CREDIT

CREDIT

1. Credit analysis is the evaluation of an organization from its debt holder

   • There is a range of credit worthiness, and Seven independent steps to credit analysis for purposes of pricing and structuring a loan.
     • 1. Financial status and strategy: It identifies the nature of the significant risks of non-payment. can they cover their current debt without loan? It lists the key risks that could lead to default and factors to control such risks if the loan were made.
     • 2. Purpose of credit: Understand purpose for structuring the terms of agreement. if refinancing then safer as prior info on payments loyalty is available. New credit is more complex as it impacts both sides of a balance sheet and thereby alter the income statement and cash flows.
     • 3. Name/Type of credit: two types - closed end and open end credit. Open end credit serves for short term thus lower risk and a pre-approved credit limit is available. Only make payments on withdrawn amount +interest (credit card). Closed end credit is a long term loan therefore high risk because of market fluctuations
       • Roll over loan is revolving loan made to refinance a loan for the period which matures on the same date
     • 4. Term/Maturity and Ability to pay: Lnegth of financing matches useful life of an asset. CA = short term loan, FA = long term loans. These are spread out over time to match the cash flow generated by the asset. The loan must eb tailored to fit the borrow so they have the ability to pay.
     • 5. Security/collateral: Lend on cash flows generated by the asset not the asset itself. Security is needed for long term loans that expose to default risk. Collateral are assets backing the loan such as inventory and receivables both are short term.
       • Factoring receivables:A bsns sell sits AR to a bank to secure short term loans. Once a payment is made y a customer to the lender the lender reduces the amount owed to them by borrow by the percentage loans against receivables. most liquid expensive to sell, 80% of value then receive 20% after collection minus a fee.
       • Inventory: used to secure a short term loan depending on when you are expected to sell or end. must be easy to sell if borrower defaults
       • Unsecured lending: Both high risk. debentures is the long term borrowing of a company, not secured by assets. Backed up by creditworthiness and reputations. Most bonds are debentures. Line of credit: arrangement between customer and bank that establishes a maximum loan balance the bank will let customer maintain.
       • 6. Covenants: outlines the rights and responsibilities of borrowers and lenders. creates a balance between the interests of the lender and borrower. Most restrictions are put on certain ratios.
         • Minimum coverage ratio: Interest cover to ensure the borrow can generate cash internally strong enough to be provided a long term loan by lender.
         • Minimum NWC: Forces an organisation to maintain its liquidity using cash generated from operations to meet its current obligations
         • Minimum ratio of total liabilities: Constraints the risk of high leverage. Thus restricts further borrowing
         • Restrict dividend pay out so that there is still enough returns to pay off loan. Debt holders prefer less risk, they have maximum pay off unlike equity holders.
         • 7. Pricing: a bank loan means you are charged fees or rates. This ensures the yield on loan covers the lenders cost of borrowed funds, cost of administering and servicing the loan, a premium for exposure to default risk and a normal return on the equity capital. Rates on loan = cost of funds +Admin costs + equity return + risk premium
           • Consumer lending: money you to get a loan. An establishment fee - basically prepaying all your interest (Harvey Normal - a fee at the start alto interest free for two years)
           • Penalties for covenant breaches: A bank can force you into bankruptcy if you breach a covenant. Altho that's not in their best interest so they will waiver for a fee

2. debt is an important source of financing , tho there are trade offs in financing with debt instead of equity

   • Risk of financial distress increases with an increase in debt financiing

3. Various players in the market for credit:

   • Commercial banks: They have intimate knowledge of clients, but are constrained in the amount of risk they can assume. Comparative advantage in reducing credit risk because:
     • They carefully monitor an organisation
     • Through close contact with management
     • They don't finance on a long term basis bc of risk.
   • Other financial institutions: They compete with banks for asset based lending, insurance companies face long term obligations, whilst investment bankers are prepared to place debt securities in the public market or with private investors.
   • Public debt markets: A firm must have he size, financial strength and credibility to bypass the banking sector and seek financing directly from investors. usually facilitated by a debt rating
   • Sellers who provide financing: These are supliers that extend short term financing to buyers, but may grant a loan believing the buyer will survive the cash shortage and remain an important customer.

4. Altman's Z score - Assess the probability that an organization will face financial distress and fail to repay loan.

   • Factors that predict bankruptcy are profitability, volatility of that profitability, and the how much financial leverage it faces.

5. Debt ratings provide important information to investors. They assess the riskiness of the debt and monitor the organization's ongoing activities.