ch capital credit risk analysis

7/31/2019 CH Capital Credit Risk Analysis

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CH Capital Partners LLC

Basics of Credit Analysis what Banker’s are not talking about

By

Sok H. Cordell Sr. Managing Director

Know who you are working with

Investment Banking the SBA Loan one deal at a time to generate jobs

for our fellow Americans



Credit Analysis

Executive

Summary of Credit

Financial Analysis

and Tax Return

Audit

Ratios and

Financial

Strength Test

Collateral

Credit

Capacity

Condition

Character

Stress Testing

Static Stress

Dynamic Stress



Sources and Types of Risks

Source Type or Nature

Domestic RecessionInflation or Deflation

Interest Rate ChangesDemographic ChangesPolitical Changes

Industry TechnologyCompetition

Availability of Raw Materials and LaborUnionization

Firm‐ Specific Management CompetenceStrategic DirectionLawsuits

Financials Current AssetsCurrent LiabilityROEROA



• A firm should continually monitor each of these and other type of risks

• A loan officers task is to understand how a firm monitors its risks

• Analysis of the financial consequences of these elements of risk using financial

statements is an important tool• Various financial reporting standards require firms to discuss in notes to financial

statements how important elements of risk affect a particular firm and the actions

it takes to manage its risks

• In addition to using information about risk disclosed in the notes to financial

statements, loan officers typically assess the dimensions of risk using ratios of various items in the financial statements

Firms Credit Policy and Monitoring Process



Profitability, Growth, Risk

Product ‐ Market Strategies Financial ‐ Market Strategies

Operating

Decisions

Investment and

Asset

Management

Decisions

Financing

DecisionsDividend

Decisions

Managing

Revenue &

Expenses

Managing

Working Capital &

Fixed Assets

Managing

Liabilities and

Equity

Managing

Dividend Payout

Profit Margin

RatiosEfficiency Ratios

Capital Structure

RatiosPayout Ratios

Profitability Analysis



• Most financial statement ‐ based risk analysis focuses on a comparison of the supply of cash and demand for cash

• Risk analysis using financial statement data typically examines

A. short ‐term liquidity risk , the near term ability to generate cash to service

working capital needs and debt service requirements, and

B. long ‐term solvency risk , the longer ‐ term ability to generate cash internally

or from external sources to satisfy plant capacity and debt repayment needs

• The field of finance identifies two types of risks:

C. credit risk , a firm’s ability to make payments on interest and principle

payments, and

D. bankruptcy risk , the likelihood that a firm will be liquidated

Liquidity, Solvency and Financial Strength



Framework for Financial Statement Analysis of Risk

ActivityAbility to Generate

Cash

Need to Use CashFinancial Statement

Analysis Performed

OperationsProfitability of

Goods and Services

Sold

Working Capital

RequirementsShort ‐ Term Liquidity

Risk

InvestingSales of Existing

Plant Assets or

Investments

Plant Capacity

RequirementsLong‐ Term Solvency

Risk

Financing Borrowing Capacity Debt Service Requirements



Analysis of Short ‐ Term Liquidity Risk

• The analysis of short ‐ term liquidity risk requires an understanding of the operating

cycle of a firm!• Current Ratio : mainly used to give an idea about the company’s ability to pay back

its short ‐ term liabilities and a sense of the efficiency of the firm’s operating cycle

and its ability to turn its products into cash (ratio ≥ 1.0 preferred)• Quick Ratio : known as acid test , measures the firm’s ability to pay off its short ‐

term debt from current liquid assets; draws a more realistic picture (trend towards

0.5)

• Operating Cash Flow Ratio : using cash flow as opposed to accounting items

provides a better indication of liquidity (40%ntypical of a healthy firm)• Short ‐ term liquidity problems also arise from longer ‐ term solvency difficulties!



Financial Ratio Formula Measurements

Current Ratio Current Assets / Current liabilities

A measure of short ‐ term liquidity.

Indicates the ability of entity

to meet its short ‐ term debts from its current assets

Quick Ratio Current Assets less inventory / Current liabilities

A more rigorous measure of short ‐

term liquidity. Indicates the

ability of the entity to meet

unexpected demands from

liquid current asses

Operating Cash Flow Ratio Cash Flows from Operations/Average Current

Liabilities

Measures a company's ability to

pay its short term liabilities.

Indicates whether the

company has generated

enough cash over the year to

pay off short term liabilities as

at the year end

Liquidity Analysis



Analysis of Long‐ Term Solvency Risk

• Increasing the proportion of debt in the financial structure intensifies the risk that

the firm cannot pay interest and repay the principle on the amount borrowed• Analysis of long ‐ term solvency risk must begin with an analysis of short ‐ term

liquidity risk

• Firms must survive in the short ‐ term if they are to survive in the long ‐ term!• Interest Coverage Ratio : gives a sense of how far earnings can fall before a firm will

start defaulting on its payments (risky if ≤ 2.0)• Long ‐Term Debt to Long ‐Term Capital Ratio : way of looking at the debt structure

and determine what portion of total capitalization is comprised of long ‐ term debt (what if ≥ 1?)

• Solvency may also lack the borrowers tax strategies, therefore the financial models

built for borrowers are inter ‐ dependent to the summary of the borrowers needs.




Debt ratio Total Liabilities / Total assetsMeasures percentage of assets

provided by creditors and

extent of using gearing

Capitalization ratio Total assets / Total shareholders’ equity

Measures percentage of assets

provided by shareholders

and the extent of using

gearing

Debt to Capital RatioTotal Debt/(Total Shareholders’ Equity +

Total Debt)

The debt ‐ to ‐ capital ratio gives

users an idea of a company's financial

structure, or how it is

financing its operations,

along with some insight

into its financial strength.

Times interest earnedOperating profit before income tax + Interest

expense / Interest expense + Interest

capitalized

Measures the ability of the

entity to meet its interest

payments out of current

profits.

Debt and Capital Analysis



Multivariate Bankruptcy Prediction Models

Altman’s Z‐ Score:

AssetsTotal Sales

s Liabilitieof Value Book

Equityof Value Market

AssetsTotal

Taxesand Interest Before Earning

AssetsTotal Earningstained

AssetsTotal Capital Working Net

score Z

0.1

6.03.3

Re4.12.1

We can convert the Z‐ score into a probability of bankruptcy using the normal density

function within Excel. The formula is: =NORMSDIST(1‐ Z score). Altman developed this model

so that higher positive Z‐ scores mean lower probability of bankruptcy. However, if the

borrowers have unique situations like deferral tax strategies, these model may not give full

extent of the financial situations of the borrowers. Each Borrowers may not pass the

Altman’s Z Test, but may be risk maybe taken by the bank. There are weaknesses to

Multivariate Bankruptcy Models.

The principle strengths of MDA are as follows:• It incorporates multiple financial ratios;• It provides the appropriate coefficients fro combining the independent variables;• It is easy to apply once the initial model has been developed.



Each ratio captures a different dimension of profitability or risk:

• Met Working Capital/Total Assets: the proportion of total assets comprising relatively

liquid net current assets (current assets minus current liabilities). It is a measure of short ‐ term liquidity risk.

• Retained Earnings/Total Assets: accumulated profitability.

• EBIT/Total Assets: this ratio measures current profitability.

• Market Value of Equity/Book Value of Liabilities: this is a form of debt/equity ratio, but

it incorporates the market’s assessment of the value of the firm’s shareholders’ equity. This ratio measures long ‐ term solvency risk and the market’s overall assessment of the

profitability and risk of the firm.

• Sales/Total Assets: this ratio is similar to the total assets turnover ratio and indicates the

ability of a firm to use assets to generate sales.

In applying this model, Altman found that Z‐ scores of less than 1.81 indicated a high

probability of bankruptcy, while Z‐ scores higher than 3.00 indicates a low probability of bankruptcy. Scores between 1.81 and 3.00 were in the gray area.

Methods of Risk Analysis



Logit Analysis

Probability of Bankruptcy of a Firm:

y

e

p

1

1

y = ‐ 1.32 – 0.407*SIZE + 6.03*TLTA – 1.43*WCTA + 0.0757*CLCA – 2.37*NITA – 1.83*FUTL + 0.285*INTWO –1.72*OENEG – 0.521*CHIN,

SIZE = ln (Total Assets/GNP Deflator)

TLTA = Total Liabilities/Total Assets

WCTA = (CA‐ CL)/Total Assets

CLCA = Current Liabilities/Current Assets

NITA = Net Income/Total Assets

FUTL = Funds (Working Capital) from Operations/Total Liabilities

INTWO = one if Net Income (NI) was negative in the last two years and zero otherwise

OENEG = one if owners’ equity is negative and zero otherwise

CHIN = [NI (this year) – NI (last year)]/[|NI (this year)| + |NI (last year)|]



Earnings Manipulation

• Beneish developed a probability model to identify the financial characteristics of firms likely to engage in earnings manipulation

)(*670.4

)(*327.0)(*172.0)(*115.0)(*892.0

)(*404.0)(*528.0)(*920.0840.4

TATA

LVGI SAI DEPI SGI

AQI GMI DSRI y

• Probability converts y into a probability using standardized normal

distribution. The command NORMSDIST within Excel, when applied to a particular

value of y, converts it to the appropriate probability value



Beneish’s eight factors and the rationale for their inclusion are as follows:

Index Rationale

Days Sales in Receivables Index (DSRI) A large increase in accounts receivables as a

percentage of sales might indicate an overstatement

of accounts receivables and sales to boost earningsGross Margin Index (GMI) Firms with weaker profitability a more likely to engage

in earnings manipulation

Asset Quality Index (AQI) An increase in the proportion indicates an increased

efforts to defer costs

Sales Growth Index (SGI) The need for low ‐ cost external financing might

motivate sales manipulation

Depreciation Index (DEPI) Slowing of the rate of depreciation and thereby

increasing earnings

Selling and Administrative Expense Index (SAI) ≥ 1 indicates increased marketing expenditures and

expected increased sales

Leverage Index (LVGI) Increase in the proportion of debt might entail a

violation of debt covenants

Total Accruals to Total Assets (TATA) Indicates the volume of earnings resulting from

accruals instead of from cash flows



Profitability Analysis

The analysis of profitability addresses two broad questions:

• How much risk economic and strategic factors pose for the operations

of a firm, its profitability and long ‐ term solvency ? We use the Rate of Return on Assets (ROA) to answer this question.

• Can the firm generate the expected return on the capital invested by

the lenders and shareholders without compromising the future of the

firm? That is, how much of ROA is left to shareholders (owners) after

subtracting the amounts owed to lenders.



Rate of Return on Assets

AssetsTotal Average Earningsin Interest Minority RateTax Expense Interest Income Net

ROA)1(*

Turnover Assets ROA for in M ofit ROA argPr

Sales Earningsin Interest Minority RateTax Expense Interest Income Net

ROA for in M ofit

)1(*

argPr

AssetsTotal AverageSales

Turnover Asset



Average Median ROA, Profit Margin for ROA, and Assets Turnover for 23 industries for 1990 to 2012



Economic Factors Affecting the Profit Margin/Assets Turnover Mix

Area in

ExhibitCapital

Intensity CompetitionStrategic

Focus

A High MonopolyProfit

Marginfor ROA

B Medium Oligopoly Both

C LowPure

CompetitionAssets

Turnover




Return on Total AssetsOperating profit before income tax +

interest expense/ Average total assets

Measures rate of return

earned through operating

total assets provided by both

creditors and owners

Return on ordinary

shareholders’ equity

Operating profit & extraordinary items

after income tax minus Preference

dividends / Average ordinary

shareholders’ equity

Measures rate of return

earned on assets provided by

owners

Gross Profit Margin Gross Profit / Net SalesProfitability of trading and

mark ‐ up

Profit MarginOperating profit after income tax / Net

Sales RevenueMeasures net profitability of each dollar of sales

Profitability Ratios



Total Assets TurnoverFinancial Ratio Formula Measurements

Receivables turnover Net sales revenue / Average receivablesbalance

Measures the effectiveness of collections; used toevaluate whether receivables balance isexcessive

Inventory turnover Cost of goods sold / Average inventory

balance

Indicates the liquidity of inventory. Measures the

number of times inventorywas sold on the average

during the period

Total Asset turnover ratio Net sales revenue / Average total assetsMeasures the effectiveness of

an entity in using itsassets during the period.

Turnover of Fixed Assets Net Sales / Fixed AssetsMeasure the efficiency of the

usage of fixed assets ingenerating sales



Return on Common Shareholders’ Equity (ROCE)

Return on

AssetsReturn to

Creditors

Return to

Preferred

Shareholders

Return to

Common

Shareholders

Leverage Financial Turnover Assets ROCE for in M ofit ROCE argPr

EquityrsShareholdeCommon Average

rsShareholdeCommonto Income Net

ROCE '

SalesrsShareholdeCommonto Income Net

ROCE for in M ofit argPr

AssetsTotal Average

SalesTurnover Assets

EquityrsShareholdeCommon Average AssetsTotal Average

Laverage Financial '



Stress Test

• Static & Dynamic Stress Test• Static Stress Test is weak in the analysis of the financial institution for couple of reasons, the

scenario is it will likely never happen, second would regulators may not accept a static test as

a true measurement of credit risk. If an underwriter increases debt interest by 2%, is that

likely, it

all

depends

on

the

index,

if

Prime

rate

was

used,

from

todays

price

of

3.25%,

5.25%

in prime would be around 61% increase in payment. That is far more then the FDIC

recommends on the rate test, so would the regulator be more lenient, the answer is no,

because the credit manager was stress testing something that will never happen in the

future or at least highly unlikely. That is the weakness of Static Stress Test.

• Dynamic Stress

Test

is

based

on

Value

at

Risk

(VaR)

which

can

be

interpreted

in

3

ways,

historical, random number and Monte Carlo simulation. In each case the risk analysis is not a

simple process. Running random numbers is highly likely will never happen, furthermore

there has to be some dependent variables like the economy, GDP, Credit Growth and Interest

Rate based on LIBOR, FHLB and even COFI. The credit manager should start looking at risk

with both static and dynamic to get a comprehensive understanding of the risk of SBA loan.



Portfolio LossEL 99.xx%

Doesn’t an Economic Capital Model Perform Stress Testing?Probability

Loss

Distribution• Extreme tail losses, used to calculate

portfolio required economic capital, occurunder simulated severe stress scenarios

• Does this mean that there is no need foradditional stress testing?

Stress Testing



Stress Testing Complements Standard EC Modeling

Three primary reasons why financial institutionscomplement their standard economic capital modeling withadditional stress scenario analyses:

1. To extend the analytical framework for measuringportfolio risk, loss, and capital adequacy

2. To help management plan responses to stressscenarios

3. To facilitate communication of management responsesto stress scenarios internally and to regulators

Types of Stress Testing



Extending the Risk Measurement Analytical Framework

Identify obligor, industry, and/or country concentrations that may not be otherwise apparently

based on exposer amounts or simple economic capital model.

Fill economic capital model analysis gaps , e.g., analysis of liquidity shocks, loan risk, loan default

reserves, and the guarantor not being fully committed to the business, finally the GDP, Economic

conditions of the sector, business cycles and the subject loan.

Illuminate tail risk scenarios – the financial models are not always accurate in the day to day real

market trends, nor is it simple to determine risk, but the tail risk is really based on the Character,Credit, Condition, Collateral, Liquidation Value and other factors that financial models try to

answer

Perform comparative ‐ static simulation ‐ based stress tests ,

i.e., altering input parameters may help to build a true risk analysis for the future of the financial

institution and believe in the longer ‐ term the strength of the financial institution is to create risk

premiums into the loan for future performance of the subject loan, pricing the risk accordingly.

Risk Measurement Analytics



‐ 4.00%

‐

2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

$0

$1,000

$2,000

$3,000

$4,000

$5,000

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Unleveraged IRR

CASH FLOW NET INCOME BEFORE DEBT SERVICE UNLEVERAGED IRR

‐ 15.00%

‐ 10.00%

‐ 5.00%

0.00%

5.00%

10.00%

($500)

$0

$500

$1,000

$1,500

$2,000

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Leveraged IRR

CASH FLOW NET INCOME AFTER DEBT SERVICE LEVERAGED IRR

IRR Returns for Business Strength



$(6,000)

$(4,000)

$(2,000)

$‐

$2,000

$4,000

$6,000

1 2 3 4 5 6 7 8 9 10 11

LTV Financial Model

Total Property Mortgage Equity

0.000000

0.100000

0.200000

0.300000

0.400000

0.500000

0.600000

0.700000

0.800000

0.900000

1.000000

$‐

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

1 2 3 4 5 6 7 8 9 10

Total Property Present Value

NOI Before Debt Discount Cash Flow PV Factor

0.000000

0.200000

0.400000

0.600000

0.800000

1.000000

$ ‐

$1,000

$2,000

$3,000

$4,000

1 2 3 4 5 6 7 8 9 10

Mortgage Component PV

Mortgage Payment Discount Cash Flow PV Factor

Financial Models Answers to Risk Analysis



$(6,000)

$(4,000)

$(2,000)

$‐

$2,000

$4,000

$6,000

1 2 3 4 5 6 7 8 9 10 11

DCR Financial Model

Total Property Mortgage Equity

0.0000000.1000000.2000000.300000

0.4000000.5000000.6000000.7000000.8000000.9000001.000000

$‐

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

1 2 3 4 5 6 7 8 9 10

Property Present Value

NOI Before Debt Discount Cash Flow PV Factor

$‐

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

1 2 3 4 5 6 7 8 9 10

Mortgage PV

Mortgage Payment Discount Cash Flow PV Factor

Financial Models Answers to Risk Analysis II



Name Cell Graph Function Min Mean Max

Category: Net Income (Loss)

Net Income (Loss) / Interim M42 RiskNormal(G14,10) - ∞ 977.2 + ∞

Category: Net Sales

Net Sales / Tax Return E14 RiskNormal(606,60.6,RiskStatic(606)) - ∞ 606 + ∞

Net Sales / Tax Return G14 RiskNormal(1015,101.5,RiskStatic(1015)) -∞

1,015 +∞

Net Sales / Tax Return I14 RiskNormal(932,93.2,RiskStatic(932)) - ∞ 932 + ∞

Net Sales / Tax Return K14 RiskNormal(1046,104.6,RiskStatic(1046)) - ∞ 1,046 + ∞

Net Sales / Interim M14 RiskNormal(289,28.9,RiskStatic(289)) - ∞ 289.0 + ∞

Category: Total Expenses

Total Expenses / Tax Return E36 RiskNormal(0,10) - ∞ 0.0 + ∞

Total Expenses / Tax Return G36 RiskNormal(0,10) - ∞ 0.0 + ∞

Total Expenses / Tax Return I36 RiskNormal(0,10) - ∞ 0.0 + ∞

Total Expenses / Tax Return K36 RiskNormal(0,10) - ∞ 0.0 + ∞

Total Expenses / Interim M36 RiskNormal(216,21.6,RiskStatic(216)) - ∞ 216.0 + ∞

Dynamic Stress Testing Net Operating Income



Example of Dynamic Stress Test

Simulation Summary InformationWorkbook Name Hotel

Number of Simulations 1

Number of Iterations 10000

Number of Inputs 11

Number of Outputs 5

Sampling Type Latin Hypercube

Simulation Start Time 4/29/12 18:43:26

Simulation Duration 00:00:36

Random # Generator Mersenne Twister

Random Seed 623328357

Summary Statistics for Net Income (Loss) / Tax Return

StatisticsPercentile

Minimum ‐ 236.8 5%‐ 91.7

Maximum 235.4 10% ‐ 70.2

Mean 9.0 15% ‐ 55.0

Std Dev 61.5 20% ‐ 42.9

Variance 3777.120076 25% ‐ 32.8

Skewness‐

0.00692026 30%‐

23.3Kurtosis 2.960802516 35% ‐ 15.1

Median 9.5 40% ‐ 6.8

Mode 14.7 45%1.1

Left X ‐ 91.7 50%9.5

Left P 5% 55%17.0

Right X 109.8 60%25.2

Right P 95% 65%32.9

Diff X 201.5 70%41.3

Diff P 90% 75%50.7

#Errors 0 80%61.1

Filter Min Off 85%72.2

Filter Max Off 90%87.7

#Filtered 0 95%109.8

Regression and Rank Information for Net Income (Loss) / Tax ReturnRank Name Regr Corr1 Net Sales / Tax

Return0.986 0.985

2 Total Expenses

/ Tax Return‐ 0.163 ‐ 0.167

3 Net Sales / Tax Return 0.000 0.007353246

4 Net Sales / Tax

Return0.000 ‐ 0.00644023

5 Net Sales / Tax

Return0.000 0.006389201

6 Net Sales /

Interim0.000 0.00615364

7 Total Expenses

/ Tax Return0.000 ‐ 0.00457497

8 Total Expenses

/

Tax

Return

0.000 ‐ 0.00425346

9 Total Expenses

/ Tax Return0.000 ‐ 0.00254219

10 Total Expenses

/ Interim0.000 ‐ 0.00106381

11 Net Income

(Loss) / Interim0.000 0.000266816



0

200

400

600

800

1000

1200

0 % 2 0 %

4 0 %

6 0 %

8 0 %

1 0 0 %

1 2 0 %

I n c o m e A f t e r D e b t S e r v i c e / 2 0 1 1

Percentile

Mean of Income After Debt Service / 2011 H15 vs Input Distribution Percentile

Income for Debt Service (NOI) / 2008 E9

Income for Debt Service (NOI) / 2009 F9

Income for Debt Service (NOI) / 2010 G9

Income for Debt Service (NOI) / 2011 H9

Means Testing Distribution on NOI



0

200

400

600

800

1000

1200

1400

‐ 3 0 %

‐ 2 0 %

‐ 1 0 %

0 %

1 0 %

2 0 %

3 0 %

I n c o m e A f t e r D e b t S e r v i c e / 2 0 1 1

Change From Base Value (%)

Mean of Income After Debt Service / 2011 H15 vs Percentage Change of Inputs

Income for Debt Service (NOI) / 2008 E9

Income for Debt Service (NOI) / 2009 F9

Income for Debt Service (NOI) / 2010 G9

Income for Debt Service (NOI) / 2011 H9

Means Testing Distribution on DSCR

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