sure that how is the company going to perform in the
periods to come and that's where we use insight, we use insight experience and our
understanding of the operating environment to try to project how the company's
going to perform and periods to come. Another thing is that we've gotta
make sure that we don't overlook qualitative factors. That's the environment,
that's the legal system, the country risk, the business model, the competition,
there are a number of quality management, succession, management competence, and so
there are a number of things are going to
make sure that we don't overlook. And sometimes analysis is sometimes we get
too bogged down in the old numbers and such that we forget to go back and
look at qualitative factors. Credit analysis, as I said in this course, we're not
going to go through the details,
but what it tends to cover, it will cover for a company profitability,
operating cash flow, the assets, working capital,
cash on the balance sheet, liquidity, debt capacity,
debt burden, the capital structure, management, how is the company
capable of going through a crisis? How has it fared in
a crisis in years past? How does it meet its regulatory and compliance obligations
on an ongoing basis? And then what's the overall
financial condition? So traditionally when a risk manager or
credit analysts were financial analyst is involved in analyzing
to come up with a risk creating, it will have analyzed most of the relevant
categories on this particular list and then come up with an overall story and
then an overall analysis.