Credit Analysis, Bond Ratings, Distress Forecast and Financial Information

Credit Analysis

The process of evaluating an applicant's loan request or a corporation's debt issue in order to determine the likelihood that the borrower will live up to his/her obligations.

Credit Analysis

Evaluate a borrowers ability and willingness to repay Questions to address

What risks are inherent in the operations of the business? What have managers done or failed to do in mitigating those risks? How can a lender structure and control its own risks in supplying funds?
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Existing Loan Decisions

Loan

Approvals Loan Monitoring Loan Terminations

Loan Application

Customer relation

Financial performance

Strategic

factor

Management quality

Risk

Economic condition

Approval

Amount

Interest rate

Collateral Yes

Covenant

Others Insurance

Monitoring

Repayment timing

Market value of collateral

Covenant

Current

Especially Mentioned

Substandard

Doubtful

Loss
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The categories: classification of existing loans into

A. Current: normal acceptable banking risk. B. Especially mentioned: evidence of weakness in the borrowers financial condition or an unrealistic repayment schedule. C. Substandard: severely adverse trends or developments of a financial, managerial, economic, or political nature that require prompt corrective actions. D. Doubtful: full repayment of the loan appears to be questionable. Some eventual loss seems likely. Interest is not accrued. E. Loss: loan is regarded as uncollectible.
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Five Cs of Good Credit

Character Capital Capacity Conditions Collateral

Five Cs of Bad Credit

Complacency Carelessness Communication Contingencies Competition

Credit Scoring

What is credit scoring?

A statistical means of providing a quantifiable risk factor for a given customer or applicant. Credit scoring is a process whereby information provided is converted into numbers that are added together to arrive at a score. (Scorecard) The objective is to forecast future performance from past behaviour.
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A Simple Linear Model to Replicate the Judgment Used in Classifying the Loan Risk
(Dietrich and Kaplan ,1982)

Yi = -3.90 + 6.42 DEi - 1.12 FCCi + 0.664 Sdi where

DEi = Total debt/total assets FCCi = funds from operation/(interest + minimum rental commitment + average debt maturing within three years) SDi = number of consecutive years of sales decline

The higher the Yi score, the higher the estimated risk of the loan.
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The hindsight for a simple scoring method

The loan officers may consider more than three variables. The loan officers may consider non-linear or nonadditive functional form. The loan officers may consider non financial information.

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Loss functions for the misclassifications

Uniform loss function. Loss functions supplied by the bank.

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The loss function for model prediction errors

C1: (Resulted from type I error) the cost of predicting a loan applicant will not repay when it subsequently repay. It will be contribution margin on the loan that was foregone, assuming that applicants predicted not to repay are refused loans. C2: (Resulted from type II error) the cost of predicting that a loan applicant will repay when it subsequently does not repay. It will be the loss associated with the interest and principal the bank can not receive when due. Note: Using estimates of C2 based on loan loss recovery statistics estimated in the 1971-1975 period, researchers have reported that a C2 error was 35 times more costly than was a C1 error.
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Scoring methods and sample sizes

There is a trade off between having a large enough set of observations to efficiently estimate a scoring method and having a set of firms that are homogeneous with respect to attributes relevant to their loan decision. Solutions: 1.Build a separated scoring system for each industry. But this always resulted in a small sample, especially very few observations for problem loan categories. 2. To control for the hypothesis source of heterogeneity across observations, such as the use of industry relative ratios as a means controlling for differences across industries in their average financial ratios.
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Credit Analysis and Financial Ratios

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Credit Analysis
Short Term Days Sales in AR Days Sales in Inventory Days Purchases in AP Cash Conversion Ratio Current Ratio Quick Ratio Op. Cash Flow to Current Liabilities

Long
Term

Common Size (To total assets) Cash AR Inventory Total Current Assets Intangibles Current Liabilities Total Liabilities Equity

LT Debt/Equity Total Liab/Equity PPE/Total Assets Interest Coverage Op. Cash Flow/Tot Liab Op. Cash Flow/PPE Exp

Relationships % Chg in AR to % Chg in Sales %Chg in Invt to % Chg in Sale

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The importance of financial ratios used in credit decision: ---Survey conducted on loan officers
1. 2.

3.
4. 5. 6.

7.
8. 9. 10.

Debt/Equity Current ratio Cash flow/Current maturities of long-term debt Fixed charge coverage Net profit margin after taxes Times interest earned Net profit margin before taxes Degree of Financial leverage Inventory turnover in days Accounts receivable turnover in days

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The importance according to the frequency adopted in loan agreements

1. 2.

3.
4. 5. 6.

7.
8. 9. 10.

Debt/Equity Current ratio Dividend payout ratio Cash flow/Current maturities of long-term debt Fixed charge coverage Times interest earned Degree of Financial leverage Equity/Asset Cash flow/Total debt Quick ratio

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What are bond ratings?

Bond ratings are opinions of relative creditworthiness, derived through fundamental credit analysis and expressed through a symbol system. Creditworthiness: tendency to pay obligations on time.

Default probability and severity of loss given default

Not statement of default timing Not Buy and sell recommendations

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The role of ratings:

Improve the information flow between borrowers and lenders.

Information asymmetry Improve transparency Owners vs managers of firms Fund sponsors vs fund manager

Minimize monitoring and principal/agent costs

Public goods
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Bond ratings and debt covenants

Categories of Covenants Aaa Affirmative Covenants 1. Furnish annual audit financial statements 2. Furnish quarterly interim financial statements 3. Maintaining accounting systems according to GAAP 4. Permit banks to have access to books/records 5. Maintaining insurance Negative Covenants 1. Minimum working capital 2. Minimum current ratio 3. Minimum tangible net worth 4. Limit on indebtedness 5. Limit on mergers and consolidations 6. Limits on dividends 7. Limit on sale of stock and/or debt of subsidiaries 8. Limit on sale of all or substantial part of assets 50% ----Aa 66% 33 ---Moodys Rating A 100% 100 17 25 50 Baa 100% 100 9 18 82 Ba 100% 80 40 -100 B 100% 50 50 50 100

----50 -50

67
---33 ---

83
33 17 33 67 50 33

91
27 27 73 82 91 64

60
60 40 100 100 60 60

75
100 75 100 100
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100 75

Bond ratingsStandard and Poors

AAA highest gradeultimate degree of protection of principle and interest AA high gradediffer from AAA in small degrees A upper medium grade Have considerable investment strength but are not entirely free from adverse effects of changes in economic and trade conditions. Interest and principal are regarded as safe. They to some extent reflect changes in economic conditions BBB or medium grade category is borderline between definitely sound obligations and those where the speculative element begins to dominate. These have adequate asset coverage and normally are protected by satisfactory earnings. They are susceptible to fluctuations due to economic conditions. This is the lowest rating that qualifies for commercial bank investment. There is a lower range of ratings ranging from BB which are lower medium grade all the way to the D category representing bonds in default.
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ITEMS AFFECTING THE RATINGS OF CORPORATE BONDS

Items considered: Asset protectionmeasures the degree to which a companys debt is covered by the value of its assets.
Tangible assets/LTD

AAA5 to 1 AA4 to 1 A3 to 3.5 to 1 BBB2.5to 1 AAAless than 25% AA less than 30% A less than 35% BBB less than 40%

LTD/(LTD + Equity)

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ITEMS AFFECTING THE RATINGS OF CORPORATE BONDS

Fixed-charges-coverage ratio

AAA rating cover interest and rental charges after tax by 5 to 7 times industrial firm AA4 times A3 times BBB2 times

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ITEMS AFFECTING THE RATINGS OF CORPORATE BONDS

Cash flowcrudelynet income plus depreciationto total funded debtnotes payable and lease obligations

65% for AAA 45-65 for AA 35-45 for A 25-30 for BBB

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ITEMS AFFECTING THE RATINGS OF CORPORATE BONDS

Management abilities, philosophy, depth and experience

Depth and breadth of management Goals, planning process, strategies for R&D, product promotion, new product planning and acquisitions

Specific provisions of debt security Conditions for issuance of future debt issues, specific security provisions-mortgaging, sinking fund, redemption, covenants

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Distress Forecast and Financial Information

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Distress analysis and financial information

Definition: financial distress means that a firm has severe liquidity problems that can not be solved without a sizable rescaling of the equitys operations or structure. Definition of Insolvency
Total liabilities of a company exceeds its assets at a fair valuation The firms inability to pay its creditors as obligations come due (technical insolvency) Some states prohibit the payment of cash dividends if the company is insolvent

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Financial Crisis, Some Warning Signals

1. 2.

3.
4. 5. 6.

7.
8. 9. 10.

Heavy borrower of working capital Gross margins narrowing Business environment subject to rapid change If volume drops, can production cover expenses Outdated marketing data Organization highly structured/decision time Equipment age/economic downturn Intensity of industry competition Increasing borrowing without an increase in sales Increasing inventory and receivables without an increase in sales

30

Distress analysis and financial information

Indicators of financial distress:

Cash flow analysis. Corporate strategy analysis. Financial statements of the firm and a set of firms in comparison. External variables such as security returns and bond ratings.

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Univariate model of distress prediction:

involves the use a single variable in prediction model.

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1. Dichotomous

classification tests:

Case study of U.S. Railroad Bankruptcies: Use the ranking of certain variable(s) to predict the bankruptcy of railroad companies. For example, Transportation expenses to operating revenues (TE/OR), and Times interest earned (TIE)

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Ranking according to (TE/OR) (cutoff = 0.4305)

Railway Companies Healthy firms (1970)

1.

(TE/OR) .524 .348 .274

(TIE) -1.37 2.16 2.91

Ann Arbor Railroad

2.Central of Georgia Railway 3.Cincinnati, New Orleans, and Texas Pacific

4.Florida East Coast Railway

5. Illinois Central Railway 6.Norfolk and Western Railway 7.Southern Pacific Transportation Co. 8.Southern Railway Company Distressed firms (1970) 1.Boston and Maine Corporation 2.Penn-Central Transportation Co.

.237
.388 .359 .400 .314

2.82
3.10 2.81 3.56 3.93

.461 .485

-0.68
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0.16

1. Dichotomous classification tests:

Railway Companies Ann Arbor Railroad Penn-Central Transportation Co. Boston and Maine Corporation Southern Pacific Transportation Co. Illinois Central Railway (TE/OR) .524 .485 .461 .400 .388 Bankrupted or not NB B B NB NB

Norfolk and Western Railway

Central of Georgia Railway Southern Railway Company Cincinnati, New Orleans, and Texas Pacific Florida East Coast Railway

.359
.348 .314 .274 .237

NB
NB NB NB NB
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1. Dichotomous classification tests:

Type I error and Type II error: A type I prediction error occurs when a nonbankrupt (NB) firm is predicted to be bankrupt (B) firm. A type II prediction error occurs when a bankrupt (B) firm is predicted to be non-bankrupt firm. Be noted that the loss function for type II error is greatly higher than that of type I error; research has shown that to be 35 times.
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Cutoff TE/OR>0.5045 TE/OR>0.4730 TE/OR>0.4305 TE/OR>0.3940 TE/OR>0.3735

Type I Error 1 1 1 2 3

Type II Error 2 1 0 0 0

Total Error 3 2 1 2 3
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1.Dichotomous classification tests:

Ranking according to (TIE) (TIE) 3.93 3.56 Bankrupted or not NB NB

Railway firms Southern Railway Company Southern Pacific Transportation Co.

Illinois Central Railway

Cincinnati, New Orleans, and Texas Pacific Florida East Coast Railway

3.10
2.91 2.82

NB
NB NB

Norfolk and Western Railway

Central of Georgia Railway Penn-Central Transportation Co. Boston and Maine Corporation Ann Arbor Railroad

2.81
2.16 0.16 -0.68 -1.37

NB
NB B B
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NB

2. Profile Analysis
Comparisons of the mean ratios of distress and non-distress firms have been common in bankruptcy prediction. For each failed firm, a non-fail firm of the same industry and the same asset size was selected. The equally-weighted means of 30 financial ratios were computed for each of the failed and nonfailed groups in each of the five years before failure. It examines if there are observable differences in the mean ratios of the two sets of firms.

39

2.Profile Analysis(1)
Cash flow Total debt
0.45 0.17

0.45

-0.12 -5 -4 - 3 -2 - 1
40

2.Profile Analysis(2)
Net Income Total Assets

0.08 0.05

0.08

-5 -4 - 3

-2 - 1

-0.20
41

2.Profile Analysis(3)
Total Debts Total Assets

0.85

0.51 0.38 0.37 -5 -4 - 3 -2 - 1

42

2.Profile Analysis(4)
WorkingCapital Total Assets

0.42

0.43

0.30

0.05

-5 -4 - 3

-2 - 1
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2.Profile Analysis(5)
Current ratio

3.5 3.2

2.5

2.1

-5 -4 - 3

-2 - 1
44

Overview of the uni-variate results

There are four categories of variables showing the most consistent difference between bankrupt and non-bankrupt firms were:

Rate of return Financial leverage Fixed payment coverage Stock return and volatility
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Multivariate models of distress prediction

We can use econometric tools by applying more than one financial variables that can effectively discriminate healthy firms from distressed firms. Those tools include Discriminant Analysis, qualitative dependent variable regressions (e.g. Linear probability models, probit regression, and logit regression), and non-linear forecasting tools, such as Neural Network techniques. The dependent variable of these models is either a prediction as to group membership (bankrupt of non-bankrupt), or a probability estimate of group membership (for example, the probability toward bankruptcy).
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(1) Discriminant Analysis:

Municipality Assessed Property General Moodys Valuation per Obligation Bond Capita Bonded Debt Rating per Capita $6,685 $6,360 $116 $87 Aa Aa

1.Arlington, Mass. 2.Highland Park, Ill.

3.Springdale, Ohio
4.El Cerrito, Calif. 5.La Grange, Ga. 6.Pampa, Tex. 7.Coon Rapids, Minn. 8.Hot Springs, Ark. 9.Mauldin, S.C.

$11,806
$2,957 $3,183 $2,408 $2,703 $1,212 $1,051

$272
$53 $47 $188 $613 $43 $366

Aa
A A A Baa Baa Baa

10.Pascagoula, Miss.

$2,684

$149

Baa
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(1) Discriminant Analysis:

1.
2.

3.

Two dependent variables (Zi). Every sample firm is featured two descriptive variables (XI,YI). These two descriptive variables have different normally distributed means and same variancecovariance matrix within each group.
So there is a discriminant function Zi aXi bYi that can effectively distinguish both groups: ZI= Moodys Rank equal to or better than A; or Moodys Rank equal to or lower than Baa. XI= Assessed Property Valuation per Capita YI= General Obligation Bonded Debt per Capita
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(1) Discriminant Analysis:

Step 1: To estimate the coefficients for the discriminant function, which is able to maximize the between group SSE of ZI and minimize the within group SSE of ZI

y 2 d x xy d y x y xy xy
2 2

=0.000329

x 2 d y xy d x x 2 y 2 xy xy

=-0.004887

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Municipality
1.Springdale, Ohio 2.Highland Park, Ill. 3.Arlington, Mass. 4.La Grange, Ga.

Predicted Z-score
2.555 1.667 1.632 .817

Moodys Bond Rating

Aa Aa Aa A

5.El Cerrito, Calif.

6.Hot Springs, Ark. 7.Pascagoula, Miss. 8.Pampa, Tex. 9.Mauldin, S.C. 10.Coon Rapids, Minn.

.713
.188 .154 -.126 -1.441 -2.106

A
Baa* Baa* A* Baa Baa
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(1) Discriminant Analysis:

Step 2:to determine a cut off point which serves as the critical value that separate distressed firms with healthy firms.

Cut-off point
Rank

Misclassification number

Rank >=A when ZI>1.2245 Rank >=A when ZI>.7650 Rank >=A when ZI>.4505 Rank >=A when ZI>.1710 Rank >=A when ZI>.0140 Rank >=A when ZI>-.7835 Rank >=A when ZI>-1.7735

3 2 1 2 3

2
3
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(1) Discriminant Analysis:

Step 3: Test out-of sample forecast validity by using another sample to test the previously set cutoff point.
Assessed Property Valuation per Capita General Obligation Bonded Debt per Capita Predicted Z-score Moodys Bond Rating

Municipality

1.Palo Alto, Calif. 2.Homewood, Ill. 3.Portland, Maine 4.East Lansing, MI. 5.Dodge City, Kan.

$6,124 4,134 11,271 2,835 2,781

$110 34 562 64 98

1.474 1.194 .962 .620 .436

Aa A Aa A A

6.Flagstaff, Ariz.
7.Cambridge, Mass. 8.Bogalusa, La. 9.Aspen, Colo. 10.Cape Coral, Fla.

1,616
3,270 1,796 11,274 25,763

50
278 333 1,159 2,304

.287
-0.282 -1.036 -1.954 -2.783

Baa
Aa Baa Baa Baa
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(1) Discriminant Analysis:

A11 A22 Correct Classification Ratio = A A A A 11 12 21 22

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(1) Discriminant Analysis:

Altmans Z-score models: Altmans Z-score for NYSE and NASDAQ firms
EBIT Net working capital Sales 1.2 1.0 Total assets total assets total assets MVE Accumulated retained earnings 0.6 1.4 BVD total assets z 3.3
Z 2.99 for normal firms Z 1.81 for distressed firms 1.81 Z 2.99 indeterminate Altmans Z-score model for private firms Net working capital Accumulated retained earnings z 6.56 3.26 total assets total assets EBIT MVE 1.05 6.72 total assets BVD

Z 2.90 for normal firms Z 1.23 for distressed firms 1.23 Z 2.90 indeterminate

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(2) Zeta Credit Risk:

The multivariate model was based on the following seven variables, though the true formula was never disclosed:

EBIT 1.Overall Profitability: Total Assets 2.Size: Total Assets

EBIT Total Interest Payment

3.Debt service:

4.Liquidity: Current Ratio

5.Cumulative Profitability:

R.E . Total Assets

5 years average of MV of Equity 5 years average of MV of Total capital

6. 7.

Market Capitalization:

Earnings StabilityThe estimated standard error of around a 10-year profitability trend.

The model was estimated by the discriminant analysis, and zero is the dividing line between the failed firms (negative) 55 and non-failed firms (positive).

(2) Zeta Credit Risk

Zeta scores between normal and failed firms five years before distress

4.0

2.0

-5 -2.0

-4

-3

-2

-1

-4.0
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(2) Zeta Credit Risk:

American Motors Zeta 1974 1975 1976 1977 2.23 .05 -.60 -.22 % 41 24 19 21 Chrysler Corp. Zeta 1.82 1.37 1.61 1.05 % 37 36 38 31 Ford Motors General Motors Zeta 4.72 4.27 4.68 4.52 % 64 63 65 62 Zeta 6.63 6.52 6.80 6.71 % 79 81 82 80 Mean Zeta for four 3.85 3.05 3.12 3.01

1978
1979 1980 1981 1982 1983

.48
1.10 -2.07 -3.64 -4.54 -5.29

27
33 10 5 4 4

.42
-1.12 -3.55 -3.68 -3.29 -2.38

27
16 5 5 6 9

4.29
4.07 2.26 1.77 1.55 2.03

59
58 41 35 33 38

6.31
6.24 4.51 3.91 3.59 3.99

77
77 61 55 52 55

2.87
2.57 .29 -.41 -.67 -.41
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(2) Zeta Credit Risk:

Year Percentile of Distribution of Zeta credit risk scores
5% 1974 15% 25% 35% 45% .18 1.27 2.22 55% 3.27 65% 75% 4.45 5.71 85% 7.08 95% 9.93

-3.61 -1.37

1975
1976 1977 1978 1979 1980 1981

-3.99 -1.39
-4.27 -1.28 -4.58 -1.35 -4.41 -1.46 -3.78 -1.18 -3.87 -1.18 -4.12 -1.00

.14
.23 .09 .03 .29 .33 .44

1.30
1.46 1.31 1.27 1.38 1.66 1.71

2.41
2.57 2.63 2.57 2.58 2.80 2.93

3.51
3.76 3.85 3.67 3.69 3.90 3.89

4.58
4.88 4.87 4.81 4.88 4.94 4.83

5.81
5.97 6.01 6.04 6.11 6.22 6.30

7.28
7.50 7.62 7.68 7.74 7.83 8.01

9.97
10.23 10.33 10.22 10.21 10.35 10.73

1982
1983

-4.92 -1.29
-4.88 -1.55

.25
.20

1.60
1.67

2.66
2.81

3.89
3.97

4.87
5.11

6.12
6.33

7.92
8.07

10.58
10.63
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Other devices that predict financial distress

Qualitative dependent variable regression: probit and logit regressions Artificial Neural Network

59