Analyzing Distressed Company for Investing Distress Company: Company which is earning less than breakeven and has very high debt to equity ratio. Both debt and equity investments by hedge funds are associated with Moyer, S., , Distressed Debt Analysis: Strategies for. Distressed Private Equity Deal-Making in a Non-Distressed Market Stephen G. Moyer, CFA - President, Distressed Debt Alpha. WORK FOREX TRAINING Resource Center Download and video AV range of educational. Comodo Internet Security logging histories. Several clients can examples of how 13 check the. Are not within the hidden preference. Switch to full well, then in and it is dynamically allocated by.
Moyer proposes that there are two types of bad managers: incompetent management or conflicted management. The actions of incompetent managers are difficult to disentangle from the other company specific causes — it is possible that all company specific causes can arise from the poor decisions made by managers, who may or may not actually be incompetent.
On the other hand, conflicted managers are quite capable of making the right decisions, but their incentives are not aligned with those of the shareholders. Argetnti , in his extensive research on the subject, identifies several detailed symptoms of a defective management structure.
From the autocratic leader, who controls the company completely without any input or discussion from colleagues, to a non-participating board, there is an infinite amount of ways that firm leadership can be inadequate. These include factors such as high financial leverage, illiquidity due to working capital mismanagement, or high operating leverage due to increased fixed costs.
Financial Leverage High levels of debt — by definition — represent a major source of bankruptcy risk. Capital Structure Theories The trade-off theory of capital structure argues that the optimal debt level is set at the point when then present value of financial distress costs become greater than the present value of the tax advantages.
Financial distress costs are a function of the probability of distress and the magnitude of the costs. Higher levels of debt in the capital structure increase the probability of distress, and at some point, the potential costs outweigh the tax shield benefits. According to the theory, the optimal level is reached when further borrowing results in a PV of tax savings that is fully offset by the increases in the PV of distress cost.
Because of this, and the fact that no all firms have expected profits to shield from taxes, the theory recognizes that optimal debt levels will vary across firms. An alternative view presented by the pecking order theory of corporate financing states that firms prefer internal funding over borrowing, and debt over equity funding because of information asymmetry.
Managers are more informed than rational investors, and will prefer to issue equity as a last resort method of financing. They would rather use internal financing, or if unavailable, issue bonds. Conversely, pessimistic managers who know that their stock is overvalued and that investors will realize this eventually prefer to issue debt as well.
Any attempt to sell stock would signal to investors that the stock is worth less than the current price, thus forcing down the stock price and lowering the proceeds from the stock issue. According to this theory, tax shields are of secondary consideration. However, equity issuance would be well received by investors if a firm is highly-levered or has many intangible assets, both of which imply a high cost of financial distress Bearly et al.
Every asset and liability on a balance sheet can be classified by how quickly it transforms into cash. Assets represent potential cash inflows as inventory and products are sold in the near-term and equipment generates profits over its long-term useful life. Liabilities represent short- and long-term commitments that must eventually turn into cash outflows as they become due. For example, consider a new piece of equipment has a useful life of ten years, but is financed with a loan that must be repaid in two years.
The maturity mismatch represents a large risk that the asset will not be able to generate the requisite cash-flows to pay off the debt as it comes due, and as such, other resources will be needed to fill the gap. New funds — which may or may not be available at that time — will be needed to pay for existing assets. As such, a balance sheet can be considered liquid if for each maturity more assets are transforming into cash than liabilities Vernimmen, For example, the consumer staples sector will tend to have cash flows that are less volatile than the consumer discretionary sector, given the pro-cyclical nature of the latter.
In general, during periods of inflation combined with low interest rates, companies tend to overinvest and over-borrow; disinflation and high real rates result in the opposite phenomenon. Vernimmen, et al. Companies within the same sector tend to have the same economic and financial characteristics, so the capital structure policies regarding debt should also be similar.
A company that chooses to increase debt levels above competitors is making a large bet on its own future profitability, which is based on both internal strategy, core capabilities and external economy, sector outlook factors. The additional financial risk makes the company vulnerable to a business cycle downturn; if necessary, managers would prefer to take business risks than financial risks. As such, industries with volatile cash flows and low levels of tangible assets should have lower debt levels than stable industries with high levels of tangible assets.
Therefore, the debt financing decision is not made on an absolute basis, but rather relative to other companies in the sector. Credit ratings have also gained increased importance when making financial decisions. Aside from lower debt costs and increased flexibility, a higher rating can benefit the company by expanding the pool of potential investors and reassuring the other stakeholders trade creditors, etc.
Because downgrades typically cause a sharp fall in share price, public companies actually protect shareholder value by preserving their credit rating. Startups have high business risk, volatile and unpredictable cash flows, low tax shield needs, and few tangible assets, therefore unable to obtain or benefit from debt financing.
As a company matures, it grows bigger, its cash flows become more predictable, and it accumulates profits and tangible assets, all of which makes it more appealing to creditors. The benefits of debt for mature companies outweigh the costs. However, in recent surveys of management, the top four factors affecting the amount of debt were financial flexibility, credit rating, tax shields and cash-flow volatility.
Surprisingly, bankruptcy costs and industry norms were not cited as major influencing factors Vernimmen, Here, EBITDA serves as an approximation of annual cash- flows from operations, excluding working capital and income tax effects for simplicity.
At this level a company could hypothetically repay its debts in four years, given that it could avoid capital expenditures and income tax Vernimmen, Types of Debt To understand the various ways companies can employ financial leverage in their capital structure, it is helpful to review the various types of debt instruments that exist.
The two main categories of debt financing available to companies can be classified into bank financing and market financing. Because of the cost, size and flexibility characteristics of each financing channel, bank borrowing is used more by small- and medium- sized companies, while larger companies tend to rely more on market financing. Banks may charge borrowing rates that do not reflect the actual risk of the borrower. Client relationships and cross-selling opportunities can result in more attractive terms for some borrowers, while geographical limits on lender competition or opportunity cost considerations under the Basel framework can result in higher fees for other borrowers with the same credit risk.
From a volume and size perspective, bank credit allows a company to borrow the exact amount needed; conversely, market issuance is limited to large issues by imposed minimum liquidity constraints. This acts as the main deterrent for smaller sized firms or for firms with limited borrowing needs. Bond issuance also presents an increase level of uncertainty with regards to the timing of the availability of funds. The issuance preparations and disclosure of information to investors may take several weeks, during which time market volatility may adversely impact the success of the bond issue.
Meanwhile, bank loan proceeds can be made available to the company fairly quickly. Covenants typically fall into four major categories that cover a variety of actions or scenarios. Positive covenants require that the company complies with certain financial or capital structure ratios. Negative covenants prevent the taking on additional debt, pledging certain assets as collateral to other lenders, or engaging in share-buybacks.
The violation of a covenant may result in the declaration of default on the loan, the levy of financial penalties on the borrower, or the immediate acceleration of all future payments due on the loan Vernimmen, Among the various types of borrowing instruments, there is a clear distinction between secured and unsecured debt. Secured debt gives the lender a security interest in a particular asset or set of assets , which allows the lender to take possession of that asset if the borrower defaults on the loan.
If the sale of the asset does not provide sufficient funds to entirely repay the loan, the remaining amount becomes a general unsecured claim against the borrower. Unsecured debt is not secured by a particular asset, but is based on the general credit and financial health of the borrower. Seniority can be established through contractual or structural subordination. Contractual subordination is established through subordination provisions, which state that the claims of the senior creditors must be satisfied before junior creditors.
Secured debt or debt given by the borrower a priority claim on repayment is repaid first, and is typically called senior debt. Unsecured debt has the next highest priority, followed by subordinated debt and, lastly equity claims.
Structural subordination addresses the priority of creditors between different legal entities within a company. Long-Term Debt Instruments Market financing debt instruments consist of medium- and long-term bonds, and asset-backed securities. Fixed interest rate bonds in the five- to ten-year segments are the most widely used by corporations and present a large variety of features.
High-yield bonds are a type of subordinated debt issued by companies with poor credit and offer high interest rates commensurate with their increased level of risk. Asset- backed securities are credits that are secured by a pool of assets such as loans, accounts receivables, inventories, or buildings. Bank lending instruments consist of business and secured loans, which are custom tailored for each individual borrower. Business loans are based on market interest rates and the individual creditworthiness of the borrower, while secured loans are collateralized by a specific set of assets.
The major types of credit facilities include committed facilities a bank commits to lend up to a certain amount , revolving credits, term loans, or letters of credit. Term loans have a set maturity, a floating interest rate based on a market reference rate plus a spread, and a set schedule of principal repayment amortization over the life of the loan. The repayment schedule may be spread out evenly over the life of the loan, or may be concentrated at the end of the term i.
In a liquidation proceeding, these claims are satisfied after the collateral sales proceeds have been applied to the first-lien loans, but before unsecured creditors receive any proceeds. A lead bank structures the loan and a syndicate of banks each lends part of the total amount.
The loans are tradable, whereas pieces of the loan can be bought and sold by other banks or financial institutions. The borrower benefits from lower interest rates and the ability to borrow larger amounts than would be available from a single bank. The lender is able to diversify its loan portfolio and reduce the risk of default, as well as access deals that may otherwise be unavailable.
Leases can also be considered a type of debt financing, whereas the company enters a commitment to make fixed payments in exchange for the ability to use a particular asset. A default on a lease will typically result in a loss of access to the asset or, in some cases, bankruptcy. Leases come in two principal categories: operating and financial.
An operating lease term is shorter than the economic life of the asset, and the asset is returned to the lessor at the end of the lease. The present value of the lease payments represents an amount that is less than the market value of the asset. Conversely, a financial lease term lasts for the entire life of the asset, and typically the lessee can purchase the asset at a reduced price at the end of the lease.
In this case, the PV of the lease payments is equal to the market value of the asset. Leases provide companies with an alternative source of financing that allows for the avoidance of bond covenants Vernimmen, Depending on the industry, a firm will usually obtain credit from suppliers to purchase production inputs, and will extend credit to customers to facilitate the sale of its products.
This creates payables and receivables that flow to and from the firm on a regular basis as part of a continuous cash-flow cycle. Because the company may not have sufficient cash on hand to finance production, banks will often extend credit to help firms fund this gap.
Extending credit to more customers or increasing the repayment period will increase the time factor due to fewer cash sales. While overall sales may increase, the allowance for bad debts must also increase. Making quicker payments to suppliers often in exchange for trade discounts will also increase the time factor. Conversely, improvements in the production process that increase production speed and efficiency will decrease the time factor, as will offering discounts to customers for cash payments.
Some firms may actually seek to increase the time factor if the overall increases in profits outweigh the additional financing costs incurred in doing so. Additionally, companies that experience high levels of seasonality in their business must take extra efforts to ensure their working capital needs are adequately met Platt, Commercial banks are the leading source of working capital financing, which can take several forms Seidman, There is a set credit limit, and interest is only paid on the actual amount borrowed; the loan may be secured on unsecured.
For the convenience of this increased flexibility, the borrower must also pay a fee to the bank regardless of actual borrowing and maintain a current balance of cash on deposit equal to a set percentage of the credit limit. The loan balance must be paid off in full during the course of the one year term period, and the loan must be extended annually with consent from the lender.
Accounts receivable financing is a method of secured borrowing employed by companies that are unable to obtain an unsecured line of credit due to lack of credit quality. Since the borrowing limit is directly tied to sales, it grows proportionately as the company expands. However, due to the higher costs incurred by lenders in order to manage the collateral, higher fees or interest rates may be charged to the borrower. Individual customer credit limits and collection periods are set at levels mutually agreed to by both the company and the factor.
The factor can either advance a portion of the money to the company when the sale of products takes place or transfer payment upon receipt of funds from the customer. The factor receives a portion of the proceeds as a fee, and may charge additional interest on the advanced funds.
This fee may be higher than the interest on a direct AR loan, depending on the credit quality of the customers. Inventory financing is a similar type of secured borrowing, albeit with inventory instead of AR assets pledged as collateral to obtain working capital loans.
Because inventory is much less fungible and represents a riskier type of collateral it can be difficult to resell or may even be perishable , the loan amounts and interest rates are often higher than when using AR financing. Because of the complexity in managing the collateral that arises, inventory financing also involves higher transaction and administrative costs than other types of financing. It is a feasible option for companies that lack the ability to obtain either of the aforementioned types of financing either due to poor credit or lack of account receivables.
Lastly, secured or unsecured term loans can be used to provide a sufficient cushion for working capital needs over a longer time period. This is typically an amortizing 3- to 7-year loan with a floating interest rate and a set of financial covenants.
Large companies with high credit ratings that have access to market financing can typically issue commercial paper on an unsecured basis to finance short-term borrowing needs. This is a money market instrument with a term between one and three months or up to a year that allows a company to borrow directly from the financial markets at lower interest rates than a bank line of credit. More specifically, extremely high or low levels of inventory and accounts receivable can lead to trouble if they reach unacceptable levels.
A large buildup of inventory can leave a company exposed to negative price fluctuations and the risk of product obsolescence. This can occur if management projects high levels of growth that fail to materialize, or there is overproduction to take advantage of economies of scale. Conversely, extremely low inventory levels result in costly stock-outs and shortages that can lead to lost sales and profit declines. As discussed in the working capital section above, disproportionately high levels of accounts receivable assets can be an indicator that the company has either relaxed its credit standards or that customers are taking longer to repay.
Regardless of the cause, an increase in uncollectible accounts will lead to lower profits. On the other hand, abnormally low levels of receivables resulting from credit policies that are too stringent can result in lost sales if creditworthy customers forgo purchases Platt, If the ratio is above one, the company has more assets maturing in less than one year than it has liabilities maturing during that time.
This difference provides a necessary margin of safety to creditors since current assets are subject to devaluation as discussed above, or more generally, as a result of decreases in sales while liabilities remain fixed. An additional point is that a current ratio less than one implies that some current liabilities are being used to fund long-term, fixed assets.
This creates a dangerous liquidity mismatch since the liabilities will come due in the very near term, while the assets have a long-dated maturity Vernimmen, However, the appropriate upper bound for the current ratio is a more subjective metric that is less frequently addressed in literature. Operating Leverage Operating leverage increases the breakeven point and earnings variability of a company and is a major contributing factor to corporate failure.
Increased investment in fixed assets such as property, plant and equipment will decrease overall variable costs at the expense of increasing fixed costs. While long-term assets have the potential to generate more profits than current assets, they also carry a higher level of risk due to the reduction in cost structure flexibility.
Higher fixed costs increase the sales breakeven point that a company must attain in order to generate a profit. This point is achieved when the contribution margin amount sales minus variable costs is equal to the fixed costs. Depending on the type of breakeven that is being calculated, the fixed costs may or may not include financing costs. For operating breakeven, only production fixed costs are used; for financial breakeven, interest payment costs are also included.
The first calculation fails to take into account the necessary return on the borrowed capital invested in the company. Interest expenses also represent an important factor when it comes to discussions on insolvency and bankruptcy. Holding everything else equal, a company with higher fixed costs will have higher earnings volatility relative to a company with lower fixed costs; EBIT and net income will increase decrease more given a similar increase decrease in sales.
Additionally, EBIT volatility is highest when a company is operating close to its breakeven point, as opposed to when its sales are far above or below it. Operating leverage is an especially important factor for companies in highly cyclical industries, where the business cycle can cause dramatic swings in sales volume. High operating leverage and inflexible cost structure in cyclical industry can create significant problems and often leads to bankruptcy.
Companies can employ several strategies to lower the level of operating leverage in their business model. Increasing labor flexibility and linking compensation to financial performance can help reduce short-term fixed costs. Outsourcing noncore activities or entering into joint ventures can decrease the necessary amount of fixed assets and reduce overall fixed costs Platt, ; Vernimmen, A downturn in the broader economy reduces aggregate demand, exposing weaknesses in marginal firms with uncompetitive products and forcing them to go out of business.
A reduction in credit availability can result in liquidity problems for over-levered companies that would have continued to operate otherwise. While most macroeconomic factors are interrelated, aggregate measures and such as GNP growth, money supply, financial market performance and number new business starts seem to be correlated with increased rates of corporate failure and financial distress. Economic downturns reduce overall business activity and place stress on all except the most countercyclical businesses.
As such, it is unsurprising that overall failure rates increase during recessions. Source: Professor Nicholas Ducarre, HEC Paris Despite being a company-specific characteristic, the age of the company can be used as a macroeconomic factor when viewed from the perspective of aggregate business formation. New companies are more susceptible to the various business and financial risks that precipitate bankruptcies and are thus especially vulnerable.
From a macroeconomic perspective, large increases in new business formation rates — which occur during expansionary periods — would likely influence the overall failure rates two to five years later very few business fail in the first year of operation Altman, Troubled firms may be able to obtain large amounts of debt during periods of low interest rates and easily available credit.
However, as credit becomes scarce, banks will refuse to lend to weaker companies, forcing them into bankruptcy. Investor flows into high-yield bond funds are correlated with new issuance activity by firms; less demand by investors translates to lower demand for bonds by portfolio managers, and in turn, lower supply of new issues by investment banks. During times of low investor demand, as measured by fund flows, tight credit conditions are likely indicative of increased failure rates.
The outstanding quantity of low-rated high yield bonds provides a proxy for credit availability effects and appears to show a significant correlation with future default rates. Since low-rated bonds B or less have a higher probability of default bond ratings are discussed in the section on predictive methods , a larger number of outstanding bonds means that more companies are likely to go into technical insolvency. The number of low-rated bonds is influenced by both, the level of issuance and the level of downgrades.
Large increases in the number of new issues are typically indicative of a period of easily available credit and the loosening of credit standards. This is more likely to occur during times of economic expansion, as was seen in the period preceding the financial crisis. Price increases are typically passed along to the consumer, resulting in potential temporary increases in profits because of artificially low inventory and depreciation book values.
This can help weaker firms survive for a longer period of time than they would under normal conditions. It is documented that unexpected price increases are inversely correlated with business failure rates. Financial Market Indicators While somewhat counterintuitive, investor expectations as reflected in the equity markets can also play a role in influencing business failure rates.
While typically both falling stock prices and business failures were considered to be leading indicators of business downturns — both likely influenced by expectations of deteriorating economic conditions — there may be a more direct relationship between the two. Since the book value of assets on the balance sheet may not be an accurate indicator of the economic fair value, accounting measures may mask the true net worth of the firm.
As such, a drop in the stock price to a negligible value may precipitate a bankruptcy filing that may have been delayed if the stock was still trading at some tangible positive value. As aggregate equity prices are more likely to fall during bear markets, it could be argued that the incidence of bankruptcies increases as a result of falling stock prices.
Investor expectations as reflected through bond yield spreads provide another variable that is correlated with business failures. Across all time periods, investors expect a higher return from risky assets relative to risk-free assets, or from assets that are less risky. The spread between yields on junk bonds and investment grade bonds will always be positive because of the risk premium. However, it is well documented that the risk premium varies in magnitude over different time periods.
As investors become less optimistic about the overall economic outlook and the ability of firms to fulfill their financial obligations, the spread between risky and risk-free bonds i. At the same time, the relative spread between high risk and low risk securities also widens in magnitude; the increased level of uncertainty impacts riskier assets proportionately more as investors lose their appetite for risk. Since this often occurs during periods of economic stress when business failure rates are at increased levels, the two variables will likely be correlated Altman, The dynamic failure path is laid out as follows: companies with defective management structures for example, as discussed earlier tend to first neglect accounting information systems and fail to respond to changes in the environment.
As a result, financial ratios start to deteriorate, and the company begins to employ creative accounting methods to delay its inevitable collapse. However, because not all companies display all of these symptoms or experience the same sequence of events, Argenti proposes three broad types of trajectories that he believes account for the vast majority of business failures.
Type 1 failures occur when a new business is simply unable to reach the necessary level of economic or financial viability, and eventually fails. Type 2 failures are young companies that are able to attain initial success and viability, but then stumble as they grow too quickly and over-expand beyond their capacity. Lastly, Type 3 failures are mature, relatively established companies that at some point lose their competitive edge and experience falling profitability.
This results in a slow gradual process, where an initial collapse leads to a plateau before the final collapse and failure of the company. Again, a variety of business and financial causes can lead to this type of scenario. Larger companies have the benefit of additional resources to weather difficult times. They also possess many assets that can be sold in the event of a downturn, and the ability to scale back operations if necessary.
Shutting down plants and laying-off employees may not be an optimal corporate strategy, but it could help a firm stay solvent long enough to eventually recover. However, size often increases the level of complexity, which can increase risk and fragility. Diversification of cash-flows arising from a diverse collection of product lines or segments can reduce the downturn risk for a company in the same way that a diversified portfolio of stocks reduces the overall portfolio risk for an investor.
If the market segments in which the company operates are sufficiently uncorrelated, then downturns in one segment can be offset by robust performance in other segments. Geographical diversification can also help mitigate the impact downturns if the business units are in regions that are diverse enough to be uncorrelated. Having a large amount of cash on the balance sheet can certainly serve as a buffer against adverse events and help prevent insolvency. Other assets, such as real estate, can also be a source of stored value, which can be liquidated if needed.
Intangible resources, such as brand, IP or specialized core capabilities can be helpful in protecting a company against changing market conditions. Ironically, excess staff, while detrimental to overall company performance during normal times, can actually act as a store of value as well.
Additional factors like barriers to entry can help firms in distress buy time to work through their problems by preventing competitors from having easy access to their market. High customer switching costs can also be an especially useful feature which can provide some protection during difficult times. Low fixed costs give firms the ability to withstand sustained decreases in gross margins and volume declines. Whether caused by price pressure, increases in input costs or overall declines in demand, these changes can have a large impact on firms with high levels of operational leverage.
Problems with working capital management or disproportionate levels of current assets can arise as a result of either business decisions that led to poor sales or financial decisions that led to a lack of liquidity. Unsustainable operating or financial leverage levels are either a result of a conscious decision to take on additional risk or a due to a lack of oversight by management. The same logic applies to non-financial causes — an uncompetitive product or an unsustainable business plan is also a result of a poor decision or critical oversight.
Since companies compete for survival against a set of competitors to reach a particular segment of customers, decisions cannot be evaluated in a vacuum; relative degrees of mismanagement are crucial. Poor leadership — or what has traditionally referred to as poor management — is another type of mismanagement resulting from inefficient decision- making by senior managers in leadership positions, or from a poorly designed organizational structure.
Conversely, the opposite can be said about the mitigating factors that may help prevent bankruptcy. As such, it is extremely difficult to identify the exact causes of a particular case of business failure, or to generalize broadly across companies and industries. Despite this, the company specific factors discussed above frequently arise as a result of diverse and often unknowable to the outside observer types of mismanagement. It first describes the basic credit analysis process from the perspective of lenders and credit agencies as a method for credit evaluation and prediction of default and then provides insight into how debt ratings for corporate bonds are assigned.
Next, it provides a detailed overview of financial ratio analysis as a prediction method and provides an overview of the main statistical prediction models developed by academics. It concludes with a discussion of the implications of the model findings with respect to the causes of corporate failure as detailed in Part I.
The earlier section on leverage levels presented several theories how companies establish their debt levels and presented the argument that there is no one-size-fits-all optimal capital structure. In practice, however, there are leverage levels above which prudent lenders would not continue to lend to a firm.
Because of this, any effective method of predicting bankruptcy must incorporate these concepts into its methodology. As such, the credit risk increases with the time duration of the loan period. Each of the three factors is inherently interrelated and must be accounted for on a relative, not absolute, basis. The key non-financial factor that influences credit risk is the credit support for the loan, or the source of the funds that will be used to repay the loan.
Any unsecured loan made to a company is implicitly backed by the present and future cash-flows generated by that company. The company may be unable to generate a sufficiently high level of cash to satisfy the lender, the cash-flows may be too volatile and unpredictable, or too many other creditors may be competing for the same limited amount of funds. If this is the case, the lender can choose to make a secured loan where collateral is used as the credit support.
Therefore, the credit support for a particular loan can be classified as cash-flows or collateral. Credit capacity is determined by either the level and stability of operating cash-flows for unsecured debt or the value of the collateral for secured debt. It is a risk-adjusted measure in the sense that it is dependent on the desired confidence level of recovering the loan; a higher confidence level will lead to a lower credit capacity measure, and vice versa.
Cash-flow support is the most stringent and most often used method for determining credit capacity. Bank loans, unlike bonds, typically require periodic repayment of loan principal as well as interest throughout the life of the loan. Typically, EBITDA earnings before interest taxes depreciation and amortization is used as a simplified proxy for operating cash-flow to ensure the comparability between firms.
For valuation purposes, interest expense is ignored in order to effectively compare results between firms with different levels of financial leverage, which represents a capital structure decision. However, during credit analysis, the interest expense is examined closely and is taken into account at a later stage. Depreciation and amortization are ignored because they represent non-cash entries. Lastly, taxes are ignored despite the fact that they are a cash expense and are relatively uniform across companies.
The reasoning behind this is that the taxable income calculation takes into account interest expense, depreciation and amortization, which again distorts comparability between firms. First, changes in working capital — which can reduce actual cash-flow — are not taken into account. Capital expenditures are also ignored, under the assumption that they are discretionary during a particular period and can be ignored. However, this may or may not be true, depending on the capital intensity of a particular business.
During credit analysis, current and future capital expenditure projections are typically used. As such, EBIT may be a better proxy in some instances because it assumes that depreciation is equal to the replacement and maintenance costs of the assets. Conversely, stable and predictable cash-flows increase the debt capacity. Along with the ability to fund repayment internally, other factors such as asset coverage, refinancing ability, and interest expense coverage are used to assess credit capacity.
Asset coverage is similar to the notion of collateral support for a secured loan except that all of the assets of the firm are taken into account not just those assets in which the lender has a security interest. The total asset value of the firm should sufficiently exceed the nominal value of the total debt. Asset coverage is typically measured as the ratio of enterprise value to total debt. The ability to refinance the loan at the end of the loan term is another critical element of borrowing capacity.
If the internally generated funds are insufficient to completely repay the loan, the unpaid balance can be repaid by taking out a new loan. Credit market conditions and short-term liquidity constraints, such as clustered debt maturities, could also impact refinancing ability. Lastly, interest expense coverage is an additional constraint on credit capacity.
Typically measured as EBITDA over total interest expense, this gauges the probability that the borrower will default on an interest payment. Either would be detrimental to the lender, the former directly, and the latter via its negative impact on the cash-generation capability of the firm going forward. Other forms of credit evaluation by lenders also take into account the general character and prior repayment history of the borrower Moyer, A default is defined as the failure to make an interest or principal payment as specified in the bond contract, and the recovery expectation is what the creditor can expect to recoup if a default occurs.
Together, the two measures represent the probability of loss to creditors. Understanding the methodology used by the rating agencies provides another perspective on how to predict corporate failure and bankruptcy. Unlike general market participants, agencies often obtain privileged access to nonpublic information and benefit from extensive in depth interactions with senior management.
Often, companies are precluded by regulations from sharing similar types of information with investors. Firms are not required to obtain ratings, but instead pay the agencies to rate their debt offerings in order to reduce their cost of capital; investors will typically accept lower interest rates on higher rated debt. Fees paid to the rating agencies are the same regardless of the outcome of the rating process.
In addition to a rating, the agencies also issue an outlook — stable, positive, or negative — that indicates the most likely progression of the rating over the subsequent two to three years. The business risk of a company is comprised of overall industry risk and company-specific factors. The key competitive factors for a particular industry are identified, and the firm is judged on how well it ranks against those factors. Industry risk is defined as the risk of a financial decline due to external factors such as structural shifts in consumer preferences, cyclicality, product obsolescence, or increases in competition.
The goal of industry analysis is to assess the short- and long-term sales growth prospects of the industry, and also to determine how the target firm is positioned within the industry. Even though all participants face the same risks, each company is affected differently due to management actions; however, unfavorable industry characteristics can limit the credit quality of all of the competitors in that space.
For example, in the forestry sector, where cost-leadership is critical, cost-position is given the largest weighting in the evaluation. Geographic and product diversity and degree of vertical integration are also important, but to a lesser extent and are thus given a lower weighting. The evaluation of company-specific factors focuses on competitive analysis, market position, earnings stability, financial flexibility and asset base quality.
The management of the company is evaluated closely on the basis of performance, risk-tolerance, and financial policies especially as these elements relate to the support of the credit quality. Historical and prospective credit ratios based on cash-flow forecasts are used to score the first three measures. Profitability measures include profit margins, return-on-investment ROI , and growth rates viewed in the context of historical trends, future projections, and peer comparisons.
Examples of the key ratios for each category are shown below. Debt obligations include everything from traditional debt securities to complex structured transactions involving asset-backed securities and project financing arrangements. Other financial obligations that must be taken into consideration include items such as operating leases, guarantees, pension obligations, potential litigation settlements, and many other examples. The quality of the balance sheet is determined not only by the overall leverage level, but also by the quality of the leveraged assets.
High-quality assets with stable values and reliable cash-flow generation potential can withstand more leverage than low-quality assets with uncertain values and variable cash-flow potential. The relevant credit ratios track overall debt payback, interest payments and capital investment. Debt payback ratios track how much cash a firm generates in relation to its total debt level, while payment ratios measure the amount of cash-flow available for making interest and principal payments.
Additionally, capital investment coverage ratios track the amount of cash available to finance capital expenditures. A liquidity event can arise from unexpected external events or from regular operating activities such as debt maturities. Sources of additional liquidity may include cash and liquid assets, asset sales, and CAPEX flexibility. Each of the elements of financial risk is then weighted to reflect its relative importance, with cash flow adequacy typically given the highest weight.
The overall credit score for the company is then determined by combining the business and financial risk scores into an overall weighted score. The weighting between the two categories is subjective in that the business risk weighting increases for companies with lower business risk. This adjustment allows companies with stable and predictable cash-flows to maintain higher levels of financial risk and more aggressive credit ratios.
The general rule is that more emphasis should be placed on the financial score for companies with less stable business performance. The final corporate credit score represents a measure of the ability of the company to pay its debt obligations in a timely manner, or the firm-specific default probability.
A separate recovery score is assigned to measure the recovery that a creditor can expect in the case that a default does occur. An example of the disparity in financial ratios between low and high credit risk scores is shown below.
For example, since the number of AAA-rated bonds at issue that have defaulted within 10 years of issue is less than 0. Credit ratings also appear to reflect relative risk levels as exhibited by debt pricing spread levels. The yield of a debt security is comprised of the risk-free rate the risk premium. The risk premium, or spread, reflects the credit risk and liquidity premium of the instrument. The former is determined by the aforementioned default probability and recovery expectation, while the latter is a factor of the supply and demand characteristics of the market.
Credit ratings appear to be a good proxy for credit risk when pricing bond, because there is a significant correlation between spreads and ratings. Also, because companies expecting a low rating can elect to issue non-rated debt, the ratings system is inherently biased towards relatively higher-quality issuers.
Accordingly, non-rated bonds have overall higher default levels on average Moyer, In a simplified form, the current price of the bond represents the probability-weighted average of two scenarios discounted at the risk-free rate: full recovery if the bond is repaid at maturity and partial recovery if the bond defaults. If the bond has coupon cash-flows remaining, the calculation is adjusted to reflect the conditional probability of non-default in each previous period. By making assumption that the probability of default during each coupon period remains the same, the formula below can be used to calculate the implied probability of default Perry, Ratios can be compared within the firm over time or across a subset of comparable firms at given point in time.
While the ratios themselves are highly objective quantitative measures, the causes that lead to a change in the ratios are often subjective in nature. Nevertheless, the evidence seems to indicate that, on average, there are substantial differences in the key ratios of failed firms versus their surviving counterparts. Generally, the types of ratios can be categorized into four broad categories according to the way they are calculated and the overall intent of the measurement. Return and turnover ratios measure the net and gross benefits gained, respectively, relative to the amount of resources expended.
Lastly, component percentage ratios measure the relative size of a component of an item to the entire item. Several commonly used liquidity ratios are listed in the table below. In general, higher ratios indicate a better ability by the company to satisfy immediate obligations, although levels that are too high may indicate an inefficient use of assets. This helps evaluate the performance of different aspects of the business.
For example, the commonly used ratios listed below measure how much of each dollar is left after cost-of-goods-sold, operating expenses, and all expenses respectively are taken into account. For example, Inventory and Accounts Receivable ratios measure how many times inventory and credit sales have been created and reduced during a period respectively, while Total and Fixed Asset Turnover ratios evaluate the effective use of assets to generate sales. The former evaluates the level of debt relative to its overall capital structure, while the latter reflects the ability to meet fixed payment obligations.
Coverage ratios are frequently used in bank loan covenant agreements to assure the lender that the company has sufficient inflows to service its loans. Predictive Ability Some of the earliest research on the topic of using financial ratios to predict financial failure was performed by Beaver using a univariate analysis method. The theory of ratio analysis explains the reasoning behind the methodology and the specific ratios chosen for the study.
The inflows are variable in nature, and the reservoir provides a necessary cushion when inflows and outflows are mismatched. Failure can be defined as the instance when the reservoir is drained and the company cannot pay its expenses or otherwise fulfill its financial obligations.
This approach has four important implications when considering the probability of failure. First, the size of the reservoir is important since a larger reservoir reduces the likelihood of insolvency. Conversely, debt levels and operating expenses decrease it, and therefore higher levels of either increase the probability of failure.
As such, the ratios that represent each of these components should vary, on average, between failing and non-failing firms. The six ratios selected for the study were those that represented each category and had been previously accepted by practitioners or academics as reflecting key relationships within an organization.
The ratios and their potential implications for failing firms are listed below. A higher ratio indicates that the company has plenty of cash coming in to pay interest and pay down debt and is thus less likely to go bankrupt. While the ROA varies across companies and industries, a higher ratio would indicate that a firm is less likely to fail.
As previously discussed, while the optimal level of debt is highly dependent on the specific company, overall bankruptcy risk increases as more debt is added to the capital structure. The dollar value of net working capital represents the amount of current assets financed by long term debt, which if substantial, decreases the chance that the company will face a short-term liquidity crisis in the near future.
While an extremely low level of working capital can indicate an imminent liquidity problem, there is generally no optimal level that can be deemed appropriate for all companies. It measures the length of time that a company could finance its current daily expenses from its liquid assets, provided that it made no additional sales. Competitive advantage. The value chain. Five forces.
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|Distressed debt investing moyer lumber||We certainly take the probabilities of these kinds of corporate actions into account when evaluating bond ideas. He has handled matters for clients in industries as varied as manufacturing, technology, transportation, energy, media, and real estate. At this level a company could hypothetically repay its debts in four years, given that it could avoid capital expenditures and income tax Vernimmen, Across all time periods, investors expect a higher return from risky assets relative to risk-free assets, or from assets that are less risky. The ratio is higher for more financially sound companies with sufficient interest coverage and liquidity.|
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|Distressed debt investing moyer lumber||Here, he articulates his philoso… More. Nevertheless, with no viable alternative the courts approved many of these loans, although frequently they amended some of the more egregious terms after some trial-and-error. The distinction in necessary because the aggregate average difference in magnitude can be skewed by a small number of firms that exhibit a relatively large difference in a particular ratio or metric relative to peers. Distressed investors were cautioned against style drift into chasing large-cap HY. Operating leverage is an especially important factor for companies in highly cyclical industries, where the business cycle can cause dramatic swings in sales volume.|
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