session 11 topics - fuqua school of businessqc2/accountg441/files...4 short-term liquidity risk...

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SESSION 11Topics:

Framework for credit risk analysis using Bishay Framework for credit risk analysis using Bishay Industries as illustration

OverviewCredit risk analysesOther related (and equally important) analyses

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CREDIT RISK ANALYSIS

Overview of Bishay industries:What was going on with Bishay? How would you What was going on with Bishay? How would you describe Bishay’s situation in 1988 and 1989? What was the industry outlook?What actions have been taken prior to October 1989?

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Overview of Bishay’s performance from 1985-1989:

Bishay Industries, Inc and SubsidiariesIncome statement for fiscal ending Oct 31, 1989 1988 1987 1986 1985 1989 1988 1987 1986

Net Sales 100% 100% 100% 100% 100% -50% -26% 6% 11%COGS 65% 72% 54% 54% 54% -54% -2% 8% 10%Gross margin 35% 28% 46% 46% 46% -39% -54% 5% 13%Advertising, promotion, SG&A 55% 57% 42% 38% 44% -52% 0% 19% -4%Other deductions (income) Discounts allowed 2% 2% 2% 2% 2% -45% -23% -1% 12%

Common size Trend

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y p

Interest expense 7% 3% 1% 1% 1% 41% 54% 4% -3% Other, net -1% 1% 0% 0% 0% -141% -411% -54% 96%Earnings (loss) before taxes -28% -33% 1% 6% -1% -57% -2414% -82% -833%Net income (loss) -28% -31% 1% 3% 0% -55% -4062% -81% -845%


There are multiple aspects of a company’s “credit risk,” that are distinct and related to each other.risk, that are distinct and related to each other.

Short-term liquidity riskLong-term solvency riskBankruptcy risk

Analysts use various ratios to capture these risks We will use Bishay industries’ case to

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risks. We will use Bishay industries case to illustrate these aspects of risk analysis

Our focus is on the interpretations of these ratios:What do these ratios tell you and what they do not tell you?

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SHORT-TERM LIQUIDITY RISK

Short-term liquidity risk: Does the firm have enough liquidity/cash to satisfy g q y yits short term obligations and to fund its daily operations?

Two types of ratios:Current ratio, quick ratio, cash ratio, and CFO/liability ratioOperating activity ratios (A/R, Inventory, and A/P ratios)

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Implicit assumptions behind these ratios?Benchmark for these ratios? How high is high?


Ratios to capture ability to satisfy short term obligations:obligations:

Current ratio = Current Assets/Current liabilitiesQuick (Acid test) ratio = Cash + Mkt Securities + A/R /Current liabilitiesCash ratio = Cash + Mkt Sec/Curr liab

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Bishay’s short term liquidity risk ratios:

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Liquidity ratios 1989 1988 1987 1986Current ratio (Curr Assets/Curr Liab) 1.93 1.09 1.94 2.96Quick ratio (Cash+MktSec+netA/R)/CurrLiab 0.99 0.33 0.83 1.64Cash ratio (Cash+MktSec)/CurrLiab 0.42 0.02 0.12 0.38CFO ratio (CFO/avg current liabilities)(CFO=NI+Dep+Amortn + Adjustment for Working capital accts) -0.39 -0.14 -0.21 0.25

What do they tell us? How to interpret these ratios?

Defensive interval (cash burn rate)(365*(Cash+MktSec+netA/R)/(COGS+SG&A) 111 39 87 101


Estimating/proxying Bishay’s Cash From Operations:

Cash from operations 1989 1988 1987 1986Net Income (Loss) (3,445) (7,605) 192 1,011 Add back: Depreciation (footnote #5, page 16) 186 230 182 150 Amortization (footnote #6, page 16) 277 98.8 36.4 40Plus changes in working capital accounts (Increase) Decrease in Receivables 607 3,295 (439) (72) (Increase) Decrease in Inventory 2,562 2,938 (3,490) (271)(Increase) Decrease in Prepaid expenses 181 233 (325) 43

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(Increase) Decrease in Prepaid expenses 181 233 (325) 43 Increase (Decrease) in Acct Payable (2,836) (597) 2,382 (52) Increase (Decrease) in Accrued liabilities (395) 16 (20) 461 Cash from operations (2,864) (1,391) (1,480) 1,309

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What liquidity ratios do not tell you:

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Window dressing of Current ratios

Total current assets

Total current

liab. Current ratio

Compared with base scenario

Base scenario A: $5 mil $4 mil 1.25Scenario 1: purchase $1mil inventory on account 6 5 1.2 decreasedScenario 2: pay off 1mil short term debt 4 3 1.33 increased

Base scenario B: 3 4 0.75Scenario 1: purchase $1mil inventory on account 4 5 0.8 increased

They are subject to window dressing:

Scenario 2: pay off 1mil short term debt 2 3 0.66 decreased

They do not tell you the source of the changes.


A closer look at Bishay’s current assets and current liabilities accounts:What caused the improvement in current ratio in 1989?

Balance sheet 1989 1988 1987 1989 1988 1987 1989 1988 1987AssetsCurrent assets Cash 1,295 154 1,062 8% 1% 5% 742% -86% -18% Short-term investments 600 - - 4% 0% 0% Receivables, net 2,573 3,180 6,475 16% 17% 29% -19% -51% 7% Income taxes refundable - 772 - 0% 4% 0% Inventories (Notes 2 and 3) 4,023 6,585 9,523 25% 36% 43% -39% -31% 58% Prepaid expenses 202 383 616 1% 2% 3% -47% -38% 111% Total current assets 8,694 11,074 17,677 53% 60% 80% -21% -37% 25%

Common size Trend

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LiabilitiesCurrent liabilities Current maturities of long-term liabilities 115 511 296 1% 3% 1% -77% 73% 4% Trade payables (Notes) 1,257 366 - 8% 2% 0% 243% Trade payables (Accounts) 2,131 4,968 5,564 13% 27% 25% -57% -11% 75%Loans payables, principally to banks 97 3,038 1,982 1% 16% 9% -97% 53%Accrued liabilities 914 1,309 1,293 6% 7% 6% -30% 1% -2% Total current liabilities 4,515 10,192 9,135 28% 55% 41% -56% 12% 91%

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Operating activity ratios:A/R collection daysA/R collection daysInventory holding daysA/P outstanding days

Operating cycle = A/R collection days + Inventory holding daysCash cycle = Operating cycle – A/P outstanding days

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Bishay’s working capital activity days:

1989 1988 1987 1986Avg A/R as % of sales 23% 20% 19% 19%A/R collection days 86 72 69 70 Avg Inventory as % of COGS 66% 46% 43% 35%Inventory holding days 241 168 159 129 Operating cycle days 327 240 228 200 A A/P % f h 65% 36% 20% 19%

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What do these numbers tell you?

Avg A/P as % of purchases 65% 36% 20% 19%A/P days 237 132 75 69 Cash cycle 90 108 153 131

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SESSION 11Framework for credit risk analysis:

O iOverviewRisk analyses:

Short-term liquidityLong-term solvencyBankruptcy risk

Other analyses

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LONG-TERM SOLVENCY RISK

Long-term solvency risk Solvency refers to a firm’s ability to make interest Solvency refers to a firm s ability to make interest and principal payments on long-term debt and similar obligations as they come due.It is closely related to firms’ long term earnings generating ability

It’s contingent on firms’ ability to meet short term liquidity needs.

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Typical solvency risk ratios:Financial leverage ratios (debt to asset debt to Financial leverage ratios (debt to asset, debt to equity)Coverage ratios

TIE (time interest earned) = EBIT/Interest expenseTIE (cash based) = CFO/Interest expTIE (FCF b d) = F h fl /i t t

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TIE (FCF based) = Free cash flow/interest exp


Bishay’s solvency ratios:Wh t d th t ll ?

Solvency ratios 1989 1988 1987 1986Debt to total assets 67% 53% 38% 35%Debt to equity 4.6 4.3 1.2 0.9TIE (EBIT/Interest expense) -2.7 -10.9 3.0 6.9TIE (CFO to interest expense) -3.2 -2.2 -3.6 3.3TIE (Free cash flow/interest expense)

Cash flow adequacy (insufficient info.) insufficent information

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What do they tell you?

Cash flow adequacy (insufficient info.)(CFO/(Capex+Debt repayment+Cash dividends)

insufficent information

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Interpreting solvency ratios:What are the benchmarks for these ratios?What are the benchmarks for these ratios?

What’s the optimal financial leverage?How high should coverage ratio be?

What does negative coverage ratio meanHow to use these ratios?

Over time changesAverage over years: one year of adverse performance may not be representative

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not be representative


What solvency ratios do not tell you:Some debts are hidden off-balance sheet (e.g.,

ti l )operating leases)Some could be classified as equity (e.g., some convertible bonds)Some are not “relevant debts”

Typically, creditors of a given subsidiary have recourse only to the assets of that subsidiary, not the assets of the parent.

Some debts’ book values do not equal their market l

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values.Western Union’s famous debt retirement…

No information about debt covenants.

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Relation between liquidity and solvency:Solvency is contingent on firm’s ability to meet its Solvency is contingent on firm s ability to meet its short term obligations.Bankruptcy is often called by long term creditors.

Using these ratios judiciously. Interpret them in the context of your specific case, and in conjunction with other relevant information.

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A QUICK REVIEW

What is solvency risk?What are the common ratios for solvency risk?What are the common ratios for solvency risk?What is the benchmark for financial leverage ratios?What are financial leverage ratios not telling you?What do interest coverage ratios tell you?

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SESSION 11Framework for credit risk analysis:

O iOverviewRisk analyses:

Short-term liquidityLong-term solvencyBankruptcy risk

Other analyses

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BANKRUPTCY RISK

Complex procedures for bankruptcy proceedingsComplicated; beyond the scope of this courseComplicated; beyond the scope of this course

Various algorithms have been devised to predict bankruptcy probability using firms financial ratios

Z-score is one of the most widely used

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BANKRUPTCY RISK

Z-score’s basic idea:For each bankrupt firm, find a similar sized non-p ,bankrupt firm in the same industry. Perform a Multiple Discriminate Analysis (MDA) between the bankrupt group and the non-bankrupt group. Identify the ratios/variables that differ the most between the groups. These ratios/variables are the one that have the most discriminating power for b k t

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bankruptcy.

BANKRUPTCY RISK

Altman’s Z-score for manufacturing firms:Z= 1.2 X Working capital / total assets g p+ 1.4 X Retained earnings / total assets+ 3.3 X EBIT / total assets+ 0.6 X Market value of equity / book value of debt+ 1.0 X Sales / total assets

Predict: bankrupt if Z<1.81; non-bankrupt if Z>2.99; in between is the “zone of ignorance.”

The e facto ea t to ca t e fi ’ li idit

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These factors meant to capture firms’ liquidity, profitability, solvency, and activity ratios.

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BANKRUPTCY RISK

Z-score’s average performance A

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Year prior to Bankruptcy % CorrectFirst 95%

Second 72Third 48

Fourth 29Fifth 36

Why wasn’t Bishay bankrupt yet as predicted by Z-score?

OTHER CONSIDERATIONSBishay’s collateral-able asset values?

How much cash can creditors get if the company liquidates on Oct 31 1989? A

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Current assets Book valueassumed discount

Estimated liquidation

value Cash 1,295 1,295 Short-term investments 600 600 Receivables, net 2,573 50% 1,287 Inventories (Notes 2 and 3) 4,023 90% 402 Prepaid expenses 202 50% 101 Total current assets 8,694 Investment in common stock of Realty Investors Corp (Notes 2 and 4) 3,050 mkt value 1,000 PPE net 2,635 2,635

liquidates on Oct. 31, 1989?

Investment in excess of net assets of purchased sub, at amortized cost (Note 1) 417 - Trade names and other intangibles 450 - Unamortized debt discount and issue expenses 667 - Deferred charges and other assets 379 - Total assets 16,291 7,320 Total liabilities 13,881 13,881 Surplus (Deficit) 2,411 (6,561)

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PARTIAL CHECK-LIST

Partial (and not all that robust) checklist for credit risk:

A/R grows faster than sales A/P grows faster than Inventory Other operating current liabilities grows faster than salesPersistent negative CFOCapex consistently exceeds CFOReductions in capex over timeSale of marketable securities exceeds purchases

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Sale of marketable securities exceeds purchasesShift of long term debt to short term debt (signals lack of confidence by lenders)Dividend reduction

SUMMARY OF CONSIDERATIONS

Credit risk: 7 Cs:Circumstances leading to need for additional capital g pinfusionCash flows CollateralCapacity for debtContingenciesConditions (Covenants)Character of management

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Character of managementWould you lend money to Bishay?

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ANALYZING BISHAY INDUSTRIES

Other useful analyses for assessing Bishay’ssituation: situation:

Accounting quality analysisAre their earnings of high quality?Does their balance sheet fairly reflect the true value of their assets?

Implications of managerial actionsWhat’s the management’s turnaround plan?Wh t th lik l fi i l t t t i t f th i

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What are the likely financial statement impacts of their plan?

Pro forma analysis:Incorporate the above into your pro forma forecastsWhat is your benchmark for the “most likely” scenario? for the “optimistic” scenario?


Turnaround plan:Prune assets and product linespDevelop new relations with suppliersReestablish store positionTighten controls and reduce costsBuild a national network for sales and distributionGain consumer confidenceIntroduce a large number of new productsF ll li f i li bilit f l

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Follow a policy of service reliability, resourceful marketing, active R&D and new exciting package designs.

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Financial implications for actions taken:High advertising, promotion and selling costsg g, p gSubstantial gross margin needed to fund the marketing effortHigh R&D costs to develop new productsGenerous credit, discounts and other financial benefits to retailers to encourage new productsLow investment in fixed assets

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Pro forma Income Statement 1986 1989 Most likely OptimisticS l 31085 12277 15 000 20 000

A simplified version of Pro Forma SCF CFO section

Sales 31085 12277 15,000 20,000 COGS 54% 65% 60% 55%Gross margin 46% 35% 40% 45%SG&A 38% 55% 55% 45%Other expenses 1% 8% 1% 1%Net Income (Loss) 1,011 (3,445) (2,400) (200)

Balance sheetAccounts Receivables 2,573 3,000 4,000 A/R as % of sales 19% 23% 20% 20%Inventory 4,023 4,500 4,400 Inventory as % of sales 19% 43% 30% 22%Accounts Payables 3,388 3,000 5,000 A/P % f l 10% 29% 20% 25%

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A/P as % of sales 10% 29% 20% 25%

Pro forma SCF, CFO sectionNI (2,400) (200)Depr+Amort Exp (Assumed) 400 400(Increase) Decrease in A/R (427) (1,427)(Increase) Decrease in Inventory (477) (377)Increase (Decrease) in A/P (388) 1,612 CFO (3,292) 8

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Cash impact of shortening A/R collection day:On the previous slide: I assume A/R ending balance is On the previous slide: I assume A/R ending balance is 20% of sales, which, together with other assumptions, implies 68 days for A/R collection.If Bishay can improve the collection days to 58 days, then A/R balance is 15% of sales.Holding everything else constant in the most likely scenario: this 10 days of shorter collection result in a CFO f (2 542) i f $0 75 il

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CFO of (2,542), an increase of $0.75 mil.

A QUICK REVIEW

What is liquidity risk? Solvency risk?How useful do you find ratios and Z scores in How useful do you find ratios and Z-scores in assessing firm’s risk? Can corporate governance reduce firms’ risk? If so, what kind of risk can it reduce?

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STEP 1 AND 2: FIRM STRATEGY ANDINDUSTRY OVERVIEW

Why are they important for FSA?They shape firms’ financial statements They shape firms financial statements

For industry-specific effects, recall the case: Identify the industry; For firm-specific effects, recall the differences between Costco and Target; how Bishay’s restructuring actions show up in its financial statements, etc.

Help set up expectation for firms’ performance.Industry comparable firms provide benchmarks for

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dust y co pa ab e s p ov de be c a s o evaluating firms’ performance.

STEP 1 AND 2: FIRM AND INDUSTRYOVERVIEW

Where to find related information?Many sources on industry overview Many sources on industry overview Firms strategy and operations:

Item 1 in 10KMD&A in annual reportSegment disclosure in footnote

How are segments defined? What types of information and inference can be made out of segment disclosure?

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STEP 3: EVALUATE FIRM’S CURRENTPOSITION

Roadmap:ProfitabilityProfitabilityCash flow situationSustainability (earnings quality)Risk

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NI + AftTax Int ExpS 1

Step 2

PROFITABILITY-DUPONT ANALYSIS

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Return on Equity (ROE)

Profit Margin (PM)

Assets

X Return on Assets (ROA)

X

Sales

Asset Turnover (TAT)

divided by

divided by

Step 1

Assets

Shareholders’ Equity

Financial Leverage (LEV)divided by

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FRAMEWORK FOR PROFITABILITYANALYSIS

Dupont analysisFocus on firms’ operation efficiency i e ROA and Focus on firms operation efficiency, i.e., ROA and ROICDecompose ROA into PM and Asset turnover to gain insight into source of ROAAdditional insight from other turnover (A/R, Inventory, PPE, A/P, operating cycle, cash cycle).Adjust for differences in accounting treatments

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LIFO/FIFO, Capital leases/Operating leases, PPE useful life estimate, among others.

PROFITABILITY ANALYSIS

Dupont analysisStart with Return to Equity. Why?q y y

Because shareholders’ wealth can be increased if and only if ROE exceeds firm’s cost of equity capital.

In FSA, we usually treat firm’s cost of equity capital as exogenous.

Calculation is: Net Income/Avg. book value of equity.Benchmark for ROE is: firm’s cost of equity capital

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Benchmark for ROE is: firm s cost of equity capital

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ABOUT ROAMeasures firm’s operating performanceBenchmark: firm’s WACCCalculation: [NI + Interest expense *(1-tax rate)] / Avg. total assets.

Denominator is assets contributed by all capital contributors including equity and debt holders Numerator is after income available to both equity and debt holders

ROA is not affected by firm’s financial leverage.Because it adds back the after tax interest expense.Detailed illustration: see the simple example in session 2

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Detailed illustration: see the simple example in session 2 slides.

RETURN ON INVESTED CAPITAL

Motivation: ROA’s numerator and denominator are still not exactly consistent. ROA’s denominator is all capital contributed (some of which are not explicit return demanding, such as A/P, etc.); while its numerator is after tax income available to return demanding capital provider.ROA’s numerator is not entirely operating profit (as NI includes non-operating related items).

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RETURN ON INVESTED CAPITAL

ROIC aims to fix these two problems by:Using invested capital as denominatorUsing invested capital as denominator.

Invested capital = interest bearing debt + SHEUsing NOPAT (net operating profit after tax) = EBIT*(1-tax rate) as numerator.

NOPAT = NI + Int exp * (1-t) if there is no non-operating related items in NI.

Bottom line: ROIC is a refined measure of ROA,

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hence its benchmark is also WACC.

ABOUT ROAROA can be further decomposed into PM and Asset Turnover.

This decomposition helps us gain insight into the sources of a firm’s ROA performance.Whether a firm can improve its ROA by PM or by turnover is affected by:

The industry the firm operates in. Example? The strategy the firm takes. Example?

In a competitive economy, firms’ ROE and ROA

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PROFITABILITY ANALYSIS

The accounting influence:Our discussion so far takes the reported numbers in pfinancial statements as givenIn reality, firms with the same economic activities may report different accounting numbers if they differ in their accounting method and estimate choices.The influence of accounting choices affect both

Our interpretation of ratios, andO l l i d i fi

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Our calculation and comparison across firms.We adjusted for leases in this course.

HOW TO USE RATIOS

Ratios are summary measures of financial statement informationstatement information

They are easy to calculate and to compare across firms.

They reflect, and can be affected by, both business activity and accounting activity.Interpretation of ratios is crucial

Do they represent true business activity?

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Do they represent true business activity?Are they being window-dressed and managed by management?

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HOW TO USE RATIOS

Different ratios have different benchmarks:Economic benchmark: ROE, ROA/ROICEconomic benchmark: ROE, ROA/ROICPractical benchmark: rule of thumb, industry average, historical average.

Must be used in conjunction with other information.

Ratios are only summary measures and often fail to reflect the complexity of a specific situation.

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MAIN POINTERS FOR EXAMINING SCFCheck CFO relative to NI; CFO growth relative to NI growthgCheck components of CFO: any unusual items that suggest CFO may not be persistent?Check Capex growth: is the company investing enough? (Benchmark: how much should the company invest?)CFO relative to CFI? How does the company fi i i ?

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finance its investment? The source of financing: debt or equity? Long term debt or short term debt?

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FRAMEWORK (POINTERS) FOR EARNINGSQUALITY ANALYSIS

Identify potential motives: does this company have incentives to manage earnings? h h i i ?how strong are these incentives?

Any major changes in the firm’s accounting policies, methods, and estimates?

Revenue recognition, expense recognition. Any red flags, esp. from SCF?Compare with comparable firms, what are the implicit assumptions?

A/R I e to PPE a o g othe

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A/R, Inventory, PPE, among othersNon-operating related items on income statements?Prepare “as if” statements using what you believe are the more appropriate methods and estimates.

POINTERS FOR EARNINGS QUALITY

High quality earnings are accurate and strong earnings. Accurate in that accounting earnings earnings. Accurate in that accounting earnings accurately reflect the true underlying economic earnings; strong in that the true underlying economic earnings imply higher sustainable payoff to investors. Typical checkpoints used by analysts:

Highly persistent

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Highly persistent Match closely to cash Based on prudent accounting choices (including conservative accounting principles)

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FRAMEWORK FOR RISK ASSESSMENT

Credit risk (liquidity, solvency, bankruptcy risk)Becomes relevant with deteriorating performance; Becomes relevant with deteriorating performance; and may be captured by various ratiosKey here is to assess the firm’s ability to generate cash, from internal operations and if short from internal sources, from external sources.

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POINTS FOR GOVERNANCE RISKS

Experiences of the management team and the board of directors.board of directors.% of independent directorsChairman/CEO separationDirectors’ attendance of meetingsEffective compensation for directors and management

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Red flags such as interlocking relationship, nepotism, and related transactions between the company and the management.

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FRAMEWORK FOR PRO FORMA ANALYSIS

Understand the mechanics of preparing pro forma.Sales-driven pro forma

I/S: sales + your analysis, hence assumptions, on the firm’s margins Asset side of B/S: sales + your analysis, hence assumptions, on the firm’s asset turnovers. Liability side of B/S: your assumptions on the firm’s leverage situation.

Pro forma is useful to Quantify the effect of firms’ strategy (Royal Caribbean)

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Quantify the effect of firms strategy (Royal Caribbean)Assess firms’ cash needs and credit risk (Bishay)Valuation (MicroStrategy, final project)

POINTERS FOR PRO FORMA

Construct simplified financial statements: focus on main accounts.

Asset side: Most likely: Cash; A/R, Inventory, PPE. Maybe: short term investment, other assets.

Liability side:Most likely: A/P, Long term debt, and Shareholders’ equityMaybe: other accrued liabilities, deferred tax liabilities.

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The ‘maybe’ items: assume as % of assets, or % of sales, same as historical averages, etc.

SCF follows through from B/S and I/S.

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FINANCIAL STATEMENT ANALYSIS

Key take-aways from this course:A framework for analyzing financial statementsy gThe ability to judiciously use financial statement information

Ratios and pro-forma as important toolsBe aware of, and be able to tell apart, the effects of accounting choices

Realize the usefulness and limitations of financial statement information

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FSA is only one part of your analysis; It often opens up more questions than it answers;At least you know the right questions to ask!

session 11 topics - fuqua school of businessqc2/accountg441/files...4 short-term liquidity risk...

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