Analyzing Credit Risk
Credit risk is the likelihood that a firm will be unable to repay periodic interest and all principal borrowed. Credit risk analysis is a holistic approach to assessing the credit worthiness of a borrower. To assess credit risk, lenders will start with the short-term liquidity and long-term solvency ratios already discussed in the chapter. However, in addition, lenders will also consider other factors, such as the following:
Credit risk is the likelihood that a firm will be unable to repay periodic interest and all principal borrowed. Credit risk analysis is a holistic approach to assessing the credit worthiness of a borrower. To assess credit risk, lenders will start with the short-term liquidity and long-term solvency ratios already discussed in the chapter. However, in addition, lenders will also consider other factors, such as the following:
- Circumstances leading to the need for the loan
- Firm’s credit history
- Firm’s cash flow
- Firm’s assets that may be used as collatera
- Firm’s capacity for deb
- Contingencie
- Character of management
- Communicatio
- Conditions or covenants
This list is neither an exhaustive catalog of such factors nor a mandatory list of factors that must be examined, but provides a context within which you can consider various firms.
Circumstances Leading to Need for the Loan
The reason a firm needs to borrow affects the riskiness of the loan and the likelihood of repayment. Consider the following examples
Example 1: W. T. Grant Company, a discount retail chain, filed for bankruptcy in 1975. Its bankruptcy has become a classic example of how poorly designed and implemented controls can lead a firm into financial distress. Between 1968 and 1975, Grant experienced increasing difficulty collecting accounts receivable from credit card customers. To finance the buildup of its accounts receivable, Grant borrowed short-term funds from commercial banks. However, Grant failed to fix the credit extension and cash collection problems with its receivables. As a result, the bank loans simply kept Grant in business in an ever-worsening credit situation. Lending to satisfy cash-flow needs related to an unsolved problem or difficulty can be highly risky.
Example 2: Toys‘‘R’’Us purchases toys, games, and other entertainment products in September and October in anticipation of heavy demand during the holiday season. It typically pays its suppliers within 30 days for these purchases but does not collect cash from customers until December, January, or later. To finance its inventory, Toys ‘‘R’’Us borrows short term from its banks. It repays these loans with cash collected from customers. Lending to satisfy cash-flow needs related to ongoing seasonal business operations is generally relatively low risk. Toys‘‘R’’Us has an established brand name and predictable demand. Although some risk exists that the products offered will not meet customer preferences in a particular year, Toys‘‘R’’Us offers a sufficiently diverse product line that the likelihood of failure to collect sufficient cash is low.
Example 3: Texas Instruments designs and manufactures semiconductors for use in computers and other electronic products. Assume that Texas Instruments wants to develop new semiconductors and needs to borrow funds to finance the design and development effort. Such a loan would likely be relatively high-risk. Technological change occurs rapidly in semiconductors, which could make obsolete any semiconductors developed by Texas Instruments. In addition, expenditures on design and development of semiconductors would not likely result in assets that could serve as collateral for the loan.
Circumstances Leading to Need for the Loan
The reason a firm needs to borrow affects the riskiness of the loan and the likelihood of repayment. Consider the following examples
Example 1: W. T. Grant Company, a discount retail chain, filed for bankruptcy in 1975. Its bankruptcy has become a classic example of how poorly designed and implemented controls can lead a firm into financial distress. Between 1968 and 1975, Grant experienced increasing difficulty collecting accounts receivable from credit card customers. To finance the buildup of its accounts receivable, Grant borrowed short-term funds from commercial banks. However, Grant failed to fix the credit extension and cash collection problems with its receivables. As a result, the bank loans simply kept Grant in business in an ever-worsening credit situation. Lending to satisfy cash-flow needs related to an unsolved problem or difficulty can be highly risky.
Example 2: Toys‘‘R’’Us purchases toys, games, and other entertainment products in September and October in anticipation of heavy demand during the holiday season. It typically pays its suppliers within 30 days for these purchases but does not collect cash from customers until December, January, or later. To finance its inventory, Toys ‘‘R’’Us borrows short term from its banks. It repays these loans with cash collected from customers. Lending to satisfy cash-flow needs related to ongoing seasonal business operations is generally relatively low risk. Toys‘‘R’’Us has an established brand name and predictable demand. Although some risk exists that the products offered will not meet customer preferences in a particular year, Toys‘‘R’’Us offers a sufficiently diverse product line that the likelihood of failure to collect sufficient cash is low.
Example 3: Texas Instruments designs and manufactures semiconductors for use in computers and other electronic products. Assume that Texas Instruments wants to develop new semiconductors and needs to borrow funds to finance the design and development effort. Such a loan would likely be relatively high-risk. Technological change occurs rapidly in semiconductors, which could make obsolete any semiconductors developed by Texas Instruments. In addition, expenditures on design and development of semiconductors would not likely result in assets that could serve as collateral for the loan.
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