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ASSESSING CREDIT RISK & FUNDAMENTALS OF CREDIT STRUCTURING

I. The Role of Assessing Credit Risk in the Lending Decision Process

The Lending decision process requires five basic assessments for any loan: Credit strategy and policy assessment Credit risk assessment Management risk assessment Market or Business risk assessment Facility structuring and facility risk assessment (including loan management).

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Objectives

The Objective of the course programme is to give an insight into the Fundamentals of credit risk management and the assessment of financial, business and contingent risks that a company faces. In this context, the Lenders do own fundamental skills of credit risk and performance management with greater empahsis of cash flow as main risk driver of a company. In addition to this, the course will provide fundamental credit structuring skills based on Enron and Kiler Retail groups original lending proposals. This workshop discusses the role that Ratio Analysis, Cash Flow Analysis, and Projections and the Credit Decision play in the lending decision process. Each of these three sections is an important element in overall credit risk assessment and focuses on several major topics. The Ratio Analysis section discusses the role that ratio analysis plays in the lending decision process as it focuses on three major topics. These topics collectively provide the basic knowledge, tools and analytical framework for assessing borrower liquidity and solvency in the context of financial risk assessment and as the focal point in evaluating whether obligations will be repaid as scheduled. Chapter 1 looks at the reasons companies borrow money. The various steps involved in both producing goods and services, as well as finally converting sales into cash, are considered. The production steps obviously differ for various industries and translate into different borrowing requirements. In addition, companies within the same industry frequently have different asset conversion cycles that lead to diverse borrowing needs. Based on the borrowings needs of companys, we will be confronting the value based lending strategy of Bank of Mitsubishi as a case study for lending policy determinant. Chapter 2 moves from a general review of borrowing causes to individual ratio analysis of a company's financial statements. This analysis and assessment focuses on calculating and interpreting profitability ratios, efficiency ratios, interest coverage ratios, liquidity ratios and

leverage ratios. Many of these ratios provide clear signals about Kiler Retail Company prospects for passing both the liquidity and solvency tests. Chapter 3 focuses on evaluating a company's financial performance compared to its peer group. This process helps a lender better appreciate areas" where a business may realistically expect to improve performance, as well as areas where performance is already strong and acceptable. The Cash Flow Analysis section discusses the role that cash flow analysis plays in the lending decision process as it focuses on two major topics. These subjects jointly provide cutting edge analytical tools and an associated analytical framework for assessing borrower liquidity and solvency as part of credit risk assessment and as the focal point in evaluating whether obligations will be repaid as scheduled. We will be elaborating the cash flow situation of Enron and Kiler Group of companies both on solo and consolidated level. Chapter 4 explores how accrual financial statements can be converted to a cash-based income statement. The objective is simple: to determine the historical sources of cash that a company used to pay interest and amortize debt as scheduled. At first glance, it may appear that this is unnecessary. After all, if a company makes a profit, it implies that it has at least met its interest expense. An analyst can always increase the recorded profit by any non-cash charge or expense the company recorded on its income statement to get an estimate of "cash flow". That estimate should in theory clearly indicate whether there is enough actual cash in the operations of the business to pay down debt as scheduled. Unfortunately, such an approach has failed lenders on numerous occasions in the past, primarily because it overlooks the impact on a company's cash position from changes that are only recorded on the balance sheet. Therefore, in constructing a cash flow statement from the accrual information, every account on the balance sheet is used and fully integrated. When the process is finished, the sources of cash at the disposal of a company to pay interest and repay debt as scheduled will be clearly identifiable. In rare instances, the income statement alone may tell the whole story. But in most instances, you cannot truly understand the cash position of a business, along with that company's historical cash generating capabilities, until you have constructed and analyzed its cash flow statement. Remember that it is cash, and only cash, that pays interest and repays loans, not accrual profits on an income statement. Chapter 5 looks behind a constructed cash flow statement in order to identify what events took place over the operating period that fundamentally explain the resulting cash position of the business. In so doing, the focus again moves to the risk drivers. That is, a method for providing a cash dimension to the changes that take place from period to period in each of the seven risk drivers will be explored. And you will see that only a slight movement in accounts receivable days, for example, can have an enormous impact on the cash position of a borrower. Chapter 6 explains how to use the cash flow management principles taught in Chapter 5 through interpreting the Moody's Financial Analyst (MFA) Cash Flow Management report. This report contains information in addition to that presented in Chapter 5. The chapter focuses on the composition and analytical usefulness of the report. In effect, this section completes the analysis of ratios and the implications for a company's liquidity and solvency that are provided by movements in key ratios.

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The Contents

SECTION A: RATIO ANALYSIS AN INSIGHT TOOL FOR CREDIT MANAGEMENT Chapter 1: Why business borrow?
In this chapter you will learn to understand why businesses borrow money. to identify the asset conversion process and how it affects the asset structure of a business. to recognize the relationship between the nature of the business, its asset structure and the reasons for borrowing money. to recognize the continuous trading cycle that differs across businesses and provides further reasons for borrowing. The first point of focus is a fundamental one and is thoroughly explored. Businesses borrow money for many reasons and there is risk associated with every borrowing transaction - for both the borrower and the lenders. Some of the reasons for borrowing money are intuitively less risky than others. For example, generally there is less risk in lending money on a short-term basis than on a longer-term basis. Further, some may feel that it is less risky to lend money for purchasing specific equipment than for operating expenses until the company can turn a profit. The basic reasons why businesses borrow money are identified, and through this process, the importance of using assets efficiently is better appreciated. Assets must be funded, or supported, and frequently this is done by borrowing. Obviously, every business wants to minimize the amount of interest expense it is obligated to pay and the amount of debt it is scheduled to repay. This chapter will be finalized with the lending strategy of Bank of Mitsubishi case.

CHAPTER 2: Financial Management with Ratio Analysis

In this chapter you will learn to calculate a series of ratios using the financial data from companies in the Case Studies book. to interpret and evaluate the resulting ratios of Kiler Retail Group focusing on: Profitability ratios Activity ratios 4

Leverage ratios Liquidity ratios to consider any set of financial statements and develop a sound working hypothesis about the company's basic strengths and weaknesses. to identify the linkage between asset efficiency and profitability. to explore the manner in which assets are financed by a company and the resulting impact on solvency. about seven commonly accepted drivers of business risk (the risk drivers). Once the reasons why businesses borrow money have been considered, the focus then shifts to a specific company that intends to borrow money. Lenders must, as a first step in assessing whether the company is creditworthy, undertake a thorough ratio analysis of the business to help achieve two basic objectives. First, lenders must determine whether the company is truly liquid. That is, the lenders determines whether the borrower has been able to pay interest and repay debt from internally generated cash in the past and whether the borrower is likely to do so in the future. Keep this one point in mind, however: ratios alone cannot clearly convey if the borrower has paid interest and repaid debt from internally generated cash. Certain key ratios can provide compelling clues and signals, but verification is found only in the cash flow statement, which is examined in the Cash Flow Analysis section. Second, the Lenders must determine whether the company is solvent. That is, the lenders determine whether there is enough cash value in liquidated assets to repay all outstanding obligations - now and in the future. Ratios provide more help in determining solvency than in determining liquidity. It is fundamental to understand a company's financial statements and the performance they suggest in order to pursue these two objectives effectively. In addition, it is important to understand the company's management since they make the ongoing decisions that largely determine whether the business is liquid and solvent.

CHAPTER 3: Common Size and Peer Group Analysis

In this chapter you will learn to construct and use a common size balance sheet and income statement to provide additional information about the performance of a company. to compare and contrast the performance of a company with other companies in the same line of business. to recognize which information sources are useful for comparing business performance by industrial groupings. 5

 to examine the change in composition of the balance sheet from one period to the next. Financial statements and individual accounts have been viewed in a number of ways to gain a clearer understanding of what the data is saying, primarily about a company's liquidity and solvency. A series of ratios has been computed and examined thoroughly as part of the interest in a company's liquidity. The task now is to recast the financial information so that trends in the composition of a company's balance sheet and income statement can be observed. A change in the relationships within a company's assets may signal a change in its asset management, while material changes in the composition of its liabilities have implications for its financial strength. A change in the composition of the income statement may point to developments within the business that provide more - or less - comfort with its overall profitability. A common size statement also provides a convenient means of comparing a company with its peer group. A company's asset composition can be quickly reviewed alongside a group of companies in its class size and industry. However, determining where a company fits within its industry as well as where the industry fits within the economy must be done carefully.

SECTION B: CASH FLOW ANALYSIS CHAPTER 4: Cash Flow Construction and Analysis
In this chapter you will learn to construct a cash flow statement from the accrual accounts provided by a business. to determine, by reference to the resulting cash flow statement, whether a company generated enough cash from its core, internal business operations to cover all its expenses, including its interest expense and debt amortization. to use the cash flow statement as a critical analytical tool in making a credit decision. Every business has a natural preoccupation with its cash flow. And every lender should have a similar preoccupation with a borrowers cash flow. When the concepts of liquidity and solvency are referred to, the emphasis is on cash.

A liquid company is one that generates enough cash from core, internal business operations to meet its ongoing obligations. A solvent company is one that generates enough cash to pay all its creditors by converting its assets to cash if and when it ceases operations. Again, something near to cash will not do. This section of the workbook refers to Kiler Retai Groups financial statements in the Case Studies book in constructing the cash flow statements. The questions then refer you to Kiler. A calculator is especially useful answering the questions in this chapter. Furthermore we will try to reconstruct the ENRON cash flow position from its financials. We shall now focus on cash and construct a statement that pinpoints the cash flowing into and out of a company.

CHAPTER 5 : Cash Flow Management for Lenders

In this chapter you will learn that sales growth generally absorbs overall cash even though a company's net income may increase. By the same token, a sales decline generally frees up overall company cash. that fluctuations in profitability generally impact the income statement and the cash flow statement with equal magnitude. that fluctuations in the relative levels of accounts receivable, inventory and accounts payable generally have little direct impact on the income statement but may have a material impact on the cash flow statement. that capital spending is generally important to the cash position of a company in both the short and long run. Whether as a businessperson or as lenders, you should be most interested in determining whether you, or the company you've loaned money to, can generate enough cash from ongoing operations to pay bills and other obligations. Since working capital is not cash, it cannot really help you today. Working capital can help you tomorrow, perhaps, when you're able to convert excess current assets into cash, but it won't necessarily help you today while current assets remain something short of cash. Throughout this chapter, you will develop an appreciation for the phenomena that determine both the cash and accrual position of a company. You should also understand what management has to control to generate enough cash from operations to pay interest and amortize debt.

It should be obvious at this point that management's major concern should be managing the flow of cash rather than working capital. At the same time lenders primary interest should center on a company's ability to generate enough cash to pay interest and amortize debt. All examples and questions refer to Kiler Retail Group. Work through the following material carefullly. It is very important that you understand how to use cash flow techniques in assessing the credit risk associated with a company.

CHAPTER 6: Using the Cash Flow Management Report in Moodys Financial Analyst
In this chapter you will learn the composition and analytical usefulness of the Moody's Financial Analyst (MFA)T Cash Flow Management report. how to use the cash flow management principles learned in Chapter 5 to interpret the results displayed in the MFA Cash Flow Management report. that the MFA Cash Flow Management report contains information in addition to that covered in Chapter 5. Analysis of a company's ability to manage cash flow can be critical to understanding the credit risk associated with that business. In the previous chapter on Cash Flow Management, some sound techniques for measuring cash management ability were introduced. You were provided with an opportunity to work through exercises to help solidify your understanding of those essential concepts. In practice, the calculations associated with cash flow management analysis can be done using a calculator, pencil and paper. However, most credit professionals today rely on software applications to generate analytically helpful reports originating with balance sheet and income statement data that are manually input. The dominant market leader in this category of spreadsheet/decision support software applications is MFA. Among a number of highly useful reports generated by MFA is one called the Cash Flow Management report. This chapter explains the report's components and how they're calculated, as well as provides information on what the figures mean in an analytical context. Time will also be spent illustrating the connection between specific numbers on the report and the cash management techniques introduced in the Cash Flow Management chapter that underpin them. Thus, you will find that much of what you learned to calculate manually in the last chapter is computed for you by the spreadsheet software. You then have only the task of understanding the results and correctly interpreting what they say about a company's credit risk. Several cash flow-related ratios are summarized in the Cash Flow Management report and several other pieces of useful information are reported as well. Still, the report is

most useful with regard to the specific cash management data it provides and this is where most of this chapter focuses. All examples and questions refer to Kiler Retail in the Case Studies book.

SECTION C: PROJECTIONS AND THE CREDIT DECISION CHAPTER 7: Background to Projections

In this chapter you will learn to appreciate the value and the limitations of projections in the credit decision process. to identify the reference points of fundamental importance in shaping the forecast assumptions about a company's future operations. to understand the basic forces shaping the competitive environment which company management must contend with in pursuing its objectives on a daily basis. to appreciate the importance of carefully crafting assumptions for the risk drivers. In earlier sections of this workbook, all aspects of a company's historical operations were considered and those operations were viewed against two benchmarks: liquidity and solvency. The historical information gathered and analyzed has implications for the future, and now the focus shifts to a company's likely future operating performance. Any extension of credit considered today will, if all goes well, be repaid from cash generated in the future. Projections are critically important to the credit decision process - and can be computergenerated relatively easily. It is no longer necessary to spend hours constructing a set of projected financial data manually. However, the first step is understanding how to shape forecast assumptions about the critical projection variables - the risk drivers. Projections are only as good as the underlying assumptions. Therefore, the focus must initially be on determining those key forecast assumptions. To accomplish this, careful review of the issues that influence the values of the seven risk drivers is required.

CHAPTER 8: The Mechanics of Projections

In this chapter you will learn

 to understand the steps involved in constructing a set of projections which can be used in the credit decision process. to understand the mechanics of projecting a balance sheet, an income statement and a cash flow statement based on a set of critical assumptions for the risk drivers. to understand how and why the initial projection statements must be adjusted to account for the projection of interest expense accurately. to identify the possible future sources of cash available to a business to pay interest and repay debt as scheduled. We have reviewed the framework for shaping assumptions about the risk drivers with special reference to historical performance, management objectives and capabilities, and the competitive environment. In the process, considerable attention has been given to Michael Porter's competitive forces framework as a means of helping to understand past and likely future values for the risk drivers. We now consider how to construct projected financial statements. The focus is on constructing the cash flow statement, but in the process, we will also construct a projected balance sheet and income statement. In this chapter, you are asked to develop cash flow projections for Kiler Retail Group and the Holding Company, the companies case study used in the Cash Flow Analysis section of this workbook. Again, have a calculator handy for working through the examples and questions.. Keep in mind that the questions following each section are as important as the background material in the sections themselves.

CHAPTER 9: Projected Liquidity and Solvency

In this chapter you will learn to adjust projected financial accounts further as a result of required changes in the risk drivers. to identify the possible sources of interest and repay debt as scheduled. to examine the likely cash value of specific collateral or security provided by either the company or by third party guarantees. to use projections in the credit decision process. So far in the projection process, Step 1 and Step 2 have been completed and all the adjustments have been made to account for additional interest expense on new debt in 10

the projected period. Now Step 3 and Step 4 need to be completed wherein adjustments are made to projected results for any change required to the values initially used for the risk drivers. The adjusted projections will then be reviewed to determine whether the business will likely generate enough cash from its operations to pay interest and repay debt as scheduled. The likelihood will be readily apparent by reference to the projected cash flow statement. Next the cash value of any assets pledged by the company as security for loans, as well as the cash value of third party guarantees, such as the personal guarantee of the owner or proprietor, will be examined. Finally, the five credit decision guidelines introduced in Chapter 7 will be applied to Kiler Retail. Even though the focus is primarily on the interpretation of projections, some adjustments remain along with their associated calculations.

CHAPTER 10: Measuring Credit Risks with MoodysKMV Expected Default Frequency Methodology
In this chapter, we will be assessing the true level of credit risk with moodys kmv edf methodology and determine the probability of default based on the moodys rating scale under Basel II scheme.

II. Credit Structuring Skills

Based on real credit proposal of Enron and Kiler Holding, the attendants will be mastering the skills of credit structuring in form of groups or individual presentations. Starting from the descripiton of a Term Sheet the course aims fort he preparation of real life cases of the lending practices. The participants learn how to structure a lending facility to a retail company and learn how to analyse the credit risks of an obligor.The work shop includes: The discussions of a term sheet The eloboration of of the business, financial and structural risks of the obligor The skills to put correct covenants The security structure The decision to lend or not

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