Book Reviews

Book Review of Credit Risk Management

Book review of Credit Risk Management by Andrew Fight.

This is an ok book that gives an introduction to credit risk for specific loans, and not about quantitative credit risk measurement or credit risk portfolio management.

A great thing about the book is a list of questions to ask / answer when making loans, so its good to consider which of these you would want to add to your investment checklist questions. This ties in very well with an earlier post writing about Mohnish Pabrai’s checklist items.

On the failure prediction models mentioned in the book (Z score and A score), there is also another one I came across called F score that looks at whether a company is cooking its books 🙂

Key Points:

  1. Credit analysis process
    1. Identify purpose of loan
    2. Specify sources of repayment (primary/secondary)
    3. Produce cash flow forecast, and establish key risks and mitigation measures, considering the following:
      1. Historical financial analysis
      2. Security evaluation
      3. Industry evaluation
      4. Environment evaluation
      5. Quality of management
  2. Analysing the financial statements (ideally 5 years)
    1. What element constitutes the greatest risk to the company? How does the company know this?
    2. Is the company selling sufficient volume? Is the stock too high, debtors too low?
    3. Is total debt too high (in terms of gearing/leverage as well as in terms of cash flow servicing interest payments)?
    4. Is the company progressing or regressing in its areas of activity?
    5. Are changes in various figures adequately explained in the annual report? What are their causes?
    6. What kind of job did the auditors do?
    7. How does the financial ratios compare against major competitors? What is their trend?
  3. Credit risk categories
    1. Borrower Risk
      1. Financial risk
        1. Financial performance: Liquidity, Receivables, Profits, Cash flows, Ratios
        2. Management’s effectiveness in managing successive business cycles
        3. Primary source of repayment (e.g. cash flow analysis), and secondary source (e.g. provision of adequate collateral)
      2. Business risk
        1. Assess competitive position, strategy and plans, industry, market, products etc.
        2. Use PEST, SWOT, Porter’s Risk Assessment Matrix, Porter’s Five Forces.
    2. Transaction Risk
      1. Facility risk
        1. Risks of managing the facility, e.g. managing multi-tranch multi-currency syndicated loan with pro-rated interest, coordination of drawdowns and repayment, hedging of interest and forex.
      2. Documentation risk
        1. Enforceability of claims in various jurisdictions, clear roles and responsibilities of participants.
  4. PEST
    1. Political
      1. Does the government restrict entry to the market? e.g. by awarding concessions
      2. Do governments impose import quotas/tariffs on the products?
      3. Are there government grants / subsidies available? In a global market how do the grants / subsidies compare to those available to the competition?
      4. Does the government impose duty or taxes on the products?
      5. Are there regulatory requirements? e.g. for safety, consumer protection, and free competition
      6. Are companies in the industry exposed to lawsuits which could have a materials adverse effect on any individual company? e.g. product liability claims (e.g. tyre manufacturer, pharmaceuticals), passenger liability claims (e.g. airlines), pollution claims (e.g. oil and chemicals), employee death/accident claims (e.g. oil exploration and production companies).
      7. Is there a limit to the maximum cover that the insurance market is prepared to provide?
    2. Economic
      1. How is the company and industry in which it operates affected by high interest rates?
      2. How does this impact customer demand and the necessity to make higher interest payments?
      3. How is the company/industry affected by fluctuating foreign exchange rates?
      4. How cyclical is the industry?
      5. How does the industry relate to the general economic cycles? Does it lead or lag the economic cycle, or is it counter cyclical?
      6. How is the industry affected by high inflation rates?
      7. How price elastic are the industry’s products and its raw materials?
    3. Social
      1. Is the industry inherently stable?
      2. Is the industry affected (either positively or negatively) by change in social tastes or fashions?
      3. Are there ‘green’ issues? What is the industry’s record on pollution?
    4. Technological
      1. Is the product obsolete and likely to be superseded by a better new product (in terms of price or quality)?
      2. Has there been a fundamental change in the cost structure of manufacturing the product?
  5. SWOT
    1. Strengths and Weaknesses are factors internal to the company (e.g. quality, management, experience, cost structure, etc.)
    2. Opportunities and Threats are factors external to the company (e.g. government regulation, economic changes)
  6. Questions on Accounts Receivables
    1. Who are the major credit clients? When do they pay – on time or late? How do they pay? Where do they pay from? Any limitations on remittance of money from abroad?
    2. What is the experience of collection of the open account export sales (i.e. payment of invoice in the future)? How much of the receivables are on an open account and how much are a documentary collection basis (buyer needs to pay first before it can take possession of the goods)?
    3. What substantial amounts have been outstanding for long periods?
    4. Hoes does the business credit control process work?
    5. What have they done to collect the long outstanding receivable amounts?
    6. If foreign open account clients do not pay on time, how is the debt recovered?
  7. Management
    1. Track Record
      1. How have the management team performed overall?
      2. What has been their joint record on profitability; on industrial relations?
      3. Who are they? What skills, experience, and expertise does each individual bring?
      4. Have there been substantial or frequent changes in management?
      5. Do they have a reputation of good morality and integrity?
      6. Have any individuals become famous or infamous for some reason?
      7. Does management have a clear strategy?  and has that been complemented with effective execution (operations)?
    2. Structure, responsibilities, and succession
      1. What is the management structure?
      2. Who has what responsibilities?
      3. Is there a skills spread appropriate to managing the business? e.g. finance, marketing, production, delivery, human resources
      4. Are there sufficient industry specific skills in the group? Are there general management kills to bring individual skills together?
      5. What is the relationship between executive and non-executive management?
    3. Incentives
      1. Does management have appropriate incentives to ensure their dedication to their responsibilities?
      2. Do they have existing shareholdings, share option schemes, and adequate remuneration? Too much is detrimental to the business if change is needed.
  8. Industry
    1. Is it at the forefront of technology (e.g. new chip production) or is it based on techniques used for many years (e.g. metal pipe production)?
    2. Is it a capital intensive industry (e.g. steel) or low capital (e.g. engineering consultancy)?
    3. Is the industry vulnerable to changes in fashion or is it classical?
    4. What is the growth potential? What economic changes will cause it to contract? How stable is the industry?
    5. Where is the industry located?
    6. What legal limitations exist which influence the industry? e.g. health and safety, environment regulations
  9. Market
    1. Where are the markets? Large or small? Local, national or international?
    2. What affects the supply and demand in the market?
    3. How large is the market, and what is the current and anticipated market share?
    4. What section of the total market does it operate within?
    5. Who are the competitors? How substantial is the competition? e.g. financial and resource strength, market share
    6. Does the company have a reliance on one market or sector?
    7. Does it have a dominance in the market?
    8. Is the market really quantifiable? How? When and by who? Where can reliable independent verification be obtained?
    9. What will be the effect of a change in technology?
    10. Is there a cyclicality in the market? A volatility in demand?
    11. What freedom is there in the sales pricing structure?
    12. What is the position of the company? e.g. manufacturer, distributor, retailer
    13. What timescales exist in the market? e.g. ship construction vs. dairy processing milk. Shorter timescale usually means large volume transactions.
  10. Product
    1. What are the products?
    2. Are they the result of a physical process (e.g. manufacturing) or a technical, academic process (e.g. training)?
    3. Where and how are they produced or sourced?
    4. Are they proven or new products?
    5. Are they staple products (e.g. bread, soap, etc.) or are they luxury, specialist, or speculative in their nature?
    6. Are they standard and there repetitive in production or are they special production (one-offs, customised)?
    7. What is the nature of supplies of raw materials?
    8. Is the product perishable?
    9. How long does the product take to make?
    10. Is it labour intensive or automated?
  11. Land and buildings
    1. Is the usage of the building freehold, leasehold, or rental?
    2. If leasehold or rental, how long will the premises be available?
    3. What contingency plans do management have if a move is necessary?
    4. What value is there in the buildings?
    5. What is the market value compared to the book value?
    6. What financial obligations do the premises have? what are the financial obligations under the lease or rental agreement?
    7. Is there a specific debt which financed the purchase?
    8. Is there adequate insurance coverage?
  12. Plant and Machinery
    1. What is the value of the equipment? market and book
    2. Any debt or obligations relating to the equipment?
    3. Are there any unnecessary equipment? e.g. all directors having company cars
    4. What is the quality, age, and general condition of the equipment? How will these impact costs and profits?
    5. How does the capacity of the existing equipment compare with expectations of demand?
  13. Questions to Ask when Projecting Financial Statements
    1. Will the firm be able to pay  back its current debt obligations out of future earnings?
    2. How much can sales revenues, profit margins, and cash flow shrink before payback is in jeopardy?
    3. How much new debt will the firm need to support its future growth?
    4. How much new debt can the company take on and service from earnings after having satisfied other needs such as working capital, capex, etc.?
    5. Does the new debt mean that the future financial structure will be too highly leveraged?
    6. Does the loan have an appropriate and specific reason (e..g project finance, expansion, acquisition, debt refinancing) or is it non-specific (a danger signal when you borrow money without a specific reason)?
    7. What kind of repayment schedule should be set up for the new debt that you are lending?
    8. What forms of protection and control need to be included in the loan agreement for maximum safety to the lender?
  14. Warning signals pointing to inability of company to generate sufficient cash flow
    1. Inadequate working capital
    2. Sharp fall in share price
    3. Low or negative retained earnings in relation to assets
    4. Unexpected change in objectives or business profile, e.g. new products or divisions
    5. Vulnerability to economic cycles from debt-heavy balance sheets or high fixed-cost operations
    6. Debt repayment schedules inappropriate in relation to cash flow
  15. Loan covenants to protect against default
    1. Primary covenants relate to capital structure
      1. Limitation of future debt and contingent liabilities
      2. Prohibition of new secured debt or obligations which will rank ahead of the proposed term loan (i.e. negative pledge)
      3. Provision for a minimum level of working capital
      4. Provision for a minimum level of net worth
      5. Cross default pledge
    2. Secondary covenants relate to operations
      1. Prohibition on sale of subsidiaries or assets
      2. Limitations on the prepayment of other debt
      3. Prohibitions on M&A without consent of the lenders
      4. Limitations on investments or capital expenditures
      5. Limitations on dividends or ‘ratcheting’ clauses requiring minimal annual increases in net worth
      6. Interest cover test
  16. Failure Prediction Models
    1. Altman Z score, from multiple discriminant analysis (MDA)
      1. Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5
      2. Z > 2.99 = Safe zone, 1.8 < Z < 2.99 = Grey zone, Z < 1.8 = Distress zone
      3. X1 = working capital / total assets
      4. X2 = retained earnings / total assets
      5. X3 = EBIT / total assets
      6. X4 = market value of equity / book value of total liabilities
      7. X5 = sales / total assets
      8. More details from the source here. It also shows different Z score coefficients for specific industry sectors.
      9. Original: Edward I Altman, ZETA Analysis, Journal of Finance 1977
    2. Argenti’s A score
      1. Adds up scores based on a checklist of defects, lower the better, maximum score is 100.
      2. Ideal company score: 0, Grey area: 18 to 25, Probability of failure: above 25.
      3. Defects (Total score 43, Passing score is 10)
        • Management
        • 8 – Chief Executive is an autocrat
        • 4 – Chief Executive is the Chairman
        • 2 – Passive board of directors
        • 2 – Unbalanced board, e.g. too many engineers or too many finance types
        • 2 – Weak finance director
        • 1 – Poor management depth
        • Accountancy
        • 3 – No budgets or budgetary controls (to assess variances, etc.)
        • 3 – No cash flow plans, or not updated
        • 3 – No costing system. Cost and contribution of each product unknown
        • 15 – Poor response to change, old fashioned product, obsolete factor, old directors, and out of date marketing.
      4. Mistakes (Total score 45, Passing score is 15)
        • 15 – High leverage, firm could get into trouble by stroke of bad luck
        • 15 – Overtrading. Company expanding faster than its funding. Capital base too small or unbalanced for the size and type of business.
        • 15 – Big project gone wrong. Any obligation which the company cannot meet if something goes wrong.
      5. Symptoms (Total score 12, Passing score is 25)
        • 4 – Financial signs, such as Z score, appear near failure
        • 4 – Creative accounting. Chief executive is the first to see signs of failure and, in an attempt to hide it from creditors and the banks, accounts are ‘glossed over’ by, for instance, overvaluing stocks, using lower depreciation, etc. Skilled observers can spot these things.
        • 3 – Non-financial signs, such as untidy offices, frozen salaries, chief executive ‘ill’, high staff  turnover, low morale, and rumours.
      6. Source: J. Argenti. ‘Company Failure Long Range Prediction is Not Enough: Accountancy’, August 1977


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