Credit Analysis

Credit Analysis

Chapter 7

Robinson, Munter, Grant

Grant, Munter & Robinson

Chapter 7 2

Learning Objectives

• Understand debt instruments, accounting disclosures and claim status

• Understand interest rates and risk considerations

• Understand bond ratings

• Perform credit analysis

• Understand off-balance-sheet financing


Chapter 7 3

Nature of Debt Instruments

• Creditors receive interest and principal payments they have been promised

• Creditors do not share in the profits of the firm

• Credit-granting decisions are based on financial statement analysis and commercial credit ratings– Including off-balance-sheet financing


Chapter 7 4

Debt Covenants

• Protect lender/bond investor by restricting certain activities (i.e., dividend payments)

• Intended to provide an early warning system for loans that may be in danger

• May result in higher bond rating and lower interest rate


Chapter 7 5

Bonds

• Indenture is the bond document

• Principal (par or face value) is the amount to be repaid, basis for interest payments

• Issued in $1,000 increments

• 10-, 20-, 30-year maturities

• Coupon or stated rate is the interest rate

• Secured or unsecured (debenture)


Chapter 7 6

Bonds

• Sinking fund – used to pay off the loan

• Puttable or redeemable at the purchaser’s option– Callable – at the issuer’s option

• Convertible – into another security

• Senior vs. junior


Chapter 7 7

Bond Selling price

• Present value of principal and interest payments

• Par, at face value

• Discount– Stated rate < investor’s required rate of return

• Premium– Stated rate > investor’s required rate of return


Chapter 7 8

Interest rates

• Market rate = Risk free rate + Risk premium

• Risk free rate ƒ(inflation rate and investor’s desired “real” return)

• Risk premium – additional return, compensation for uncertainty


Chapter 7 9

Bond investment risks

• Default risk – issuer unable to make payments• Interest rate risk – potential variation in market

rates• Reinvestment rate risk – investor’s ability to

reinvest coupon payments at the same rate• Call risk – possibility that issuer will redeem the

bond• Purchasing power risk – yield < inflation• Currency risk – for foreign bonds


Chapter 7 10

Accounting for Debt Instruments

• Original cost/consideration received• Minus principal payments• Plus discount amortization• Less premium amortization• Example:

– 5-year, $10,000,000 bond– 4% semiannual interest payment– 5% prevailing market rate


Chapter 7 11

Bond example• Issue price = $9,227,827

– Present value of interest, $3,088,694

– Present value of principal, $6,139,133

• Discount = $772,173– Represents additional interest

• Initially report:

Bond par value $10,000,000

Unamortized discount (772,173)

Bond Carrying value $ 9,227,827


Chapter 7 12

Bond example

Payment Expense AmortizationUnamortized

balanceAt issue 772,173 9,227,827

1 400,000 461,391 61,391 710,782 9,289,218 2 400,000 464,461 64,461 646,321 9,353,679 3 400,000 467,684 67,684 578,637 9,421,363 4 400,000 471,068 71,068 507,569 9,492,431 5 400,000 474,622 74,622 432,948 9,567,052 6 400,000 478,353 78,353 354,595 9,645,405 7 400,000 482,270 82,270 272,325 9,727,675 8 400,000 486,384 86,384 185,941 9,814,059 9 400,000 490,703 90,703 95,238 9,904,762

10 400,000 495,238 95,238 0 10,000,000

DiscountCarrying

value

InterestPeriod


Chapter 7 13

Bond example• Market interest drops to 3%• Issue price = $ 10,853,020

– Present value of interest, $3,412,081– Present value of principal, $7,440,939

• Premium = $853,020– Represents a reduction in interest

• Initially report: Bond par value $10,000,000Unamortized premium 853,020Bond Carrying value $10,853,020


Chapter 7 14

Bond example

Payment Expense AmortizationUnamortized

balanceAt issue (853,020) 10,853,020

1 400,000 325,591 (74,409) (778,611) 10,778,611 2 400,000 323,358 (76,642) (701,969) 10,701,969 3 400,000 321,059 (78,941) (623,028) 10,623,028 4 400,000 318,691 (81,309) (541,719) 10,541,719 5 400,000 316,252 (83,748) (457,971) 10,457,971 6 400,000 313,739 (86,261) (371,710) 10,371,710 7 400,000 311,151 (88,849) (282,861) 10,282,861 8 400,000 308,486 (91,514) (191,347) 10,191,347 9 400,000 305,740 (94,260) (97,087) 10,097,087

10 400,000 302,913 (97,087) (0) 10,000,000

DiscountCarrying

value

InterestPeriod


Chapter 7 15

Credit rating

• Rely on qualitative and quantitative analyses• Standard & Poor’s (AAA to D)

– Intermediate “+/-” scores

• Moody’s (Aaa to C)– Intermediate “1,2,3” scores

• Fitch (AAA to D)


Chapter 7 16

Standard & Poor’s rating method

1. EBIT interest coverage

2. EBITDA interest coverage

3. Funds from operations/Total debt %

4. Free operating cash flow/Total debt %

5. Return on capital %

6. Operating income/Sales

7. Long-term debt/Capital

8. Total debt/Capital


Chapter 7 17

Financial distress

• Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans.

• Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets.

• Financial distress can be predicted.


Chapter 7 18

Prediction of financial distressUnivariate models

• Beaver (1966) relied on• Cash flow to total debt

• Net income to total assets

• Total debt to total assets

• Working capital to total assets

• Current ratio

• No-credit (defensive) interval


Chapter 7 19

Prediction of financial distressMultivariate models

• Altman Z-score– (Current assets – current liabilities)/total assets– Retained earnings/Total assets– EBIT/Total assets– Preferred and common stock market value/Book value of

liabilities– Sales/Total assets

• Nokia = 9.88• Motorola = 1.71 (below the 2.99 nonbankrupt

benchmark)


Chapter 7 20

Motorola Liabilities December 31, 2001 2000

LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilitiesNotes payable and current portion of long-term debt 870 6,391 Accounts payable 2,434 3,492 Accrued liabilities 6,394 6,374

Total current liabilities 9,698 16,257

Long-term debt 8,372 4,293 Long-term deferred income taxes - 1,504 Other Liabilities 1,152 1,192 Company-obligated... preferred securities… 485 485


Chapter 7 21

Motorola, Note 3Long-term debt December 31, 2001 2000

Puttable Reset Securities due 2011 (puttable annually beginning 2003)

825 —

Zero coupon notes due 2013 (puttable in 2003 and 2008) 79 776.75% debentures due 2004 498 498Zero coupon notes due 2009 (puttable in 2004) 18 176.5% debentures due 2025 (puttable in 2005) 398 3986.75% debentures due 2006 1,399 —7.6% notes due 2007 300 3006.5% senior notes due 2007 (debt portion of equity security 1,200 —6.5% notes due 2008 200 1995.8% debentures due 2008 323 3237.625% debentures due 2010 1,190 1,1898.0% notes due 2011 598 —7.5% debentures due 2025 398 3986.5% debentures due 2028 440 4408.4% debentures due 2031 3 2005.22% debentures due 2097 227 226Other long-term debt 419 36

8,515 4,301Less: current maturities -143 -8Long-term debt 8,372 4,293


Chapter 7 22

Motorola, Note 3

Short-term debt December 31, 2001 2000Notes to banks 189 139Commercial paper 514 6,244Other short-term debt 24 —

727 6,383Add: Current maturities 143 8Notes payable and current portion of long-term debt 870 6,391

Weighted average interest rates on short-term borrowingsCommercial paper 4.70% 6.40%Other short-term debt 4.00% 5.80%


Chapter 7 23

Motorola, Note 8Off-balance-sheet financing

“At December 31, 2001, future minimum lease obligations, net of minimum sublease rentals, for the next five years and beyond are as follows: 2002—$150 million; 2003—$117 million; 2004—$97 million; 2005—$76 million; 2006—$63 million; beyond—$90 million.”

•The present value of these payments, at 7%, is $484 million•Inclusion of these items increases debt by 5%


Chapter 7 24

Nokia Liabilities

2001 2000196 177

207 173177 6976 69

460 311

831 1,0690 47

3,074 2,8143,477 2,8602,184 1,8049,566 8,594

Nokia Consolidated Balance Sheet, IAS (EURm)December 31,

Minority interestsLong-term liabilitiesLong-term interest-bearing liabilitiesDeferred tax liabilitiesOther long-term liabilities

Current liabilitiesShort-term borrowingsCurrent portion of long-term debtAccounts payableAccrued expensesProvisions


Chapter 7 25

Nokia debt note detailBy lender: (EURm) 31-Dec-01

Repayment date > 5 years

31-Dec-00

Bonds 90 0 138Financial institutions 76 0 62Pension loans 25 15 12Other long-term finance loans 16 0 8Other long-term liabilities 76 76 69

283 91 289By maturity dates:

2002 02003 892004 1032005 02006 0

Thereafter 91283


Chapter 7 26

Nokia debt note detailOperating lease payments

Payments due Amount PV factor PV2002 254 € 0.9346 237 €2003 213 € 0.8734 186 €2004 178 € 0.8163 145 €2005 165 € 0.7629 126 €2006 162 € 0.7130 116 €

Beyond 274 € 0.6663 183 €993 €Total estimated liability


Chapter 7 27

Elements of Free Operating Cash Flow

2001 Nokia (EURm) Motorola ($m)

EBITDA 5,735 (4,039)

Non-cash items 248 (2,273)

Fund from operations 5,983 (6,312)

Capital expenditures (1,041) (1,321)

Working capital change 978 1,527

Free operating cash flow 5,920 (6,106)


Chapter 7 28

Debt Analysis Ratios

2001 2000 2001 2000EBIT interest coverage 37.11 31.91 (10.22) 2.97 EBITDA interest coverage 49.44 37.06 (6.26) 8.68 Funds from operations/Total debt 4.63 5.04 (0.58) 0.29 Free operating cash flow/Total debt 4.59 2.97 (0.56) (0.40) Return on end of year capital 0.31 0.50 (0.27) 0.04 Operating income/Sales 0.160 0.195 0.018 0.116 Long-term debt/Capital 0.085 0.066 0.421 0.238 Total debt/Capital 0.094 0.115 0.443 0.427

Nokia Motorola


Chapter 7 29

Additional considerations

• Mezzanine items– Could be debt or equity

• Off-balance-sheet liabilities– Operating leases– Contingent liabilities– Environmental liabilities


Chapter 7 30

Summary

• Debt, interest, risk and covenants

• Bonds– Discount and premium

• Risk analysis

• Financial statement presentation

• Financial statement analysis

Credit Analysis

Documents

rate of returnchapter

ratesmarket rate

bond par value

bond documentprincipal

ratecall risk possibility

bond exampleissue price

higher bond rating

bond examplechapter