Business Credit Analysis
Corporate and business Credit Research Arnold Ziegel Mountain Advisors Associates Section 3 -- Fundamentals of Credit and Credit Research (Part 1) March, 08 © 2008 Arnold Ziegel Mountain Teachers Associates
" Lending can be not based primarily upon money or property. Not any sir, the vital thing is character” – J. P. Morgan The goal of credit rating analysis is usually to make a judgment regarding an obligor's ability and willingness to pay back what it is in debt for, when it is owed. This means that the analyst must understand all the issues elevated by Mr. Morgan – money, house, and figure. This chapter (chapter III) is about the basic principles principles of extending credit. The next section (chapter IV) will describe the technicians of credit rating analysis – assessing traditional operating performance and cashflow, liquidity examination, capital framework adequacy, forecasting future efficiency, and personal debt capacity. The goals of credit research and financial analysis are similar, and achieved through income analysis and forecasting. The equity expert is working to establish value, usually dependant on the present value of foreseeable future cash goes. The credit analyst is working to identify the degree to which a company will be able to service it is debt inside the near term and in the near future. Estimated long term net cashflow is the basis for creating the probability that the obligor will be able to support its financial debt. In order to figure out a industry�s ability to generate cash to service debt in the future, you ought to understand ancient cash era, and the means by which a firm has been money its assets. There are many cases of organization failures that were missed simply by analysts and bankers because they dismissed a simple reality the company's cash flow had not been adequate to fund advantage growth, though it may be been reporting revenue. Enron is a superb example of this kind of. Enron were an extremely profitable company, practically up to the point of its individual bankruptcy. But it was not 1- Lesson 3
making sufficient cash from its procedures to fund its growth. In the two years prior to its demise, Enron had negative earnings, after purchases, in the variety of $2 billion. This was every funded by debt. Enron's problem was exacerbated by the fact that a lot of this financial debt was invisible from experts and investors via off balance sheet cars. Its quick cause of bankruptcy was the loss of confidence by simply its suppliers of credit. Once they realized that Enron's leverage was much higher than many realized, the collectors refused to keep to work with the organization. It is possible that Enron was obviously a viable firm prior to it is bankruptcy. Instant cause of it is rapid failure was that the suppliers of credit to Enron feared that it was going to run out of money very quickly. They " happened to run for the exits”. In Lesson I actually we found that the fundamental issue a credit rating analyst needs to answer is definitely: " Precisely what is the degree of risk that an obligor will have enough cash for compensating an obligation on a timely basis, and the motivation to do so? ” If the requirement is temporary, and the obligor has a lot of liquidity, the answer then is probably easy to determine. In the event the time frame can be longer, the answer then is not so easy. The credit analyst need to assess a large number of factors that could impact the obligor's ability to pay in the foreseeable future, including the willingness to shell out. If a confident conclusion can not be reached, the transaction will probably be rejected, or structured to minimize the risks, usually through the currently taking of assets or reliability (a " second way out”). When a creditor noesn't need a lot of confidence in the identified method of getting paid back (the " first method out”), it will look to a back up means of getting repaid (the " second method out”) – perhaps by means of additional security or a 3rd party guarantee. In modern risk management, the degree of risk relative to a specific obligor or obligation is usually expressed by means of a quantitative risk rating. This is analogous to a debt rating coming from...