The Analysis of Credit Risk

ACC 4345: Financial Statement Analysis

ACC 3350: Financial Statement Analysis
Semester 2 - 2023

Prof. Athula Manawaduge

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 What you will learn from this chapter
• How default risk determines the price of credit (the cost of debt capital)
• What determines default risk
• How default risk is analyzed
• How credit scoring models work
• The difference between Type I and Type II errors is predicting defaults
• How pro forma analysis aids in assessing default risk
• How value-at-risk analysis is used to assess default risk
• How financial planning works
 What you will learn from this Chapter
At the end of this lesson you should be able to:
• Reformulate and annotate financial statements in preparation for credit analysis.
• Calculate liquidity, solvency, and operational ratios that are pertinent to credit analysis.
• Calculate credit scores using financial ratios.
• Calculate the probability of bankruptcy using financial ratios.
• Trade-off Type I and Type II default forecasting errors.
• Prepare pro-formas for default scenarios.
• Prepare value-at-risk profiles for debt.
• Forecast default points.
• Prepare a default strategy.
The Suppliers of Credit
• Public debt market investors who include (long-term) bondholders and
(short-term) commercial paper holders.
• Commercial banks that make loans to firms.
• Other financial institutions such as insurance companies, finance
houses, and leasing firms make loans, much like banks, but usually with
specific assets serving as collateral.
• Suppliers to the firm who grant (usually short-term) credit upon
delivery of goods and services.
Default Risk and Default Premiums
• Required Return on Debt = Risk-free Rate + Default Premium
• The default premium is determined by the risk that the debtor
could default
• Similar terms:
• Required return on debt
• Cost of debt
• Price of credit
Default Risk and Default Premiums
• Each supplier of credit has a price for granting credit—the
required return—and each needs to analyze the risk of default
and charge accordingly.
• Bondholders charge a yield to maturity based on their risk
assessment and set bond prices accordingly.
• Banks charge an interest rate over a base rate (the prime rate for
their safest customers) that depends on default risk.
• Suppliers charge a higher price for goods and services if the
default risk is high.
• If risk is deemed to be unacceptable, no price is acceptable to the
lender, so credit is denied.
 Ratio Analysis for Default Evaluation
• Credit analysis identifies ratios that indicate the likelihood of
default. Therefore, it is also referred to as default analysis.

• The credit analyst identifies ratios from financial statements

that have first been reformulated for the purpose.
Steps:
1. Reformulate financial statements
2. Calculate ratios
 Reformulate financial statements
• Reformulation involves reclassifying items in the financial
statements and bringing more dollar detail into the financial
statements from the footnotes.

• For credit analysis, the statements must be in a form to

uncover what is most important to creditors, the ability to
repay the debt.
 Reformulating the Financial Position Statement for
Credit Analysis
The key idea in the reformulation of Financial Position Statement is to order assets by liquidity and
liabilities by maturity.
Issues:
• Detail on different classes of debt and their varying maturities is available in the debt footnotes;
this detail can be brought on to the face of reformulated statements.
• The debt of unconsolidated subsidiaries (where the parent owns less than 50%, but has effective
obligations) should be recognized.
• Long-term marketable securities are sometimes available for sale in the short term if a need for
cash arises. Therefore, reclassify them as short-term assets.
• Remove deferred tax liabilities that are unlikely to reverse, from liabilities to shareholders’ equity.
• Add the LIFO reserve to inventory and to shareholder’s equity to convert LIFO to a FIFO basis.
FIFO inventory is closer to the current cost, so it is a better indicator of cash that can be generated
from inventory.
• Off-balance-sheet debt should be recognized on the face of the statement.
• Contingent liabilities that can be estimated should be included in the reformulated statements.
• The risk in derivatives and other financial instruments should be noted.
 Off-Balance-Sheet Financing (19.1)
• Off-balance-sheet financing transactions are arrangements to finance assets and create
obligations that do not appear on the balance sheet.
• Examples:
• Operating leases

• Agreements and commitments:

• third-party agreements
• through-put agreements
• take-or-pay agreements
• repurchase agreements
• sales of receivables with recourse
• Special purpose entities not consolidated

• Unfunded pension liabilities not booked

• Guarantees of third-party or related-party debt

• Positions in derivatives off balance sheet

Reformulated Income Statements and Cash Flow Statements
Income Statement:
• Distinguish income from operations that “covers” net financial expense
• The analyst reviews the income statement to assess the ability of the firm to generate
operating income to cover net interest payments.
• Thus, the reformulated income statement that distinguishes after-tax operating
income from after-tax net financial expense serves the debt analysis
Cash Flow Statement:
• Distinguish (unlevered) cash flow from operations that can be used to make
payments on debt
The reformulation follows that in Chapter 10
Ratio Analysis: Short-Term Liquidity Ratios

• Liquidity Stock Measures

Current Assets
Current Ratio=
Current Liabilities

Cash+Short-term Investments+Receivables
Quick or Acid Test  Ratio=
Current Liabilities

Cash+Short-term Investments
Cash Ratio=
Current Liabilities
Ratio Analysis: Short-Term Liquidity Ratios
• Liquidity Flow Measures

Cash Flow from Operations

Cash Flow Ratio=
Current Liabilities

Cash+Short-term Investments +Receivables

Defensive Interval= ×365
Capital Expenditures

Cash Flow to Capital Expenditures=

 Unlevered  Cash Flow from Operations
Capital Expenditures
 Ratio Analysis: Short-Term Liquidity Ratios
Liquidity Flow Measures
• The cash flow Ratio indicates how well the cash flow from operations
covers the cash needed to settle liabilities in the short term.
• The defensive interval ratio measures the liquidity available to meet
capital expenditures without further borrowing. Multiplying by 365 yields
the number of days expenditures can be maintained out of near-cash
resources.
• The cash flow to Capital expenditure ratio measure is free cash flow in
ratio form and indicates to what extent capital expenditures can be
financed out of cash from operations.
• Sometimes forecasted expenditures are used in the denominators of the
second and third measures.
Ratio Analysis: Long-term Solvency Ratios
• Solvency Stock Measures
Total Debt  Current+Long-term 
Debt to Total Assets=
Total Assets  Liabilities+Total Equity 

Total Debt
Debt to Equity=
Total Equity

Long-term Debt
Long-term Debt Ratio=
Long-term Debt + Equtiy
Ratio Analysis: Long-term Solvency Ratios
• Solvency Flow Measures
Operating Income
Interest Coverage=
Net Interest Expense
Times Interest Earned 
Unlevered Cash Flow from Operations
Interest Coverage=
Net Cash Interest
Cash Basis 
Operating Income+Fixed Charges
Fixed Charge Coverage=
Fixed Charges
Unlevered Cash Flow from Operations + Fixed Charges
Fixed Charge Coverage=
Fixed Charges
Cash Basis 
Unlevered Cash Flow from Operations
CFO to Debt=
Total Debt
 Ratio Analysis: Operating Ratios
• The ratios just listed above pertain directly to liquidity and solvency. But liquidity and
solvency are driven in large part by the outcome of operations.
• Operating ratios are also indicators of debt risk as both short-term liquidity and long-
term solvency problems are far more likely to be induced by poor operating
profitability.
• Poor profitability increases the likelihood of default.
• The profitability analysis and the risk analysis are inputs into credit analysis. Watch
particularly for declines in
• RNOA
• Operating profit margins
• Sales growth
 FORECASTING AND CREDIT ANALYSIS
• Liquidity, solvency, and operational ratios reveal the current state of the firm.
• But the credit analyst is concerned with default in the future. Do the ratios predict
default?
• Some of them might be symptoms of financial distress rather than predictors.
• Discovering that interest coverage is low is important to the analyst. But the
anticipation of a low-interest coverage ahead of time is more important.
• The analyst thus turns to forecast.
• The aim is to produce a credit score that indicates the probability of default.
Forecasting and Credit Risk
Prelude to Forecasting:
The analyst needs to understand the following points and include salient ones in the
observations to the reformulated statements:

• Know the business

• Appreciate the “moral hazard” problem of debt
• Understand the financing strategy
• Understand the current financing arrangements
• Understand the quality of the firm’s accounting
• Understand the auditor’s opinion, particularly any qualification to the opinion
With this background, the analyst develops forecasts. Two forecasting tools are:
1. The credit scores based on predictions from financial ratios.
2. The pro forma profitability analysis and value-at-risk analysis to the task of credit
analysis.
 The Credit Rating Process
• General approach to credit analysis is the credit rating process
by credit rating agencies

• Assess and communicate the probability of default by an

issuer on its debt obligations (e.g., commercial paper, notes,
and bonds).

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 The Credit Rating Process
• Independent Assessment of the credit quality (credit risk /
Default risk) of bonds
• Credit quality means the ability and willingness to service
promised obligations on a timely basis.
• Ratings assigned on the basis of the credit quality

• Major Rating Agencies: Standard and Poor’s Corporation,

Moody’s Investor Services

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 The Credit Rating Process
• The credit rating process involves both the analysis of a
company’s financial reports as well as a broad assessment of a
company’s operations.

• In assigning credit ratings, rating agencies emphasize the

importance of the relationship between a company’s business
risk profile and its financial risk.

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 The Credit Rating Process
• For corporate entities, credit ratings typically reflect a
combination of qualitative and quantitative factors.
• Qualitative factors generally include an industry’s growth
prospects, volatility, technological change, and competitive
environment.
• Quantitative factors generally include profitability, leverage,
cash flow adequacy, and liquidity.

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RATING FACTORS
Business Risk
Industry characteristics
Competitive position
Management

Financial Risk
Profitability
Capital structure/ leverage
Cash flow protection
Financial flexibility
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Key financial ratios used by Standard & Poor’s in evaluating industrial companies

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Forecasting Default with Credit Scoring
A bond rating published by Standard & Poor’s and Moody’s is a composite score.
• Standard & Poor’s ratings range from AAA (for firms with highest capacity to
repay interest and principal) through AA, A, BBB, BB, B, CCC, CC, C to D (for
firms actually in default). The ability to repay debt rated BB and below is deemed
to have significant uncertainty.
• Moody’s rankings are similar: Aaa, Aa, and A for high-grade debt, then Baa, Ba,
B, Caa, Ca, C, and D.
• These debt ratings are published as an indicator of the required bond yield, and
indeed the ratings are highly correlated with yields.
 Ratio Analysis and Credit-Scoring
Credit scores combine a number of indicators into one score that estimates the
probability of default.
• Figure 19.1 depicts the deterioration of a number of ratios over five years prior to
bankruptcy (failure).
• The graphs are from one of the original studies on bankruptcy prediction by William
Beaver in the 1960s, but they apply much the same today.
• Average ratios for bankrupt firms are compared with those of comparable firms that
did not go bankrupt.
• They become significantly worse as bankruptcy approaches. So, benchmarking ratios
against those for comparable firms, combined with trend analysis, does give an
indication of future bankruptcy.
Ratio Analysis and Credit-Scoring
Ratio Analysis and Credit-Scoring
 Forecasting Default with Credit Scoring

Two issues arise in getting default predictions from accounting

ratios:
1. Many ratios must be considered, and the analyst needs to summarize the
information they provide as a whole. A composite credit score needs to
be developed.
2. Errors in predicting default and the cost of prediction errors have to be
considered.
Forecasting Default with Credit Scoring
Credit scores combine a number of indicators into one score that estimates the
probability of default.

Credit Scoring Method:

• Multiple Discriminate Analysis (MDA)
Multiple Discriminate Analysis- (Z-scoring)

Original Altman Model:

 Working Capital   Retained Earnings 
Z-score=1.2   +1.4  Total Assets 
 Total Assets   

 Earnings Before Interest and Taxes 

+3.3  
 Total Assets 

 Market Value of Equity 

+0.6 
 Book Value of Liabilities 

 Sales 
+1.0  
 Total Assets 
How Should an Investor Interpret the Altman Z-Score?
Investors can use Altman Z-score to evaluate corporate credit risk:

• A score below 1.8 signals the company is likely headed for bankruptcy, while
companies with scores above 3 are not likely to go bankrupt.

• Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3
and selling, or shorting, a stock if the value is closer to 1.8.

• In more recent years, Altman has stated a score closer to 0 rather than 1.8
indicates a company is closer to bankruptcy.

• Altman found that firms with Z-scores of less than 1.81 went bankrupt within one
year while scores higher than 2.99 always indicated non-bankruptcy.

• Scores from 1.81 to 2.99 were the gray areas.

How Should an Investor Interpret the Altman Z-Score?
Below are ratios for some of the firms that have appeared in this book, for their 2022 fiscal year.

Working Retained Earnings before Market

Capital/ Earnings/ Interest and Taxes/ Value of Sales/
Equity/
Total Total Total Book Value Total
Firm Assets Assets Assets of Liabilities Assets
Coca-Cola - 0.12 1.05 0.29 15.4 0.98
Nike 0.34 0.58 0.15 9.0 1.67
Reebok 0.43 0.66 0.06 0.7 1.85
Hewlett-Packard 0.24 0.50 0.13 3.6 1.40
Dell, Inc. 0.38 0.09 0.31 27.9 2.65
Gateway Computer 0.27 0.34 0.19 5.2 2.59
Microsoft 0.45 0.34 0.32 46.7 0.65

a. Calculate Z-scores from these ratios.

b. Explain why Nike has a different Z-score from Reebok.
c. What reservations do you have about the Z-score as an indicator of creditworthiness?
Credit Scoring: Prediction Error Analysis
• Type I error: Classifying a firm as not likely to default when it actually does default
• Type II error: Classifying a firm as likely to default when it does not default

Cost of errors: Both errors have costs.

• In a Type I error, the bank or bondholder loses in the default.
• In a Type II error, the bank or bond investor misses out on a good investment. For a
bank, the cost of a Type II error may be considerable. It may lose good loans and
good customers and businesses might migrate to banks with better credit models
and better error analysis.

• Trade-off Type I and Type II errors: choose a cut-off score that minimizes the cost of
errors
Credit Scoring: Prediction Error Analysis
• Error analysis aims to determine the optimal cutoff for classifying firms.
• One simple way is to choose a cutoff point that minimizes the total of Type I
and Type II errors.
• This cutoff can be discovered from historical data analysis (preferably on a
set of firms that were not used to estimate the credit scoring model), and
this historical analysis can be updated through experience.
• Altman’s original analysis found that a Z-score of 2.675 minimized the
number of total errors.
Full Information Forecasting: Using Pro Forma Analysis for Default
Forecasting

Full-Information Forecasting
• Credit scoring from ratios uses the limited information in current
financial statements.

• The full information about firms is captured by the pro forma analysis

• This analysis, along with the value-at-risk analysis, can readily be

adapted to assess the likelihood of default.
Pro Forma Analysis and Default Prediction

• Rather than using current liquidity, solvency, and operational ratios to

forecast default, pro forma analysis uses the full information available
to the analyst to forecast future liquidity, solvency, and operational
ratios that result in default.

• Pro forma analysis explicitly forecasts the firm’s ability to generate

cash to meet debt payments.
Pro Forma Analysis and Default Prediction

• Pro forma analysis for equity valuation focuses on forecasting

operating income and net operating assets for the residual income
calculation.

• Pro forma analysis for credit evaluation focuses on forecasting cash

available for debt service. Accordingly, the “bottom line” in the pro
forma is the cash available for the debt service line.
Default occurs when cash available for debt service is less
than the debt service requirement.
Default Points

Cash Available for Debt Service  Free Cash Flow - Net Dividends

 OI - NOA - Net Dividends

Debt Service Requiremen t  Required Interest and Preferred Dividend Payments

 Required Net Principal Payments

 Lease Payments
Full Information Forecasting: Using Pro Forma Analysis for Default
Forecasting
PPE Inc. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Scenario 1:
Sales (growth = 5% per year) 124.90 131.15 137.70 144.59 151.82 159.41
Core operating income (PM = 7.85%) 9.80 10.29 10.81 11.35 11.92 12.51
Financial income (expense) (0.70) (0.77) (0.57) (0.35) (0.10) 0.18
Net income 9.10 9.52 10.24 11.00 11.82 12.69

Net operating assets (ATO = 1.762) 74.42 78.15 82.05 86.16 90.46 94.99
Net financial assets (7.70) (5.71) (3.47) (0.97) 1.81 4.91
Common equity 66.72 72.44 78.58 85.19 92.27 99.90

Free cash flow 5.28 6.57 6.90 7.25 7.61 7.99

Dividend 5.28 3.81 4.10 4.40 4.73 5.08
Cash Available for Debt Service 0.0 2.76 2.80 2.85 2.88 2.91
______________________________________________
Debt to Total Assets 10.3% 7.3% 4.3% 1.1% 2.0% 5.2%
Debt to Equity 11.5% 7.9% 4.4% 1.1% 2.0% 4.9%
Interest Coverage 14.0 13.4 19.0 32.4 19.2 
Fixed Charge Coverage  4.7 4.9 5.0 5.1 
RNOA 14.0% 13.8% 13.8% 13.8% 13.8% 13.8%
ROCE 14.5% 14.3% 14.1% 14.0% 13.9% 13.8%
Debt Service Requirement 0.0 0.0 0.0 0.0 0.0 0.0
_____________________________________________________________________________________________
Using Pro Forma Analysis for Default Forecasting
PPE Inc.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Scenario 2:
Sales (decline= 5% per year) 124.90 118.66 112.72 107.09 101.73 96.65
Core operating income (PM = 1%) 9.80 1.19 1.13 1.07 1.02 0.97
Financial income (expense) (0.70) (0.77) (0.69) (0.60) (0.52) (0.42)
Net Income 9.10 0.42 0.44 0.47 0.50 0.55

Net operating assets 74.42 74.00 73.60 73.20 72.80 72.40

Net financial assets (7.70) (6.86) (6.02) (5.15) (4.25) Default
Common equity 66.72 67.14 67.58 68.05 68.55 Default

Free cash flow 5.28 1.61 1.53 1.47 1.42 1.37

Dividend 5.28 0.0 0.0 0.0 0.0 0.0
Cash Available for Debt Service 0.0 1.61 1.53 1.47 1.42 1.37
______________________________________________
Debt to Total Assets 10.3% 9.3% 8.2% 7.0% 5.8%
Debt to Equity 11.5% 10.2% 8.9% 7.6% 6.2%
Interest Coverage 14.0 1.5 1.6 1.8 2.0
Fixed Charge Coverage  1.7 1.7 1.7 1.7
RNOA 14.0% 1.6% 1.5% 1.5% 1.4% 1.3%
ROCE 14.5% 0.6% 0.7% 0.9%
Debt Service Requirement 0.0 0.0 0.0 0.0 4.25 Default
_____________________________________________________________________________________________
Value-at-Risk Profiles for Default Forecasting
• Scenario 2 is a default scenario, but it is just one default scenario:
• It forecasts particular sales growth, profit margin, and so on.
• It also forecasts that the dividend would be dropped and that no cash
would be raised from new debt to reduce the debt service requirement.
• Other operating and financing scenarios are possible and the
analyst is interested in the full set of default scenarios.
• The value-at-risk analysis is a method for examining the full set of
likely scenarios. The analysis was applied to equities but is also
applicable to debt: Under what set of scenarios is the value of
debt at risk?
Value-at-Risk Profiles for Default Forecasting
• The equity analysis profiles the possible variation in residual income.
• The debt analysis profiles the possible variation in cash available for
debt service.
Follow these steps:
1. Generate profiles of cash available for debt service for a full set of
scenarios from pro forma analysis
2. Establish the debt service requirement
3. Identify the default point where cash available for debt service is
below the debt service requirement, and so identify the default
scenarios
4. Assess the probability of the set of default scenarios occurring
Value-at-Risk Profile
Liquidity Planning and Financial Strategy
• A default strategy is a strategy to avoid default
• Pro forma analysis of default points can be used as a planning tool to avoid default
• Modify plans to increase liquidity in order to avoid default and build those plans into
the financial strategy pro forma
• Modify operations to reduce operational risk that generates default risk.
• Issue equity.
• Issue or roll over debt; renegotiate borrowing terms.
• Establish an open line of credit.
• Sell off assets.
• Sell off the whole firm (in an acquisition).
• •Hedge risks.
Thank you

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