Introduction to Traditional Corporate Credit Analysis

Bondholders and equity holders are on the same team, to a point. Both parties want the firm to survive, and to do well. Traditional credit analysis of corporate debt securities views the firm in a similar way as a stockholder, in that the ability of a firm to service its debt comes largely from its success in operations. It needs to do well. If it does, the bondholders get their coupon payments, and the equity holders get the earnings. Everyone wins.

Consider TCA Industries. TCA has a strong management team and successful operations, but is struggling a little with its debt load; it's fairly high for the industry. But management knows they need to stay on top of it. After all, who do they really work for?

No, just one of these two, actually.

Absolutely! The stockholders are the bosses, and management's job is to maximize shareholder value. So of course they have an interest in keeping the company solvent to continue chasing profits, but they are not incentivized to keep the firm's cash flows as low-risk as the bondholders would prefer.

No, not at all. Think about who are real owners of the company.

If the firm does well, then both bondholders and stockholders benefit. Sort of. Consider TCA's simplified balance sheet. | Assets | Liabilities | Equity | |---|---|---| | $6M | $4M | $2M |

That's a _really_ simple balance sheet. But it's meant to illustrate an important point: consider a project (okay, really a gamble) which could give the firm an amazing year, where the firm could earn a 50% return on assets. What would the new balance sheet look like?

No, getting the balance sheet to this point would require some sort of early debt retirement.

That's right! TCA would have 50% more assets, and their high debt levels allow them leverage in turning that 50% return on assets into an even larger return on equity (150% to be precise). That's really nice for stockholders. The important thing to note is the completely one-sided way these returns fall. The bondholders get their coupon payments, yes. But nothing else. All the upside goes to the stockholders.

No, this shows an equal sharing of the gains among investors. It's a nice sentiment, but that's not how it would end up.

Now suppose this project went the other way. Start with the same balance sheet as before. | Assets | Liabilities | Equity | |---|---|---| | $6M | $4M | $2M | Imagine now that the gamble didn't pay off, and instead TCA suffered a 50% loss on assets. Now what happens to the balance sheet?

Exactly! So in this case, the equity holders still get all the return for themselves, even though it's a disaster. Negative equity usually means impending bankruptcy, and for a clear reason: there's just not enough assets to cover all of that debt. So while both parties hope the firm does well, equity investors are generally willing to take on more risk. The idea of a 50% gain or loss might sound good to some adventurous stockholders, but sound horribly unstable to bondholders. A spectrum for all investors is one of growth vs. stability. Stockholders want more growth, and bondholders want more stability. And it's no wonder, if they hit it big, the stockholders get it all. And if they lose, well, they were betting the bondholders' money, anyway.

No, this represents just a 33% loss on equity instead of 50%. One more million has to go.

No, this implies some "sharing" of the loss among debtholders. Unfortunately, that may well be the ultimate outcome, but it's not the immediate consequence.

What is a question you might want to ask TCA management in assessing their capacity to repay?

No, while this is an interesting feature of a bond, the level of coupon payment wouldn't indicate anything about the firm's ability to pay that coupon, or the principal.

Yes! This is one of the many valid questions in many categories of metrics regarding capacity. It's the biggest part of credit analysis.

No, the stock price isn't related to a firm's ability to repay. A relative stock valuation might provide some indication of the market's assumption about the health of the firm, but you can't really get anything useful from a stock price.

Related to capacity are the __covenants__ found in the bond indenture. These are legally binding promises in the indenture that state what the issuer will do and won't do in order to protect bondholders. Good covenants will help to maintain good capacity. Also related to capacity is the idea of __character__. The character of a firm focuses more on management's strategy, track record, and any past incidents of fraud. Finally, if all else fails, there will be a default. In this case, a firm's __collateral__ becomes important. This part of credit analysis assesses the quality of the firm's assets in case they need to be liquidated.

Suppose that TCA takes aggressive steps to avoid paying taxes. The authorities are not happy at all about this, and a legal battle ensues. Which portion of credit analysis will likely look at this issue?

No, this doesn't directly affect the assets of the firm, although a judgment against the firm could be costly.

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No, not necessarily. It's possible there is a covenant about paying taxes when due, but the firm is simply working around the laws. Or so they hope.

No, this isn't the most obvious connection, although any punitive measures following a conviction of tax evasion probably wouldn't help TCA in its capacity to service its debt.

Absolutely! Management is advertising their willingness to bend the rules in order to benefit owners, and this might be a red flag to debtholders looking at the firm as a potential investment. These four Cs of credit analysis are interconnected. While it may be interesting to rank them in order of importance, each has a substantial role in providing an overall picture of a firm's credit quality.

Every part of credit analysis can be largely categorized into those "Cs of credit analysis." Recall four of those Cs as capacity, covenants, character, and collateral. __Capacity__ to pay back the loan refers to industry characteristics, the firm's own cash flow, market share, financial ratios, and various other fundamentals.

Bondholders

Stockholders

Both bondholders and stockholders

$9M in assets, $6M in liabilities, and $3M in equity

$9M in assets, $4M in liabilities, and $5M in equity

$9M in assets, $2M in liabilities, and $7M in equity

$3M in assets, $3M in liabilities, and $0M in equity

$4M in assets, $4M in liabilities, and $0M in equity

$3M in assets, $4M in liabilities, and -$1M in equity

"What is your stock price?"

"What is your debt-to-equity ratio?"

"What is the coupon rate on your new bond issue?"

Capacity

Covenants

Character

Collateral

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