Financial Statement Analysis

1
Financial Statement Analysis
2
Financial Statement Analysis Contents

• Overview and objective of financial statement
  analysis
• Review and Re-formatting Statements for Financial
  Analysis
• Income Statement EBITDA and NOPLAT
• Cash Flow Statement - Free Cash Flow and Equity
  Cash Flow
• Financial ratio analysis
• Management Performance
• Valuation
• Credit Analysis
• Financial Model Drivers
• Reference Slides
• Financial Ratio Calculations
• Discussion of Economic Profit

3
Financial Statement Analysis - Introduction

• Financial Statement Analysis should tell a story
  about the company How profitable is the
  company, what are the trends, how much risk is
  there etc.
• You should be comfortable in reading various
  different financial statements to be effective at
  financial modeling and financial analysis.
• Financial statement analysis is also important
  in
• Assessing management performance of a company
  and whether projections of improvement or
  sustainability are reasonable.
• Assessing the value of a company from historic
  performance.
• Assessing the reasonableness of financial
  projections provided by a company or the validity
  of earnings projections
• Assessing whether the financial structure of a
  company is of investment grade quality

4
Objectives of Financial Statement Analysis

• Financial statement analysis is like detective
  work How can we use information in financial
  statements to make assessments of various issues.
  The financials should paint a picture of what
  has happened to the company
• How can we quickly review the income statement,
  balance sheet and cash flow statement to
  determine how the stock market value of a company
  compares to inherent value.
• How can we look the financial statements and
  assess risks associated with a company and
  whether the company has sufficient cash flow to
  pay off debt.
• Finance and valuation are about projecting the
  future -- how can financial statement analysis
  be used in making projections.
• The problem in any financial analysis and
  valuation is that measuring risk is very difficult

5
Double Counting and Judgments in Financial Ratio
Analysis

• In analyzing financial statements judgments must
  be made in computing key data such as EBITDA and
  in developing financial ratios.
• Examples
• Whether or not to include Other Income in EBITDA
• If other income not in EBITDA, then should not
  add non-consolidated subsidiary companies in
  invested capital
• Exploration Expenses taken out of EBITDA
• Make consistent between companies with different
  accounting policies
• Goodwill (ROIC with or without goodwill depending
  on analysis issue)
• Minority Interest (if include or exclude do for
  both income and balance)
• Total of minority interest is in EBITDA,
  therefore must include financing of minority
  interest in invested capital
• A key principle is that the financial data and
  the financial ratios are consistent and logical
  work through simple examples

6
Income Statement
7
Income Statement

• Review trends in EBITDA, EBIT, EBT and Net Income
  and explain what is happening to the company
• EBITDA includes operating earnings and other
  income, but it does not include foreign exchange
  gains or losses, minority interest, extraordinary
  income or interest income.
• EBITDA is a rough proxy for free cash flow
• EBITDA is not generally shown on Income Statement
• Potential Adjustments for items such as
  exploration expense
• Compare EBIT to Net Assets and Net Capital
• Ratio of EBITDA to Revenues should be shown for
  historic and projected periods
• EBITDA is related to un-levered cash flow while
  Net Income and EPS are after leverage
• NOPLAT is computed by EBIT less adjusted taxes,
  where taxes are computed through adjusting income
  taxes.

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Standard Computation of EBITDA
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Problems with EBITDA

• EBITDA is useful in its simplicity, and can be a
  good reference for comparison of debt and value,
  but it has weaknesses
• EBIT is more important than DA, because must use
  cash for replacing depreciation and amoritsation
• In credit analysis, EBITDA works better for low
  rated credits than high rated credits. (Moodys)
• EBITDA is a better measure for companies with
  long-lived assets
• EBITDA can be manipulated through accounting
  policies (operating expenses versus capital
  expenditures)
• EBITDA ignores changes in working capital, does
  not consider required re-investment, says nothing
  about the quality of earnings, and it ignores
  unique attributes of industries.

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Simplified Income Statement

• Sales- COGS
• Gross Margin- SGA- Other Expenses
• Other Income
• EBITDA
• - Depreciation and Amortization
• EBIT
• - Interest Expense (income)
• EBT- Income Taxes
• - Minority Interest
• Net Income
• NOPLAT EBIT x (1-tax rate)
• NOPLAT Net Income Interest Expense x (1-tax)

There is a debate about how to handle other
income from non-consolidated subsidiary
companies. One school of thought (McKinsey) is
that they should be valued separately since they
will have different cost of capital etc. In this
case, do not include in EBITDA and remove the
asset balance from the invested capital. Must be
consistent
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Analysis of Income Statement Computation of
EBITDA, Minority Interest, Preferred Dividends,
Exploration Expense
12
Income Statement Analysis

• Example of Adjustments to EBITDA
• Exploration Expenses (EBITDAX)
• Rental and Lease Payments (EBITDR)
• EBITDA Computation
• Top Down move other income
• Bottom-up (Indirect)
• EBITDA Notes
• Interest Income out of EBITDA
• Interest Expense not in EBITDA
• Understand Non-cash Expenses
• Deferred Mining Costs
• Equity Income
• Minority Interest

13
Discounted Cash Flow Analysis Real World Example

• Credit Suisse First Boston estimated the present
  value of the stand-alone, Unlevered, after-tax
  free cash flows that Texaco could produce over
  calendar years 2001 through 2004 and that Chevron
  could produce over the same period. The analysis
  was based on estimates of the managements of
  Texaco and Chevron adjusted, as reviewed by or
  discussed with Texaco management, to reflect,
  among other things, differing assumptions about
  future oil and gas prices.
• Ranges of estimated terminal values were
  calculated by multiplying estimated calendar year
  2004 earnings before interest, taxes,
  depreciation, amortization and exploration
  expense, commonly referred to as EBITDAX, by
  terminal EBITDAX multiples of 6.5x to 7.5x in the
  case of both Texaco and Chevron.
• The estimated un-levered after-tax free cash
  flows and estimated terminal values were then
  discounted to present value using discount rates
  of 9.0 percent to 10.0 percent.
• That analysis indicated an implied exchange ratio
  reference range of 0.56x to 0.80x.

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Employee Stock Options

• One can debate the treatment of employee stock
  options for EBITDA, free cash flow and valuation.
• Think of options as giving stock to employees
• If the treatment has changed over the years and
  it is a significant expense, make adjustments to
  current or prior statements for consistency.
• Think of options as giving free shares to
  employees. The value of existing shareholders is
  diluted.
• One can argue that this is two things
• First, employees are compensated and the cash
  should be accounted for
• Second, invested capital is increased and the new
  equity should be included in the capital base

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Cash Flow Statement
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Cash Flow Statement

• Modern Cash Flow Statement has separation between
• Operations
• Capital expenditures (to maintain and grow
  operations) and
• Financing
• Operating Cash Flow
• Add back items from the income statement that do
  not use cash (depreciation, dry hole costs etc)
• Analyze how much cash flow the company generated
  and how it raised funds or disposed funds
• Use Cash Flow statement as a basis to compute
  free cash flow although cash flow not presented
  on the statement
• Problem Interest Expense related to financing
  and not operations is in the Net Income and is
  included in Cash From Operations

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Cash Flow Statement

• A. Operating Cash Flows
• 1) Net Income including interest expense,
  interest income and taxes
• 2) Depreciation
• 3) Deferred Taxes
• 4) Working Capital Changes
• 5) Minority Interest on Income Statement and
  Other Items
• B. Investing Cash Flows
• 1) Capital Expenditure and Asset Purchases
• 3) Sale of Property, Plant, Equipment
• 4) Inter-Corporate Investment
• C. Financing Cash Flows
• 1) Dividend Payments
• 3) Proceeds from Equity or Debt Issuance
• 4) Equity Repurchased
• 5) Debt Principal Payments

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Cash Flow Statement Example
19
The Notion of Free Cash Flow

• In practice the term cash flow has many uses.
  For example, operating cash flow is net income
  plus depreciation.
• Free cash flow is the cash flow that is available
  to investors FREE of obligations such as
  capital expenditures and taxes -- to both debt
  and equity investors after re-investing in
  plant, and financing and paying taxes.
• Accountants define cash flow from operations as
  net income plus depreciation and other non-cash
  items less changes in working capital. However,
  this cash flow is not available for distribution
  to equity holders and debt holders. The free
  cash flow must account for capital expenditures,
  repayments of debt, deferred items and other
  factors.
• Free cash flow consists of
• Cash flow to equity holders
• Cash flow to debt holders

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Theoretical Context Miller and Modigliani

• Theory that changed finance in 1958
• Value assets on fundamental operating
  characteristics such as the capacity utilisation,
  the cost and the efficiency of assets and not the
  manner in which assets are financed debt versus
  equity or the manner in which assets are hedged.
• This has led to the discounted cash flow model
  that underlies most valuations
• The proof was based on a simple arbitrage idea
  that you could buy stock in a company that has no
  debt and then borrow against the stock. This
  will yield the same results as if the company
  borrowed money instead of you.
• The implication of this is that project finance
  is irrelevant

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Fundamental Distinction in Financial Analysis
Free Cash Flow and Equity Cash Flow

• Free Cash flow that is independent from financing
• Valuation
• Performance in managing assets
• Claims on free cash flow
• Cash flow to pay debt obligations
• Comparisons unbiased by capital structure policy
• Equity cash flow
• Valuation of equity securities
• Performance for shareholders

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Importance of Free Cash Flow

• Alternative Definitions, but one correct concept
• Free Cash Flow Is Also Known As Unleveraged Cash
  Flow
• Unleveraged Cash Flow Is Not Distorted By The
  Capital Structure
• Free Cash Flow should not change when the capital
  structure changes
• Free Cash Flow should be the same as equity cash
  flow if no debt is outstanding and not cash
  balances are built up.
• Free Cash Flow in Valuation
• PV of Free Cash Flow Defines Enterprise Value
• The Relevant Discount Rate Is The Unlevered
  Discount Rate or the Weighted Average Cost of
  Capital
• IRR on Free Cash Flow is the Project IRR
• Free Cash Flow in Economic Value
• FCF Carrying Charge Economic Profit

23
Cash Flow Statement in Financial Model

• Analysis in Cash Flow Statements
• Compute Cash Flow before Financing
• Operating Cash Flow minus Capital Expenditures
• Use Cash Flow Before Financing in Deriving Free
  Cash Flow
• Equity Cash Flow
• Dividends less Cash Investments
• Cash Flow Before Financing less Maturities plus
  New Debt Issues
• Last Line on Cash Flow Statement Includes
• Change in Cash Balance
• Change in Short-term Debt or Overdrafts
• Beginning Balance Change Ending Cash
• Beginning Balance of STD Change Ending
  Short-term Debt

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Free Cash Flow Formulas

• Free cash flow can be computed from the income
  statement or from the cash flow statement.
• From the cash flow statement, the formula is
• Cash Before Financing
• Plus Interest Expense
• Less Tax Shield on Interest
• From the income statement, the formula is
• EBITDA
• Less Taxes on EBIT
• Less Working Capital Investment
• Less Capital Expenditures
• From Net Income
• Net Income
• Add Net of Tax Interest
• Add Depreciation, Deferred Taxes and Other
  Non-Cash Changes
• Less Changes in Working Capital
• Less Capital Expenditures

Some argue that free cash flow should not include
non-operating items. Here the non-consolidated
companies are treated in a similar manner as
liquid investments
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Free Cash Flow from NOPLAT

• Free cash flow can be computed using the notion
  of net operating profit less adjusted tax as
  follows (assuming no extraordinary income)
• Step 1 Compute NOPLAT
• Net Income
• Plus Net Interest after Tax
• Plus Deferred tax
• Equals NOPLAT
• Step 2 Compute Free Cash Flow
• NOPLAT
• Plus Depreciation
• Less Change in Working Capital
• Less Capital Expenditures
• Equals Free Cash Flow

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Free Cash Flow Example
One could make adjustments for dividends payable,
interest payable and other items in the working
capital analysis.
In actual situations, must adjust the free cash
flow for deferred tax
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Balance Sheet
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Balance Sheet Adjustments

• When analysing the balance sheet, various items
  should be adjusted and grouped together
• Net Debt
• Total short and long term debt minus liquid
  investments held and surplus cash
• Cash Bucket
• For modelling, subtract short-term debt from
  surplus cash and liquid investments
• Surplus Cash
• Include temporary investments and also include
  long-term investments
• Current Assets and Current Liabilities
• Separate the surplus cash from current assets and
  the debt from current liabilities and relate
  remaining working capital items to revenue and
  expense items

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Balance Sheet Issues

• Treat surplus cash as negative debt and debt as
  negative cash
• Rule of thumb cash is 2 of revenues
• Example when developing a basic cash flow
  model, group the cash and the debt as one account
  and then separate this account on the balance
  sheet.
• Unfunded pension expenses should be treated like
  debt they involve a fixed obligation and they
  can be replaced with debt when they are funded.
• Deferred taxes depend on the way deferred taxes
  are modelled for cash flow purposes. If you
  model future changes in deferred taxes and take
  account of these in projections, do not put
  deferred taxes as a component of equity.

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Problems with Equity Balance

• Would like the return on equity and the return on
  invested capital to measure equity invested by
  shareholders for return on investment and return
  on equity
• Problems with using equity balance on the balance
  sheet to measure equity investment
• Write-offs of plant
• Accumulated Other Comprehensive Income
• Goodwill
• Re-structuring losses
• Employee Stock options
• Can make adjustments to equity balance

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Financial Ratio Analysis
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Tension between Equity Analysis and Asset Analysis

• Free Cash Flow
• Project IRR
• ROIC (ROCE)
• WACC
• Enterprise Value
• EV/EBITDA
• Market to Replacement Cost

• Equity Cash Flow
• Equity IRR
• ROE
• Cost of Equity
• Market Capitalisation
• P/E
• Market to Book Ratio

EV S Value of Business Units Debt Equity
Value In ratio analysis, cash negative debt
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IRR Mathematics and IRR Exercise
Why we raise to a power with two year case FV
PV (1r) (1r) FV PV (1r)2 FV/PV
(1r)2 (FV/PV)(1/2) (1r) (FV/PV)(1/2) 1
r

• IRR is simply rate of return
• Example Invest 100 and receive 120 in 1 year
• IRR 120/100 120 - 100 20
• If the cash flow is over two years
• IRR -100 , 60 , 60 ? 13.07
• Modified IRR with 5 Re-investment
• 60 receives 5 in year two ? 60 x (1.05) 63
• Plus final 60 123
• MIRR (123/100)(1/2) - 1 10.9

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Financial Ratio Analysis

• Purpose
• Evaluate relation between two or more
  economically important items (one is the starting
  point for further analysis)
• Cautions
• Accounting analysis is important (deferred taxes
  etc.)
• Interpretation is key
• What does the P/E mean
• Is an interest coverage of 3.5 good
• Why is the ROIC low
• Should we use MB, PE or EV/EBITDA
• Document financial ratios (numerator and
  denominator) with footnotes and comments
• Show components of numerator and denominator in
  rows above the ratio calculation

35
General Discussion of Financial Ratios

• Financial Ratios Often Compares Income Statement
  or Cash Flow with Balance Sheet
• In developing ratios, understand why the formula
  is developed (e.g. other income and other
  investments in return on invested capital)
• There is Not Necessarily One Single Correct
  Formula
• For example, pre-tax or after-tax return on
  assets.
• Keep the numerator consistent with the
  denominator
• Financial Ratios should be evaluated in the
  context of benchmarks
• Credit ratios and bond rating standards
• Returns and cost of capital
• Operating ratios and history

36
Classes of Financial Ratios

• Management Performance
• Ratios that measure the historic economic
  performance of management and evaluate whether
  the economic performance can be maintained (e.g.
  ROIC)
• Valuation
• Ratios that are used to give an indication of the
  value of the company (e.g. P/E)
• Credit Analysis
• Ratios that gauge the credit quality and
  liquidity of the company (e.g. Interest coverage
  and current ratio)
• Model Evaluation
• Ratios used to evaluate the assumptions and
  mechanics of financial forecasts

37
Ratios that Measure Management Performance
38
Class 1 Financial Indicators of Management
Performance

• Evaluate Whether Management is Doing a Good Job
  with Investor Funds (Not if the company is
  appropriately valued)
• Return on Invested Capital
• Return on Assets
• Return on Equity
• Market/Book Ratio
• Market Value/Replacement Cost
• Key Issue
• Evaluate relative to risk
• ROE versus Cost of Equity
• ROIC versus WACC

39
ROIC, WACC and Growth

• ROIC is before interest and the return covers
  both debt and equity financing EBIT is before
  interest and investment includes both debt and
  equity investment
• WACC is the blended average of debt and equity
  required returns
• ROIC versus WACC measures the ability to make
  true economic profit
• Once have economic profit, should grow the
  business as much as possible.

40
Basic Economic Principles, ROIC and Financial
Analysis

• When you measure value, you are gauging the
  ability of a firm to realize economic profit.
  For example, when you compare the equity IRR with
  the equity cost of capital.
• When you assess assumptions in a financial
  forecast, you must assess whether economic profit
  implicit in the assumptions can in fact be
  realized. For example, if the financial forecast
  has a very high ROE, is that reasonable.
• When you interpret financial statistics, you are
  gauging the strategy of the company in terms of
  whether economic profit is being realized. In
  reviewing the return on invested capital, does
  this demonstrate that the company has the
  potential to earn economic profit.

41
Return on Invested Capital Analysis

• ROIC is not distorted by the leverage of the
  company
• ROIC can be used to gauge economic profit and
  whether the company should grow operations
• ROIC can be used to assess the reasonableness of
  projections
• For example, if ROIC is very high and the company
  is in a competitive business with few barriers to
  entry, the forecast is probably not realistic.
• ROIC can be computed on a division basis EBIT and
  allocation of capital to divisions from net
  assets to gauge the profit of parts of the
  company
• ROIC comes from sustainable competitive advantage
  and high market share

42
Formula for Return on Invested Capital

• The return in invested capital formula can be for
  a division or an entire corporation. It is after
  tax and after depreciation. Cash balances should
  be excluded from the denominator and interest
  income from the numerator. Goodwill and goodwill
  amortization should be excluded.
• Formula
• ROIC EBITAT/Invested Capital
• Where
• EBITAT Earnings before Interest Taxes and
  Goodwill Amortization less taxes on EBITAT
• Taxes on EBITAT Cash Income Taxes Less Tax on
  Interest Expense and Interest Income and Tax on
  Non-operating Income
• Invested Capital less cash balance
• Adjustments
• Other Assets
• Cash Balances
• Goodwill
• Other

43
Issues in Management Performance Evaluation

• Basic Formula ROIC versus WACC
• How to compute ROIC
• NOPLAT/Average Invested Capital
• May or may not include goodwill If goodwill is
  not included, compute NOPLAT without subtracting
  goodwill write-off and subtract net goodwill from
  invested capital
• Reduce the invested capital by surplus cash
  balances
• Some dont include other income then the
  invested capital should be reduced by other
  investments
• Can compute with ratios
• EBIT Margin x (1-t) Asset Turn
• Asset Turn Sales/Assets EBIT Margin
  EBIT/Sales
• ROCE vs ROIC
• ROCE is generally computed in an indirect way by
  starting with net income, and adding net of tax
  interest and adding minorities

44
Exxon Mobil Return on Average Capital Employed

• Return on average capital employed (ROCE) is a
  performance measure ratio. From the perspective
  of the business segments, ROCE is annual business
  segment earnings divided by average business
  segment capital employed (average of beginning
  and end-of-year amounts).
• These segment earnings include ExxonMobils share
  of segment earnings of equity companies,
  consistent with our capital employed definition,
  and exclude the cost of financing.
• The corporations total ROCE is net income
  excluding the after-tax cost of financing,
  divided by total corporate average capital
  employed. The corporation has consistently
  applied its ROCE definition for many years and
  views it as the best measure of historical
  capital productivity in our capital intensive
  long-term industry, both to evaluate managements
  performance and to demonstrate to shareholders
  that capital has been used wisely over the long
  term. Additional measures, which tend to be more
  cash flow based, are used for future investment
  decisions.

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Exxon Mobil Return on Capital Employed Where
are they making expenditures
46
Exxon Mobil Return on Capital
 
(1) All other financing costs net in 2003 includes interest income (after tax) associated with the settlement of a U.S. tax dispute.
47
Example of ROIC Calculation - AES
48
Illustration of Invested Capital Computation
49
ROE and ROIC Note how to compute growth rates
from ROE and Retention
50
Example of Return on Capital Employed (Return on
Invested Capital) in Financial Analysis

• The argument has been made that the best measure
  to evaluate management performance that is not
  distorted by leverage (as in the case of ROE) or
  has the problems of ROA is the return on invested
  capital. An example of use of this ratio is in
  the Exxon Mobile Merger
• J.P. Morgan reviewed and analyzed the return on
  capital employed ("ROCE") of both Exxon and Mobil
  since 1993. J.P. Morgan observed that Exxon's
  ROCE has consistently been 2-3 above that of
  Mobil.
• J.P. Morgan's analysis indicated that if Mobil
  were to be merged with Exxon, the combined
  entity's capital productivity would eventually be
  higher than the pro forma capital productivity of
  Exxon and Mobil.
• J.P. Morgan indicated that it would be reasonable
  to assume that the benefits of this capital
  productivity increase would occur within three
  years of the closing of the merger.

51
Relationship Between Various Ratios and DuPont
Analysis
Asset Utilization

• Profitability

Working Capital/ Sales Plus Long-term capital/
Sales EqualsCapital employed/ Sales 1 divided by
Capital Employed/ Sales Equals Asset Turnover
(Sales/ Capital Employed)
Gross Margin Gross profit/ Sales Less
Operating costs/ Sales Equals EBIT Margin (EBIT/
Sales)
Multiplied by
ROCE(EBIT/ Capital Employed )
Multiplied by (1 minus Tax Rate)
ROCE(EBIT after Tax/ Capital Employed )
52
Class 2 Financial Indicators of Market Value

• Financial Ratios can be used to analyze whether
  the valuation of a company is appropriate.
  Analysts should understand the drivers of
  different ratios. Valuation Ratios include
• Universal Financial Ratios
• Price to Earnings Ratio
• Enterprise Value/EBITDA
• PEG (P/E to Earnings Growth) Ratio
• Market to Book Ratio
• Industry Specific Financial Ratios
• Value/Reserve
• Value/Customer
• Value/Plane Seat

53
Valuation Ratios and Benchmarks

• Valuation ratios measure the stock market value
  of a company relative to some accounting measure
  such as EPS, EBITDA, Book Value/Share or growth
  in EPS
• The ratios can be used as benchmarks in valuing
  non-traded companies by using industry average
  valuation ratios.
• Example to value non-traded company
• Value of company EPS of Company x Industry
  Average P/E Ratio
• Valuation ratios will be further discussed in the
  portion of the course where corporate models are
  used to value companies.

54
P/E Ratio

• The P/E Ratio is the most prominent valuation
  ratio. It is affected by estimated earnings
  growth, the ability of a company to earn economic
  profits and the growth in profitable operations.
• Formula
• Share Price/Earnings per Share
• Issues
• Trailing Twelve Months and Forward Twelve Months
  Generally use forward EPS
• Formula (1-g/r)/(k-g)
• Problems
• Affected by earnings adjustments
• Causes too much focus on EPS
• Distortions created by financing

55
Illustration of EV Ratios and Computation of
Market Value of Balance Sheet Components
56
Investment Banker Analysis of Comparable Multiples
57
Investment Banker Analysis of Multiples
58
Use of PE in Valuation

• The long-run P/E ratio is often used in
  valuation. This process involves
• Project EPS
• Compute Stable EPS
• Compute P/E Ratio using formula
• P/E (1-g/r)/(k-g)
• g growth in EPS or Net Income
• r rate of return earned on equity
• k cost of equity capital
• Related Formula for terminal value with NOPLAT
  (EBITAT)
• (1-g/ROIC)/(WACC g)
• The formula demonstrates where value really comes
  from

59
Risk Assessment of Debt and Analysis of Credit
Spreads
60
Liquidity and Solvency
Credit worthiness Ability to honor credit
obligations (downside risk)

• Liquidity
• Ability to meet short-term obligations
• Focus
• Current Financial conditions
• Current cash flows
• Liquidity of assets

• Solvency
• Ability to meet long-term obligations
• Focus
• Long-term financial conditions
• Long-term cash flows
• Extended profitability

61
Solvency Ratios

• Ratios are the center of traditional credit
  analysis that assesses whether a company can
  re-pay loans. These ratios should be compared to
  benchmarks.
• Solvency
• Debt Payback Ratios
• Funds from Operations to Total Debt
• Debt to EBITDA
• Leverage Ratios
• Debt to Capital (Include Short-term Debt)
• Market Debt to Market Capital
• Payment Ratios
• Interest Coverage
• Debt Service Coverage Cash Flow/(Interest
  Principal)
• Capital Investment Coverage
• Operating Cash Flow/Capital Expenditures

62
Liquidity

• Current Ratio
• Current Assets to Current Liabilities
• Current Assets less Inventory to Current
  Liabilities
• Model Working Capital
• Current Assets less Cash and Temporary Securities
  minus Current liabilities less Short-term Debt
• Liquidity Assessment
• Debt Profile (Maturities)
• Bank Lines (Availability, amount, maturity,
  covenants, triggers)
• Off Balance Sheet Obligations (Guarantees,
  support, take-or-pay contracts, contingent
  liabilities)
• Alternative Sources of Liquidity (Asset sales,
  dividend flexibility, capital spending
  flexibility)

63
Banks or Rating Agencies Value Debt with Risk
Classification Systems
Map of Internal Ratings to Public Rating Agencies
64
SP Ratio Definitions
65
SP Benchmarks
66
Example of Using Ratios to Gauge Credit Rating

• The credit ratios are shown next to the achieved
  ratios. Concentrate on Funds from operations
  ratios.

Note that based on business profile scores
published by SP
67
Credit Rating Standards and Business Risk
68
Debt Capacity and Interest Cover

• Despite theory of probability of default and loss
  given default, the basic technique to establish
  bond ratings continues to be cover ratios,\.

69
Default Rates and Credit Spreads
70
Credit Spreads
Increase of 5
Credit Crisis
71
Moodys Forecast of Default Rates
Defaults versus Long-term Average
Moody's Speculative Grade Trailing 12-Month
Default Rates
Actual Jan. 2000 to Aug. 2002 / Forecasted Sept.
2002 to Feb. 2003
12.0
10.7
11.0
10.5
10.5
10.5
10.3
10.3
10.3
10.1
10.0
10.0
10.0
10.0
9.8
9.8
9.3
9.6
10.0
9.0
8.8
8.8
9.0
8.5
7.9
7.7
7.7
8.0
7.1
6.7
7.0
6.2

6.0
5.0
4.0
3.77
3.0
2.0
1.0
0.0
Jul-01
Jul-02
Jan-01
Feb-01
Mar-01
Apr-01
May-01
Jun-01
Oct-01
Jan-02
Feb-02
Mar-02
Apr-02
May-02
Jun-02
Oct-02
Jan-03
Feb-03
Aug-01
Sep-01
Nov-01
Dec-01
Aug-02
Sep-02
Nov-02
Dec-02
Months
Note Long run annual default rate is 3.77
72
Updated Transition Matrix
73
Probability of Default

• This chart shows rating migrations and the
  probability of default for alternative loans.
  Note the increase in default probability with
  longer loans.

74
Bond Ratings and Historic Credit Spreads
75
Credit Spreads for Utility Debt
76
DSCR Criteria in Different Industries in Project
Finance

• Electric Power 1.3-1.4
• Resources 1.5-2.0
• Telecoms 1.5-2.0
• Infrastructure 1.2-1.6
• Minimum ratio could dip to 1.5
• At a minimum, investment-grade merchant projects
  probably will have to exceed a 2.0x annual DSCR
  through debt maturity, but also show steadily
  increasing ratios. Even with 2.0x coverage
  levels, Standard Poor's will need to be
  satisfied that the scenarios behind such
  forecasts are defensible. Hence, Standard
  Poor's may rely on more conservative scenarios
  when determining its rating levels.
• For more traditional contract revenue driven
  projects, minimum base case coverage levels
  should exceed 1.3x to 1.5x levels for
  investment-grade.

77
Credit Spread on Debt Facilities

• The spread on a loan is directly related to the
  probability of default and the loss, given
  default.

S
The Credit Triangle
S P (1-R)
P
R

• The credit spread (s) can be characterized as
  the default probability (P) times the loss in
  the event of a default (R).

78
Expected Loss Can Be Broken Down Into Three
Components
Borrower Risk
Facility Risk Related
EXPECTED LOSS
Probability of Default (PD)
Loss Severity Given Default (Severity)
Loan Equivalent Exposure (Exposure)
x
x

What is the probability of the counterparty
defaulting?
If default occurs, how much of this do we expect
to lose?
If default occurs, how much exposure do we expect
to have?
The focus of grading tools is on modeling PD
79
Comparison of PD x LGD with Precise FormulaCase
1 No LGD and One Year

• .

80
Comparison of PD x LGD with Precise FormulaCase
2 LGD and Multiple Years

• .

81
Default Rates by Industry
82
Recovery Rates
83
Mathematical Credit Analysis
84
General Payoff Graphs from Holding Investments
with Future Uncertain Returns
85
Payoff Graphs from Call Option Payoffs when
Conditions Improve
86
Payoff Graphs from Buying Put Option Returns
are realized to buyer when the value declines
87
Payoff Graphs from Selling Put Option Value
Changes with Value Decreases
88
The Black-Scholes/Merton Approach

• Consider a firm with equity and one debt issue.
• The debt issue matures at date T and has
  principal F.
• It is a zero coupon bond for simplicity.
• Value of the firm is V(t).
• Value of equity is E(t).
• Current value of debt is D(t).

89
Payoff to claimholders
At maturity date T, the debt-holders receive face
value of bond F as long as the value of the firm
V(T) exceeds F and V(T) otherwise. They get F -
MaxF - V(T), 0 The payoff of riskless debt
minus the payoff of a put on V(T) with exercise
price F. Equity holders get MaxV(T) - F, 0,
the payoff of a call on the firm.
Value of the company and changes in value to
equity and debt investors
Nominal Debt Repayment
Equity
F
Debt
V(T)
Value of Firm in Time T
90
Payoff to debt holders
Credit spread is the payoff from selling a put
option
A1
A2
Assets
B
The payoffs to the bond holders are limited to
the amount lent B at best.
91
Mertons Model

• Mertons model regards the equity as an option on
  the assets of the firm
• In a simple situation the equity value is
• max(VT -D, 0)
• where VT is the value of the firm and D is the
  debt repayment required
• Assumptions
• Markets are frictionless, there is no difference
  between borrowing and lending rates
• Market value of the assets of a company follow
  Brownian Motion Process with constant volatility
• No cash flow payouts during the life of the debt
  contract no debt re-payments and no dividend
  payments
• APR is not violated

92
Mertons Structural Model (1974)

• Assumes a simple capital structure with all debt
  represented by one zero coupon bond problem in
  project finance because of amortization of bonds.
• We will derive the loss rates endogenously,
  together with the default probability
• Risky asset V, equity S, one zero bond B maturing
  at T and face value (incl. Accrued interest) F
• Default risk on the loan to the firm is
  tantamount to the firms assets VT falling below
  the obligations to the debt holders F
• Credit risk exists as long as probability (VltF)gt0
• This naturally implies that at t0, B0ltFe-rT
  yTgtrf, where pTyT-rf is the default spread which
  compensates the bond holder for taking the
  default risk

93
Merton Model Propositions

• Face value of zero coupon debt is strike price
• Can use the Black-Scholes model with equity as a
  call or debt as a put option to directly measure
  the value of risky debt
• Can use to compute the required yield on a risky
  bond
• PV of Debt Face x (1y)t
• or
• (1y)t PV/Face
• (1y) (PV/Face)(1/t)
• y (PV/Face)(1/t) 1
• With continual compounding - Ln(PV/Face)/t
• Computation of the yield allows computation of
  the required credit spread and computation of
  debt value
• Borrower always holds a valuable default or
  repayment option. If things go well repayment
  takes place, borrower pays interest and principal
  keeps the remaining upside, If things go bad,
  limited liability allows the borrower to default
  and walk away losing his/her equity.

94
Default Occurs at Maturity of Debt if V(T)ltF
Asset Value
VT
V0
F
Probability of default
Time
T
95
Resources and Contacts

• My contacts
• Ed Bodmer
• Phone [phone]
• E-mail edbodmer_at_aol.com
• Other Sources
• Financial Library project finance case studies
  including Eurotunnel and Dabhol
• Financial Library Monte Carlo simulation
  analysis