Want to Read. Delete Note Save Note. Check nearby libraries Library. Share this book Facebook. December 8, History. An edition of Fundamentals of corporate credit analysis Written in English — pages. Fundamentals of corporate credit analysis , McGraw-Hill. Not in Library. Libraries near you: WorldCat. We conclude this chapter by providing a brief description of credit rating agencies and their studies of default risk and credit migration over time. We conclude by presenting ratings and certain credit models.

These case studies reflect credit issues such as mergers, acquisitions, governance, highly leveraged transactions, and sovereign issues. The intellectual debate has always been which is better: the topdown approach i.

It does not really matter where credit analysts start; what matters is what was considered and analyzed to get to a decision. Investment managers and credit analysts sometimes may not have a long time to make a credit decision, and it is impractical to expect that every last piece of information about an entity will be available before making a credit decision. When time permits, however, they should complete that preliminary assessment by a full-fledged review of the borrowing entity and of the debt instruments.

This book hopefully shows the way to do that. NOTES 1. Several definitions of default exist. Some place it at the first occurrence of nonpayment after a contractual grace period has lapsed , some see it as occurring 90 days after nonpayment assuming that it has not been remedied during that period , and yet another group place it after bankruptcy.

In this book, we use the first and most restrictive of these definitions of default. P A R T I Corporate Credit Risk Part I addresses all the factors that influence and determine the operating and financial performance of a corporation, and thus ultimately its credit strength.

The development of corporate credit quality begins with the macroeconomic and business environment surrounding a company. It then is fully developed by the quality of the assets and the business, by how management utilizes those assets, and eventually by the realization of the financial performance produced by those assets. The chapters in Part I identify all the major analytical areas that an analyst should cover, and the last chapter provides a step-by-step cash flow modeling exercise.

Governments have a wideranging impact. In addition, the physical and human nature of a country plays a great role in determining the types of businesses that arise in that country and how successful they become. In Chapter 2, we focus on how every industry is different and how each industry has credit risk built into it that could limit the credit quality of the companies in that industry. We discuss the different types of sales growth patterns witnessed, such as high growth, mature, or cyclical.

Some industries develop barriers to entry that sort out the viable competitors from the pretenders. We identify the areas in which barriers can develop and how to analyze them. Competitive analysis and competitor analysis is the key first step. We discuss the importance and the limitations of market share analysis, and the various elements that lead to consistency or volatility of operating performance, such as diversity, flexibility, size, and regulations.

In Chapter 4, the role of management is characterized as the linchpin between business risk and financial performance. Its importance cannot be overstated. We emphasize getting to know the management team and understanding its risk tendencies, since that typically influences financial and operating decisions. Finally, we list many questions to ponder regarding corporate governance. In Chapter 5, we address the financial measures related to the balance sheet, profitability, cash generation, and liquidity.

Understanding the accounting behind the numbers is key for any analyst, and we list numerous accounting topics to study. While the trends and absolute levels are important, financial forecasting is paramount. We identify the key ratios and how to interpret them. In Chapter 6, a financial model is created that projects cash flows and generates other credit ratios. We present two sample models, one for Coca-Cola and the other for Honda.

They establish the legal rights of the people, the regulatory framework, and the fundamental rules of engagement for businesses. Of course, that means that a sovereign government can create an environment in which business truly flourishes or an environment that stifles opportunities and success.

In particular, each country has its own unique characteristics that shape the businesses and corporations in that country. This includes its infrastructure, including roads, ports, telecommunications, utilities, buildings, a labor force, an educational system, a legal system, financial markets, and natural resources, and the businesses that develop around that infrastructure.

Ultimately, the degree of corporate success or failure comes down to how well the available resources are used in conjunction with the governing business regulations. Most of the time, however, this is usually a case of the haves and the have-nots.

In Africa, for instance, many countries have tremendous amounts of natural resources that are valued highly by other countries, such as oil, gold, and diamonds. One could assume that numerous successful businesses would emerge from countries with such resources. Sadly though, in some of these countries, corrupt governments and a poor educational system limit or even prevent business success.

As a direct consequence, corporations based in these countries are viewed as being of high risk. The bank, working with academics, consultants, and law firms, measured the costs of five business development functions in nations.

The World Bank determined that the least regulated and most efficient economies were in countries with wellestablished common law traditions. In addition, other top-performing economies were several social democracies Denmark, Norway, and Sweden that had recently streamlined their business regulations.

See Table for comparative growth rates of different countries. United Kingdom 0. Importantly, future business success can also be linked to the physical aspects of a country, such as the natural resources, the infrastructure, and the labor pool. This chapter breaks down the analysis into five critical drivers about the country and its sovereign government that influence the business environment.

These risk drivers are the sovereign powers, the political and legal risks, the physical and human infrastructure, the financial markets, and the macroeconomic environment. Yet not all sovereign governments are the same.

There are democracies, dictatorships, and kingdoms, with different histories and with styles of governing that can be and usually are very different. The main power is first and foremost the overarching right to create and change business regulations. Next, of course, is the taxing and tariff authority, and last is the ability to enact foreign currency exchange controls. Regardless of the type of government or whether the government is corrupt or upstanding, these are the issues a credit analyst cares about.

Simply because these are the key tools a government has that allow it to access money and affect the business environment. But sovereigns use these tools for different reasons and at different times.

Politics being what it is, analysts should investigate the extent to which any company has influence over the political process, CHAPTER 1 Sovereign and Country Risks 7 since that could affect the form and content of regulations. For example, a government could force renegotiation of tax subsidies or royalty arrangements and could change the amount of taxes on imports, exports, or foreign debt.

The characteristics of a supportive government differ depending on whether one is analyzing a local or a foreign entity i. Still, a supportive environment would include at least consistent business regulations. Tariffs Tariffs, or taxes paid by foreign companies trying to sell their goods in a country, are another way in which a government can extract money from corporations. The most recent example was the tariffs the U. The impact was to raise the price of foreign steel sold into the United States, allowing the struggling U.

While this did benefit the U. This drove the U. The obvious point to credit analysts is that tariffs can and do affect the demand for goods and are a very important factor to consider. Fiscal Policy—Taxation Income taxes are the primary mechanism by which a sovereign government can generate the revenue it needs to finance its activities.

The income taxes a company pays are, of course, a substantial portion of its overall costs: anywhere from 25 to 50 percent of income, depending on the country. This is typically the cash outlay that corporations work the hardest to reduce.

Likewise, it is an expenditure that credit analysts should try to understand and forecast very seriously. Unfortunately, analysts sometimes ignore income taxes because they are usually characterized as a set percentage payment. The diligent analyst should take the time to analyze the tax regime in a country and the efforts a corporation could go to to reduce its income taxes.

Monetary Policy In times of financial stress, governments will act to control the monetary flow in the country to its benefit. This is different from foreign currency valuation risk, i. Instead, foreign exchange controls, otherwise known as transfer and convertibility risks, are imposed by sovereign governments that are having difficulty making payments on their own debts.

A sovereign government that has not met or may not be able to meet its foreign financial obligations is likely to seek to retain its foreign currency reserves. They are reactionary actions to a deteriorated economic situation. Before these events occur, credit lenders and analysts should be paying more attention to the other sovereign powers and the basic country dynamics because those characteristics generally occur before a government decides to control its currency.

They help to predict negative credit trends in a deteriorating economic environment. The Republic of Argentina in and is the most comprehensive example in which a sovereign government imposed broad foreign exchange controls. Political and Legal Risks By their very nature, the political and legal environment in a country or in an entire region can be quite volatile and a dominating issue as far as business success goes. In this regard, credit analysts should be aware of the possibility for civil unrest that could disrupt operations.

There are many countries around the world in which public uprisings have led to work stoppages, declines in revenue, and increases in costs, and even the physical destruction of business facilities.

In , for example, Venezuelan oil workers engaged in two prolonged work stoppages in a political insurrection against the administration of President Hugo Chavez. Oil production declined more than 70 percent, and no refined oil products were produced. Among the OPEC producers, Venezuela is the third largest oil producer, pumping almost 3 million barrels of oil daily. In a less global situation, the Colombian national government for many years has been in a constant battle against the illegal drug warlords, whose tactics against the government include frequent attacks on oil pipelines and their employees.

Disruptions in Colombian oil deliveries are a regular event. Obviously, in both of these circumstances, lenders of credit have to have their eyes wide open and reflect the substantial risk inherent in their investments. One way to get comfortable with lending in a country is to evaluate its legal system. It is very important to know how dependable the rule of law actually is and whether there is an independent judicial system.

The level of corruption at the government or business level is harder to determine, but it would help to know that the judicial system is fighting it. At one extreme is the United States, which has a history of business case law dating back to the late s, and as a result provides a strong legal foundation for the formation of new businesses.

At the opposite extreme is Iraq, which currently has no legal infrastructure to protect business and is only now in considering what appropriate laws need to be established to support commerce. In particular, is there a bankruptcy code, and is it opaque or transparent? If there is a bankruptcy code, does it support lenders or borrowers?

Is there legal case history? That is, a creditor-friendly code could create an environment in which borrowers are not afraid to default on their debts, whereas a lender-friendly code if strictly enforced would prevent such an environment. See Chapter 8 for an expanded discussion of creditorfriendly and creditor-unfriendly regimes. For example, minerals oil, diamonds, gold, copper, iron, salt, and so on beget the various mining and manufacturing industries, forests beget the pulp and paper industries, and farm- CHAPTER 1 Sovereign and Country Risks 11 land begets the agriculture industries.

The quality, quantity, and economic extractability of these resources can also encourage entities from outside the country to invest in the development of those resources for the purpose of exporting them to other countries. Some countries, like the United States, are blessed with an abundance of natural resources.

But the ability to use these resources for business and for profit is tied very closely to the business regulations established by the government. An overly protective government could inhibit business growth, and an aggressive, businessoriented government could strip the land of its resources too quickly. The U. Physical Infrastructure A physical infrastructure that supports the movement of people and goods is critical because without it, only small amounts of business can occur.

Roadways, railroads, airports, and harbors with seaports all facilitate the delivery of raw materials and finished products to their appropriate destination. Infrastructure is vital to any industry involved with natural resources, since these resources are either exported or moved to a manufacturing or processing facility. For example, the mining of any metals or precious stones would be very slow or impossible without a railroad system. When analyzing an entity that needs to move raw or finished products long distances, analysts should investigate whether there are infrastructure challenges such as potential port or highway bottlenecks, and the permission to use existing infrastructure for commercial business purposes.

Other challenges usually include the availability and sufficiency of electric power. Many times corporate entities have to either build their own electric power plants, roadways, and harbors, or significantly refurbish the existing facilities. Therefore, a key question is the cost of using existing infrastructure and the cost of constructing or maintaining infrastructure.

Again, business regulations can play a large role since they can dictate the procedures for moving goods and the costs such as through tariffs of doing so. Typically, senior corporate executives work closely with regulators and politicians in the negotiation of business regulations and the construction of the needed infrastructure.

The quality of the educational system and of the training available, the skill level of the labor force, and the sophistication of the business community are important structural features, as they will affect the complexity and acceleration of business growth. It can be a problem in the lesser-developed countries, but then again the cheaper labor costs found in Southeast Asia and Latin America are a real boon for many companies. Analysts should be wary of the development of complex businesses in far-flung regions where the labor force and the business population may not be as well developed as in other parts of the world.

This could require the importation of foreign expertise. However, sovereign governments have different views on the benefits of foreign employees. Some see the bringing in of employees as negative, as it takes jobs away from natives, while others see it as a quicker and better way to generate new businesses and therefore new tax revenues. Nevertheless, the availability, quality, and cost of the workforce are key issues for all businesses. Labor Labor issues are even more pronounced during stressful economic times, when many businesses are vulnerable to failure, and one of their first actions is to reduce employee rolls and benefits.

Understanding the financial condition of the local government is important, too. If it is in financial distress, it may not pay its employees or it may just cut back on public services utilities, trash disposal, and so on , probably resulting in labor strife or insurrections that disrupt business activities. However, not all countries have all the needed components of a strong capital markets system. Instead, many countries rely on the large financial institutions from the United States and Europe to play these various roles in the markets.

Credit analysts need to be aware of the breadth of financial options available in a country. Banking System A well-established domestic banking system is important for providing needed capital to help finance the initial and ongoing development of a business or an asset.

Credit analysts need to be aware of the availability of commercial lending because the accessibility of the global public and private capital markets is not always very good. In fact, companies in emerging markets Latin America, Southeast Asia, the greater China region, Eastern Europe, and Africa are subject to wavering international investor confidence and do not always have the cross-border European and U.

Frequently these companies only have local lending available. Credit analysts should know how well these companies fare in their domestic lending markets. Is a company a top-tier borrower that has access to capital during a sovereign financial crisis? Furthermore, does it receive better credit terms than other entities during the good economic times?

Limited access to capital is typically a problem for emerging market companies. Yet even the strongest private-sector debt issuers can have difficulties accessing local or international capital markets during periods of sovereign stress.

Credit analysts should know the depth of the local domestic banking markets because in times of sovereign financial stress, the local banks will also suffer from weakened liquidity. So, to the extent that a borrowing entity has a preferred standing with creditors and, importantly, has committed credit lines, it would be better off than other companies. A heavy reliance on just capital lines poses risks, though, especially during times when the sovereign government is controlling its currency.

Thus, access to other sources of capital, such as trade credit business-to-business lending and foreign direct investment, could boost financial liquidity. The presence of a regulatory enforcement body, such as the U. Securities and Exchange Commission, is critically important but, of course, does not prevent financial or accounting shenanigans. Still, analysts cannot ignore the accounting and disclosure differences among companies and regions.

Conducting comparisons i. This entails a review of the very many macroeconomic indicators. While this is an art that is usually left for economists to disagree over, analyzing economic trends is a critically important aspect of credit analysis.

Credit analysts, therefore, can determine how those broad trends are affecting the performances of separate industry sectors and individual companies within those sectors.

Consumer Spending While it is difficult to pinpoint the most important economic indicator, some economists would argue that the ability of the consumer to spend money drives all other indicators.

While the authors of this book tend to agree with this premise, we will not and cannot defend the point, since we are credit analysts i. Nevertheless, consumer-spending patterns are important to follow, as they ultimately influence the demand for products to be manufactured and sold.

The supplies of products to be manufactured and sold are driven by other different factors, including the availability of raw materials, labor, CHAPTER 1 Sovereign and Country Risks 15 and manufacturing capacity.

There is substantial circularity when analyzing economic figures. For instance, the level of employment and wages clearly affects the ability of the general consumer to spend. The rise and fall in consumer spending determines the need for manufacturing plants and retail outlets, which in turn creates the need for more or less labor.

The point is that whether an analyst is evaluating a manufacturing or a retail entity, a comprehensive review of all economic indicators is needed, since these indicators are interrelated see Table Analysts, of course, must be aware of this.

Inflation and Interest Rates In countries with high inflation rates see World Inflation Rates in Table , business regulations with pricing flexibility that permits the pass-through of rising expenses becomes a critical factor to stability for many companies. Many times, though, pricing flexibility can occur only in reasonably healthy economic times. In periods of stress, consumers will buy what they need and spend what they can afford. Also, sovereign governments sometimes impose price controls, to the benefit of consumers but probably at the expense of overall economic growth.

So, the elasticity of prices can vary for different products and services. The counterpoint, though, is that in countries with high and maybe even consistently high interest rates, access to the international capital markets may be inconsistent or totally unavailable; leaving the high-cost local lenders as the primary borrowing option. Analysts should review local lending documents to check for possible indexing of rates to a local reference such as inflation, bank deposit rates, or foreign exchange rates.

Borrowing costs may be not only expensive but also volatile. The biggest risk occurs when Japan 3. An example would be a global manufacturer of any product who imports raw materials from one country, builds the product in a plant in a second country, and sells the product in a third country. In this case, raw material and labor costs are in different currencies from revenues.

To complicate the scenario further, a company can borrow in many different currencies as well. When currency values swing, disconnects between the value of the cash flows available and the values of the required debt payments can create a severe payment vulnerability. Fluctuations in currencies can also affect the prices of goods in different countries and, therefore, the demand for products. For example, in the U. The consequence was that U. In other words, the demand for U. In conclusion, there are macroeconomic indicators that help keep analysts informed about the broad trends in an economy and in specific industry sectors.

Some macroeconomic factors have very real impacts on the performance of individual entities. Inflation, interest rates, and foreign currency values not only affect the nominal value of revenues and expenses, but also can affect pricing and the demand for goods. Since these economic figures are typically made public very frequently, analysts should follow the announcements and track the trends religiously. The sovereign government has special rights and powers to establish laws, infrastructure, and business rules, to set and change taxes and tariffs, and to control the monetary flow in the country via foreign currency controls.

Knowing these business laws and rules is an important first step in analyzing these businesses and assessing overall credit risk. If the political environment is volatile and the rule of law is not strong, the business environment will be unstable; however, a stable environment with strong laws does not guarantee business success.

The physical and human infrastructure in a country affects the types of businesses that develop in that country. Without this infrastructure, new business and businesses will not be created, and it certainly is hard to succeed without it. Analysts should pursue the presence and the costs of the infrastructure, since it can be critical to the success of a business. Nevertheless, having this infrastructure does not guarantee business success. Financial Statement Analysis: Learning Objectives: 1.

Prepare and interpret financial statements in comparative and common-size form. Compute and interpret financial ratios that would be most useful to a common stock holder. Compute and interpret financial ratios that would be most useful to a short-term creditor Compute and interpret financial ratios that would be most useful to long -term creditors. Definition and Explanation of Financial Statement Analysis: Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions.

But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone.

However, the information provided in thefinancial statements is of immense use in making decisions through analysis and interpretation offinancial statements. Tools and Techniques of Financial Statement Analysis: Following are the most important tools and techniques of financial statement analysis: 1. Horizontal and Vertical Analysis 2.

Ratios Analysis 1. Horizontal and Vertical Analysis: Horizontal Analysis or Trend Analysis: Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form.

Click here to read full article. Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages.

Trend percentage states several years' financial data in terms of a base year. Vertical Analysis:. Vertical analysis is the procedure of preparing and presenting common size statements.

Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements.

Ratios Analysis: Accounting Ratios Definition, Advantages, Classification and Limitations: The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another.

A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. Profitability Ratios: Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Liquidity Ratios: Liquidity ratios measure the short term solvency of financial position of a firm.

These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations.

Following are the most important liquidity ratios. Activity Ratios: Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales.

Long Term Solvency or Leverage Ratios: Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios. Financial-Accounting- Ratios Formulas: A collection of financial ratios formulas which can help you calculate financial ratios in a given problem. Miller [I7b. Seeds, Dana Backman [ipI.

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