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® 1 Rudiments of Credit Analysis May 18, 2001 Credit for Bluffers – Part I.

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Presentation on theme: "® 1 Rudiments of Credit Analysis May 18, 2001 Credit for Bluffers – Part I."— Presentation transcript:

1 ® 1 Rudiments of Credit Analysis May 18, 2001 Credit for Bluffers – Part I

2 ® 2 Agenda What is credit risk? What types of transactions give rise to credit risk? Who is the credit counterparty? How is the magnitude of credit risk determined? Methods to assess probabilities of default of a credit counterparty Key considerations in credit analysis General Financial statement analysis Key considerations in determining recovery amounts Jargon

3 ® 3 Credit Risk In addition to the counterpartys ability to fulfill its payment obligation, the creditors efforts to collect and the counterpartys willingness to pay are important factors in credit risk. What is it? The risk of a financial loss that could be incurred if a counterparty fails to fulfill its obligation to deliver cash, a commodity, or another item of value pursuant to a contract.

4 ® 4 Types of Transactions that give rise to credit risk: Loans Accounts receivable Derivative transactions and other transactions with cost of cover or make-whole termination provisions Other (including equity)

5 ® 5 Who is the credit counterparty? Who are the specific legal entity(ies) party to the contract? If we are relying on a parent company for credit support, is there a guarantee so that the parent company is the effective creditor counterparty? If there is no guarantee or other credit support, we will be looking only to the legal entity that is our counterparty for payment. What restrictions apply to the counterparty receiving cash flows that may appear on its historical or projected financial statements?

6 ® 6 Example X Corporation Domestic Holding Company International Holding Company Russian Subsidiary Libyan Subsidiary Indonesian Subsidiary Transmission Subsidiary Production Subsidiary Marketing Subsidiary

7 ® 7 Magnitude of Credit Risk The magnitude of credit risk, distilled to its essence, can be determined by answering the following two questions: What is the probability of payment default by the creditor counterparty? (i.e., what is the probability that the counterparty will be unable to pay its contractual obligations?) Upon default, how much of the obligation owed will be recovered by the creditor? (i.e., what assets are available to repay the creditors claim and to what extent must these be share with other creditors?)

8 ® 8 Methods to Assess Probabilities of Default of a Credit Counterparty Internally generated credit analysis and rating models for the credit counterparty Debt ratings for the counterparty from rating agencies (Moodys, Standard & Poors, etc.) Public or private debt spreads for the counterparty relative to benchmark rates (US Treasuries, LIBOR, etc.)

9 ® 9 Key Considerations in Credit Analysis – General General macroeconomic outlook for global and specific domestic economies Industry macroeconomic environment Character and quality of management

10 ® 10 Key Considerations in Credit Analysis – General contd. Financial flexibility What access does the counterparty have to multiple capital markets? Does the counterparty have the ability to sell assets without materially impairing its business? Does the counterparty have the ability to offset losses in one business unit by gains in another? Competitive analysis Where does the counterparty fit in its industry: is it a leader, a viable competitor, or a marginal player? Is it well-established or a new competitor and, if new, does it have any significant competitive advantages? Does it rely on a single customer, product, or contract that may vanish or dissipate?

11 ® 11 Key Considerations in Credit Analysis – General contd. Operating leverage Are fixed costs high relative to revenues? Are revenues volatile? Is cost structure high relative to competitors? What are the exposures to commodity prices? Capital Expenditures Are significant capital expenditures for replacements or repairs necessary? Are these capital expenditures expected to generate additional revenue or merely maintain revenues?

12 ® 12 Key Considerations in Credit Analysis – Enterprise Risk Identification Enterprise Risk Asset Risk Demand Elasticity Operating Costs Capital Replacement / Repairs Environmental / Regulatory / Legal Commodity Risk Fixed Price Basis Index Financial Risk Interest Rate Foreign Exchange Debt / Other Debt-like Obligations Refinancing

13 ® 13 Key Considerations in Credit Analysis – Financial Statement Analysis Leverage What is the relationship of the counterpartys debt and other debt-like obligations to the: book value or market value of its assets or net worth and operating cash flow or Earnings before Interest, Taxes, and Depreciation, Depletion, and Amortization expenses (EBITDA) it generates? How much of this debt is senior to (or subordinated to) the counterpartys obligations under our contract? Does the counterparty have additional debt capacity?

14 ® 14 Key Considerations in Credit Analysis – Financial Statement Analysis contd. Interest or Fixed Charge Coverage What is the relationship of cash flow available for payment of debt service (generally Earnings before Interest and Taxes (EBIT) or EBITDA to: Interest (both expensed and capitalized) Fixed Charges - Interest plus other interest-like financial charges (e.g, rent payments, put obligations, preferred stock dividends) Additional expected cash maintenance and normalized or maintenance capital expenditures

15 ® 15 Key Considerations in Credit Analysis – Financial Statement Analysis contd. Liquidity How much cash and other current assets does the counterparty have on its balance sheet (particularly in relationship to its current assets)? How much unused committed revolving credit availability does the counterparty have? What maturing debt and debt-like obligations does the counterparty have during, and shortly after, the term of our contract?

16 ® 16 Key Considerations in Determining Recovery Amounts Priority of claim relative to other creditors – Is our claim secured or unsecured, senior or subordinated? Quality and liquidity of counterpartys assets securing or available for repayment of our obligation as well as generally Volatility of counterpartys asset values and correlation of asset values with defaults

17 ® 17 Jargon Basis point Cost of cover LIBOR Make-whole Negative pledge Ratable pledge Refinancing Risk Subordination Structural subordination Treasury

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