Credit Risk Management

Lesson 1: Purpose of Analysis

Topic 2:
Credit and Financial Analysis
Credit and Financial Analysis
What is Credit Analysis?

Institutions that lend money or invest in debt issues (creditors) will ask
fundamental questions?
• Will the borrower (the company or the project) achieve sustained, stable
financial performance to be able to meet all debt obligations (interest and
principal payments)?
• How is performance translated into operating cash available for debt service?
• How will the company perform in different operating scenarios?
• What is the likelihood (probability) of default by the borrower or counterparty?
• What will the loss be if default occurs?

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Credit and Financial Analysis
What is Credit Analysis?

• What rewards do lenders and creditors expect for the risk they take?
• What can lenders and creditors do to reduce the risks of not being paid
(interest and principal)?
• How can exposure to a company be hedged, transferred, or managed?
• How should loans, bonds or other forms of debt financing be structured
appropriately for corporate borrowers? (Terms, collateral, tenor,
pricing)?

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Credit and Financial Analysis
What is Credit Analysis?

Exposure Lenders
Investors
Counterparties
• Products
• Obligations to pay
Company • Pricing
• Obligations to
• Terms, tenor, collateral
Counterparty perform
• “Waterfall” and rankings
Borrower • Assessment
• Analyze financial • Rating
condition to assess • Strategy
the ability to meet • Structures
obligations on an • After default
ongoing basis

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Credit Risk Analysis
Credit Rationale, Argument and Presentation
The analyst’s objective is to present a complete, thorough argument:
Understanding and explaining the integrated financial
story

Drawing conclusions about creditworthiness, stating the

outlook, making a risk decision, structuring debt

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Credit Risk Analysis
Credit Rationale, Argument and Presentation
The analyst presents a case to do the transaction or deal, book the loan,
bring in the client, engage with the counterparty, or accept the risk
exposure.
The analyst’s objective is to present a complete, thorough argument:
Convincing Rational

Logical Defensible

Quantitative Forward-looking
Qualitative

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Credit Risk Analysis
Credit Rationale, Argument and Presentation
The argument and presentation will likely include the following and flow in
the manner below:
• Industry, business model, business environment
• Risk analysis: primary business risks, mitigants, financial impact, management
response
• Management assessment (performance, growth, crisis response, operations
efficiencies, succession, corporate culture, public reputation and brand)
• Financial analysis (“The financial story”)
• Overall risk assessment, risk rating, risk outlook, risk strategy
• Financing needs, proposals, expected credit exposure, transaction structures
• Conclusions/recommendations, execution plans

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Credit and Financial Analysis
• Assess creditworthiness: The ability of the borrower (obligor) to make future
contractual payments: interest payments and principal repayments
• Credit analysis will also be used to assess and manage risks arising from many other
activities, as well: counterparty trading, financial processing, cash-management
activity, etc.
• Establish the lender’s (or creditor or debt investor’s) position for repayment vis a vis
other lenders (senior, junior, subordinated positions; secured, unsecured positions;
short-term, long-term exposures)
• Determine secondary sources of repayment or other forms of recourse

Primary sources of payback Secondary sources of

payback

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Credit and Financial Analysis
• What is the purpose of the
Corporate Balance Sheet exposure or debt?
Accrued
Operating Expenses • What are the forms of debt?
Assets
Short-term • What are the risks of debt?
debt
Fixed Assets • How will the debt be
Long-term debt serviced?

Intangibles • What are the primary and

Capital secondary sources of
payment?
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Credit Analysis
Balance Sheet

• Cash reserves • Debt investors and

• Operating cash lenders rely on cash
flow flows and assets to
Short-term
Operating debt ensure debt obligations
Assets Long-term will be paid as scheduled.
debt
Fixed Assets • Their objectives and
assessment of risks
coincide with objectives
and outlook of equity
Equity
investors
capital
Credit Analysis: Core Concepts
Borrower Balance Sheet

Liabilities
Operating cash flow Assets
Suppliers
Operating assets Expenses
Cash
AR Working capital
Inventory Debt service Funding sources, STD

Long-Term Funding
LTD
Fixed assets
Infrastructure
PPE
Returns on investment
Intangibles
Equity capital Dividends
Goodwill
Share re-purchases
Corporate Debt • Term loans A, B
Operating Entity • Working-capital
Holding Company • Revolving
Sourcescredit
of Debt loan
facility
Funding • Corporate bonds
Assets • Confirmed loan • Mezzanine
STD • Guidance loan financing
Cash • Short-term loan • Bridge loan
Inventory • Long-term loan • Subordinated
Receivable • Amortizing loan loan
s LTD • Balloon payment • Tranches
• Secured/unsecur • Convertible bond
ed • Bonds with
Fixed- • Syndicated loan warrants
Assets Equity • Club loan • Private
placements
Corporate Debt and Analysis
Operating Entity Debt Analysis
Holding Company • What is the purpose of existing debt? How were
proceeds used? What are the costs of debt
(pricing, interest rate, credit spreads)?
Assets
STD • What is the company’s strategy regarding
managing debt? Will it increase or decrease
Cash
over time?
Inventory
Receivable • How has the company performed while it
s LTD manages obligations?

• Is the company vulnerable to deterioration?

Fixed- • Can the company take on any new amounts of
Assets Equity debt (leverage)? Is the company too highly
leveraged (over-burdened with debt)?
Credit Analysis: Debt Purpose and Payback
Understanding “purpose” and “payback” helps to keep credit analysis focused and
targeted.

• Tracking the purpose of the financing helps explain and highlight the primary
source of repayment (e.g., cash from operations).

• The use and purpose of funds borrowed should be deployed to generate sources
of payback: cash from revenues, related asset sales, etc.

• If the primary source declines or disappears, are there other sources? Is there a
secondary source?

Primary Sources Secondary Sources

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Financial Analysis: Benefits and Deficiencies
Benefits:
• Measures performance over time
• Measures financial condition at a point in time
• Detects trends that indicate or reinforce notions of strategy, business models, long-term
growth
• Highlights vulnerabilities, worst-case scenarios, and company’s “readiness” for downturns
• Provides ways to detect inconsistencies, flaws, deceptions by management or possible
fraud
• Used as starting point to project financial performance or the impact of worst-case
scenarios
• Contributes substantially to risk ratings, strategy and risk decisions
Deficiencies:
• Presents an assessment based on past performance (old numbers)
• May overlook qualitative factors and current operating environment

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Credit and Financial Analysis
A primary goal in credit analysis is to use information and insight to rate the following
to (a) conclude on the company’s financial condition and (b) assess whether the
company can meet financial obligations.

Profitability Management
Operating cash flows Operations and controls
Asset quality, efficiency, Crisis preparation
productivity
Working capital Market reputation
Liquidity and cash reserves Regulatory and compliance
Leverage, debt capacity Overall financial condition

Capital structure Outlook

Capital cushion and adequacy

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