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.

As the first step the financial risk of a company has to be assessed. As the next step the business risk has to be defined and its effect on the financial risk has to be explained because various business strategies will result in different finanical profiles. The third component is event risk which is partly influenced by management, but also external factors which are out of the control of management. The trend in a company’s financial risk profile is determined to a large extent by the underlying business. The analysis of business risk deals with the stability, quality and predictability
of a company’s business throughout the entire economic cycle, for example, cash flows and earnings of car manufacturers depend to a large extent on the economy and investors will require higher risk premia in weak economic periods which results in the spread widening for bonds issued by car manufacturers. In this case a comparable analysis of an issuer’s market position versus its peers and the ability to manage weak economic periods in the past should be incorporated in the dynamic part of the credit analysis.

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.