Introduction to Credit Management

The financial analysis uses the information from the income statement, the balance sheet and the cash flow statement to compute various financial ratios. The purpose of the financial statement analysis is to evaluate the firm’s financial decision-making process and operating performance.

Nevertheless, we have to recognize that the information value of individual data items from the financial statements is quite limited. Financial ratios have to be examined in the context of the firm’s history, the industry, major competitors and the state of the economic cycle.

Furthermore, it has to be pointed out that the assessment of the financial situation of a company should not be static, but a dynamic analysis has to support the investment process. Financial numbers of a company have to be forecasted by the implementation of scenario analysis (e.g. worst case – base case – best case). By this means it can be shown whether a company will succeed in future and sales-, investment- and financing-plans will help to assess the dynamic liquidity position of a company.

Credit investors also face other event risks which are out of control for management and we will discuss this topic later. The subjective assessment of a credit analyst can provide valuable information about future changes of an issuer’s credit quality and hence the performance of bonds.

As the next step the capital structure and covenants have to be analyzed which is particularly important for high-yield issues. Sometimes bonds of issuers with a negative credit trend have coupon step-up language which means that bondholders will receive, for example, 25 bp in the case of 1 notch downgrade by one rating agency. This way a company can show committment to its current rating and bondholders have some protection in the case of a downgrade.

In a final step a relative value analysis has to be conducted in order to make a final investment decision based on the fundamental analysis results. Analysts and portfolio managers are used to express their views relative to a chosen average, for example, statements like bond X should trade 15–20 bp wide to bond Y are quite common. At this point spread volatility and the liquidity of single bonds have to be considered in the final decisionmaking process.

How does all this make you feel? Even if you have large profits in your stock account, has it been worth it? Few investors have the emotional makeup to be happy in a long-term relationship with stocks.

A happy stock investor can process emotions quickly and act appropriately. He is not numb or emotionless in his investing. He sees losses in his portfolio, feels the pain, and the pain motivates him to do his research. He does not blindly hope to get out when he breaks even. He is realistic about conflicts of interest with employees and brokers. He takes action or determines not to act based on research, not stock prices. Numb investors avoidthe pain of losses until they crack under stress. They are the ones who panic at the final bottom.

The happy mutual fund investor is aware of fund fees, turnover, taxes, trading costs, and sales pressure. After fully researching funds, she accepts reasonable costs as a tradeoff to allow her to focus on other areas of her life. She never buys a fund based on sales pressure or loyalty to the fund family. Rather, she owns funds on their merits. She feels her losses and her gains, and then makes buy and sell decisions based on fund fundamentals and not on fund prices.

The happy investor has many emotional ups and downs, but makes few trades. He recognizes that stock investing is a long-term commitment. He can sit for years on his stocks and funds and not make a single trade even though prices double and get cut in half. Meanwhile, he enjoys research and information gathering. The unhappy stock investor experiences these same ups and downs as trauma.

Unfortunately, with equity culture so widespread, the tech wreck destroyed far more than a few hundred ridiculously priced tech stocks. All those investors and companies sucked in by jealousy, envy, and regret were hurt. So too were nonparticipants. Regions of the country dropped into recession.

Individuals with no savings lost their jobs. At least the Internet millionaires had homes and cars they could sell for cash until they found new professions.

All bull markets create the belief that stocks are a sure road to high profits. The 1990s bull market added the notion that though there will be ups and downs, in the long term, stocks always beat all other asset classes; In fact, everyone can have free money if they just buy stocks and hold on. The certainty with which this notion has been espoused has prevented investors from hearing a quiet inner voice. That little voice has been whispering for a long time: This cannot go on forever; a price must be paid for all these riches.

Stocks are the 800-pound gorilla of the investment world. Once you agree to dance with the gorilla, the dance is not over until the gorilla says it is. Freeing yourself from the equity culture is very difficult. Stock investors need to consider whether they have the ability to adapt to other investment classes if equities fail to produce positive returns.

In the United States, financial institutions have succeeded in imposing stocks into the culture as the primary investment for the long-term. Legislatures have gone along to coddle voters. IRAs, 40l(k)s, and other tax-favored schemes can only be funded with stocks, bonds, and mutual funds; real estate, gold, and most other asset classes are not allowed. In the 1990s, the number of stock investors and the trading on stock exchanges tripled. There are many dark sides to this besides the fact that there is no conclusive proof that stocks will be the best investment in the future. Equity culture breeds stock jealousy, envy, and regret, which in turn create social tension and recessions. The recent tech boom and bust is one example.

During the tech bubble, many stock investors were jealous of the young entrepreneurs who, through IPOs, became instant millionaires. Many investors envied the employees who received stock options, rather than having to buy stock on the open market. Other investors regretted that they failed to buy the IPOs that doubled, tripled, and quadrupled. In a small asset class, with few investors, another’s success becomes an inspiration rather than a regret. In stocks, these emotions churned up a fever to get in on the action. Businesses that serviced the new economy were so envious that they began to accept stock as payment for services rather than cash.

Hardworking employees quit their jobs and became day traders. Companies paying good salaries added stock options to their compensation packages to retain envious employees. Insatiable investors agreed to pay exorbitant commissions and make unnecessary trades in exchange for a few IPO shares.