FIRM OR OBLIGOR CREDIT RISK

What is the role of credit analysis?

The extent of the credit analysis is determined by

•the size and nature of the enquiry
•the potential future business with the company
•the availability of security to support loans
•the existing relationship with the customer.
 CREDIT EVENTS

• All events that impact the creditworthiness of the obligor/

borrower/ counterparty are known as credit events.

• Credit events of non financial nature are known as operating

risks

• Credit events of a financial nature are known as financial risks

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 What are credit events?
The following list gives the principal types as usually defined in the
documentation for these instruments.
•Bankruptcy or insolvency under corporate law: in this case the legal
entity is dissolved, having been declared bankrupt or insolvent by a
commercial court.
•Credit upon a merger: assets are transferred (with a negative impact
on the ability to pay) or the legal entity is consolidated into another
company.
•Cross-acceleration: other obligations of the legal entity become due
prior to maturity owing to a breach of contract. (In debt contracts,
covenants –which are legally binding requirements on the borrower –
are breached, which leads to repayment being mandated.)
• Cross-default: obligations of the legal entity have been declared in
default. Under debt contracts, failure of one set of obligations to
perform leads to the automatic declaration of other obligations to be
in default, even if these obligations have not experienced any
breach of contract (covenant).
• Currency convertibility: foreign exchange controls in a particular
country or countries prevent repayments in the affected currency or
currencies. Note that currency convertibility is usually linked with
currency risk. Country risk is the risk associated with lending to a
particular country, whereas default risk is usually company specific.
• Downgrade: the situation where an obligor has a downward, hence
adverse, change made in the independently and publicly available
credit opinion (known as a credit rating) on the obligor. This can
include the cancellation of the available rating. A downgrade may
lead to holders having to sell the obligor’s debt securities.
• Restructuring: the legal entity defers or reschedules
outstanding debt(s): reduces the interest payable, postpones
payments, changes the obligation’s seniority or extends its
maturity.
• Failure to pay: the legal entity is not able to or does not make
the contractual payment.
• Government action: any action(s) by a government or an
agency of government that results in outstanding claims
becoming unenforceable against the legal entity.
• Market disruption: the situation where the tradable securities
of the obligor cease trading.
• Moratorium on debts: the legal entity declares a standstill on
its existing debts and interest payments.
• Obligation acceleration: a contractual obligation becomes
payable before its due maturity owing to default by the legal entity.
This is similar to, but not identical to, cross-default, since it refers
to a direct obligation with an affected party (whereas cross-default
refers to a third party).
• Obligation default: an event of default has occurred in the legal
entity’s obligations.
• Repudiation: the legal entity disaffirms or disclaims its debts.
FIRM CREDIT RISK EVALUATION-OBLIGOR RISK

Firm or obligor credit risk

Financial risk Business or

Operating (non
financial )risk

External Industry Internal

risks risks (company
level) risks
 RISK MATRIX

RELATION BETWEEN OR AND FR

FR LOW MEDIUM HIGH

OR

LOW VL CR LOW-MED CR MED-H CR

MEDIUM LOW CR MED CR HIGH CR

HIGH MED-H CR HIGH CR VH CR

 Different Risk Levels
• Low operating/ low financial risk: Stable market conditions,
good management: dominant market position.
• Low operating risk/ Medium financial risk: sustainable
competitive advantages, quality of the management, strong
brands
• Low operating risk/ high financial risk: unstable financial
performance, liquidity crisis, high finance costs,, poor
collections, high cost of capital
• Medium operating risk/ low financial risk: severity of
competition, strong bargaining power of suppliers/buyers,
cyclical business, fluctuations in the operating environment. Low
debt usage, strong debt servicing and access to capital markets.

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• Medium operating risk/ medium financial risk: firm not
perceived as market leader, moderate debt usage, average debt
servicing capability and asset quality. Profitability, solvency and
liquidity positions are satisfactory.
• Medium operating risk/ high financial risk: balance sheet is
overloaded with significant external deb, negligible support from
external owners/ shareholders. High leverage, liquidity problems,
high cost of capital, high interest burden, unproductive and high
overheads.
• High operating risk/ low financial risk: cyclical business facing
recession induced by low demand, projecting losses in the
foreseeable future.
• High operating risk/ medium financial risk: weak management,
financial position and financial management are not comforting,
credit asset is inadequately protected by the net worth of the
borrower/
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• High operating risk/ high financial risk: decline in
creditworthiness of the borrower/ obligor is a gradual process,
write off.

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1. EXTERNAL RISKS
 EXTERNAL RISKS
• Business Cycle:

Recession: rising unemployment, slowing sales and profits;

Recessionary phase is defined with rising NPAs

Trough: highest unemployment, bankruptcies, credit losses,

bottoming of stock markets

Recovery: improvement in parameters, additional investments

Peak: over confident investments-over capacity.

Study of business cycles is a highly potent tool for a sound CRA

Non-cyclical businesses are able to tide over

 ECONOMIC CONDITIONS
Y=C+I+G+(X-M)
Y=Gross National Income
C=Consumption: taxation policy, future expectations, income
levels
I=Investment: FDI, FII, Multilateral agencies
G=Government Spending: infra, defense, social welfare, fiscal
spending
X=Exports
M=Imports

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 BENEFITS OF STUDYING NI

• Revenue and Profits: increase in consumption will increase

demand in consumer goods

• Identification of Business Categories/ Sectors: more credit risk

exposures may be taken for sectors that display better prospects

• Business Confidence: Additional investments stimulate

additional variables such as additional employment, demand for
finance, creation of new assets.

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• Credit Risk Analysis should attempt to identify the contribution of the
particular business segment to the overall economy.
• Understand the stability of various economic activities.
• Inflation and Deflation: high inflation-high interest rates-impact
foreign exchange rates-adverse credit risk migration-render domestic
goods uncompetitive-may also lower exports
– High interest rates-squeeze profits for leveraged firms.
– Deflation-drop in price levels-losses for businesses-shutdown-
unemployment-depress demand in the economy
• Balance of payments and Exchange Rates: volatility in currency;
devaluation and appreciation of currency
• Political Developments: political uncertainties dampen investment
• Fiscal Policy: lowering import tariffs; increase in income tax; level of
internal and external debt and forex holdings; debt/GDP
• Monetary Policy: achieve stability in price levels, forex rates
• Demographic factors: population structure and composition

• Regulatory framework: Companies Act, excise duty, customs,

sales tax

• Technology: vital source of operating risk

• Environmental issues: complying with norms

• International developments
 MONITORING EXTERNAL RISKS

• Geo-Political Situation
• Crude Oil Price
• Inflation
• Significant Stock Correction
• Significant Real Estate Correction
• Level of foreign currency reserves
• Government Debt/GDP

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2. INDUSTRY RISKS
 Types of Industry Risks

•Risks Emanating from External Environment: changes in

consumer preferences, government lowering import tariffs.

•Industry specific risks: Porter Model

•Risks Emanating from Industry Drivers: drivers of construction

industry would be demand for residential housing, commercial and

industrial buildings, infrastructure (roads, bridges, flyovers)

 INDUSTRY LIFE CYCLE
• Pioneering stage: uncertain future with modest sales growth

• Rapid Growth Stage: increasing demand, accelerated sales

and profits

• Maturity Growth: demand slackens, new entrants, sales

growth above that of economy but no acceleration

• Stabilization: longest phase, sales move in tandem with

economy

• Decline: decline in sales, better and new substitutes, changes

in consumer tastes and new technologies.
 INDUSTRY AND BUSINESS CYCLE

• Cyclical Industry: industry moves in tandem with business

cycles

• Non Cyclical: industries are not impacted by cycles

• Counter-Cyclical: demand goes up when other industries are

declining
 INDUSTRY PROFITABILITY-PORTER 5 FORCES

• Bargaining Power of Buyers

• Bargaining Power of Suppliers

• Threat of Substitute Products

• Threat of New Entrants

• Competition Among Existing Firms

3. INTERNAL /ENTITY RISKS
1. Nature of Business

Resources acquired form the environment: factors of

production, logistics

Processes: R&D, technology

Marketing and Distribution

After sales operations

2. Risk Context and Management
Goals and Objectives
Business Strategies
3. Internal Risk Identification Steps

Interviews and Questioning

Audited financial results: last 5 years
Latest Management accounts
MOA and AOA
Industry background, industry competition factors,
customer’s position in the industry
Order Book
Corporate Governance
Succession plan
4. SWOT Analysis
5. Business Strategy Analysis
– Cost Leadership:
– Differentiation:
– Contraction
– Market Penetration
– New Markets
– New Products/ Product Synergy Diversification
– Consolidation
– Merger/ Takeover
– Expansion
– Cost Control
– Focus
6. Pitfalls in Strategy
7. Management Analysis
– One Man Rule
– Joint Chairman/CEO
– Imbalance in Top Management Team
– Weak Finance Function
– Lack of Skilled Managers
– Disharmony in Management
– Change in Ownership
– Cultural Rigidity
– Lack of Internal Controls
– Low Staff Morale
– Fraudulent Management
– Myopic View
 – Big Projects
– Inadequate Response to Change
– Poor Corporate Governance
• Other Internal Risks
– Financial Risks
– Production Risks
– Corporate Risks
– Human Resource Risks
– Product Risks
– Customer/ Supplier Concentration Risks
– Limited Geographic Area
– Key-Man Risk
– Legal Risk
– Sibling Rivalry
– Image/Reputation Risks
4. FINANCIAL RISKS
 QUALITY OF FINANCIAL STATEMENTS

• Audited Financial Statements Cover a Fixed Period of Time

• Management’s Responsibility for the Financial Statements

• Auditors Responsibility
 QUANTITY OF FINANCIAL STATEMENTS

• Captures business performance through different economic

cycles

• Insight into management policies

 Types of financial statements

• The company’s annual report

• Other types of financial statements
Interim statements
Estimated (unaudited) statements:
Consolidated financial statements:
Pro-forma financial statements:
Notes to the financial statements
Auditors’ remarks
 FINANCIAL ANALYSIS
• Balance Sheet
– Adjusting Inventory Valuation
– Reassessing the value of Balance Sheet variables
– Converting Off-Balance Sheet items in to On-Sheet Items
– Dividend Payable
– Intangibles
– Unsubordinated Shareholders Loans
– Dues from/ to related parties
– Alternative Accounting Policy
• Income Statement
• Cash Flow Statement
 Various Financial Analysis Tools

Accounting
analysis

Financial
Ratio Common
Statements
Analysis size
Analysis

Indexed
Trend
Analysis
 Analyzing the spreadsheets

• What element constitutes the greatest risk to the company?

How does the company know this?
• Is the company selling sufficient volume? Is the stock too
high, debtors too low?
• Is total debt too high (both in terms of gearing/leverage as
well as in terms of cash-flow servicing interest payments)?
• Is the company progressing or regressing in its areas of
activity?
• Are changes in various figures adequately explained in the
annual report? What are their causes?
• What kind of job did the auditors do?
 Qualitative Evaluation
• Integrity
• Honesty
• Resourcefulness
• Reliability
• Management competency
• Managerial and staff expertise
• Experience of managers holding top positions
• Performance of related enterprises or sister concerns
• Qualitative evaluation of securities provided as guarantor
• Due diligence report on credit proposal
• Governance reports
 SOLVENCY RATIOS
• Liquidity
– Current Ratio
– Quick Ratio
– Cash Ratio
– Defensive Interval Ratio: CA/Daily Operating Expenses
• Solvency
– Debt/Equity
– Equity Funding of Assets
– EBITDA Leverage Ratio: Net Debt/EBITDA
– Interest bearing Debt Funding of Assets
– Debt Service Coverage Ratio
• External Finance Ratios
– Interest Cover Ratio
– Finance costs to Sales Ratio
– Payout Ratio
– Retention Ratio
– Sustainable Growth Ratio: ROE* Retention ratio
• Cash Flow Ratios
– Short-term Debt Cash Cover: NCFO-interest-tax/STL
– External Debt Repayment Period: Total Interest bearing
debt/Annual free cash flow
– Dividend Cash Cover: CFO-interest-tax/ Dividends paid
+Dividends declared
– Interest cash cover: NCFO/ interest
• Performance Ratios
– Sales Growth/ Decline
– Sales to Operating Capital Employed (SOCE)
– Fixed Asset Utilisation Ratio: Sales/FA
• Profitability Ratios
 Gross Profit ratio
 Operating Profit margin
 Other Income to PBIT
 Net profit Margin
 Return on Assets
 Return on Capital Employed: OPM* SOCE
 Return on equity
• Activity Ratios
– Stock Holding Period
– Debtor Collection Period
– Trade Creditors Payment Period
– Working Capital to Total Assets Ratio
– Working Capital to Sales Ratio
– Fixed Assets to Total Assets Ratio
• Operating Leverage
• Financial Leverage
• Total Leverage
• CVP Ratios
– Break-even Point
• Du Pont Model
 IDENTIFYING SIGNIFICANT CREDIT RISKS

• Probability (likelihood of Occurrence): low/ Moderate/ High

• Consequences if it Occurred: Weak/ Moderate/ Strong

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 MITIGANTS OF CREDIT RISK-QUALITATIVE
• Strengths
Deep pockets/ Substantial resources
Market Leadership
Natural Advantages
• Strategies
Developing core competencies
Identifying Alternative sources
Comparative and Sustainable Advantages
Other Factors

04/11/11
MITIGATION OF CREDIT RISKS-QUANTITATIVE

• Risk-Based Pricing

• Credit insurance and credit derivatives

• Covenants

• Diversification
 MONITORING CREDIT RISKS
• Follow religiously KYC principle
• A good understanding
• Timely receipt and analysis of financial information
• History often repeats itself
• Early warning signals
• Wealthy business families
• Growth plans
• Understand the liquidity of the obligor
• Check with lenders
• Conduct a suitable sensitivity analysis
 Profitability, Growth, Risk

Product-Market Strategies Financial-Market Strategies

Investment and
Operating Asset Financing Dividend
Decisions Management Decisions Decisions
Decisions

Managing Managing Managing

Managing
Revenue & Working Capital Liabilities and
Dividend Payout
Expenses & Fixed Assets Equity

Profit Margin Efficiency Capital

Payout Ratios
Ratios Ratios Structure Ratios
• Most financial statement-based risk analysis focuses on a
comparison of 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 debt repayment needs
• The field of finance identifies two types of risks:
(1) credit risk, a firm’s ability to make payments on interest
and principle payments, and
(2) bankruptcy risk, the likelihood that a firm will be
liquidated
Framework for Financial Statement Analysis of Risk

Ability to Need to Use Financial Statement

Activity
Generate Cash Cash Analysis Performed

Profitability of
Working Capital Short-Term Liquidity
Operations Goods and
Requirements Risk
Services Sold

Sales of Existing
Plant Capacity
Investing Plant Assets or
Requirements
Investments
Long-Term Solvency
Risk
Borrowing Debt Service
Financing
Capacity Requirements
 Analysis of Short-Term Liquidity Risk
• The analysis of short-term liquidity risk requires an
understanding of the operating cycle of a firm!
• Current Ratio: mainly used to give an idea about the company’s
ability to pay back its short-term liabilities and a sense of the
efficiency of the firm’s operating cycle and its ability to turn its
products into cash (ratio ≥ 1.0 preferred)
• Quick Ratio: known as acid test, measures the firm’s ability to
pay off its short-term debt from current liquid assets; draws a
more realistic picture (trend towards 0.5)
• Operating Cash Flow Ratio: using cash flow as opposed to
accounting items provides a better indication of liquidity
(40%ntypical of a healthy firm)
• Short-term liquidity problems also arise from longer-term
solvency difficulties!
Financial Ratio Formula Measurements

A measure of short-term
liquidity. Indicates the
Current Ratio Current Assets / Current liabilities ability of entity to meet its
short-term debts from its
current assets

A more rigorous measure of

short-term liquidity.
Current Assets less inventory / Current Indicates the ability of the
Quick Ratio
liabilities entity to meet
unexpected demands
from liquid current asses
Measures a company's ability
to pay its short term
liabilities. Indicates
Operating Cash Flow Cash Flows from Operations/Average whether the company
Ratio Current Liabilities has generated enough
cash over the year to pay
off short term liabilities as
at the year end
 Analysis of Long-Term Solvency Risk
• Increasing the proportion of debt in the financial structure
intensifies the risk that the firm cannot pay interest and repay the
principle on the amount borrowed
• Analysis of long-term solvency risk must begin with an analysis of
short-term liquidity risk
• Firms must survive in the short-term if they are to survive in the
long-term!
• Interest Coverage Ratio: gives a sense of how far earnings can fall
before a firm will start defaulting on its payments (risky if ≤ 2.0)
• Long-Term Debt to Long-Term Capital Ratio: way of looking at the
debt structure and determine what portion of total capitalization is
comprised of long-term debt (what if ≥ 1?)
Financial Ratio Formula
Debt ratio Total Liabilities / Total assets
Total assets / Total shareholders’
Capitalization ratio
equity
Total Debt/(Total Shareholders’
Debt to Capital Ratio
Equity + Total Debt)
Operating profit before income tax +
Times interest earned Interest expense / Interest
expense + Interest capitalized
Measurements
Measures percentage of assets
provided by creditors and
extent of using gearing
Measures percentage of assets
provided by shareholders and
the extent of using gearing
The debt-to-capital ratio gives
users an idea of a company's
financial structure, or how it is
financing its operations, along
with some insight into its
financial strength.
Measures the ability of the entity
to meet its interest payments
out of current profits.
 Profitability Analysis
The analysis of profitability addresses two broad questions:
• How much risk economic and strategic factors pose for the
operations of a firm, its profitability and long-term solvency ?
We use the Rate of Return on Assets (ROA) to answer this
question.
• Can the firm generate the expected return on the capital
invested by the lenders and shareholders without
compromising the future of the firm? That is, how much of
ROA is left to shareholders (owners) after subtracting the
amounts owed to lenders.
 Rate of Return on Assets

Net Income  Interest Expense* (1  Tax Rate)  Minority Interest in Earnings

ROA 
Average Total Assets

ROA  Pr ofit M arg in for ROA  Assets Turnover

Pr ofit M arg in for ROA 

Net Income  Interest Expense * (1  Tax Rate)  Minority Interest in Earnings

Sales

Sales
Asset Turnover 
Average Total Assets
 Profitability Ratios
Financial Ratio Formula Measurements

Measures rate of
Operating profit before
return earned through
Return on Total income tax + interest
operating total assets
Assets expense/ Average total
provided by both
assets
creditors and owners
Operating profit &
Return on extraordinary items after Measures rate of
ordinary income tax minus return earned on
shareholders’ Preference dividends /  assets provided by
equity Average ordinary owners
shareholders’ equity
Gross Profit Profitability of
Gross Profit / Net Sales
Margin trading and mark-up
Operating profit after Measures net
Profit Margin income tax / Net Sales profitability of each
Revenue dollar of sales
 Total Assets Turnover
Financial Ratio Formula Measurements

Measures the effectiveness

of collections; used to
Net sales revenue / Average receivables
Receivables turnover evaluate whether
balance
receivables balance is
excessive

Indicates the liquidity of

inventory. Measures the
Cost of goods sold / Average inventory number of times
Inventory turnover
balance inventory was sold on
the average during the
period

Measures the effectiveness

Total Asset turnover
Net sales revenue / Average total assets of an entity in using its
ratio
assets during the period.

Measure the efficiency of

Turnover of Fixed
Net Sales / Fixed Assets the usage of fixed assets
Assets
in generating sales
Return on Common Shareholders’ Equity (ROCE)

Return on Return to Return to

Return to
Assets Preferred Common
Creditors
Shareholders Shareholders

ROCE  Pr ofit M arg in for ROCE  Assets Turnover  Financial Leverage

Net Income to Common Shareholders

ROCE 
Average Common Shareholders' Equity

Net Income to Common Shareholders

Pr ofit M arg in for ROCE 
Sales
Sales
Assets Turnover 
Average Total Assets

Average Total Assets

Financial Laverage 
Average Common Shareholde rs' Equity
 Analytic Templates for Credit Assessment

CAMPARI
•C character (of firm and its managers)
•A ability (of managers/directors)
•M means (of repayment based on financial resources of credit)
•P purpose (of credit)
•A amount (in absolute and relative terms)
•R repayment (how, when, likelihood)
•I insurance (what will ensure repayment – if anything)
ICE

•I interest (paid on borrowing)

•C commissions (paid to the lender)

•E extras (cost of granting credit)