Fundamentals Of Credit

Analysis
Reading 59

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 Credit
Spread Risk

Downgrade
Default Risk
Risk

Credit
Risk
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Sources of Information
• Credit rating agencies provide three sources of information:
– Credit Rating – Probability of default and loss to investor if
default occurs
– Rating Watch – The announcement of reviewing particular issue
for potential upgrade/ downgrade in the short term
– Rating Outlook – Long term projections of the issue

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Components of Credit Analysis
1. Character:
- Management integrity and commitment to repay loan
- Management ability to react appropriately to unexpected
events
- Management’s strategic directions, firm philosophy,
conservatism, track record, succession planning
- Corporate governance structure
- Companies with large institutional ownership and outside
directors have lower band yields and higher credit rating
- Only the traditional credit analysis may not be useful to access
lower rated corporate bonds

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Components of Credit Analysis
2. Covenants:
- Terms and conditions of bond issue
- Put restriction on management’s ability to make operating and
financial decisions
- Analysis of covenants is important for high yield issue
Affirmative Negative
Covenants Covenants

Prohibit borrowers from

Debtor to take certain certain action like issue
action like pay interest, additional debt, dividends
principal, taxes and require to maintain
ratios, cash flows

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Components of Credit Analysis
3. Collateral:
- The assets offered as security for debt
- Company borrowing may be secured/unsecured
- Collateral analysis is least useful in credit analysis

4. Capacity to pay:
- Borrower’s ability to generate cash flow or liquidate short term
assets to repay debt obligation
- Firm’s liquidity position is key determinant factor

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Components of Credit Analysis
• Factors used to assess issuer capacity to repay:
– Industry trends
– Regulatory environment
– Operating and competitive position
– Financial position and sources of liquidity, company structure,
event risk
– Working capital requirement
– Dependable cash flow
– Back-up facilities
– Securitization of assets
– Third party agreements

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Credit Analysis with Ratios
1. Profitability ratios:
Assess issuer’s ability to generate earnings sufficient to pay
interest and principal
DuPont framework -

ROE = NI = Net Income x Sales X Assets

Equity Sales Total Assets Equity

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Credit Analysis with Ratios
2. Short term solvency ratio:
- ability to repay short term debt obligations by liquidating short
term assets
- current ratio and acid test ratio used to determine short term
solvency
- industry average is used as benchmark
3. Financial Leverage (Capitalization) Ratio :
- firms ability to take on additional risk associated
with increased borrowing

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Credit Analysis with Ratios
– Long Term debt-to-capitalization ratio:

– Total debt-to-capitalization ratio:

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Credit Analysis with Ratios
4. Coverage ratio:
Ability to repay its debt and lease obligations out of CFO

EBITDA Coverage Ratio:

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 Thank You…

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