The Mechanics of Credit Risk Analysis

Core modules

Unit 1: Learning Aims & Objectives

An Introduction to Credit Risk Analysis

• Understand the essence of credit and how the credit market works
• Learn how to clear process that is foundational for credit risk analysis set out
• Gain the ability to apply the key issues around the strategic intent of credit risk management

Understanding the Foundation of Credit

• What is credit
• How does the credit market work
• The advantages of credit
• The disadvantages of credit
• The banks and credit

The Foundations of Credit Risk Analysis

• The risk and return profile in the context of credit risk analysis
• How is credit risk undertaken
• The 5 Cs of credit risk
• Why the banks undertake credit risk analysis

The Role of Credit Risk Management

• What is credit risk management
• How does credit risk management differ from credit risk analysis
• The structure of credit risk management
• The objectives of using credit risk management
• The appetite for credit risk
• The process and stages of credit risk management

Unit 2: Learning Aims & Objectives

Credit Risk Applicable to Corporates

• Gain a clear understanding and approach to the credit process from both a qualitative and quantitative perspective
• Obtain an understanding of the environment in which a potential client operates in from a macro level
• Understand the industry in which the corporate operates and the specific risks in which the client operates
• Ability to review the company from both a strategic perspective as well as from an understanding of management competencies

Macro Risks

• PESTEL analysis
• political
• economic indicators:
• Government spending
• Consumer consumption
• Investments (Foreign Direct Investments – FDI)
• Exports vs. imports
• National income
• Inflation and deflation
• Monetary policy
• social – demographics
• technology
• environmental
• legal – regulatory
• Economic cycles

Industry Risks

• Industry life cycles
• Product life cycles
• Understanding the industry:
• understanding the market and competitive strategies
• drivers of the sector – earnings, working capital
• and capital expenditure
• sector dynamics and corporate performance
• asset conversion cycle
• Different types of industry
• Risks specific to the industry
• Understanding competition
• Porters Five Forces (Tool for evaluating competitive position):
• bargaining power of suppliers
• bargaining power of buyers
• threat of new entrants
• threat of substitutes
• rivalry
• Benchmarking and comparable analysis
• Company specific challenges:
• regulations
• concentrated vs. fragmented
• overtrading

Company Risks

• Understanding the business model
• Revenue and cost drivers – the business activities
• Key Performance Indicators (KPIs)
• Strategic analysis:
• SWOT analysis – internal vs. external perspective
• Porters model
• Differentiation
• Cost leadership
• Ansoff’s model
• Product penetration
• Market penetration
• Diversification
• Boston Consulting Matrix
• organic vs. acquisition

Management analysis:

• corporate governance
• Strategy and impact of change to credit risk

Unit 3: Learning Aims and Objectives

Financial (Quantitative) Risks

• Gain an understanding of ‘what the business actually does to make a profit
• Establish the principles on which the financials have been prepared and on what basis can they be relied on for credit (the auditor’s report)
• Determine how to interpret the financial statements for credit with a focus on establishing the quantitative risks
• Ability to use financial ratios to obtain additional insight to the financial statements
• Ensure there is a sound understanding of working capital and the impact on the business and the cash flow

Understanding the Business

• Understanding the business in terms of a business model
• The generic business model
• Deriving the revenue drivers and cost drivers
• Critical success factors

Financial Regulations and the Auditors

• Regulatory framework
• Corporate governance
• Chairman’s statement
• Operating and financial review
• Director's report
• Audit report and the role of auditors

Format of the annual report:

• statement of financial position
• income statement
• statement of comprehensive income
• statement of changes in equity
• statement of cash flows
• notes to the financial statements
• International Financial Reporting Standards (IFRS)
• Use of IFRS for domestic reporting
• Review of major IFRS pronouncements
• The Statement of Financial Position (Balance Sheet)
• The accounting equation
• Structure of the balance sheet and salient features
• Non-current assets
• Investments

Current assets:

• inventory – slow moving, different policies
• receivables – ageing, provisions, collections, working capital cycle and working investment cycle
• Non-current

Liabilities:

• current - short-term
• non-current - long-term, depreciation methods
• Accruals and provisions
• Equity

Investments:

• investments at cost of fair market value
• associate companies
• subsidiaries and consolidated financial statements
• Goodwill
• Reading the footnotes in conjunction with the balance sheet
• Special situations and red flags and off balance sheet items
• Analysing the balance sheet
• Key analysis question formation and list from the balance sheet – risk identification

Income Statement and Statement of Comprehensive Income

• Revenue model

Revenue and receivables quality:

• ageing
• provisions
• collections
• Compound Annual Growth Rate (CAGR)

Cost structure:

• fixed and variable costs
• break-even analysis
• Defining expenses
• Comprehensive Income Statement
• Reading the footnotes in conjunction with the income statement
• Segment reporting

Profitability:

• gross margins
• operating margins
• Growth margins
• Analysing the income statement
• Benchmarking
• Key analysis question formation and list from the income statement – risk
• identification

Statement of Cash Flows

• Cash vs. accrual
• Direct and indirect cash flow statement

The structure and content of the cash flow statement:

• operating cash flow
• investing cash flow
• financing cash flow
• analysing the cash flow statement
• How to use the cash flow statement for projections
• Cash flow calculations
• Financial ratios and the statements of cash flows
• Relationship of income and cash flows
• Free cash flow
• How to use the cash flow statement to quantify debt capacity – Debt Service
• Cover Ratio (DSCR)
• Ratio Analysis

Ratios used in operating performance and profitability:

• turnover
• EBITDA
• net working capital
• cash flow

Ratios used in capital structure:

• leverage vs. gearing
• debt coverage ratios
• discretionary vs. non-discretionary
• off-balance sheet funding inclusions
• Asset efficiency ratios
• Credit Ratios: liquidity, solvency and fixed charge coverage
• Capital return ratios (Return on Capital Employed vs. Return on Equity)
• Du pont ratio analysis (Profitability, Efficiency and Leverage)
• Interpretation of ratios, what each ratio is really telling
• When are ratios useful
• What are their limitations
• Trend analysis
• Industry comparisons
• Key analysis question formation and list from the cash flow statement – risk
• identification

Working Capital

• The working capital cycle
• The link of the working capital cycle with liquidity and cash flow
• Ratios which are relevant to working capital
• Working capital vs. working investment
• The structure for financing working capital

Factors influencing working capital:

• demand and supply
• change in volumes
• price changes
• trade terms

Potential risks in working capital:

• inflation
• overtrading
• incorrect impairments
• margin squeeze and cash flow reductions
• inappropriate financing
• Risk mitigants in working capital

Unit 4: Learning Aims and Objectives

Cash Flow Forecasting and Modelling

• Learn how to project and forecast the financial statements - using concepts in earlier units
• Understand that cash flow pays back the loan – incorporating the business model to the cash flow forecasts established the ability of the borrower to pay back the loan

Projections and Forecasts

• Tools for projecting financial statements
• Defining assumptions
• Which dependent variables do we want to project
• Projecting the income statement
• Seasonality
• Using value drivers to make decisions on future business profile
• The key cash drivers
• Forecasting cash flows
• Looking at historical cash flows as basis for future cash flow
• Forecasting the balance sheet
• Assessing a company’s financing needs
• Working capital projections
• New funding requirement and affordability
• Ratios in projections
• Sensitivity analysis - adjusting critical assumptions and value drivers

Building the Business Model and Projections

• Limitations on the information provided through financial accounts
• Understanding the reliability of financial data

The five cash drivers:

• profits - profitability ratios, sales growth, gross margin, operating margin, interest cover ratios, return on capital employed
• asset cash conversion cycle – sales volume and growth, accounts receivable days, inventory days, accounts payable days
• capital expenditure – mandatory, maintenance and discretionary (and why discretionary often isn’t), delays, cost overruns, completion risk, FX risks, use of the asset turn ratio
• equity – access to equity capital, dividend policy, leverage ratios
• debt – access to debt capital, maturity profile and cash flow subordination issues, contingent exposures, leverage ratios, current and quick ratios
• key balance sheet and income statement ratios
• Direct and indirect presentations of cash flows - variety of cash flow statements to be assessed and analysed; approaches to cash flow calculation and interpretation
• Different cash flow definitions – FFO, RCF, FCF, RCF, levered and unlevered cash flow measures

Methodology for assessing corporate projections and/or to prepare them for less sophisticated clients:

• background to projections
• projection methodology
• setting meaningful forecast assumptions for growth, margins and financing requirements
• determine assumption set and forecast the 5 cash drivers and debt service capacity for the next two years

Unit 5: Learning Aims and Objectives

Pricing Credit Risk

• Gain an understanding of the how credit pricing is established in a bank
• Review and understand the different pricing methods

The Principles of Credit Pricing

• Risk return profile
• Premium for taking on more risk
• Cost of capital and the Capital Asset Pricing Model (CAPM)
• Risk and the loan portfolio
• Risk and the related sectors
• The structure – interest rate and fees

What type of loan facility is suitable for borrowing:

• seasonal lending
• term lending
• permanent asset based working capital finance
• bridging loans
• Understanding how debt structure and security should be linked to the reason for the borrowing
• What is the source of repayment
• A borrower's status and credit
• The role of maturity in pricing

Methodologies for Credit Pricing

• Using the Micro Finance model
• Establish the capital structure of a bank and the Basel III idea of capital
• Return on Risk Adjusted Capital (RORAC)
• Pricing and the market
• Different types of pricing methods

Unit 6: Learning Aims and Objectives

Collateral and Covenants

• Understand what collateral is and how it works as a credit enhancer
• Learn how to structure covenants which are beneficial for both the lender and borrower

Collateral

• What is collateral
• The characteristics of good and bad collateral
• Practical issues of taking, valuing and enforcing collateral
• Basis of valuation
• market values vs. book values vs. liquidation values
• collection costs
• realisation as a going concern vs. wind up
• How robust is a security charge over commercial real estate?
• commercial property prices
• what is an asset worth?
• cash flows and discount rates
• all lending is ultimately based on cash flow
• The need to think about alternative sources of collateral and security to real estate
• Security interests and general obligations
• Guarantees – key issues to consider about both guarantee and guarantor when taking this form of protection
• How collateral impacts pricing debt

Methods of security:

• mortgages
• lien
• pledge

Covenants

• Non-financial clauses and conditions
• Negative pledge, cross default, material adverse change
• Change of control clauses: definitions, strengths and weaknesses
• Financial covenants – when and how do they protect the bank
• Balance sheet and income based covenants
• Cash flow covenants in detail
• Designing intelligent covenant packages that provide timely early warning of problems and allow the bank to act to protect its interests

Unit 7: Learning Aims and Objectives

Writing a Credit Report

• Gain the techniques to plan and write the credit information memorandum which should capture all of the analysis work in one document with the view to be used for making the final credit decision

The Contents of the Credit Report

• Purpose of the loan facility
• Structure of the facility
• Review of the client
• Financial information
• Review of financial information
• How will the loan be repaid
• Company risks and mitigants
• Covenants
• Collateral
• Decision