Credit Analysis and Lending

Management
Chapter 3: Credit Environment

6-1

Objectives

Explain the phases of the industry life cycle

Macroeconomic Environment ; Industry Risk Analysis ; Business Risk

Analysis

6-2

6-3

Development Stage I
Companies

getting started with new idea, product,

or production technique that makes them unique

Usually

privately owned and financed with owners

money, as well as capital from friends, family,
and/or a bank

If

successful, may attract venture capital

Pays

no dividends because all profits are

reinvested into the firm

Risky

investment with large potential return

6-4

Growth Stage II

Industry or company that has achieved market

acceptance for its products or services

Retains earnings for reinvestment

Sales and returns on assets growing at an increasing rate

Becomes profitable

Pays stock dividends to preserve capital

May pay low cash dividends as need for capital declines

or new sources of capital appear

Risky investment with large potential return

6-5

Expansion Stage III

Sales and earnings continue expanding, but at a decreasing rate

Crossover point

Change from accelerating growth to decelerating growth

More competition enters the market

Asset expansion slows

Cash dividends

Increase in dividend payout ratio

Stock dividends and splits still common

Stock prices may decline as investors realize growth rates will be

declining

6-6

Maturity Stage IV

Industry sales grow at rate equal to the economy as

measured by long-term GDP growth

Plant and equipment are in place

Financing alternatives are available domestically and

internationally

Cash flow from operations usually sufficient to meet

growth requirements of firms

Dividends may range from 40 50 percent of earnings

6-7

Decline Stage V
Industries

suffer declines in sales if product

innovation has not increased product base over the
years

May

be specific to a country

Industry

may undergo consolidation

Weakest

companies fail

Bankruptcy
Dividend

payout ratios sometimes rise to 100% or

more of earnings, followed by drastic cuts or
elimination of dividends

6-8

Industry Structure
Determines

potential profitability of firms

Special

considerations such as government

regulation that positively or negatively impact the
industry
Cost

advantages and product quality that may

create a dominant company within the industry

6-9

Industry Economic Structure

Monopolies

single firm is the whole industry

not common in United States except as public utilities

almost always in mature industries

regulations tend to limit growth and profitability

6-10

Industry Economic Structure continued

Oligopolies
few

firms in open rivalry

common

in large, mature U.S. industries

Automobiles, steel, oil, airlines, aluminum

competition

between firms can be intense

profitability

may suffer from price wars and fights over

market share

increasingly

strategies

face international competition altering their

6-11

Industry Economic Structure continued

Pure Competition

many firms, none significant in size, no product differentiation

not widely found in the United States

companies compete intensely, try to create perceived differences in product

quality or service

6-12

Industry Economic Structure

continued

Other Economic Factors to Consider

Supply and demand relationships

Cost variable

Availability of raw material

Energy costs

Government Regulation

Some industries face increasing regulation

Other industries face deregulation and more competition

Government expenditures

6-13

Industry Competitive Structure

Porters five forces
1.

Threat of entry by new competitors

2.

Threat of substitute goods

3.

Bargaining power of buyers

4.

Bargaining power of suppliers

5.

Rivalry among existing competitors

6-14

6-15

Pharmaceutical Industry

An Example
Global
High

industry

barriers to entry

Drugs

have predictable life cycles

Development
Approval

process

process

Remainder

of life under patent protection (10

years maximum)
6-16

Pharmaceutical Industry

An Example
Life-Cycle Analysis

Most large pharmaceuticals in expansion stage of life cycle

Individual firms go thru cycles as patents expire on popular
drugs

Portfolio of product life cycles are well diversified

Industry growing faster than economy or S&P 500 Index

Growth is decelerating (not accelerating)

Test of sustainability is firms R&D capability to generate
new products and get FDA approval

Mergers have led to large firms

6-17

Pharmaceutical Industry
An Example
Government Regulation

These firms sell their products throughout the world and

are regulated by many governments

The U.S. Food and Drug Administration (FDA) one of the

most risk-averse and strict enforcement agencies in world

Quite often, drugs are approved for use in other countries

before being approved for sale in the United States by FDA

Can take up to ten years of R&D before submission to FDA

for approval

6-18

Pharmaceutical Industry
An Example
Research and Development

Large amounts of money invested in research and development (R&D)

Benchmark

is the ratio of dollars spent on R&D

as a percentage of sales

Small

firms disadvantaged because of limited

funds to devote to R&D and thus fewer drugs

With

only a 3.3% success in passing FDA

approval much R&D is spent on failures but a
success can reap large profits for a firm
6-19

Pharmaceutical Industry
An Example
Research and Development

Recent company mergers have:

created large companies able to pool resources to develop larger economies of

scale

been the result of large firms unsuccessful at research buying smaller innovative
companies

6-20

Pharmaceutical Industry
An Example
Other issues:

Product Diversity

Large and small companies with industry

Unusual

to find more than three drugs with high market

share treating the same problem

Within

industry, not much direct competition

Usually

one or two drugs dominate the market

Value

of pharmaceutical company influenced more by

potential blockbuster drugs in pipeline than current
drugs that may come off patent protection in next few
years
6-21

Pharmaceutical Industry
An Example
Other issues:

Patents and Generic Drugs

U.S. Patent Office issues patents that protect drugs from competition for a limited
number of years

After a patent runs out, generic copies reduce profitability

Global patent protection is important issue since many countries violate or do not
enforce international patents

6-22

Pharmaceutical Industry
An Example
Other issues continued:

Demographics and Managed Care

As world population ages, demand for drugs will grow

Drive to restrain the rise in drug prices through both managed care and government
programs will put downward pressure on profit margins

New Medicare drug coverage may create enough of an increased demand to compensate
for possible pricing constraints imposed on the pharmaceutical industry

6-23

Industry Groups and Rotational Investing

Industries can be classified into groups that may exhibit similar behavior
during different phases of the business cycle

Different industries benefit from economic changes that accompany the

business cycle

Rotational investing

the practice of moving in and out of various industries over the business cycle

6-24

Industry Groups and Rotational Investing

continued

Example:

Falling interest rates

Rising interest rates

Housing, home building, lumber, household durable good

stocks

Food, pharmaceutical, beverage, tobacco stocks

Rising inflation

Basic materials, energy stocks and commodities

6-25

6-26

Business Cycle theory

5-27

6-27

Peak
The peak stage of the business cycle follows an expansion
phase. The peak stage demonstrates the height, the pinnacle of
the expansion phase.
In a peak phase, an economy experiences little or no
unemployment. The cost of goods continues to increase, but not
as rapidly as in the expansion phase, as production levels satisfy
consumers' demand for goods almost exactly.
The business cycle's peak stage reveals a high GDP during its
length. An economy's peak stage is normally recognized after it
has ended, however. Only a decrease in GDP distinguishes a
peak stage from its predecessor, the expansion phase.

5-28

6-28

Depression Phase
When there is a continuous decrease of output, income,
employment, prices and profits, there is a fall in the standard
of living and depression sets in.
The features of depression are :Fall
Fall

in volume of output and trade.

in income and rise in unemployment.
Decline in consumption and demand.
Fall in interest rate.
Deflation.
Contraction of bank credit.
Overall business pessimism.

5-29

6-29

Trough
The business cycle's trough stage directly contrasts its peak
phase. During a trough stage, an economy experiences a
high unemployment rate.
Increases in the cost of goods do not occur as consumer
demand and confidence levels remain low. Similar to a peak
phase, a trough stage can only be recognized after it passes.
A trough stage will be identified by a decrease in an
economy's GDP when compared with its level during the
preceding contraction phase. If an economy's GDP
decreases or remains at a low level for an extended number
of fiscal quarters, the economy's trough stage may be a
depression.
5-30

6-30

Recovery Phase
The turning point from depression to expansion is termed as
Recovery or Revival Phase. During the period of revival or recovery,
there are expansions and rise in economic activities. When demand
starts rising, production increases and this causes an increase in
investment.
There is a steady rise in output, income, employment, prices and
profits. The businessmen gain confidence and become optimistic.
This increases investments.
The stimulation of investment brings about the revival or recovery of
the economy. The banks expand credit, business expansion takes
place and stock markets are activated. There is an increase in
employment, production, income and aggregate demand, prices and
profits start rising, and business expands.
Revival slowly emerges into prosperity, and the business cycle is
5-31
repeated.
6-31

6-32

Macroeconomic Environment

Economic Policy

Fiscal Policy

Monetary Policy

Government Policy, Real Growth, & Inflation

5-33

6-33

Economic Policy

Stable prices
low

Business stability at high levels of production

low

inflation rate

levels of unemployment

Sustained real growth in gross domestic product

actual

economic growth after deducting inflation

Balance in international payments

balance

of exports and imports as well as cash flows into and out of

the United States

5-34

6-34

Fiscal Policy Tools

Changes in Government Spending

Changes in Taxation

Changes in both Government Spending and Taxation

5-35

6-35

Monetary Policy Tools

Federal Reserve has responsibility to maintain price

stability and foster maximum employment

Reserve requirements

Discount rate

Open-market operations

5-36

6-36

Government Policy, Real Growth, and

Inflation

Gross Domestic Product (GDP)

Measures output and consumption within a year

Does not include products made by Malaysian firms in foreign countries

Consumer Price Index

Based on a basket of goods consumed by an average person

5-37

6-37

6-38

6-39

6-40

6-41

6-42