Credit Process: Credit Decision – factors

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Industry analysis

Industry analysis is more subjective than quantitative in nature. Two analysts can agree on the broader outlook for the same industry but still, differ on the impact of that outlook on a specific business. We will settle for the fact that industry conditions exert a strong influence over profitability, pricing and future outlook for any firm, but to quantify the exact impact in numbers is next to impossible.

A really good example is the current situation in the telecommunication, cell phone and semi conductor segments. Primarily due to a slowing global economy, maturing product & saturated markets cell phone manufacturers have expected slowing sales for the past 12 months. Motorola finally issued an earnings warning in 2000, followed closely by Erickson & Nokia. This was followed by Erickson’s decision to exit cell phone manufacturing completely. Stock prices of semi conductor manufacturers that specialize in DSP (digital signal processing – used in cell phones) chips such as Texas Instrument and Cypress Semiconductors took big hits falling by as much 60% over the next few months. Although analyst agreed that the sector was suffering a major slow down with no immediate end in sight, the impact on the financial performance of the five companies above was very different.

The life cycle of an industry or business usually follows the stages below:

  1. Introduction
  2. Growth
  3. Maturity
  4. Decline

Revenue growth, market share, profitability, cash flows & future outlook depend on which of the stages an industry is in. In introductory stage, the number of small firms is higher and there is a tremendous investment in resources, efforts & capital. Products are relatively simple and comparable and the overall customer base is small. Virtually all businesses are cash flow negative. In growth stage market share increases, repeat use increases, customer base grows larger and businesses start to show a profit. In maturity stage, competition increases, firms with excess capital, efficient production basis and market share stay, while other exit, number of products blooms as new variations are tried and almost all remaining businesses are cash flow positive. During decline stage overall market size shrinks, an increasing number of firms exit and new products start replacing existing offerings.

Industry analysis is a great benchmark to compare a firm’s historical and projected future performance. The framework used for this comparison may include:

  1. Prevailing intra-industry competition. (the competition between Pepsi and Coke in the beverage industry or between Erickson and Nokia in the cell phone business)
  2. Inter – industry competition. (Competition between trucking-transport industry, the air cargo industry and the rail-transport industry.)
  3. Regulatory issues of the industry and level of interference from the government.
  4. The state of the industry in terms of consolidation (or fragmentation). A consolidating industry is one where there are a large number of mergers and acquisitions taking place & the number of players in the market is declining. Such a situation occurs usually during maturity when overall industry growth has leveled off and companies have to grab market share from competition to grow. A fragmented industry, on the other hand, is one where there are many players in the market, each one being small and independent. Such a situation exists usually in the initial stages of the life cycle.
  5. Economic and technological conditions within the industry. Some firms are more economically and technologically advanced than others and this has an impact on the way the industry operates. (Intel versus Transmetta, Red Hat Linux against Microsoft, Compaq versus Dell.
  6. Most large businesses today have facilities in foreign countries. The laws, customs and traditions of the country in which the company has facilities, also determine the risk associated with the industry and various players.

Business Analysis – Other Qualitative Factors

Business Factors

As a loan officer, you are expected to consider both quantitative and qualitative aspects of a business for credit analysis. Quantitative aspects include ratio analysis, cash flow analysis and financial statement analysis.

Besides industry analysis, there are other subjective characteristics of a business that strengthen our analysis of a particular business. These include:

  • Location of business
  • Number of years in business
  • Number of times management has changed
  • Strategic direction the firm has adopted
  • Number of products/brands
  • Number of successful or well-known products/brands
  • Cyclical nature of earnings and cash flows
  • Leadership position (present or not)
  • Strategies followed (low-cost producer, differentiator, focus, etc)
  • Competitive edge and product positioning
  • Scope of operations (geographic and otherwise)
  • Firm’s reputation amongst stakeholders and competitors

Business Risk

Business Risk analysis identifies risk factors in the business environment, ignoring the risks arising from leverage. It establishes the base level of risk for risk analysis and helps spot developments that might lead to an upgrade or a downgrade of a credit rating in the future. What factors are used for this assessment?

  • Overall industry conditions (growth, structure, number of players)
  • Competitive conditions
  • Demand conditions
  • Suppliers network
  • Cost structure
  • Overall company strategy
  • Product strategy
  • Financial strategy

How is a business that sells cardigans different from one that sells toothpaste? Or one that manufactures custom sports cars versus one that manufacturers automobile tires? Given two businesses selling cardigans or custom sports cars, how would the breakdown between fixed and variable costs effects business risk? How would these businesses fare in economic booms and recessions? What kind of problems niche product businesses face in a maturing market versus one with a portfolio of dozens of products? How would the failure of a critical supplier or customer affect a business?

This list is just the beginning. The key is to look for and investigate any characteristic that may seem out of the ordinary. All these factors help the analyst build an overall picture about a particular firm and its ability and willingness to pay back a loan. It is important to note an analyst’s past experiences, which form the basis of his intuition, gut and rules of thumbs, generally drives qualitative analysis.

Management/ Ownership Quality

Does the management of a company inspire enough confidence in the lender to approve a loan? This is the question that you need to answer. How can you evaluate such a qualitative factor?

There are a number of common indicators in use for quality management. Dependability, reliability, delivery and fairness top almost all lists. You can also check out how often management has lived up to its promises and commitments made to customers, employees, investors, suppliers and other stakeholders. Looking at how well (or badly) existing lenders have been treated by the business is another great yardstick. Length of current term, successes, failures, crisis and crisis management help in establishing a track record for being a reliable, stable & important part of the business that has performed consistently over the past few years

Management influences a company’s creditworthiness in a number of ways. It selects strategies, executes them, controls operations and reports to lenders and investors. The quality of its efforts in all these activities affects operating performance, financial condition and the probability of honoring obligations when they are due. Creditworthiness is all about willingness (intent) and ability of a firm (read: management) to pay back a loan.

If quality of management is questionable (presence of red flags), it is a good enough reason for a lender to decline a loan application.

External Credit Rating Agencies

There are a number of third party organizations in the United States that rate the creditworthiness (and credit risk) of businesses and their obligations. Moodys, Standard and Poors (S&P), Dun and Bradstreet (D&B) are some of well-known Credit Rating Agencies (CRA) that assign credit ratings to businesses. CRA’s perform credit analysis and assign ratings to companies based on their own criteria (proprietary credit analysis & models) and industry and organization specific information in their databases

The standard interpretation for the ratings provided by major credit rating companies like S&P and Moody’s are given below:

Standard & Poor Moody’s
Businesses with high probability of default CCC CAA
Speculative grade businesses BB BA
Investment grade businesses AAA AAA

In the table given above, investment grade businesses have the lowest level of credit risk; speculative grade businesses are those that have high risk, but are still worth considering (higher the risk, higher the return and vice versa); businesses near default are those that have a very high risk associated with them; they are sure to default.

Analyses performed by credit rating agencies focus primarily on the probability of default. Studies are conducted on all types of businesses whether they are leveraged or not. In the latter case, the analysis focuses on whether a firm can meet its obligations if it were to take on any debt. Ratings are applicable to legal obligations of companies across a wide range of industries & nationalities.

As is the case with independent analysts, the starting point for credit analysis performed by rating agencies is historical data; however, the focus is futuristic or forward looking. Analysts are interested in the probability of payback (or default) in the future, so all analysis revolves around what will or can happen in the intermediate term or long term. Similar to commercial lenders rating agencies are also interested in credit history, existing debt burden, size of individual loans, interest rate on each loan, maturities, collateral, balance sheet capacity to support additional debt, etc. These questions need to be addressed because in the event of bankruptcy, stakeholders are paid off in the following order:

  1. Preferred creditors: group of government agencies that have any claim by way of taxes, social security payments etc
  2. Secured creditors: those who have lent against a collateral
  3. Unsecured creditors and
  4. Shareholders

The seniority of a financial claim is important. It refers to the order in which a lender will have the right to claim a business’ assets in case of bankruptcy. Obligations senior and junior to a particular loan can affect that loan’s downside protection. For example, if a creditor has what seems to be reasonable leverage, but if it (debt) carries a lien on 90% of assets, the remaining subordinated debt is a lot riskier than it appears on the surface. Credit Ratings take into account the extent of potential loss on loans that do go into default. For companies with an investment grade corporate rating (low-risk), secured debt is rated one sub-grade higher than unsecured debt, and subordinated debt is rated one sub-grade lower. We can see that senior debt loses much less value than subordinated types and secured debt loses less than unsecured.

What factors do rating agencies consider when conducting credit analysis? More or less the same as everyone else: business analysis, financial analysis & industry analysis. Remember, that scores assigned by rating agencies have a great deal of impact on how much potential creditors are willing to lend to businesses in the future. Also, the rate of interest that a banker or any other lender can charge a potential borrower is affected by the firm’s rating; higher the rating, lower the interest rate that will be charged.

There is one major limitation of credit reports and ratings obtained from agencies: The universe of rated companies is limited. It’s very much possible that a new business or a small business applying for a loan or a credit line is not rated.

Cash Flow Analysis in Credit Analysis

Cash is the lifeblood of a business. It enables a company to fund its day-to-day operations, grow and survive. The income statement provides a figure for net income, taking into consideration non-cash expenditures such as depreciation. A lender is more concerned with actual inflows and outflows of cash in the business rather than a figure for net income. It needs to gauge what the sources of cash are, if the generated cash is enough and how it is applied.

For credit analysis, cash flows (past and present) measure a business’s ability to pay back its loans in the future. Special attention is paid to the operating performance of a firm; will the firm’s operations generate enough ‘cash’ to pay back loans as and when they mature?

Firms traditionally pay back loans with:

  • Operating Profits
  • Conversion of Assets into Cash
  • Additional Loans
  • Equity Investment
  • Disposal of Assets

Of these the first two are part of normal operations, the next two could be classified as financing activities and the very last as disposal of existing investments. Interestingly enough uses of cash can also be classified in the same categories – Operations, Financing & Investments. A Statement of Cash Flows presents a consolidated figure for cash inflows and outflows under these three categories:

Cash Flow Statements

Cash flow statements are the principal way in which businesses report their cash position. The statement identifies how a company generates (the sources) and spends cash (applications or uses). It shows a company’s cash balance at the beginning and end of an accounting period and the activities that have occurred throughout the period to bring about changes in those balances.

The cash flow statement identifies three major sources and uses of cash:

  1. Operating activities
  2. Financing activities
  3. Investing activities

Operating Activities

A company performs these activities in the course of production and delivery of goods or services. The Net income of a company comprises mainly of Cash flows from operating activities.

Cash Inflows from operations are mainly the result of the following activities:

  • Collections from customers for goods sold
  • Change in current assets of the business
  • Dividend receipts from equity investments
  • Interest receipts on loans made

Cash Outflows mainly are the result of the following operating activities:

  • Cash payments to suppliers, employees, the government
  • Payment for other expenses
  • Interest payments

The ‘operations’ section of the cash flow statement commands a creditor’s central focus because interest and principal payments are made from operating profits. This is why analysts and prospective creditors study the Income Statement and the Statement of Cash Flows (the section on Operating Activities particularly) in conjunction to get an overall picture of the cash flow status of a business.

Financing activities

Financing activities revolve around obtaining or returning financial resources from either creditors or owners. We must note, however, that interest payments are made from operating cash flows and are recorded in the operating section of the cash flows statement.

Cash Inflows are due to the following Financing activities:

  • Funds obtained from the issuance of debt, mortgage, notes and other short-term or long-term borrowing
  • Proceeds from the issuance of equity

Cash Outflows are the result of the following Financing activities:

  • Payment of dividends
  • Repayment of principal amount of loans taken
  • Payments made to repurchase the firm’s shares

It is important to note that long-term borrowing and repayment of borrowed amounts are financing activities. Day-to-day transactions of the firm such as short-term liabilities like accounts payable etc are operating activities.

Investing activities

In order to maximize profits, firms tend to invest any idle cash they might have. Managers must make the best possible use of the resources available to them. Cash is one such resource. Although maintaining liquidity is important, managers make the best possible use of available resources. Therefore, investing idle money in short term securities is an accepted practice.

Cash inflows from investing activities involve:

  • Principal repayments by borrowers. (However, interest receipts on the loans made are recorded in operating activities.)
  • Sale of loans (receivables) to other firms
  • Sale of investments made in other firms in the form of debt or equity securities
  • Sale of property, plant and equipment

Cash outflows from investing activities include:

  • Loans made by a firm
  • Sale of investments made in other firms in the form of debt or equity securities.
  • Purchase of property, plant and equipment