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Credit Analysis and Distress Prediction

• An auditor asks: How likely is it that this firm will survive beyond the short run?
In evaluating the firm™s financials, should I consider it a going concern?
• An actual or potential employee asks: How confident can I be that this firm will be
able to offer employment over the long term?
• A potential customer asks: What assurance is there that this firm will survive to pro-
vide warranty services, replacement parts, product updates, and other services?
• A competitor asks: Will this firm survive the current industry shakeout? What are
the implications of potential financial distress at this firm for my pricing and market

An understanding of credit analysis requires an appreciation for the various players in
the market for credit. We describe those players brie¬‚y here.

Suppliers of Credit
The major suppliers in the market for credit are described below.

COMMERCIAL BANKS. Commercial banks are very important players in the market
for credit. Since banks tend to provide a range of services to a client, and have intimate
knowledge of the client and its operations, they have a comparative advantage in extend-
ing credit in settings where (1) knowledge gained through close contact with manage-
ment reduces the perceived riskiness of the credit and (2) credit risk can be contained
through careful monitoring of the ¬rm.
A constraint on bank lending operations is that the credit risk be relatively low, so
that the bank™s loan portfolio will be of acceptably high quality to bank regulators. Be-
cause of the importance of maintaining public con¬dence in the banking sector and the
desire to shield government deposit insurance from risk, governments have incentives
to constrain banks™ exposure to credit risk. Banks also tend to shield themselves from
the risk of shifts in interest rates by avoiding ¬xed-rate loans with long maturities. Since
most of banks™ capital comes from short-term deposits, such long-term loans leave them
exposed to increases in interest rates, unless the risk can be hedged with derivatives.
Thus, banks are less likely to play a role when a ¬rm requires a very long-term commit-
ment to ¬nancing. However, in some such cases they assist in providing a placement of
the debt with, say, an insurance company, a pension fund, or a group of private investors.

OTHER FINANCIAL INSTITUTIONS. Banks face competition in the commercial
lending market from a variety of sources. In the U.S., there is competition from savings
and loans, even though the latter are relatively more involved in ¬nancing mortgages. Fi-
nance companies compete with banks in the market for asset-based lending (i.e., the
Credit Analysis and Distress Prediction

14-3 Part 3 Business Analysis and Valuation Applications

secured ¬nancing of speci¬c assets, such as receivables, inventory, or equipment). Insur-
ance companies are involved in a variety of lending activities. Since life insurance com-
panies face obligations of a long-term nature, they often seek investments of long
duration (e.g., long-term bonds or loans to support large, long-term commercial real es-
tate and development projects). Investment bankers are prepared to place debt securities
with private investors or in the public markets (discussed below). Various government
agencies are another source of credit.

PUBLIC DEBT MARKETS. Some ¬rms have the size, strength, and credibility neces-
sary to bypass the banking sector and seek ¬nancing directly from investors, either
through sales of commercial paper or through the issuance of bonds. Such debt issues
are facilitated by the assignment of a debt rating. In the U.S., Moody™s and Standard and
Poor™s are the two largest rating agencies. A ¬rm™s debt rating in¬‚uences the yield that
must be offered to sell the debt instruments. After the debt issue, the rating agencies con-
tinue to monitor the ¬rm™s ¬nancial condition. Changes in the rating are associated with
¬‚uctuation in the price of the securities.
Banks often provide ¬nancing in tandem with a public debt issue or other source of
¬nancing. In highly-levered transactions, such as leveraged buyouts, banks commonly
provide ¬nancing along with a public debt issue that would have a lower priority in case
of bankruptcy. The bank™s “senior ¬nancing” would typically be scheduled for earlier re-
tirement than the public debt, and it would carry a lower yield. For smaller or startup
¬rms, banks often provide credit in conjunction with equity ¬nancing from venture cap-
italists. Note that in the case of both the leveraged buyout and the startup company, the
bank helps provide the cash needed to make the deal happen, but does so in a way that
shields it from risks that would be unacceptably high in the banking sector.

SELLERS WHO PROVIDE FINANCING. Another sector of the market for credit are
manufacturers and other suppliers of goods and services. As a matter of course, such
¬rms tend to ¬nance their customers™ purchases on an unsecured basis for periods of 30
to 60 days. Suppliers will, on occasion, also agree to provide more extended ¬nancing,
usually with the support of a secured note. A supplier may be willing to grant such a loan
in the expectation that the creditor will survive a cash shortage and remain an important
customer in the future. However, the customer would typically seek such an arrange-
ment only if bank ¬nancing is unavailable, because it could constrain ¬‚exibility in se-
lecting among and/or negotiating with suppliers.

At ¬rst blush, credit analysis might appear less dif¬cult than the valuation task discussed
in Chapters 11 and 12. After all, a potential creditor ultimately cares only about whether
the ¬rm is strong enough to pay its debts at the scheduled times. The ¬rm™s exact value,
its upside potential, or its distance from the threshold of credit-worthiness may not ap-
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Credit Analysis and Distress Prediction

pear so important. Viewed in that way, credit analysis may seem more like a “zero-one”
decision: either the credit is extended, or it is not.
It turns out, however, that credit analysis involves more than “just” establishing
credit-worthiness. First, there are ranges of credit-worthiness, and it is important to un-
derstand where a ¬rm lies within that range for purposes of pricing and structuring a
loan. Moreover, if the creditor is a bank or other ¬nancial institution with an expected
continuing relationship with the borrower, the borrower™s upside potential is important,
even though downside risk must be the primary consideration in credit analysis. A ¬rm
that offers growth potential also offers opportunities for income-generating ¬nancial
Given this broader view of credit analysis, it should not be surprising that it involves
most of the same issues already discussed in the prior chapters on business strategy
analysis, accounting analysis, ¬nancial analysis, and prospective analysis. Perhaps the
greatest difference is that credit analysis rarely involves any explicit attempt to estimate
the value of the ¬rm™s equity. However, the determinants of that value are relevant in
credit analysis, because a larger equity cushion translates into lower risk for the creditor.
Below we describe one series of steps that is used by commercial lenders in credit
analysis. Of course, not all commercial lenders follow the same process, but the steps
are representative of typical approaches. The approach used by commercial lenders is of
interest in its own right and illustrates a comprehensive credit analysis. However, analy-
sis by others who grant credit often differs. For example, even when a manufacturer con-
ducts some credit analysis prior to granting credit to a customer, it is typically much less
extensive than the analysis conducted by a banker because the credit is very short-term
and the manufacturer is willing to bear some credit risk in the interest of generating a
pro¬t on the sale.
We present the steps in a particular order, but they are in fact all interdependent. Thus,
analysis at one step may need to be rethought, depending on the analysis at some later step.

Step 1: Consider the Nature and Purpose of the Loan
Understanding the purpose of a loan is important not just for deciding whether it should
be granted, but also for structuring the loan. Loans might be required for only a few
months, for several years, or even as a permanent part of a ¬rm™s capital structure. Loans
might be used for replacement of other ¬nancing, to support working capital needs, or
to ¬nance the acquisition of long-term assets or another ¬rm.
The required amount of the loan must also be established. In the case of small and
medium-sized companies, a banker would typically prefer to be the sole ¬nancier of the
business, in which case the loan would have to be large enough to retire existing debt.
The preference for serving as the sole ¬nancier is not just to gain an advantage in pro-
viding a menu of ¬nancial services to the ¬rm. It also re¬‚ects the desirability of not per-
mitting another creditor to maintain a superior interest that would give it a higher priority
in case of bankruptcy. If other creditors are willing to subordinate their positions to the
bank, that would of course be acceptable so far as the bank is concerned.
Credit Analysis and Distress Prediction

14-5 Part 3 Business Analysis and Valuation Applications

Often the commercial lender deals with ¬rms that may have parent-subsidiary rela-
tions. The question of to whom one should lend then arises. The answer is usually the en-
tity that owns the assets that will serve as collateral (or that could serve as such if needed
in the future). If this entity is the subsidiary and the parent presents some ¬nancial
strength independent of the subsidiary, a guarantee of the parent could be considered.

Step 2: Consider the Type of Loan and Available Security
The type of loan considered is a function of not only its purpose, but also the ¬nancial
strength of the borrower. Thus, to some extent, the loan type will be dictated by the ¬-
nancial analysis described in the following step in the process. Some of the possibilities
are as follows:
• Open line of credit. An open line of credit permits the borrower to receive cash up
to some specified maximum on an as-needed basis for a specified term, such as one
year. To maintain this option, the borrower pays a fee (e.g., 3/8 of 1 percent) on the
unused balance, in addition to the interest on any used amount. An open line of
credit is useful in cases where the borrower™s cash needs are difficult to anticipate.
• Revolving line of credit. When it is clear that a firm will need credit beyond the
short run, financing may be provided in the form of a “revolver.” Sometimes used
to support working capital needs, the borrower is scheduled to make payments as
the operating cycle proceeds and inventory and receivables are converted to cash.
However, it is also expected that cash will continue to be advanced so long as the
borrower remains in good standing. In addition to interest on amounts outstanding,
a fee is charged on the unused line.
• Working capital loan. Such a loan is used to finance inventory and receivables, and
is usually secured. The maximum loan balance may be tied to the balance of the
working capital accounts. For example, the loan may be allowed to rise to no more
than 80 percent of receivables less than 60 days old.
• Term loan. Term loans are used for long-term needs and are often secured with
long-term assets, such as plant or equipment. Typically, the loan will be amortized,
requiring periodic payments to reduce the loan balance.
• Mortgage loan. Mortgages support the financing of real estate, have long terms,
and require periodic amortization of the loan balance.
• Lease financing. Lease financing can be used to facilitate the acquisition of any as-
set, but is most commonly used for equipment, including vehicles. Leases may be
structured over periods of 1 to 15 years, depending on the life of the underlying asset.
Much bank lending is done on a secured basis, especially with smaller and more
highly levered companies. Security will be required unless the loan is short-term and the
borrower exposes the bank to minimal default risk. When security is required, one con-
sideration is whether the amount of available security is suf¬cient to support the loan.
The amount that a bank will lend on given security involves business judgment, and it
depends on a variety of factors that affect the liquidity of the security in the context of a
558 Credit Analysis and Distress Prediction

Credit Analysis and Distress Prediction

situation where the ¬rm is distressed. The following are some rules of thumb often ap-
plied in commercial lending to various categories of security:
• Receivables. Accounts receivable are usually considered the most desirable form of
security because they are the most liquid. One large regional bank allows loans of
50 to 80 percent of the balance of nondelinquent accounts. The percentage applied
is lower when (1) there are many small accounts that would be costly to collect in
the case the firm is distressed; (2) there are a few very large accounts, such that
problems with a single customer could be serious; and/or (3) the customer™s finan-
cial health is closely related to that of the borrower, so that collectibility is endan-
gered just when the borrower is in default. On the latter score, banks often refuse
to accept receivables from affiliates as effective security.
• Inventory. The desirability of inventory as security varies widely. The best case
scenario is inventory consisting of a common commodity that can easily be sold to
other parties if the borrower defaults. More specialized inventory, with appeal to
only a limited set of buyers, or inventory that is costly to store or transport, is less
desirable. The large regional bank mentioned above lends up to 60 percent on raw
materials, 50 percent on finished goods, and 20 percent on work in process.
• Machinery and equipment. Machinery and equipment is less desirable as collateral.
It is likely to be used, and it must be stored, insured, and marketed. Keeping the
costs of these activities in mind, banks typically will loan only up to 50 percent of
the estimated value of such assets in a forced sale, such as an auction.
• Real estate. The value of real estate as collateral varies considerably. Banks will of-
ten lend up to 80 percent of the appraised value of readily salable real estate. How-
ever, a factory designed for a unique purpose would be much less desirable.
When security is required to make a loan viable, a commercial lender will estimate
the amounts that could be loaned on each of the assets available as security. Unless the
amount exceeds the required loan balance, the loan would not be extended.
Even when a loan is not secured initially, a bank can require a “negative pledge” on
the ¬rm™s assets”a pledge that the ¬rm will not use the assets as security for any other
creditor. In that case, if the borrower begins to experience dif¬culty and defaults on the
loan, and if there are no other creditors in the picture, the bank can demand the loan be-
come secured if it is to remain outstanding.

Step 3: Analyze the Potential Borrower™s Financial Status
This portion of the analysis involves all the steps discussed in our chapters on business
strategy analysis, accounting analysis, and ¬nancial analysis. The emphasis, however, is
on the ¬rm™s ability to service the debt at the scheduled rate. The focus of the analysis
depends on the type of ¬nancing under consideration. For example, if a short-term loan
is considered to support seasonal ¬‚uctuations in inventory, the emphasis would be on the
ability of the ¬rm to convert the inventory into cash on a timely basis. In contrast, a term
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