Corporate Credit Analysis
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
“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