Section 7

Credit risk analysis

“A man goes bankrupt gradually, then suddenly.”

--Ernst Hemingway

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Learning objectives

After studying this chapter, you will understand

• A typical process of the financial distress of the firm
• How financial ratios can be used to predict financial
distress and credit risk
• How other information of the firm helps predicting
distress and credit risk

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Key concepts

• Credit risk refers to the risk of default by the borrower

• The lender risks losing interest payments and loan
principal
• A company’s ability to repay debt is determined by its
capacity to generate cash from operations, asset sales,
or external financial markets in excess of its cash needs.
• A company’s willingness to repay debt depends on
which of the competing cash needs management
believes is most pressing at the moment

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Firm has to balance between cash
sources and needs

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Credit analysis
Step 1: • Business model and strategy
Understand
• Key risks and success factors
the business
• Industry competition
Step 2: Evaluate • Spot potential distortions
accounting quality • Adjust reported numbers as needed

Step 3: • Examine ratios and trends

Evaluate current
• Look for changes in profitability, financial
profitability and health
conditions, or industry position
Step 4: Prepare “pro forma” • Develop financial statement forecasts
cash flow forecasts • Assess financial flexibility

Step 5:
Due diligence • Kick the tires

Step 6: Comprehensive risk • Likely impact on ability to pay

assessment • Assess loss if borrower defaults
• Set loan terms

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 Financial ratios and credit risk
• A firm defaults when it fails to make
principal or interest payments
• Lenders can then
– Adjust the loan payment schedule
– Increase the interest rate and
require loan collateral
– Seek to have the firm declared
insolvent
• Financial ratios play two roles in credit
analysis
– They help quantify the borrower’s
credit risk before the loan is Default rates by Moody’s credit rating
Source: Moody’s Investors Service
granted.
– Once granted, they serve as an
early warning device for increased
credit risk

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Liquidity

• Liquidity refers to the ability of a firm to meet its short-

term financial obligations when they fall due
• Quick ratio and Current ratio are commonly used
liquidity measures
• Both ratios contain the assets in the numerator to
include items that potentially can be converted into cash
• The higher both the ratios, the higher the liquidity
position of the firm

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Current ratio
• Frequently used measure of liquidity
• Assumes that current assets have a liquidation value, i.e.
the firm could sell all its current assets to pay back its
current liabilities, if it runs out its business
• Is calculated as follows (without time subscipts):
CURRENT ASSETS
CURRENT RATIO =
CURRENT LIABILITIES

• Some guidelines to asses the level of Current ratio:

CR > 2 Good
1<= CR <=2 Satisfactory
CR < 1 Weak

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Case: Current ratio of Kone, 2013

CURRENT ASSETS2013
CURRENT RATIO2013 =
CURRENT LIABILITIES2013

3405,0
=
3217,4
= 𝟏, 𝟎𝟔

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 Quick ratio

• Another frequently used measure of liquidity

• Assumes that inventories do not necessarily have any
liquidation value, if they are sold
• Is calculated as follows (without time subscipts):
CURRENT ASSETS − INVENTORIES
QUICK RATIO =
CURRENT LIABILITIES

• Some guidelines to asses the level of Quick ratio:

QR > 1 Good
0,5 <= QR <= 1 Satisfactory
QR < 0,5 Weak

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Case: Quick ratio of Kone, 2013

𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝐴𝑆𝑆𝐸𝑇𝑆2013 − 𝐼𝑁𝑉𝐸𝑁𝑇𝑂𝑅𝐼𝐸𝑆2013

𝑄𝑈𝐼𝐶𝐾 𝑅𝐴𝑇𝐼𝑂2013 =
𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝐿𝐼𝐴𝐵𝐼𝐿𝐼𝑇𝐼𝐸𝑆2013

3405,0 − 1103,9
=
3217,4
= 0,72

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Net working capital ratio
• Measures the difference between current assets and
current liabilities
• Net working capital is OFTEN defined as follows
(without time subscipts):

NET WORKING CAP. = CURRENT ASSETS − CURRENT LIABILITIES

• Net working capital ratio is calculated as follows:

NET WORKING CAPITAL

NET WORKING CAPITAL =
SALES

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Case: Net working capital ratio of Kone,
2013

Current assets 3405,0

Current liabilities -3217,4
= NET WORKING CAPITAL 187,6

NET WORKING CAPITAL2013

NET WORKING CAPITAL RATIO 2013 =
SALES2013

187,6
=
6932,6
= 2,7%

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Turnover ratios

• These ratios measure how effectively a firm uses the

components of net working capital
• A firm should minimize the amount of working capital
– Reduces invested capital, and hence,increases EVA
• On the other hand, a firm must meet all its obligations
when they are due
• Frequently used ratios
– Account receivables turnover rate
– Account payables turnover rate
– Inventory turnover rate

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Account receivables turnover rate

• How quickly (or slowly…) the firm receives its

receivables from sales

SALES
ACCOUNT RECEIVABLES TURNOVER =
ACCOUNT RECEIVABLES

• Kone, 2013:
6932,6
ACCOUNT RECEIVABLES TURNOVER2013 =
1164,6
= 6,0

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Account payable turnover rate

• How quickly (or slowly…) the firm pays its bills

PURCHASES
ACCOUNT PAYABLE TURNOVER =
ACCOUNT PAYABLES

These numbers are

• Kone, 2013: from the footnote #5 in
the I/S of Kone

2839,0+577,4+489,3
ACCOUNT PAYABLE TURNOVER2013 = 511,2

=7,6

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Inventory per sales-%

• How effectively inventory management works

INVENTORY
INVENTORY PER SALES−% =
SALES

• Kone, 2013:

1103,9
INVENTORY PER SALES−%2013 = 6932,6
= 15,9%

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Financial ratios and credit risk
• Financial ratios predict
– Profitability: Weakened earnings may launch the process that
leads firms into financial distress (early warning signs)
– Financial leverage: All too much debt is a signal of already-
existing financial troubles (mid-term warning signs)
– Liquidity and working capital: Liquidity straits are a strong signal
of anticipated distress (final warning signs)
• Main questions are
– How to use financial rations in distress prediction?
– Can we improve their prediction power by using other
information?

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Univariate distress prediction by ROA

0,1
0,05
0
Nonfailed
-0,05 5 4 3 2 1
firms
-0,1 Failed firms

-0,15
-0,2
-0,25
Years before failure

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Univariate distress prediction by Debt to
Total Assets
0,9
0,8
0,7
0,6 Failed firms
0,5
0,4 Nonfailed
0,3 firms
0,2
0,1
0
5 4 3 2 1
Years before failure

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Univariate distress prediction by
Working Capital to Total Assets
0,45
0,4
0,35
0,3 Nonfailed
0,25 firms
0,2 Failed firms
0,15
0,1
0,05
0
5 4 3 2 1
Years before failure
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Multivariate distress prediction models
• Combine several financial ratios
• Multivariate models perform better than univariate
models
• Classical multivariate models
– Altman’s model
– Ohlson’s model
• More recent models include other variables but financial
ratios
– Stock-market based variables
– Executives’ personal traits

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Altman’s Z-score for listed firms
• Original Altman’s Z-score for listed firms is as follows
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5, where
• X1 = Working Capital / Total Assets
• X2 = Retained Earnings / Total Assets
• X3 = Earnings Before Interest and Taxes / Total Assets.
• X4 = Market Value of Equity / Book Value of Total Liabilities.
• X5 = Sales/ Total Assets.

• Zones of discrimination between the firms are

• Z > 2.99 “Safe” Zone
• 1.81 < Z < 2.99 “Grey” Zone
• Z < 1.81 “Distress” Zone

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Altman’s Z-score for private firms
• Original Altman’s Z-score for private firms is as follows
Z = 0.717X1 + 0.847X2 + 3.11X3 + 0.42X4 + 0.998X5, where
• X1 = Working Capital / Total Assets
• X2 = Retained Earnings / Total Assets
• X3 = Earnings Before Interest and Taxes / Total Assets
• X4 = Book Value of Equity / Total Liabilities
• X5 = Sales/ Total Assets

• Zones of discrimination between the firms are

• Z > 2.9 “Safe” Zone
• 1.23 < Z < 2.9 “Grey” Zone
• Z < 1.23 “Distress” Zone

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Altman’s Z-score for other firms and
countries
• Altman (1968) estimated the original Z-score for the
sample of 66 manufacturing firms
• Since then, the model has been estimated for other
industries and for firms in different countries
• Parameters of the model vary in these updates

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Credit ratings
• A debt rating is an indicator of the likelihood of timely
repayment of principal and interest by a borrower
• The more likely is the timely repayment, the higher is the
rating
• Rating is usually expressed in terms of certain
categories
• Commercial debt ratings
– Moody’s and Standard&Poors in US
– Suomen Asiakastieto in Finland

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Research evidence on distress prediction
• Kallunki and Pyykkö (2013, RAST) explore whether
appointing CEOs and directors with past personal
payment default entries increases the likelihood of
financial distress of the firm
– “If managers cannot manage their own money, how could they
manage the money of their company…?”
• So far, distress prediction and credit rating models have
based solely on financial ratios or similar firm-level data
• This is the first paper to use information on managers’
personal characteristics in distress prediction
• Results show that it pays to check CEOs’ and directors’
personal credit defaults
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Research evidence on distress prediction

Proportion of defaulting CEOs and directors between

distress and non-distress firms

Bankrupt firms Insolvent firms Non-distressed

firms
Defaulting CEOs 6.8% 5.1% 1.2%
Defaulting 11.9% 11.6% 2.8%
directors

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Research evidence on distress prediction
0,02
Proportion of bankrupt firms

0,018
0,016
0,014
0,012
0,01
0,008
0,006
0,004
0,002
0
0 0-0.5 > 0.5

Proportion of directors with payment default entries

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Research evidence on distress prediction
0,07
Proportion of insolvent firms

0,06
0,05
0,04
0,03
0,02
0,01
0
0 0-0.5 > 0.5

Proportion of directors with payment default entries

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Research evidence on distress prediction

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Summary

• Credit risk refers to the risk of default by the borrower

• Financial ratios play an important role in credit risk
analysis
• Financial distress may lead to default or (costly)
restructuring
• Multivariate distress prediction models perform better
than univariate models
• Credit ratings indicate the risk of default
• Managers’ personal characteristics affect defaul risk

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