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FSA Week10 Credit Analysis - Coggle Diagram
FSA Week10 Credit Analysis
Short term liquidity risks
Liquidity
: ability to convert assets into cash to meet short-term obligations.
Current ratio:
relative static measure of current liability coverages.
Applications
Comparative/Trend analysis
Ratio management: press collection of receivables/reduce inventory/delay normal purchase.
2:1 as threshold: superior or deficient coverage
Note of Caution: quality matters, working capital requirements vary from industries.
Working capital:
current assets-current liabilities
Operating activity
analysis of Liquidity
Receivable liquidity measures
: higher the better. usually compared with industry averages. Normally use net amount. Carefully with bad debts.
Accounts Receivable Turnover
Days' sales in receivables
Inventory turnover measures:
Quality of inventory. Trend analysis (why decrease?)
Inventory turnover ratio
Days' sales in inventory
Current liability measures
: determine safety margin. Urgency.
Days of payable outstanding
Accounts payable turnover
Conversion period/operating cycle:
Days sales in receivable + Days sales in inventory: measure of speed with inventory converted to cash
Cash conversion cycle(CCC):
Days sales in inventory + Days sales in receivable - Days of payable outstanding: number of days of funding required to pay current obligations and stay in business.
Other liquidity measures
Quick/acid-test ratio
Cash flow ratio
Long term solvency risks
Solvency:
long-run financial ability to cover long term debts
Capital Structure:
financing sources and their attributes
Equity financing: Uncertain return and payment pattern. lose voting rights, more costly.
Debt financing: repaid with interest. specific repayment pattern. tax-deductible. less costly, preferred options.
Financial leverage: amount of debt in a capital structure.
Capital structure ratios
Interest bearing debt/assets
total debt to equity
long term debt to equity
short term debt to total debt
Earnings coverage:
cash generated as a source of interest/principle repayments.
Earnings to fix charges ratios: may vary between firms
CFO to fixed charges
Interest coverage ratio
insights into the ability of meeting its fixed charges
Credit risks
5 Cs
1. Capacity:
ability of a borrower to serve their debt. Conduct industry and company analysis.
2.Collateral:
tangible assets that could be sold to recover the debt owned to bondholders.
3. Character:
reputation in paying back liabilities.
management strategy
past strategies
aggressive accounting policies
history of fraud
poor treatment of bondholders
4.Conditions:
Terms of loans and economic conditions.
5. Covenants:
protect creditors. Mutual expectations of the borrowers and lenders. IF break, punishments e.g. immediate pay back or higher interest rate
Positive covenants:
what actions firms should take: maintain a level of working capital, profitability.
Negative covenants
: what actions firms should not do: limited debt to take on.
debt service covenants ratio
Bankruptcy risks
Altman's Z-score model
Results
<1.2: high probability of bankruptcy
if > 2.9 low probability of bankruptcy
in between: grey area, no short term risk, need to revaluate in 3-5 years
Criticisms
variables included
subjective scores
backward looking, not good to predict future bankruptcy
Seminar
Why credit risk analysis important?
parameters used
Liquidity:
ability to meet short-term obligations. current liabilities should be covered by current assets,
Working capital intensity:
performance in managing individual items of working capital, CCC.
Profitability
: generate sufficient profitability
Capital structure/Gearing:
company's long term liquidity, profitability, solvency.
Coverage:
profits generated are adequate to cover interest/principle payments.
Efficiency:
assets to generate future period sales or revenue
ratios used
Liquidity ratios
Current ratio
Quick ratio
Working capital ratio
Debtor collection period
inventory holding period
creditor days
CCC
Profitability ratio
Gross profit ratio. EBIT ratio. return on net worth.
Capital structure ratio
LTD to equity ratio. total debt to equity ratio.
Coverage ratio
Interest coverage ratio
Debt service coverage ratio
Turnover/efficiency ratio
Total assets turnover ratio. total fixed assets turnover ratio.
Trend analysis of financial ratios
Industry comparison