Introduction to Credit Management

The optimal debt/equity ratio depends on many variables like capital costs of other companies in the industry, the access for further debt financing and the stability of earnings. Another important measure for the company’s financial situation which can be drawn from the balance sheet is the working capital need, defined as the difference between current assets and current liabilities. Working capital must be related to other financial statement elements such as sales or total. The management of working capital is important for cash flows because it shows how efficiently a company manages its cash. It is defined as:

Working capital = Accounts receivable + inventory – accounts payable.

The amount of cash, marketable securities and noncore assets help to assess the liquidity situation and the financial flexibility of the company as well.

Property, Plant and Equipment are of particular interest to bondholders in case of financial distress, because the proceeds from asset sales are used to service the debt obligations.

Pension liabilities are an important topic in the analysis of corporate balance sheets and hence play an important role in the evaluation of corporate bonds. The two main pension schemes are:

• Defined contribution: the employer pays into a designated pension fund for the benefit of the employee. After the contribution the employer has no further obligation to the employee.
• Defined benefit: the employer agrees to pay to the employee an annuity (or lump sum) of a defined amount at retirement. This pension represents an ongoing liability for the employer.

The evaluation of a company’s future prospects of being a profitable business and the ability and willingness to improve the financial risk profile is a very important part in the investment decision process. The quality and experience of management is of particular interest because the compatibility of the business strategy with the financial profile of a company is fundamental for successful companies. Financial and nonfinancial factors like strategic management decisions (feasibility of the business plan) and the competitive environment set the parameters for the improvement of credit quality in the future. Management has always the option to surprise market participants with the announcement of unexpected company actions which will alter the capital structure. The change of a previously announced strategy is a major component of the event risk. It is impossible to quantify event risk for a company hence it is a subjective factor in the valuation process.

Typical examples are:

• Mergers and Acquisitions
• Share buyback programs
• Focus on new business segments
• Leveraged Buy-outs
• All actions which result in an increased leverage.

The main anchors of credit analysis are cash flows, asset value, profitability, management assessment and covenants. Every company has to be able to generate positive cash flows in the long run. Companies with permanently negative cash flows will face liquidity constraints at some point in future. Another focus lies on balance sheet strength. The value of assets is very important for bondholders because they can be pledged against liabilities. For particularly high leveraged companies a situation might evolve where asset sales are the last option for deleveraging. The management assessment is another important factor for credit analysis particularly for assigning probabilities to various event risks. Finally, covenants have the main purpose of limiting event risk in terms of a company undertaking bondholder-unfriendly actions.  Another focus lies on the equity-market performance and the implied volatility of a company’s stock. We can identify periods where equity and corporate bonds move in the same direction and times where they decouple; in distressed cases the decoupling will be permanent because equity will have no value and the remaining value will reside with debt.