Corporate Credit Analysis Arnold Ziegel Mountain Mentors Associates Chapter 3 - Fundamentals of Credit and Credit Analysis (Part 1) March, 2008 © 2008 Arnold Ziegel Mountain Mentors Associates
“Lending is not based primarily on money or property. No sir, the first thing is character” – J.P. Morgan The goal of credit analysis is to make a judgment about an obligor’s ability and willingness to pay back what it owes, when it is owed. This means that the analyst must understand all of the issues raised by Mr. Morgan – money, property, and character. This chapter (chapter III) is about the basics principles of extending credit. The next chapter (chapter IV) will describe the mechanics of credit analysis – assessing historic operating performance and cash flow, liquidity assessment, capital structure adequacy, forecasting future performance, and debt capacity. The goals of credit analysis and financial analysis are similar, and achieved through cash flow analysis and forecasting. The equity analyst is working to establish value, usually based upon the present value of future cash flows. The credit analyst is working to determine the degree to which a company is able to service its debt in the near term and in the future. Estimated future net cash flow is the basis for establishing the probability that the obligor will be able to service its debt. In order to understand a company’s ability to generate cash to service debt in the future, it is necessary to understand historic cash generation, and the means by which a company has been funding its assets. There are many cases of company failures that were missed by analysts and bankers because they ignored a simple fact that the company’s cash flow had not been sufficient to fund asset growth, even though it may be been reporting profits. Enron is an excellent example of this. Enron appeared to be an extremely profitable company, almost up to the point of its bankruptcy. But it was not 1- Lesson 3
generating sufficient cash from its operations to fund its growth. In the two years prior to its demise, Enron had negative cash flow, after investments, in the range of $2 billion. This was all funded by debt. Enron’s problem was exacerbated by the fact that a lot of this debt was hidden from analysts and investors via off balance sheet vehicles. Its immediate cause of bankruptcy was the loss of confidence by its suppliers of credit. Once they understood that Enron’s leverage was much higher than many realized, the creditors refused to continue to work with the company. It is possible that Enron was a viable company prior to its bankruptcy. The immediate cause of its rapid failure was that the suppliers of credit to Enron feared that it was going to run out of cash very quickly. They “ran for the exits”. In Lesson I we learned that the fundamental question a credit analyst needs to answer is: “What is the degree of risk that an obligor will have sufficient cash to pay back an obligation on a timely basis, and the willingness to do so?” If the obligation is short term, and the obligor has a lot of liquidity, the answer is probably easy to determine. If the time frame is longer, the answer is not so easy. The credit analyst must assess many factors that will impact the obligor’s ability to pay in the future, including the willingness to pay. If a confident conclusion cannot be reached, the transaction will be rejected, or structured to reduce the risks, usually through the taking of collateral or security (a “second way out”). If a creditor doesn’t have a lot of confidence in the identified means of getting paid back (the “first way out”), then it will look to a back up means of getting paid back (the “second way out”) – perhaps in the form of additional collateral or a third party guarantee. In modern risk management, the degree of risk relative to a specific obligor or obligation is usually expressed in the form of a quantitative risk rating. This is analogous to a debt rating from...
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