14-7 Part 3 Business Analysis and Valuation Applications
loan to support plant and equipment must be made with con´¬üdence in the long-run earn-
ings prospects of the ´¬ürm.
Key Analysis Questions
Some of the questions to be addressed in analyzing a potential borrowerÔÇ™s ´¬ünancial
status include the following:
ÔÇó Business strategy analysis:
How does this business work? Why is it valuable? What is its strategy for sus-
taining or enhancing that value? How well quali´¬üed is the management to
carry out that strategy effectively? Is the viability of the business highly de-
pendent on the talents of the existing management team?
ÔÇó Accounting analysis:
How well do the ´¬ürmÔÇ™s ´¬ünancial statements re´¬‚ect its underlying economic
reality? Are there reasons to believe that the ´¬ürmÔÇ™s performance is stronger or
weaker than reported pro´¬ütability would suggest? Are there sizable off-bal-
ance-sheet liabilities (e.g., operating leases) that would affect the potential
borrowerÔÇ™s ability to repay the loan?
ÔÇó Financial analysis:
Is the ´¬ürmÔÇ™s level of pro´¬ütability unusually high or low? What are the sources
of any unusual degree of pro´¬ütability? How sustainable are they? What risks
are associated with the operating pro´¬üt stream?
How highly levered is the ´¬ürm?
What is the ´¬ürmÔÇ™s funds ´¬‚ow picture? What are its major sources and uses of
funds? Are funds required to ´¬ünance expected growth? How great are fund
´¬‚ows expected to be, relative to the debt service required? Given the possible
volatility in those fund ´¬‚ows, how likely is it that they could fall to a level in-
suf´¬ücient to service debt and meet other commitments?
Ultimately, the key question in the ´¬ünancial analysis is how likely it is that cash ´¬‚ows
will be suf´¬ücient to repay the loan. With that question in mind, lenders focus much at-
tention on solvency ratios: the magnitude of various measures of pro´¬üts and cash ´¬‚ows
relative to debt service and other requirements. To the extent such a ratio exceeds one, it
indicates the ÔÇťmargin of safetyÔÇŁ the lender faces. When such a ratio is combined with an
assessment of the variance in its numerator, it provides an indication of the probability
Ratio analysis from the perspective of a creditor differs somewhat from that of an
owner. For example, there is greater emphasis on cash ´¬‚ows and earnings available to
all claimants (not just owners) before taxes (since interest is tax-deductible and paid out
of pretax dollars). To illustrate, the creditorÔÇ™s perspective is apparent in the following
solvency ratio, called the ÔÇťfunds ´¬‚ow coverage ratioÔÇŁ:
560 Credit Analysis and Distress Prediction
Credit Analysis and Distress Prediction
EBIT + Depreciation
Funds flow coverage = ----------------------------------------------------------------------------------------------------------------------------
Interest + Debt repayment + ---------------------------------------------- Preferred dividends
( 1 ÔÇ“ tax rate ) ( 1 ÔÇ“ tax rate )
We see earnings before both interest and taxes in the numerator. This measures the
numerator in a way that can be compared directly to the interest expense in the denom-
inator, because interest expense is paid out of pretax dollars. In contrast, any payment of
principal scheduled for a given year is nondeductible and must be made out of after-tax
pro´¬üts. In essence, with a 50 percent tax rate, one dollar of principal payment is ÔÇťtwice
as expensiveÔÇŁ as a one-dollar interest payment. Scaling the payment of principal by
(1 Ôł’ tax rate) accounts for this. The same idea applies to preferred dividends, which are
not tax deductible.
The funds ´¬‚ow coverage ratio provides an indication of how comfortably the funds
´¬‚ow can cover unavoidable expenditures. The ratio excludes payments such as common
dividends and capital expenditures on the premise that they could be reduced to zero to
make debt payments if necessary.1 Clearly, however, if the ´¬ürm is to survive in the long
run, funds ´¬‚ow must be suf´¬ücient to not only service debt but also maintain plant assets.
Thus, long-run survival requires a funds ´¬‚ow coverage ratio well in excess of 1.2
It would be overly simplistic to establish any particular threshold above which a ratio
indicates a loan is justi´¬üed. However, a creditor clearly wants to be in a position to be re-
paid on schedule, even when the borrower faces a reasonably foreseeable dif´¬üculty. That
argues for lending only when the funds ´¬‚ow coverage is expected to exceed 1, even in a
recession scenarioÔÇ”and higher if some allowance for capital expenditures is prudent.
The ´¬ünancial analysis should produce more than an assessment of the risk of nonpay-
ment. It should also identify the nature of the signi´¬ücant risks. At many commercial
banks, it is standard operating procedure to summarize the analysis of the ´¬ürm by listing
the key risks that could lead to default and factors that could be used to control those
risks if the loan were made. That information can be used in structuring the detailed
terms of the loan so as to trigger default when problems arise, at a stage early enough to
permit corrective action.
Step 4: Utilize Forecasts to Assess Payment Prospects
Already implicit in some of the above discussion is a forward-looking view of the ´¬ürmÔÇ™s
ability to service the loan. Good credit analysis should also be supported by explicit fore-
casts. The basis for such forecasts is usually management, but, not surprisingly, lenders
do not accept such forecasts without question.
In forecasting, a variety of scenarios should be consideredÔÇ”including not just a ÔÇťbest
guessÔÇŁ but also a ÔÇťpessimisticÔÇŁ scenario. Ideally, the ´¬ürm should be strong enough to re-
pay the loan even in this scenario. Ironically, it is not necessarily a decline in sales that
presents the greatest risk to the lender. If managers can respond quickly to a sales dropoff,
it should be accompanied by a liquidation of receivables and inventory, which enhances
cash ´¬‚ow for a given level of earnings. The nightmare scenario is one that involves large
Credit Analysis and Distress Prediction
14-9 Part 3 Business Analysis and Valuation Applications
negative pro´¬üt margins, perhaps because managers are caught by surprise by a downturn
in demand and are forced to liquidate inventory at substantially reduced prices.
At times, it is possible to reconsider the structure of a loan so as to permit it to ÔÇťcash
´¬‚ow.ÔÇŁ That is, the term of the loan might be extended, or the amortization pattern
changed. Often, a bank will grant a loan with the expectation that it will be continually
renewed, thus becoming a permanent part of the ´¬ürmÔÇ™s ´¬ünancial structure. (Such a loan
is labeled an ÔÇťevergreen.ÔÇŁ) In that case, the loan will still be written as if it is due within
the short term, and the bank must assure itself of a viable ÔÇťexit strategy.ÔÇŁ However, the
´¬ürm would be expected to service the loan by simply covering interest payments.
Step 5: Assemble the Detailed Loan Structure, Including Loan Covenants
If the analysis thus far indicates that a loan is in order, it is then time to pull together the
detailed structure: type of loan, repayment schedule, loan covenants, and pricing. The
´¬ürst two items were discussed above. Here we discuss loan covenants and pricing.
WRITING LOAN COVENANTS. Loan covenants specify mutual expectations of the
borrower and lender by specifying actions the borrower will and will not take. Some
covenants require certain actions (such as regular provision of ´¬ünancial statements); oth-
ers preclude certain actions (such as undertaking an acquisition without the permission
of the lender); still others require maintenance of certain ´¬ünancial ratios. Violation of a
covenant represents an event of default that could cause immediate acceleration of the
debt payment, but in most cases the lender uses the default as an opportunity to re-ex-
amine the situation and either waive the violation or renegotiate the loan.
Loan covenants must strike a balance between protecting the interests of the lender
and providing the ´¬‚exibility management needs to run the business. The covenants rep-
resent a mechanism for insuring that the business will remain as strong as the two parties
anticipated at the time the loan was granted. Thus, required ´¬ünancial ratios are typically
based on the levels that existed at that time, perhaps with some allowance for deteriora-
tion but often with some expected improvement over time.
The particular covenants included in the agreement should contain the signi´¬ücant
risks identi´¬üed in the ´¬ünancial analysis, or to at least provide early warning that such
risks are surfacing. Some commonly used ´¬ünancial covenants include:
ÔÇó Maintenance of minimum net worth. This covenant assures that the firm will main-
tain an ÔÇťequity cushionÔÇŁ to protect the lender. Covenants typically require a level
of net worth rather than a particular level of income. In the final analysis, the lender
may not care whether that net worth is maintained by generating income, cutting
dividends, or issuing new equity. Tying the covenant to net worth offers the firm
the flexibility to use any of these avenues to avoid default.
ÔÇó Minimum coverage ratio. Especially in the case of a long-term loan, such as a term
loan, the lender may want to supplement a net worth covenant with one based on
562 Credit Analysis and Distress Prediction
Credit Analysis and Distress Prediction
coverage of interest or total debt service. The funds flow coverage ratio presented
above would be an example. Maintenance of some minimum coverage helps assure
that the ability of the firm to generate funds internally is strong enough to justify
the long-term nature of the loan.
ÔÇó Maximum ratio of total liabilities to net worth. This ratio constrains the risk of high
leverage and prevents growth without either retaining earnings or infusing equity.
ÔÇó Minimum net working capital balance or current ratio. Constraints on this ratio
force a firm to maintain its liquidity by using cash generated from operations to re-
tire current liabilities (as opposed to acquiring long-lived assets).
ÔÇó Maximum ratio of capital expenditures to earnings before depreciation. Con-
straints on this ratio help prevent the firm from investing in growth (including the
illiquid assets necessary to support growth) unless such growth can be financed in-
ternally, with some margin remaining for debt service.
In addition to such ´¬ünancial covenants, loans sometimes place restrictions on other
borrowing activity, pledging of assets to other lenders, selling of substantial parts of as-
sets, engaging in mergers or acquisitions, and payment of dividends.
Covenants are included in not only private lending agreements with banks, insurance
companies, and others, but also in public debt agreements. However, public debt agree-
ments tend to have less restrictive covenants, for two reasons. First, negotiations result-
ing from a violation of public debt covenants are costly (possibly involving not just the
trustee, but also bondholders), and so they are written to be triggered only in serious cir-
cumstances. Second, public debt is usually issued by stronger, more creditworthy ´¬ürms.
(The primary exception would be high-yield debt issued in conjunction with leveraged
buyouts.) For the most ´¬ünancially healthy ´¬ürms, with strong debt ratings, very few cov-
enants will be usedÔÇ”only those necessary to limit dramatic changes in the ´¬ürmÔÇ™s oper-
ations, such as a major merger or acquisition.
LOAN PRICING. A detailed discussion of loan pricing falls outside the scope of this
text. The essence of pricing is to assure that the yield on the loan is suf´¬ücient to cover
(1) the lenderÔÇ™s cost of borrowed funds; (2) the lenderÔÇ™s costs of administering and ser-
vicing the loan; (3) a premium for exposure to default risk; and (4) at least a normal re-
turn on the equity capital necessary to support the lending operation. The price is often
stated in terms of a deviation from a bankÔÇ™s prime rateÔÇ”the rate charged to stronger bor-
rowers. For example, a loan might be granted at prime plus 11Ôü„2 percent. An alternative
base is LIBOR, or the London Interbank Offer Rate, the rate at which large banks from
various nations lend large blocks of funds to each other.
Banks compete actively for commercial lending business, and it is rare that a yield
includes more than 2 percentage points to cover the cost of default risk. If the spread to
cover default risk is, say, 1 percent, and the bank recovers only 50 percent of amounts
due on loans that turn out bad, then the bank can afford only 2 percent of their loans to
fall into that category. This underscores how important it is for banks to conduct a thor-
ough analysis and to contain the riskiness of their loan portfolio.
Credit Analysis and Distress Prediction
14-11 Part 3 Business Analysis and Valuation Applications
FINANCIAL STATEMENT ANALYSIS AND PUBLIC DEBT
Fundamentally, the issues involved in analysis of public debt are no different from those
of bank loans and other private debt issues. Institutionally, however, the contexts are dif-
ferent. Bankers can maintain very close relations with clients so as to form an initial as-
sessment of their credit risk and monitor their activities during the loan period. In the case
of public debt, the investors are distanced from the issuer. To a large extent, they must de-
pend on professional debt analysts, including debt raters, to assess the riskiness of the
debt and monitor the ´¬ürmÔÇ™s ongoing activities. Such analysts and debt raters thus serve an
important function in closing the information gap between issuers and investors.
The Meaning of Debt Ratings
As indicated above, the two major debt rating agencies in the U.S. are MoodyÔÇ™s and
Standard and PoorÔÇ™s. Using the Standard and PoorÔÇ™s labeling system, the highest possi-
ble rating is AAA. Firms with this rating are large and have strong and steady earnings
and little leverage. Only about 1 to 2 percent of the public industrial companies rated by
Standard & PoorÔÇ™s have the ´¬ünancial strength to merit this rating. Among the few are
Merck, General Electric, and Johnson & JohnsonÔÇ”all among the largest, most pro´¬üt-
able ´¬ürms in the world. Proceeding downward from AAA, the ratings are AA, A, BBB,
BB, B, CCC, CC, C, and D, where ÔÇťDÔÇŁ indicates debt in default. To be considered invest-
ment grade, a ´¬ürm must achieve a rating of BBB or higher. Many funds are precluded by
their charters from investing in any bonds below that grade. Table 14-1 presents exam-
ples of ´¬ürms in rating categories AAA through CCC, as well as average values for select-
ed ´¬ünancial ratios across all ´¬ürms in each category.
Note that even to achieve a grade of BBB is dif´¬ücult. Delta Airlines, one of the largest
airlines in the U.S., was rated as ÔÇťonlyÔÇŁ BBBÔÇ”barely investment gradeÔÇ”in 1998. Over-
all, ´¬ürms in the BBB class are only moderately leveraged, with about 45 percent of long-
term capitalization coming in the form of debt. Earnings tend to be relatively strong, as
indicated by a pretax interest coverage (EBIT/interest) of 3.0 and a cash ´¬‚ow debt cov-
erage (cash ´¬‚ow from operations/total debt) of nearly 34 percent.
Firms with below investment-grade ratings tend to face some signi´¬ücant risk, even
though many are quite pro´¬ütable. Table 14-1 places Northwest Airlines in the BB cate-
gory. In 1998 Northwest was the fourth largest airline carrier in the U.S. However, it had
suffered from a recent pilot strike and declining demand in Asia, a key international mar-
ket. The B category includes Apple Computer, Greyhound Lines, and Loehmanns, all of
which had faced recent ´¬ünancial dif´¬üculty. The CCC category includes ´¬ürms whose debt
is 80 percent of long-term capital, on average. An illustrative CCC ´¬ürm is Oxford Health
Plans, a health bene´¬üt plan provider. Oxford Health Plans came close to bankruptcy in
1997 after computer malfunctions and poor ´¬ünancial controls led to massive delays in
claims processing and customer dissatisfaction.
564 Credit Analysis and Distress Prediction
Credit Analysis and Distress Prediction