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Financial Statement Analysis


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Title: Financial Statement Analysis

Financial Statement Analysis
Financial Statement Analysis Contents
  • Overview and objective of financial statement
  • Review and Re-formatting Statements for Financial
  • 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

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
  • Assessing management performance of a company
    and whether projections of improvement or
    sustainability are reasonable.
  • Assessing the value of a company from historic
  • 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

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

Double Counting and Judgments in Financial Ratio
  • 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

Income Statement
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

Standard Computation of EBITDA
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
  • 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.

Simplified Income Statement
  • Sales- COGS
  • Gross Margin- SGA- Other Expenses
  • Other Income
  • - 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
Analysis of Income Statement Computation of
EBITDA, Minority Interest, Preferred Dividends,
Exploration Expense
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

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.

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
  • 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

Cash Flow Statement
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

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

Cash Flow Statement Example
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
  • Free cash flow consists of
  • Cash flow to equity holders
  • Cash flow to debt holders

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

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

Importance of Free Cash Flow
  • Alternative Definitions, but one correct concept
  • Free Cash Flow Is Also Known As Unleveraged Cash
  • 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
  • IRR on Free Cash Flow is the Project IRR
  • Free Cash Flow in Economic Value
  • FCF Carrying Charge Economic Profit

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

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
  • 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
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
  • Plus Depreciation
  • Less Change in Working Capital
  • Less Capital Expenditures
  • Equals Free Cash Flow

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
Balance Sheet
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

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
  • 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.

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

Financial Ratio Analysis
Tension between Equity Analysis and Asset Analysis
  • Free Cash Flow
  • Project IRR
  • WACC
  • Enterprise Value
  • 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
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
  • 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

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
  • 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

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
  • For example, pre-tax or after-tax return on
  • Keep the numerator consistent with the
  • 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

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.
  • 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

Ratios that Measure Management Performance
Class 1 Financial Indicators of Management
  • 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

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.

Basic Economic Principles, ROIC and Financial
  • 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.

Return on Invested Capital Analysis
  • ROIC is not distorted by the leverage of the
  • ROIC can be used to gauge economic profit and
    whether the company should grow operations
  • ROIC can be used to assess the reasonableness of
  • 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
  • ROIC comes from sustainable competitive advantage
    and high market share

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

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
  • Some dont include other income then the
    invested capital should be reduced by other
  • Can compute with ratios
  • EBIT Margin x (1-t) Asset Turn
  • Asset Turn Sales/Assets EBIT Margin
  • 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

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

Exxon Mobil Return on Capital Employed Where
are they making expenditures
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.
Example of ROIC Calculation - AES
Illustration of Invested Capital Computation
ROE and ROIC Note how to compute growth rates
from ROE and Retention
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
  • 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.

Relationship Between Various Ratios and DuPont
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/
Multiplied by
ROCE(EBIT/ Capital Employed )
Multiplied by (1 minus Tax Rate)
ROCE(EBIT after Tax/ Capital Employed )
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

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.

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

Illustration of EV Ratios and Computation of
Market Value of Balance Sheet Components
Investment Banker Analysis of Comparable Multiples
Investment Banker Analysis of Multiples
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
  • (1-g/ROIC)/(WACC g)
  • The formula demonstrates where value really comes

Risk Assessment of Debt and Analysis of Credit
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

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
  • 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
  • Capital Investment Coverage
  • Operating Cash Flow/Capital Expenditures

  • Current Ratio
  • Current Assets to Current Liabilities
  • Current Assets less Inventory to Current
  • 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
  • Alternative Sources of Liquidity (Asset sales,
    dividend flexibility, capital spending

Banks or Rating Agencies Value Debt with Risk
Classification Systems
Map of Internal Ratings to Public Rating Agencies
SP Ratio Definitions
SP Benchmarks
Example of Using Ratios to Gauge Credit Rating
  • The credit ratios are shown next to the achieved
    ratios. Concentrate on Funds from operations

Note that based on business profile scores
published by SP
Credit Rating Standards and Business Risk
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,\.

Default Rates and Credit Spreads
Credit Spreads
Increase of 5
Credit Crisis
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

Note Long run annual default rate is 3.77
Updated Transition Matrix
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.

Bond Ratings and Historic Credit Spreads
Credit Spreads for Utility Debt
DSCR Criteria in Different Industries in Project
  • 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

Credit Spread on Debt Facilities
  • The spread on a loan is directly related to the
    probability of default and the loss, given

The Credit Triangle
S P (1-R)
  • The credit spread (s) can be characterized as
    the default probability (P) times the loss in
    the event of a default (R).

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

What is the probability of the counterparty
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
Comparison of PD x LGD with Precise FormulaCase
1 No LGD and One Year
  • .

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

Default Rates by Industry
Recovery Rates
Mathematical Credit Analysis
General Payoff Graphs from Holding Investments
with Future Uncertain Returns
Payoff Graphs from Call Option Payoffs when
Conditions Improve
Payoff Graphs from Buying Put Option Returns
are realized to buyer when the value declines
Payoff Graphs from Selling Put Option Value
Changes with Value Decreases
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).

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
Value of Firm in Time T
Payoff to debt holders
Credit spread is the payoff from selling a put
The payoffs to the bond holders are limited to
the amount lent B at best.
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
  • APR is not violated

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

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
  • 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.

Default Occurs at Maturity of Debt if V(T)ltF
Asset Value
Probability of default
Resources and Contacts
  • My contacts
  • Ed Bodmer
  • Phone 001-630-886-2754
  • E-mail
  • Other Sources
  • Financial Library project finance case studies
    including Eurotunnel and Dabhol
  • Financial Library Monte Carlo simulation
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