Financial Analysis for Credit and Risk: Understanding Debt Ratings and Creditworthiness, Study Guides, Projects, Research of Finance

Download Financial Analysis for Credit and Risk: Understanding Debt Ratings and Creditworthiness and more Study Guides, Projects, Research Finance in PDF only on Docsity! Financial Statement Analysis Credit and Risk Analysis Suppliers of Credit • Commercial Banks – Good knowledge of existing clients reduces the perceived riskiness – Ongoing credit risk can be monitored more closely • Other financial institutions – Along with banks, other institutions offer asset-based lending (secured financing of specific assets) – Life Insurance companies with obligations of a long term match with long term investments such as long term bonds or loans. • Public debt markets – Companies can issue debt direct to the market in the form of commercial paper or bonds. Such debt issues are given a debt rating by one of the major rating agencies. Changes in the rating can cause a change in the price of the security. • Sellers who provide financing – Many manufacturers sell their products on 30 to 60 days credit, interest free and on an unsecured basis. Some will extend this to longer periods. Debt Ratings • A debt rating is an indicator of the likelihood of timely repayment of principal and interest by a borrower • The more likely the borrower will repay both the principal and interest, in accordance with the time schedule in the borrowing agreement, the higher will be the rating assigned to the debt security. formula. • Agencies stress that ratings are based on the judgement of their analysts who arrive at their rating after assimilating quantitative as well as qualitative data available to them. Function of Debt Ratings • Superior information source on the ability of companies, councils, or even governments to make timely repayment of principal and interest on borrowings. • Low-cost source of credit information. • Source of “legal insurance” for an investment trustee. • Source of additional certification of the financial and other representations of management. • Monitor the actions of management. • Facilitate a public policy that restricts speculative investments by institutions such as banks, insurance companies, and pension funds. The social costs can be high when such institutions become bankrupt. Quantitative Models of Debt Ratings • If the goal of a mathematical model is simply to duplicate the rating agencies classification, why bother? • Some debt offerings are not rated • Ratings are not continually revised • Model can be used to: – monitor the debt after the original rating is made – forecast ratings change • The variables in a predictive model can give insight into factors that determine the perceived riskiness of debt Models • Models developed to predict ratings assigned to debt securities generally follow the Altman model (discriminant analysis). • More recently researchers have applied logit and probit analysis. • Main problem is selecting the set of independent variables. • Ratings firms do not disclose the process used to confer ratings. Ideally there should be some economic rationale for the variables included in the model. n y pe r s o nne l In t e ri m re p o rt s 5 9 2 3 1 8 V is it to c o m p a n y pr e m i s e s 28 53 19 Univariate Models • Number of individual financial and other ratios examined in distress prediction studies in the last 20 years is well over 100. • Beaver (1966) compared patterns of 29 ratios in the 5 years preceding bankruptcy. The purpose was to see which ratios could forecast bankruptcy and how many years in advance the forecast could be made. Multivariate models Altman’s multivariate model (1968; original model) Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E – Altman noted that "any firm with a Z score below 1.8 is considered to be a prime candidate for bankruptcy, the lower the score, the higher the failure probability.” Taffler (1982; UK study) – EBIT/Total Assets – Total Liabilities/Net Capital Employed – Short term debt/ total invested capital – Current ratio – Fixed charge coverage ratio – 5-Year cash flow/5-year(Capex+stock change+ordinary dividends) Example of Ratings Definitions Of Long-term Government Debt Highest Quality ... AAA Very Good Quality ... AA Good Quality ... A Medium Quality ... BBB Lower Medium Quality ... BB Poor Quality ... B Speculative Quality ... C Default ... D (per Canadian Bond Rating Service) Default rates of corporate bonds 1971 - 1997 by Standard and Poor's rating at date of issue Percentage defaulting within: Rating at time of issue 1 Year after issue 5 Years after issue 10 Years after issue AAA 0.0 0.1 0.1 AA 0.0 0.7 0.7 A 0.0 0.2 0.6 BBB 0.0 1.6 2.8 BB 0.4 8.3 16.4 B 1.5 22.0 33.0 CCC 2.3 35.4 47.5 Default rates of corporate bonds 1971 - 1997 by Standard and Poor's rating at date of issue Source: R.A. Waldman, E.I. Altman and A.R. Ginsberg, “Defaults and Returns on High Yield Bonds: Analysis through 1997” Saloman Smith Barney, New York 1998 The Independent April 22, 2008 BAA FLYING SOLO; The airports operator says it is now tackling problems at Heathrow, but restructuring plans are unlikely to head off monopoly complaints from competition watchdogs today. By Danny Fortson; After the announcement of the latest delay to (..) refinancing - to the third quarter of this year - Standard & Poor's, the credit rating agency, last week downgraded the bonds of BAA and ADIL, the investment vehicle set up by Ferrovial to buy the company, to BBB-, just one grade above "junk". In its report last week, the agency warned that if the commission forces an asset sale, it would probably cut it again. Relegating the rating to "junk" could wreck the refinancing deal altogether or force its bankers at RBS and Citi-group to restructure the offering, which proposes to use BAA's regulated airports as collateral for new bonds. "Our concern is that [an airport disposal] could derail BAA's strategy and timeline, as it is impossible to predict market willingness to go ahead with a refinancing before BAA's future is certain," S&P said. "We will closely scrutinise progress on the refinancing and, if there is any