PHP CP10

10 Credit analysis and distress
prediction
Credit analysis is the evaluation of a firm from the perspective of a holder or potential holder of its debt, includ-
ing trade payables, loans, and public debt securities. A key element of credit analysis is the prediction of the
likelihood a firm will face financial distress. Credit analysis is involved in a wide variety of decision contexts:
●● A commercial banker asks: Should we extend a loan to this firm? If so, how should it be structured? How
should it be priced?
●● If the loan is granted, the banker must later ask: Are we still providing the services, including credit, that
this firm needs? Is the firm still in compliance with the loan terms? If not, is there a need to restructure
the loan, and if so, how? Is the situation serious enough to call for accelerating the repayment of the loan?
●● A potential investor asks: Are these debt securities a sound investment? What is the probability that the
firm will face distress and default on the debt? Does the yield provide adequate compensation for the
default risk involved?
●● An investor contemplating purchase of debt securities in default asks: How likely is it that this firm can be
turned around? In light of the high yield on this debt relative to its current price, can I accept the risk that
the debt will not be repaid in full?
●● A potential supplier asks: Should I sell products or services to this firm? The associated credit will be
extended only for a short period, but the amount is large, and I should have some assurance that collec-
tion risks are manageable.
Finally, there are third parties – those other than borrowers and lenders – who are interested in the general
issue of how likely it is that a firm will avoid financial distress:
●● An auditor asks: How likely is it that this firm will survive beyond the short run? In evaluating the firm’s
financials, should I consider it a going concern?
●● An actual or potential employee asks: How confident can I be that this firm will be able to offer employ-
ment over the long term?
●● A potential customer asks: What assurance is there that this firm will survive to provide warranty services,
replacement parts, product updates, and other services?
●● A competitor asks: Will this firm survive the current industry shakeout? What are the implications of
potential financial distress at this firm for my pricing and market share?
This chapter develops a framework to evaluate a firm’s creditworthiness and assess the likelihood of financial
distress.
Why do firms use debt financing?

Before discussing the credit market and credit analysis, it is worth understanding why firms use debt financing.
Debt financing is attractive to firms for two key reasons:
●● Corporate interest tax shields. In many countries tax laws provide for the corporate tax deductibility of
interest paid on debt. No such corporate tax shield is available for dividend payments or retained earn-
ings. Therefore corporate tax benefits should encourage firms with high effective tax rates and few forms
of tax shields other than interest to favour debt financing.
386
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Chapter 10 Credit analysis and distress prediction 387
●● Management incentives for value creation. Firms with relatively high leverage face pressures to generate
cash flows to meet payments of interest and principal, reducing resources available to fund unjustifiable
expenses and investments that do not maximize shareholder value. Debt financing therefore focuses man-
agement on value creation, reducing conflicts of interest between managers and shareholders.
However, in addition to these benefits of debt, there are also costs of debt financing. As a firm increases its use
of debt financing, it increases the likelihood of financial distress, where it is unable to meet interest or principal
repayment obligations to creditors. When a firm is in serious financial distress, its owners’ claims are likely to
be restructured. This can take place under formal bankruptcy proceedings or out of bankruptcy, depending on
the jurisdiction in which the firm operates. Financial distress has multiple negative consequences for the firm:
●● Legal costs of financial distress. Restructurings are likely to be costly, since the parties involved have to
hire lawyers, bankers, and accountants to represent their interests, and to pay court costs if there are for-
mal legal proceedings. These are often called the direct costs of financial distress.
●● Costs of foregone investment opportunities. Distressed firms face significant challenges in raising
capital, as potential new investors and creditors will be wary of becoming embroiled in the firm’s legal
disputes. Thus firms in distress are often unable to finance new investments even though they may be
profitable for its owners.
●● Costs of conflicts between creditors and shareholders. When faced with financial distress, creditors focus
on the firm’s ability to service its debt while shareholders worry that their equity will revert to the creditors
if the firm defaults. Thus managers face increased pressure to make decisions that typically serve the inter-
ests of the stockholders, and creditors react by increasing the costs of borrowing for the firm’s stockholders.
Debt Financing and Free Cash Flow
T he debt introduced as a result of leveraged buyouts (LBOs) is viewed by many as an example of debt creating
pressure for management to refocus on value creation for shareholders. The increased debt taken with the LBO
forces management to eliminate unnecessary perks, to limit diversification into unrelated industries, and to cancel
unprofitable projects. For example, in 2017 the German pharmaceutical company Stada – a specialist in the production
of generic drugs – was being acquired for €4.3 billion by private equity firms Bain and Cinven, in one of the largest
European leveraged buyout deals in five years. The funds used to finance this large leveraged buyout included €825
million of high-yield bonds, €400 million of revolving loans, and €1.95 billion of syndicated loans. Stada had the typical
characteristics of a leveraged buyout target. The generic drugs producer operated in a mature, competitive industry
and had relatively stable cash flows, but was being accused by an activist investor of underperforming and having
weak corporate governance.
Financial ratio and prospective analysis can help analysts assess whether there are currently free cash flow inefficien-
cies at a firm as well as risks of future inefficiencies. Symptoms of excessive management perks and investment in
unprofitable projects include the following:
●● High ratios of general and administrative expenses and overhead to revenue. If a firm’s ratios are higher than
those for its major competitors, one possibility is that management is wasting money on perks.
●● Significant new investments in unrelated areas. If it is difficult to rationalize these new investments, there might
be free cash flow problems.
●● High levels of expected operating cash flows (net of essential capital expenditures and debt retirements) from pro
forma income and cash flow statements.
●● Poor management incentives to create additional shareholder value, evidenced by a weak linkage between man-
agement compensation and firm performance.
388 PART III Business analysis and valuation applications
Firms are more likely to fall into financial distress if they have high business risks and their assets are easily
destroyed in financial distress. For example, firms with human capital and brand intangibles are particularly
sensitive to financial distress since dissatisfied employees and customers can leave or seek alternative suppliers.
In contrast, firms with tangible assets can sell their assets if they get into financial distress, providing additional
security for lenders and lowering the costs of financial distress. Firms with intangible assets are therefore less
likely to be highly leveraged than firms whose assets are mostly tangible.
The preceding discussion implies that a firm’s long-term decisions on the use of debt financing reflect a
trade-off between the corporate interest tax shield and incentive benefits of debt against the costs of financial
distress. As the firm becomes more highly leveraged, the costs of leverage presumably begin to outweigh the
tax and monitoring benefits of debt.
Table 10.1 shows median leverage ratios for publicly traded stocks in selected industries for the fiscal years
1998–2017. Median ratios are reported for all listed companies and for large companies (with market capital-
izations greater than €300 million) only.
Median debt-to-book equity ratios are highest for the electric services and auto leasing industries, which
are typically not highly sensitive to economy risk and whose core assets are primarily physical equipment and
property that are readily transferable to debt holders in the event of financial distress. In contrast, the software
and pharmaceutical industries’ core assets are their research staffs and sales force representatives. These types of
assets can easily be lost if the firm gets into financial difficulty as a result of too much leverage. In all likelihood
management would be forced to cut back on R&D and marketing, allowing their most talented researchers and
sales representatives to be subject to offers from competitors. To reduce these risks, firms in these industries
have relatively conservative capital structures.1 Construction and air transportation firms have leverage in
between these extremes, reflecting the need to balance the impact of having extensive physical assets and being
subject to more volatile revenue streams.
It is also interesting to note that large firms tend to have higher leverage than small firms in the same
industries. This probably reflects the fact that larger firms tend to have more product offerings and to be more
diversified geographically, reducing their vulnerability to negative events for a single product or market, and
enabling them to take on more debt.
TABLE 10.1 Median interest-bearing debt-to-book equity and interest-bearing debt-to-market equity for selected European indus-
tries in 1998–2017
Interest-bearing debt-to-book equity

Industry All listed firms Large listed firms
Computer programming and data processing 19% 27%

Pharmaceutical 35% 38%
Air transportation 89% 103%
Heavy construction 91% 147%
Electric services 117% 136%
Truck, auto rental, and leasing 189% 207%
The market for credit

An understanding of credit analysis requires an appreciation of the various players in the market for credit. We
now briefly describe the major suppliers of debt financing.
Commercial banks
Commercial banks are very important players in the market for credit. Since banks tend to provide a range
of services to a client and have intimate knowledge of the client and its operations, they have a comparative
advantage in extending credit in settings where (1) knowledge gained through close contact with management
reduces the perceived riskiness of the credit and (2) credit risk can be contained through careful monitor-
ing of the firm. This is even more so in countries where commercial banks also provide investment banking
services to their clients. Examples of investment banking services are asset management, investment advice,
and the underwriting of clients’ securities. Banks that engage in investment banking sometimes hold sub-
stantial equity stakes in other companies, including their clients’ operations. The combination of commercial
banking and investment banking services, which is called universal banking, therefore not only helps banks
to become better informed about their clients’ operations but also makes banks more influential over their
clients through the equity stakes that they control. Following the global financial crisis of 2008, the universal
banking model came under pressure as a result of stricter capital requirements and regulatory pressure to
make banks simpler.2
Bank lending operations are constrained by a low tolerance for risk to ensure that the overall loan portfolio
will be of acceptably high quality to bank regulators. Because of the importance of maintaining public con-
fidence in the banking sector and the desire to shield government deposit insurance from risk, governments
have incentives to constrain banks’ exposure to credit risk. Banks also tend to shield themselves from the risk
of shifts in interest rates by avoiding fixed-rate loans with long maturities. Because banks’ capital mostly comes
from short-term deposits, such long-term loans leave them exposed to increases in interest rates, unless the risk
can be hedged with derivatives. Thus banks are less likely to play a role when a firm requires a very long-term
commitment to financing. However, in some cases banks place the debt with investors looking for longer-term
credit exposure.
Non-bank financial institutions

Banks face competition in the commercial lending market from a variety of sources. Finance companies com-
pete with banks in the market for asset-based lending (i.e., the secured financing of specific assets such as
receivables, inventory, or equipment). Insurance companies are also involved in a variety of lending activities.
Since life insurance companies face obligations of a long-term nature, they often seek investments of long
duration (e.g., long-term bonds or loans to support large, long-term commercial property and development
projects). Investment bankers are prepared to place debt securities with private investors or in the public mar-
kets (discussed next). Various government agencies are another source of credit.
Public debt markets

Some firms have the size, strength, and credibility necessary to bypass the banking sector and seek financing
directly from investors, either through sales of commercial paper or through the issuance of bonds. Such debt
issues are facilitated by the assignment of a public debt rating, which measures the underlying credit strength of
the firm and determines the yield that must be offered to investors.
Banks often provide financing in tandem with a public debt issue or other source of financing. In highly
levered transactions, such as leveraged buyouts, banks commonly provide financing along with public debt
that has a lower priority in case of bankruptcy. The bank’s “senior financing” would typically be scheduled
for earlier retirement than the public debt, and it would carry a lower yield. For smaller or start-up firms,
banks often provide credit in conjunction with equity financing from venture capitalists. Note that in the
case of both the leveraged buyout and the start-up company, the bank helps provide the cash needed to
make the deal happen, but it does so in a way that shields it from risks that would be unacceptably high in
the banking sector.
Sellers who provide financing

Another sector of the market for credit is manufacturers and other suppliers of goods and services. As a matter
of course, such firms tend to finance their customers’ purchases on an unsecured basis for periods of 30 to 60
days. Suppliers will on occasion also agree to provide more extended financing, usually with the support of a
secured note. A supplier may be willing to grant such a loan in the expectation that the creditor will survive a
cash shortage and remain an important customer in the future. However, the customer would typically seek
such an arrangement only if bank financing is unavailable because doing so could constrain flexibility in select-
ing among and/or negotiating with suppliers.
Country differences in debt financing

Country factors and credit types
The preceding described suppliers of credit are not equally important in every country. One source of differences
across countries is the extent to which national bankruptcy laws protect credit providers. A stylized classification
of bankruptcy laws involves two groups: laws that provide extensive creditor protection in the case of default
versus laws that are oriented towards keeping the company in default a going concern and shielding the com-
pany from the influence of creditors. The former types of laws typically offer creditors a first right to repossess
collateral and enforce other contractual rights when their borrower is in default. These laws therefore increase
the probability that creditors recover their loans but reduce the probability that borrowers survive bankruptcy.
The latter types of laws typically impose court-administered bankruptcy procedures on the borrower in default
and its creditors as well as an automatic stay on the borrower’s assets. An automatic stay on the assets means that
creditors cannot repossess their collateral during the period in which the borrower’s financial obligations are
being restructured. The United Kingdom is an example of a European country that has strong creditor protection
laws. Examples of European countries that have weak creditor protection laws, or borrower-friendly bankruptcy
laws, are France, Italy, and Portugal. Germany takes a position in between these two extremes. In Germany courts
impose bankruptcy procedures on the borrower and its creditors, but there is no automatic stay on the borrower’s
assets, and creditors have considerable influence on the borrower’s reorganization process.3
The orientation of a country’s bankruptcy laws can affect the characteristics of credit provided in various
ways. A few examples of how legal differences matter are the following:
●● Multiple-bank borrowing. In countries where the legal rights of banks are weakly protected and banks
experience difficulties in repossessing collateral when a borrower defaults, they are likely to be hesitant in
extending long-term credit. As an alternative, companies may borrow smaller proportions of debt from
multiple banks. Because it is more difficult for a company in default to renegotiate its loans with multiple
banks than with one bank, multiple-bank borrowing reduces the company’s incentive to strategically
default. Research has found that multiple-bank borrowing is most common in Belgium, France, Italy,
Spain, and Portugal, where banks are indeed weakly protected in case of bankruptcy.4
●● Supplier financing. Supplier financing is also an efficient alternative form of debt financing when creditor
rights are weakly protected.5 A reason for this is that suppliers are often well informed about their debtors’
operations and they have a straightforward way to discipline their debtors. That is, in case of default of
payment, suppliers can repossess the delivered goods and withhold future deliveries. In fiscal year 2017
public companies in Belgium, France, Italy, Spain, and Portugal had an average payables-to-revenue ratio
of 18.4 percent. The ratio ranged from 16.3 percent in Belgium to 23.4 percent in Italy. In contrast, pub-
lic companies in Denmark, Finland, Germany, the Netherlands, Norway, Sweden, S witzerland, and the
United Kingdom had an average payables-to-revenue ratio of 10.3 percent.
●● Off-balance sheet financing. Research has indicated that in countries where companies’ access to bank
debt is restricted or relatively expensive, companies may also resort to off-balance sheet financing.6 One
example of off-balance sheet financing is the factoring of receivables, where companies sell their customer
receivables to a lender at a discount. In the first half of the 2000s, the use of factoring was fastest growing
in Eastern Europe, where bankruptcy laws were weak. Further, companies in Italy made relatively more
use of factoring than companies in other parts of Europe.
●● Public debt. Public debt markets are also not equally developed in all parts of the world. Table 10.2 shows
the average annual total proceeds of public debt issues (made by publicly listed non-financial companies)
as a percentage of Gross Domestic Product (GDP) or total equity market capitalization in 12 European
countries during the period 2005 to 2014. These percentages show that publicly listed non-financial com-
panies issued comparatively more public debt in Belgium, France, and Italy, suggesting that public debt is
sometimes used as an alternative to bank debt in countries with borrower-friendly bankruptcy laws.
TABLE 10.2 Public debt issues in 12 European countries (2005–2014)
Average annual total proceeds Average annual total proceeds as a percentage

Country as a percentage of GDP of total equity market capitalization
Belgium 2.89% 7.56%

Denmark 0.58% 1.29%
Finland 1.46% 2.10%
France 2.34% 4.45%
Germany 0.52% 1.87%
Italy 1.02% 5.56%
Netherlands 0.93% 2.19%
Portugal 0.20% 0.79%
Spain 0.38% 0.94%
Sweden 0.59% 0.90%
Switzerland 0.81% 0.57%
UK 0.94% 1.19%
Source: SDC Global New Issues database and Compustat Global.
Country factors and the optimal mix of debt and equity

In summary, the preceding discussion shows that in countries with borrower-friendly, creditor-unfriendly
bankruptcy laws:
●● Creditors extend more short-term debt because this allows them to frequently review the borrower’s
financial position and adjust the terms of the loan when necessary.
●● Companies make greater use of supplier financing.
●● Companies make greater use of off-balance sheet financing such as the factoring of customer receivables.
●● Public debt markets tend to be more developed.
The net effect of these country differences in loan maturity, off-balance sheet financing, supplier financing,
and public debt markets’ importance on country differences in leverage is unfortunately anything but straight-
forward. For example, we showed that Belgian, French, and Italian companies have, on average, greater amounts
of trade payables on their balance sheets. In these three countries, however, equity markets are still not as well
developed as in some other parts of Europe. Thus supplier financing might just as well serve as a substitute for
long-term debt and equity, leaving the debt-to-capital ratio unchanged.
To provide a rough indication of how the mix of debt and equity financing varies across Europe, Table 10.3
shows median debt-to-equity, cash-to-equity, and net debt-to-equity ratios for 13 European countries in 2017.
Denmark, Sweden, Switzerland, and the United Kingdom tend to have the lowest net debt-to-equity ratios.
Cash and marketable securities holdings of the median company in these countries tend to be close to the book
value of its interest-bearing debt. Maybe surprisingly, the net interest-bearing debt-to-equity ratios are highest
in countries with borrower-friendly, creditor-unfriendly bankruptcy laws, such as Italy, Portugal, and Spain.
Two reasons may explain this.
First, in countries where bankruptcy laws shield management from its creditors in situations of financial
distress, the threat of creditors intervening in the company’s operations and repossessing collateral is less severe.
Consequently, managers in these countries may feel comfortable with taking on more debt. As argued, despite
being weakly protected, creditors are willing to extend debt because they can force borrowers to borrow smaller
proportions of debt from multiple banks and can choose to extend loans with short maturities.
Second, the net debt-to-equity ratios are lowest in the countries where equity markets are most developed,
such as the United Kingdom and Switzerland. Companies from these countries can more easily use equity
financing as an alternative to debt financing than companies from countries with weakly developed equity
markets, such as Portugal and Italy.
TABLE 10.3 Median cash and marketable securities holdings and leverage for 13 European countries in 2017
Interest-bearing Cash and cash equivalents- Net interest-bearing Net interest-bearing

Country debt-to-book equity (%) to-book equity (%) debt-to-book equity (%) debt-to-market equity (%)
Portugal 124 20 108 121

Spain 107 24 74 31
Italy 84 29 54 30
Belgium 67 21 53 24
France 64 34 32 13
Netherlands 64 23 43 14
Finland 57 23 31 14
Germany 57 27 27 11
Norway 56 28 33 16
Switzerland 44 27 8 1
Sweden 38 20 21 8
Denmark 36 16 22 9
UK 33 22 18 8
The credit analysis process in private debt markets

Credit analysis is more than just establishing the creditworthiness of a firm, that is, its ability to pay its debts
at the scheduled times. The decision to extend credit is not a binary one – the firm’s exact value, its upside
potential, and its distance from the threshold of creditworthiness are all equally important. There are ranges
of creditworthiness, and it is important for purposes of pricing and structuring a loan to understand where a
firm lies within that range. While downside risk must be the primary consideration in credit analysis, a firm
with growth potential offers opportunities for future income-generating financial services from a continuing
relationship.
This broader view of credit analysis involves most of the issues already discussed in the prior chapters on
business strategy analysis, accounting analysis, financial analysis, and prospective analysis. Perhaps the greatest
difference is that credit analysis rarely involves any explicit attempt to estimate the value of the firm’s equity.
However, the determinants of that value are relevant in credit analysis because a larger equity cushion translates
into lower risk for the creditor.
Next we describe a representative but comprehensive series of steps that are used by commercial lenders
in credit analysis. However, not all credit providers follow these guidelines. For example, when compared to a
banker, manufacturers conduct a less extensive analysis on their customers, since the credit is very short-term
and the manufacturer is willing to bear some credit risk in the interest of generating a profit on the sale.
We present the steps in a particular order, but they are in fact all interdependent. Thus analysis at one step
may need to be rethought depending on the analysis at some later step.
Step 1: Consider the nature and purpose of the loan

Understanding the purpose of a loan is important not just for deciding whether it should be granted but also
for structuring the loan based on duration, purpose, and size. Loans might be required for only a few months,
for several years, or even as a permanent part of a firm’s capital structure. Loans might be used for replace-
ment of other financing, to support working capital needs, or to finance the acquisition of long-term assets or
another firm.
The required amount of the loan must also be established. When bankruptcy laws provide a bank sufficient
protection, it would typically prefer to be the sole financier of small and medium-sized companies. This prefer-
ence is not only to gain an advantage in providing a menu of financial services to the firm but also to maintain a
superior interest in case of bankruptcy. If other creditors are willing to subordinate their positions to the bank,
that would of course be acceptable so far as the bank is concerned.
Often the commercial lender deals with firms that may have parent-subsidiary relations, posing the question
of the appropriate counterparty. In general, the entity that owns the assets that will serve as collateral (or that
could serve as such if needed in the future) acts as the borrower. If this entity is the subsidiary and the parent
presents some financial strength independent of the subsidiary, a guarantee of the parent could be considered.
National bankruptcy laws in the country where the potential borrower is located also affect the maturity of
the loan. When the bankruptcy laws provide weak protection to the credit provider, it may decide only to extend
a loan with a short maturity. Short-term loans carry the advantage that the lender can frequently review the
borrower and make adjustments to the terms of the loan when necessary.7 Commercial lenders are inclined to
shorten loan maturities, especially when lending to firms with little collateral, such as in tangible-intensive firms.8
Step 2: Consider the type of loan and available security

The type of loan is a function of not only its purpose but also the financial strength of the borrower. Thus, to
some extent, the loan type will be dictated by the financial analysis described in step 3. Some of the possibili-
ties are as follows:
●● Open line of credit. An open line of credit permits the borrower to receive cash up to some speci-
fied maximum on an as-needed basis for a specified term, such as one year. To maintain this option,
the borrower pays a fee (e.g., 3/8 of 1 percent) on the unused balance, in addition to the interest on any
used amount. An open line of credit is useful in cases where the borrower’s cash needs are difficult to
anticipate.
●● Revolving line of credit. When it is clear that a firm will need credit beyond the short run, financing
may be provided in the form of a “revolver.” The terms of a revolver, which is sometimes used to s upport
working capital needs, require the borrower to make payments as the operating cycle proceeds and inven-
tory and receivables are converted to cash. However, it is also expected that cash will continue to be
advanced so long as the borrower remains in good standing. In addition to interest on amounts outstand-
ing, a fee is charged on the unused line.
●● Working capital loan. Such a loan is used to finance inventory and receivables, and it is usually secured.
The maximum loan balance may be tied to the balance of the working capital accounts. For example, the
loan may be allowed to rise to no more than 80 percent of receivables less than 60 days old.
●● Term loan. Term loans are used for long-term needs and are often secured with long-term assets such as
plant or equipment. Typically, the loan will be amortized, requiring periodic payments to reduce the loan
balance.
●● Mortgage loan. Mortgages support the financing of real estate, have long terms, and require periodic
amortization of the loan balance.
●● Lease financing. Lease financing can be used to facilitate the acquisition of any asset, but is most com-
monly used for equipment, including vehicles and buildings. Leases may be structured over periods of
one to 15 years, depending on the life of the underlying asset.
Much bank lending is done on a secured basis, especially with smaller and more highly leveraged
companies. Security will be required unless the loan is short-term and the borrower exposes the bank
to minimal default risk. When security is required, an important consideration is whether the amount
of available security is sufficient to support the loan. The amount that a bank will lend on given security
involves business judgment, and it depends on a variety of factors that affect the liquidity of the security
in the context of a situation where the firm is distressed. It also depends on the extent to which creditor
protection laws permit banks to quickly repossess collateral in the event of default. In countries where
bankruptcy laws provide weak creditor protection, such as France, banks typically require more collateral
for a given loan amount.9 The following are some rules of thumb often applied in commercial lending to
various categories of security:
●● Receivables. Trade receivables are usually considered the most desirable form of security because they
are the most liquid. An average bank allows loans of 50 to 80 percent of the balance of nondelinquent
accounts. The percentage applied is lower when:
1 There are many small accounts that would be costly to collect in case the firm is distressed.
2 There are a few very large accounts, such that problems with a single customer could be serious.
3 Bankruptcy laws are creditor-unfriendly and preclude the bank claiming and collecting the receivables
while the borrower in default is being restructured.
4 The customer’s financial health is closely related to that of the borrower, so that collectibility is endan-
gered just when the borrower is in default.
On the latter score, banks often refuse to accept receivables from affiliates as effective security.
●● Inventory. The desirability of inventory as security varies widely. The best-case scenario is inventory
consisting of a common commodity that can easily be sold to other parties if the borrower defaults. More
specialized inventory, with appeal to only a limited set of buyers, or inventory that is costly to store or
transport is less desirable. An average bank typically lends up to 60 percent on raw materials, 50 percent
on finished goods, and 20 percent on work in process.
●● Machinery and equipment. Machinery and equipment is less desirable as collateral. It is likely to be
used, and it must be stored, insured, and marketed. Keeping the costs of these activities in mind, banks
typically will lend only up to 50 percent of the estimated value of such assets in a forced sale such as an
auction.
●● Real estate. The value of real estate as collateral varies considerably. Banks will often lend up to 80 percent
of the appraised value of readily saleable real estate. On the other hand, a factory designed for a unique
purpose would be much less desirable.
Even when a loan is not secured initially, a bank can require a “negative pledge” on the firm’s assets – a pledge
that the firm will not use the assets as security for any other creditor. In that case, if the borrower begins to
experience difficulty and defaults on the loan, and if there are no other creditors in the picture, the bank can
demand the loan become secured if it is to remain outstanding.
Step 3: Conduct a financial analysis of the potential borrower

This portion of the analysis involves all the steps discussed in our chapters on business strategy analysis,
accounting analysis, and financial analysis. The emphasis, however, is on the firm’s ability to service the debt
at the scheduled rate. All the factors that could impact that ability, such as the presence of off-balance sheet
lease obligations and the sustainability of the firm’s operating profit stream, need to be carefully examined. The
focus of the analysis depends on the type of financing under consideration. For example, if a short-term loan
is considered to support seasonal fluctuations in inventory, the emphasis would be on the ability of the firm
to convert the inventory into cash on a timely basis. In contrast, a term loan to support plant and equipment
must be made with confidence in the long-run earnings prospects of the firm. This step incorporates both an
assessment of the potential borrower’s financial status using ratio analysis and a forecast to determine future
payment prospects.
Ratio analysis
Ultimately, since the key issue in the financial analysis is the likelihood that cash flows will be sufficient to
repay the loan, lenders focus much attention on solvency ratios: the magnitude of various measures of profits
and cash flows relative to debt service and other requirements. Therefore ratio analysis from the perspective
of a creditor differs somewhat from that of an owner. There is greater emphasis on cash flows and earnings
available to all claimants (not just owners) before taxes (since interest is tax-deductible and paid out of pre-tax
euros). The funds flow coverage ratio illustrates the creditor’s perspective:
EBIT 1 Depreciation
Funds flow coverage 5
Debt repayment Preference dividends
Interest 1 1
(1 2 tax rate) (1 2 tax rate)
Earnings before both interest and taxes in the numerator are compared directly to the interest expense in
the denominator, because interest expense is paid out of pre-tax euros. In contrast, any payment of principal
scheduled for a given year is nondeductible and must be made out of after-tax profits. In essence, with a 50
percent tax rate, one euro of principal payment is “twice as expensive” as a one-euro interest payment. Scaling
the payment of principal by (1 − tax rate) accounts for this. The same idea applies to preference dividends,
which are not tax-deductible.
The funds flow coverage ratio provides an indication of how comfortably the funds flow can cover unavoid-
able expenditures. The ratio excludes payments such as dividend payments to ordinary shareholders and capital
expenditures on the premise that they could be reduced to zero to make debt payments if necessary.10 Clearly,
however, if the firm is to survive in the long run, funds flow must be sufficient to not only service debt but also
maintain plant assets. Thus long-run survival requires a funds flow coverage ratio well in excess of 1.11
To the extent that the ratio exceeds 1, it indicates the “margin of safety” the lender faces. When such a ratio
is combined with an assessment of the variance in its numerator, it provides an indication of the probability of
nonpayment. However, it would be overly simplistic to establish any particular threshold above which a ratio
indicates a loan is justified. A creditor clearly wants to be in a position to be repaid on schedule, even when the
borrower faces a reasonably foreseeable difficulty. That argues for lending only when the funds flow coverage
is expected to exceed 1, even in a recession scenario – and higher if some allowance for capital expenditures
is prudent.
The financial analysis should produce more than an assessment of the risk of nonpayment. It should also
identify the nature of the significant risks. At many commercial banks it is standard operating procedure to
summarize the analysis of the firm by listing the key risks that could lead to default and factors that could be
used to control those risks if the loan were made. That information can be used in structuring the detailed terms
of the loan so as to trigger default when problems arise, at a stage early enough to permit corrective action.
Forecasting
Implicit in the discussion of ratio analysis is a forward-looking view of the firm’s ability to service the loan.
Good credit analysis should also be supported by explicit forecasts. The basis for such forecasts is usually
management, though lenders perform their own tests as well. An essential element of this step is a sensitivity
analysis to examine the ability of the borrower to service the debt under a variety of scenarios such as changes
in the economy or in the firm’s competitive position. Ideally, the firm should be strong enough to withstand
the downside risks such as a drop in revenues or a decrease in profit margins.
At times it is possible to reconsider the structure of a loan so as to permit it to “cash flow.” That is, the term
of the loan might be extended or the amortization pattern changed. Often a bank will grant a loan with the
expectation that it will be continually renewed, thus becoming a permanent part of the firm’s financial structure
(labelled an “evergreen” loan). In that case the loan will still be written as if it is due within the short term, and
the bank must assure itself of a viable “exit strategy.” However, the firm would be expected to service the loan
by simply covering interest payments.
Step 4: Assemble the detailed loan structure, including loan covenants

If the analysis thus far indicates that a loan is in order, the final step is to assemble the detailed structure. Hav-
ing previously determined the type of loan and repayment schedule, the focus shifts to the loan covenants and
pricing.
Writing loan covenants

Loan covenants specify mutual expectations of the borrower and lender by specifying actions the borrower will
and will not take. Covenants generally fall into three categories:
1 Those that require certain actions such as regular provision of financial statements.
2 Those that preclude certain actions such as undertaking an acquisition without the permission of the lender.
3 Those that require maintenance of certain financial ratios.
Loan covenants must strike a balance between protecting the interests of the lender and providing the flex-
ibility management needs to run the business. The covenants represent a mechanism for ensuring that the
business will remain as strong as the two parties anticipated at the time the loan was granted.
The principal covenants that govern the management of the firm include restrictions on other borrowing,
pledging assets to other lenders, selling substantial assets, engaging in mergers or acquisitions, and paying of
dividends. The financial covenants should seek to address the significant risks identified in the financial analy-
sis, or to at least provide early warning that such risks are surfacing. Some commonly used financial covenants
include:
●● Maintenance of minimum net worth. This covenant assures that the firm will maintain an “equity cush-
ion” to protect the lender. Covenants typically require a level of net worth rather than a particular level of
profit. In the final analysis, the lender may not care whether that net worth is maintained by generating
profit, cutting dividends, or issuing new equity. Tying the covenant to net worth offers the firm the flex-
ibility to use any of these avenues to avoid default.
●● Minimum coverage ratio. Especially in the case of a long-term loan, such as a term loan, the lender may
want to supplement a net worth covenant with one based on coverage of interest or total debt service. The
preceding funds flow coverage ratio would be an example. Maintenance of some minimum coverage helps
assure that the ability of the firm to generate funds internally is strong enough to justify the long-term
nature of the loan.
●● Maximum ratio of total liabilities to net worth. This ratio constrains the risk of high leverage and pre-
vents growth without either retaining earnings or infusing equity.
●● Minimum net working capital balance or current ratio. Constraints on this ratio force a firm to main-
tain its liquidity by using cash generated from operations to retire current liabilities (as opposed to acquir-
ing long-lived assets).
●● Maximum ratio of capital expenditures to earnings before depreciation. Constraints on this ratio help
prevent the firm from investing in growth (including the illiquid assets necessary to support growth)
unless such growth can be financed internally, with some margin remaining for debt service.
Required financial ratios are typically based on the levels that existed at the time that the agreement was
executed, perhaps with some allowance for deterioration but often with some expected improvements over
time. Violation of a covenant represents an event of default that could cause immediate acceleration of the debt
payment, but in most cases the lender uses the default as an opportunity to re-examine the situation and either
waive the violation or renegotiate the loan.
Covenants are included not only in private lending agreements but also in public debt agreements. However,
public debt agreements tend to have less restrictive covenants for two reasons. First, since negotiations resulting
from a violation of public debt covenants are costly (possibly involving not just the trustee, but bondholders
as well), the covenants are written to be triggered only in serious circumstances. Second, public debt is usually
issued by stronger, more creditworthy firms, though there is a large market for high-yield debt. For the most
financially healthy firms with strong debt ratings, very few covenants will be used, generally only those neces-
sary to limit dramatic changes in the firm’s operations, such as a major merger or acquisition.
Dividend payout restrictions are not only included in debt contracts, but may also be mandated by law. For
example, in several Continental European countries firms are legally obliged to transfer a proportion of their
profits to a legal reserve, out of which they cannot distribute dividends. The law then prescribes the minimum
legal reserve that a company must maintain.
Loan pricing
A detailed discussion of loan pricing falls outside the scope of this text. The essence of pricing is to assure that
the yield on the loan is sufficient to cover:
1 The lender’s cost of borrowed funds.
2 The lender’s costs of administering and servicing the loan.
3 A premium for exposure to default risk.
4 At least a normal return on the equity capital necessary to support the lending operation.
The price is often stated in terms of a deviation from a bank’s base rate – the rate charged to stronger borrowers.
For example, a loan might be granted at base rate plus 2 percent. An alternative base is LIBOR, or the London
Interbank Offered Rate, the rate at which large banks from various nations lend large blocks of funds to each
other.
Banks compete actively for commercial lending business, and it is rare that a yield includes more than two
percentage points to cover the cost of default risk. If the spread to cover default risk is, say, 1 percent, and the
bank recovers only 50 percent of amounts due on loans that turn out bad, then the bank can afford only 2 per-
cent of its loans to fall into that category. This underscores how important it is for banks to conduct a thorough
analysis and to contain the riskiness of their loan portfolio.
Financial statement analysis and public debt

Fundamentally, the issues involved in analysis of public debt are no different from those of bank loans and
other private debt issues. Institutionally, however, the contexts are different. Bankers can maintain very close
relations with clients so as to form an initial assessment of their credit risk and monitor their activities during
the loan period. In the case of public debt, the investors are distanced from the issuer. To a large extent, they
must depend on professional debt analysts, including debt raters, to assess the riskiness of the debt and moni-
tor the firm’s ongoing activities. Such analysts and debt raters thus serve an important function in closing the
information gap between issuers and investors.
The meaning of debt ratings

A firm’s debt rating influences the yield that must be offered to sell the debt instruments. After the debt issue,
the rating agencies continue to monitor the firm’s financial condition. Changes in the rating are associated
with fluctuation in the price of the securities. The three major debt rating agencies in the world are Moody’s,
Standard and Poor’s, and Fitch Ratings.
Using Moody’s labelling system, the highest possible rating is Aaa. Proceeding downwards from Aaa, the
ratings are Aa, A, Baa, Ba, B, Caa, Ca, and C, where C indicates debt in default. Similarly, under Standard and
Poor’s labelling system, the highest possible rating is AAA, followed by AA, A, BBB, BB, B, CCC, CC, C, and D
(where D indicates default). Table 10.4 presents examples of firms in rating categories AA (or Aa) through CCC
(or Caa), as well as the average interest expense as a percentage of total debt across all firms in each category. As
of early 2018, none of the European public non-financial companies rated by Standard and Poor’s (S&P) had the
financial strength to merit an AAA rating. Among the few that had an AAA rating but received a downgrade
in 2007 or 2008 are the European firms Novartis and Nestle – both among the largest, most profitable firms
in the world. AA firms are also very strong and include pharmaceuticals Novo Nordisk, Roche, and Sanofi.
Firms rated AAA and AA have the lowest costs of debt financing; during the period 1998 to 2017 their average
interest expense was roughly 3.5 percent of total debt.
TABLE 10.4 Debt ratings: European example firms and average interest expense by category
Equivalent Percentage of Average (pre-tax)

S&P debt Moody’s debt European example firms with same interest expense to
rating rating firms early 2018 rating, 2013–2017 debt, fiscal 1998–2017
AA Aa Nestlé, Novartis, Novo Nordisk, Roche, Sanofi 2.0% 3.5%

A A Airbus, Anheuser-Busch InBev, Bayer, BMW, 16.3% 3.6%
Daimler, Diageo, LVMH II, Royal Dutch Shell,
Unilever
Baa BBB AstraZeneca, British American Tobacco, 40.0% 3.7%
Continental, Enel, Groupe Danone, Heineken,
Vodafone
BB Ba Fiat Chrysler, Nokia, Smurfit Kappa, Telecom 25.2% 4.8%
Italia, Tesco, ThyssenKrupp
B B Hapag-LLoyd, NH Hotel Group, Thomas Cook 13.7% 6.3%
CCC Caa Astaldi, Deoleo, Public Power Corp 2.9% 6.7%
Source: S&P, Moody’s, and Compustat Global.
To be considered investment grade, a firm must achieve a rating of BBB (Baa) or higher. Many funds are
precluded by their articles from investing in any bonds below that grade. Even to achieve a grade of BBB is dif-
ficult. Vodafone, one the largest telecommunications companies in Europe, was rated as “only” BBB, or barely
investment grade in 2018. Car manufacturer Fiat Chrysler and paper and packaging companies Smurfit Kappa
and Stora Enso were in the BB category. The B category included Hapag-LLoyd, NH Hotel Group, and Thomas
Cook, all of which were facing financial difficulty. In Europe only a few of the industrial companies rated by
S&P are in a category below the B category. An example of a firm that was rated CCC in 2018 is Spain-based
olive oil processing company Deoleo, which had reported a series of losses, suffered from the effect of increas-
ing olive oil prices, and was going through a financial restructuring to avoid bankruptcy.
Table 10.4 shows that the cost of debt financing rises markedly once firms’ debt falls below investment grade.
For example, between 1998 and 2017 the interest expenses of companies with BBB (Baa)-rated debt were 3.7
percent of debt, on average; interest rates for BB (Ba)-rated companies were 4.8 percent; and interest rates for
firms with B-rated debt were 6.3 percent.
Table 10.5 shows median financial ratios for firms by debt rating category. Firms with AAA or AA ratings
have very strong earnings and cash flow performance as well as minimal leverage. Firms in the BBB class are
only moderately leveraged, with about 54 percent of capital coming in the form of debt. Earnings tend to be
relatively strong, as indicated by an interest coverage (NOPAT plus NIPAT/ interest after tax) of 5.0 and a cash
flow debt coverage (operating cash flow/ debt) of around 23 percent. Firms with B or CCC ratings (and lower),
however, face significant risks: they typically report small profits or losses, have high leverage, and have interest
coverage ratios close to 1.
TABLE 10.5 Debt ratings: Median financial ratios by category
Median ratios for overall category between 1998 and 2017

(European non-financial companies only)
S&P’s debt Return on Interest coverage Operating cash flow Debt to

rating invested capital (%) (times) to debt (%) capital (%)
AAA/AA 9.6 10.0 40.7 43.3
A 8.8 5.9 26.0 52.6
BBB 7.6 5.0 23.4 53.5
BB 6.3 3.1 19.1 51.9
B 3.6 1.3 13.0 60.7
<B 0.7 0.5 9.5 65.1
Source: S&P and Compustat Global.
Interest coverage is calculated as NOPAT plus NIPAT to interest after tax.
Factors that drive debt ratings

Research demonstrates that some of the variation in debt ratings can be explained as a function of selected
financial statement ratios, even as used within a quantitative model that incorporates no subjective human
judgment. Some debt rating agencies rely heavily on quantitative models, and such models are commonly used
by insurance companies, banks, and others to assist in the evaluation of the riskiness of debt issues for which
a public rating is not available.
TABLE 10.6 Factors used in quantitative models of debt ratings
Firm 1 Firm 2 Firm 3
Profitability measures Return on net capital Return on net capital Return on net capital
Leverage measures Non-current debt to Non-current debt to capitalization Non-current debt to capitalization
capitalization Total debt to total capital
Profitability and leverage Interest coverage Cash flow Interest coverage Cash flow to Fixed charge coverage Coverage of
to non-current debt non-current debt current debt and fixed charges
Firm size Revenue Total assets
Other Standard deviation of return
Subordination status
Table 10.6 lists the factors used by three different firms in their quantitative debt rating models. The firms
include one insurance company and one bank, which use the models in their private placement activities, and
an investment research firm, which employs the models in evaluating its own debt purchases and holdings.
In each case profitability and leverage play an important role in the rating. Two firms also use firm size as an
indicator, with larger size associated with higher ratings.
Several researchers have estimated quantitative models used for debt ratings. Two of these
debt rating prediction models, developed by Kaplan and Urwitz and shown in Table 10.7, highlight the relative
importance of the factors.12 Model 1 has the greater ability to explain variation in bond ratings. However, it
includes some factors based on equity market data, which are not available for all firms. Model 2 is based solely
on financial statement data.
The factors in Table 10.7 are listed in the order of their statistical significance in Model 1. An interesting
feature is that the most important factor explaining debt ratings is not a financial ratio at all – it is simply firm
size! Large firms tend to get better ratings than small firms. Whether the debt is subordinated or unsubordi-
nated is the next most important factor, followed by a leverage indicator. Profitability appears less important,
but in part that reflects the presence in the model of multiple factors (ROA and interest coverage) that capture
profitability. It is only the explanatory power that is unique to a given variable that is indicated by the ranking
in Table 10.7. Explanatory power common to the two variables is not considered.
When applied to a sample of bonds that were not used in the estimation process, the Kaplan-Urwitz Model 1
predicted the rating category correctly in 44 of 64 cases, or 63 percent of the time. Where it erred, the model
was never off by more than one category, and in about half of those cases its prediction was more consistent
with the market yield on the debt than was the actual debt rating. The discrepancies between actual ratings and
those estimated using the Kaplan-Urwitz model indicate that rating agencies incorporate factors other than
financial ratios in their analysis. These are likely to include the types of strategic, accounting, and prospective
analyses discussed throughout this book.
We have also estimated a debt ratings prediction model that is conceptually similar to the Kaplan-Urwitz
model but includes the factors from Table 10.5 (plus firm size and performance volatility) as predictors. The
sample of debt ratings that we used to estimate the model is a sample of 1,453 ratings of public debt securities of
European non-financial companies that were issued by Standard & Poor’s or Moody’s (or outstanding) during
the years 1998 to 2017. Table 10.8 lists the factors and their coefficients in order of their statistical significance.
When applied to the sample of 1,453 European debt ratings, the model predicted the rating category correctly
for 48 percent of the companies. The model was off by one category for 45 percent of the companies and off by
two or three categories for 7 percent of the companies.
TABLE 10.7 Kaplan-Urwitz models of debt ratings
Coefficients
Firm or debt characteristic Variable reflecting characteristic Model 1 Model 2
Model intercept 5.67 4.41

Firm size Total assetsa 0.0009 0.0010
Subordination status of debt 1 = subordinated; 0 = unsubordinated −2.36 −2.56
Leverage Non-current debt to total assets −2.85 −2.72
Systematic risk Market model beta, indicating sensitivity of share price −0.87 –
to market-wide movements (1 = average)b
Profitability Profit or loss to total assets 5.13
Unsystematic risk Standard deviation of residual from market model −2.90 –
(average = 0.10)
Riskiness of profit stream Coefficient of variation in profit or loss over five years – −0.53
(standard deviation/mean)
Interest coverage Pre-tax funds flow before interest to interest expense 0.007 0.006
The score from the model is converted to a bond rating as follows:
If score > 6.76, predict Aaa/AAA; score 6.76 − 5.19, predict Aa/AA; score 5.19 − 3.28, predict A; score 3.28 − 1.57, predict Baa/BBB; score 1.57 − 0.00, predict Ba/BB;
score < 0.00, predict B
a. The coefficient in the Kaplan-Urwitz model was estimated at 0.005 (Model 1) and 0.006 (Model 2). Its scale has been adjusted to reflect that the estimates were based on
assets measured in US dollars from the early 1970s. Given that $1 from 1972 was approximately equivalent to $5.86 in 2017, the original coefficient has been divided by 5.86.
On December 31, 2017, $1 was approximately equal to £0.74, €0.83, DKK6.21, and SEK8.21.
b. Market model is estimated by regressing stock returns on the market index, using monthly data for the prior five years.
TABLE 10.8 Debt ratings prediction model estimated on a sample of European public debt securities
Firm or debt characteristic Variable reflecting characteristic Coefficients
Model intercept 1.678

Firm size Natural logarithm of invested capital (in € billions) 0.480
Profitability Return on invested capital 4.193
Riskiness of profit stream Standard deviation of return on invested capital over five years −3.632
Interest coverage NOPAT plus NIPAT to interest expense after tax 0.018
Cash flow performance Operating cash flow to debt 0.591
Leverage Debt to capital −0.369
Note that all variables in the model are expressed as fractions (instead of percentages). To reduce the influence of extreme observations, interest coverage and cash flow perfor-
mance are capped above at, respectively, 30 and 1; minimum firm size is capped below at 0. The score from the model is converted to a debt rating as follows:
If score > 4.93, predict AA/Aa (or higher); score 4.93 – 3.55, predict A; score 3.55 – 2.14, predict BBB/Baa; score 2.14 – 1.24, predict BB/Ba; score 1.24 – 0.00, predict B;
score < 0.00, predict CCC/Caa (or lower)
In the “European” debt ratings prediction model, factors similar to those in the Kaplan-Urwitz model are
most significant. That is, European debt ratings between 1998 and 2017 were driven by firm size, profitability,
riskiness of the profit stream, interest coverage, cash flow performance, and leverage (in order of statistical
significance). We did not include equity market data in the model to make it usable for privately held firms,
which may be one of the reasons why this model predicts debt ratings slightly less accurately than the Kaplan-
Urwitz model.
Given that debt ratings can be explained reasonably well in terms of a handful of financial ratios, one might
question whether ratings convey any news to investors – anything that could not already have been garnered
from publicly available financial data. The answer to the question is yes, at least in the case of debt rating
downgrades. That is, downgrades are greeted with drops in both bond and share prices.13 To be sure, the capital
markets anticipate much of the information reflected in rating changes. But that is not surprising, given that
the changes often represent reactions to recent known events and that the rating agencies typically indicate in
advance that a change is being considered.
Prediction of distress and turnaround

The key task in credit analysis is assessing the probability that a firm will face financial distress and fail to repay
a loan. A related analysis, relevant once a firm begins to face distress, involves considering whether it can be
turned around. In this section we consider evidence on the predictability of these states.
The prediction of either distress or turnaround is a complex, difficult, and subjective task that involves all of
the steps of analysis discussed throughout this book: business strategy analysis, accounting analysis, financial
analysis, and prospective analysis. Purely quantitative models of the process can rarely serve as substitutes for
the hard work the analysis involves. However, research on such models does offer some insight into which
financial indicators are most useful in the task. Moreover, there are some settings where extensive credit checks
are too costly to justify and where quantitative distress prediction models are useful. For example, the com-
mercially available “Zeta” model is used by some manufacturers and other firms to assess the creditworthiness
of their customers.14
Models for distress prediction

Several financial distress prediction models have been developed over the years.15 They are similar to the debt
rating models, but instead of predicting ratings, they predict whether a firm will face some state of distress,
typically defined as bankruptcy, with a specified period such as one year. One study suggests that the factors
most useful (on a stand-alone basis) in predicting bankruptcy one year in advance are the firm’s level of prof-
itability, the volatility of that profitability (as measured by the standard deviation of ROE), and its leverage.16
Interestingly, liquidity measures turn out to be much less important. Current liquidity won’t save an unhealthy
firm if it is losing money at a fast pace.
A number of more robust, multifactor models have also been designed to predict financial distress. One
such model, the Altman Z-score model, weights five variables to compute a bankruptcy score.17 For public
companies the model is as follows:18
Z 51.2(X 1 ) 11.4(X 2 ) 1 3.3(X 3 ) 1 0.6(X 4 ) 11.0(X 5 )
where X1 5 net working capital/total assets (measure of liquidity)

X 2 5 retained earnings/total assets ( measure of cumulative profitability )
X 3 5 EBIT/total assets ( measure of return on assets )
X 4 5 market value of equity/book value of total liabilities ( measure of market leverage )
X 5 5 revenue/total assets ( measure of revenue generating potential of assets )
The model predicts bankruptcy when Z < 1.81. The range between 1.81 and 2.67 is labelled the “grey area.” The
following table presents calculations for apparel retailer French Connection, for two consecutive fiscal years:
Fiscal 2017 Fiscal 2016

Model
coefficient Ratio Score Ratio Score
Net working capital/Total assets 1.2 0.289 0.347 0.222 0.266
Retained earnings/Total assets 1.4 0.315 0.441 0.237 0.332
EBIT/Total assets 3.3 0.016 0.054 -0.003 -0.011
Market value of equity/Book value of 0.6 0.408 0.245 0.264 0.158
total liabilities
Revenue/Total assets 1.0 1.232 1.232 0.889 0.889
2.319 1.635
French Connection’s Z-scores highlight its relatively poor but slowly improving performance. In the past few
years, difficult market conditions in the traditional segment of the apparel retail industry drove down the
retailer’s margins and made it report below-normal returns on equity. In fiscal 2016 French Connection’s liabili-
ties were almost four times greater than its market capitalization, an indication of its precarious financial state.
French Connection’s focus on closing down unprofitable stores helped the retailer to improve profitability and
reduce its debt, such that its Z-score moved from the “distress area” to the “grey area” in 2017.
Such models have some ability to predict failing and surviving firms. Altman reports that when the model
was applied to a holdout sample containing 33 failed and 33 nonfailed firms (the same proportion used to esti-
mate the model), it correctly predicted the outcome in 63 of 66 cases. However, the performance of the model
would degrade substantially if applied to a holdout sample where the proportion of failed and nonfailed firms
was not forced to be the same as that used to estimate the model.
The Altman Z-score model was estimated on a sample of US firms. When applying this model to a sample
of non-US firms, the following complications must be considered. First, accounting practices may differ from
country to country. In particular, under some accounting systems total liabilities may be substantially under-
stated because of firms’ use of off-balance sheet financing. When comparing the Altman Z-scores of two firms
with different accounting practices, the preferred approach would be to undo these firms’ financial statements
from accounting distortions and bring all off-balance sheet liabilities on the balance sheet before calculating
the scores. Second, although the model may be equally useful across countries in predicting financial distress,
the likelihood that financial distress leads to bankruptcy depends on national bankruptcy laws and thus varies
from country to country.
One way to overcome the preceding problems is to use distress prediction models that were estimated in a
particular firm’s home country. An international survey of distress prediction models suggests that more than
40 variants of such models exist worldwide.19 A common characteristic of these models is that they all include
some measures of profitability and leverage. For example, one model that was developed by Taffler and is com-
monly used in the United Kingdom calculates Z-scores as follows:20
Z 5 3.20 112.18(X 1 ) 1 2.50(X 2 ) 210.68(X 3 ) 1 0.0289(X 4 )
where X1 5 profit before tax/current liabilities

X 2 5 current assets/total liabilities
X 3 5 current liabilities/total assets
X 4 5 no-credit interval ( in days )
The no-credit interval is defined as immediate assets (current assets excluding inventories and prepaid
expenses) minus current liabilities divided by total operating expenses excluding depreciation and multiplied
by 365 days. This variable measures how long the firm can finance its current operations when other sources
of short-term finance are unavailable. The model predicts bankruptcy when Z < 0.
While simple distress prediction models like the Altman and the Taffler models cannot serve as a replace-
ment for in-depth analysis of the kind discussed throughout this book, they do provide a useful reminder of the
power of financial statement data to summarize important dimensions of the firm’s performance. In addition,
they can be useful for screening large numbers of firms prior to more in-depth analysis of corporate strategy,
management expertise, market position, and financial ratio performance.
Investment opportunities in distressed companies

The debt securities of firms in financial distress trade at steep discounts to par value. Some hedge fund man-
agers and investment advisors specialize in investing in these securities – even purchasing the debt of firms
operating under bankruptcy protection. Investors in these securities can earn attractive returns if the firm
recovers from its cash flow difficulties.
Distressed debt investors assess whether the firm is likely to overcome its immediate cash flow problems
and whether it has a viable long-run future. Two elements of the framework laid out in Part 2 of this book are
particularly relevant to analyzing distressed opportunities. The first is a thorough analysis of the firm’s indus-
try and competitive positioning and an assessment of its business risks. This is followed by the construction
of well-reasoned forecasts of its future cash flow and earnings performance in light of the business analysis.
Credit ratings, default probabilities, and debt valuation

Debt rating prediction models and financial distress prediction models can help in estimating the value of debt.
To illustrate how, consider the following debt valuation formula, which defines debt value as a function of future
contractual coupon and face value payments; the expected return on debt (denoted as rd); and the expected
cumulative probabilities that a firm will default on its debt payments within one to T years (denoted as π 1,…, πT).
Debt value 5
(1 2 p1 ) 3 Coupon1 1 (1 2 p2 ) 3 Coupon 2 1 (1 2 pT ) 3 CouponT 1 (1 2 pT ) 3 Face value
(1 1 rd ) (1 1 rd )2 (1 1 rd )T
Note that, for simplicity, this formula assumes that debt holders will receive nothing if the firm defaults on its
loans. In practice, however, recovery rates on defaulting debt are often greater than zero. Some studies estimate
recovery rates on, for example, senior unsecured bonds at close to 50 percent. It is possible to adjust the debt
valuation formula for such non-zero recovery rates, albeit at the expense of making calculations somewhat
more complicated. Including the possibility that in case of default debt holders receive ρ percent of face value,
changes the debt valuation formula to:
Debt value 5
(1 2 p1 ) 3 Coupon1 1 p1 3r 3 Face value 1 (1 2 p2 ) 3 Coupon 2 1 ( p2 2 p1 ) 3r 3 Face value 1…
(1 1 rd ) (1 1 rd )2
1
(1 2 pT ) 3 CouponT 1 (1 2 pT ) 3 Face value 1 ( pT 2 pT 21 ) 3r 3 Face value
(1 1 rd )T
Assuming for the moment that the contractual payments and the required return on default risk-free debt are
known, there are essentially two practical approaches to estimating debt value. First, an analyst can explicitly esti-
mate expected default probabilities and recovery rates (if relevant), and use the preceding formulae to calculate
debt value. Second, and alternatively, as a short-cut approach an analyst can discount the contractual payments
at the effective yield on debt with similar default risk characteristics, as in the following debt valuation formula.
Coupon1 Coupon 2 Coupon T 1 Face value
Debt value 5 1 2 1… 1
(1 1 y ) (1 1 y ) (1 1 y )T
Under this approach the effective yield (y) conveniently summarizes the analyst’s expectations about future
default (π1,…, πT), recovery rates (ρ) and the required return on debt (rd) into one rate of return (y). Debt rat-
ing and financial distress prediction models can thus contribute to debt valuation by informing the analyst on
either expected default probabilities and required returns on debt or effective yields.
Table 10.9 shows Standard and Poor’s estimates of the percentage of firms that default within one to eight
years in seven debt rating categories ranging from AAA to CCC. The debt rating agency derives these percent-
ages from European companies’ historical default rates between 1981 and 2017. The percentages in Table 10.9
indicate that firms with CCC ratings have a 40.1 percent probability to default within three years, compared
with an 8.9 percent probability for firms with B ratings. In the lower rating categories, the marginal probability
to default (measured as the year-to-year change in the cumulative probability) decreases over time. For example,
firms with CCC ratings that do not default during the first year have an average marginal probability of only
8.96 percent (35.56 – 26.60) to default in the second year (compared with a default probability of 26.60 percent
in the first year). This is because some of the low-rated firms that survive the first year improve their financial
health and move up to higher rating categories.
One complication in estimating debt value using the preceding default probability percentages is that the
expected return on debt – rd in the debt valuation formula – is not simply equal to the riskless rate of return.
Instead, the expected return on debt depends on the debt’s systematic risk and various other (non-default)
risk factors, all of which in turn may be a function of a firm’ s financial health. In a manner analogous to the
calculation of the cost of equity, the expected return on debt can be estimated using an extended version of the
CAPM model (see Chapter 8), which expresses the expected return on debt as the sum of a required return on
riskless assets plus (1) a premium for beta or systematic risk and (2) a premium for other risk factors:
rd 5 rf 1b  E ( rm ) 2 rf  1 rOTHER
where rf is the riskless rate; [E(rm)−rf ] is the risk premium expected for the market as a whole, expressed as the
excess of the expected return on the market index over the riskless rate, β is the systematic risk of the debt; and
rOTHER is the premium for other risks.
Contrary to equity betas, debt betas cannot be easily obtained for each individual firm. To circumvent the
complication of estimating firm-specific betas, some analysts therefore assume that financial health is the main
driver of debt betas and set the firm-specific debt beta equal to the average debt beta in the firm’s debt rating
category. Such debt beta estimates typically range from close to zero for low-risk AAA/Aaa-rated debt to 0.4 or
higher for high-risk CCC/Caa-rated debt. Much research has shown, however, that default risk probabilities and
systematic risk do fully explain the observed variation in bond prices or expected returns on debt (rd). Which
other risk factors are relevant in debt valuation remains a topic of debate, although many researchers agree that
TABLE 10.9 European companies’ default probabilities by debt rating category
Cumulative probability (in %) that the firm defaults within . . . year(s)
S&P debt rating 1 2 3 4 5 6 7

AAA 0.00 0.00 0.00 0.00 0.00 0.00 0.00
AA 0.00 0.03 0.07 0.13 0.21 0.28 0.32
A 0.04 0.08 0.12 0.18 0.28 0.36 0.47
BBB 0.07 0.21 0.36 0.50 0.60 0.82 1.04
BB 0.38 1.25 2.12 2.87 3.96 4.90 5.86
B 2.25 5.75 8.88 11.29 13.37 14.77 15.57
CCC/C 26.60 35.56 40.05 44.17 46.37 46.37 47.27
Source: Standard & Poor’s. Reproduced with permission.
the risk of incurring losses from debt instruments’ low liquidity (referred to as liquidity risk) is a significant
determinant of the expected return on debt.21
The uncertainty about the exact effect of systematic risk, liquidity risk, and other risk factors on debt value
explains the popularity of using effective yields as an alternative (short-cut) approach to debt valuation. To
follow this approach all that an analyst needs to assess is the average effective yield in the firm’s debt rating cat-
egory. If for a particular firm a debt rating is unavailable, the debt rating prediction models, which we described
in one of the previous sections, can be used to produce an approximate estimate of the firm’s creditworthiness.
Table 10.10 shows the average spread (difference) between the effective yields in six debt rating categories rang-
ing from A to B and that in category AAA/AA. During the period 2013 to 2017, the median effective yield on
A-rated corporate bonds was 0.4 percent higher than the effective yield on AAA/AA-rated corporate bonds;
the median effective yield spread between B-rated corporate bonds and AAA/AA-rated bond was 4.9 percent.
Note that the effective yield increases sharply once firms’ debt falls below investment grade BBB. This yield
increase compensates debt holders for the substantially higher default risk, higher beta risk, and potentially
higher liquidity risk. Further, keep in mind that the effective yields in Table 10.10 are those of long-term bonds
with average maturities greater than five years. Because the marginal default probabilities of lower-rated bonds
tend to decrease over the forecast horizon (as can be seen from Table 10.9), the effective yield spreads for lower-
rated short-term bonds likely exceed those reported in Table 10.10.
TABLE 10.10 Spreads between the effective yields on AAA/AA-rated long-term corporate bonds and those on lower-rated bonds
between 2013 and 2017
Effective yield spreads(%)

Debt rating (S&P) Lower quartile Median Upper quartile
AAA/AA 0.0 0.0 0.0

A 0.3 0.4 0.4
BBB 1.1 1.3 1.4
BB 2.5 2.9 3.2
B 4.3 4.9 5.3
Source: Bank of America – Merrill Lynch Corporate Bond Indices
Consider the following example to illustrate how debt rating prediction models and effective yield spreads
can be used to value debt. The following table presents the calculation of apparel retailer Next plc’s debt rating
score at the end of the fiscal year ending January 2018 (fiscal year 2017):
Next plc
Model coefficient Ratio Score
Intercept 1.678 1.000 1.678

Firm size 0.480 1.069 0.513
Profitability 4.193 0.377 1.581
Riskiness of profit stream −3.632 0.069 −0.251
Interest coverage 0.018 21.709 0.391
Cash flow performance 0.591 0.800 0.473
Leverage −0.369 0.695 −0.256
4.129
The debt rating score of 4.129 corresponds with a debt rating of A. At the end of fiscal 2017, Next plc had three
bonds outstanding, one of which was a £250 million 4.375 percent coupon bond due on October 2, 2026. This
bond had been issued at an effective yield of close to 4.5 percent. At the end of January 2018, the effective yield
on AA/Aa-rated UK corporate bonds was close to 2.4 percent. Given an expected yield spread of 0.4 percent
for A-rated corporate bonds (relative to AA/Aa-rated bonds), Next’s effective yield at the end of January 2018
can therefore be estimated at 2.8 percent, and the value of the retailer’s £250 million bond is:
Coupon (4.375% × £250)

Payment date and face value (a) Discount factor (b) (a) × (b)
Oct. 2018 10.938 1/(1+0.028)9/12 10.713

Oct. 2019 10.938 1/(1+0.028) 21/12
10.421
Oct. 2020 10.938 1/(1+0.028)33/12 10.138
Oct. 2021 10.938 1/(1+0.028) 45/12
9.862
Oct. 2022 10.938 1/(1+0.028)57/12 9.593
Oct. 2023 10.938 1/(1+0.028)69/12 9.332
Oct. 2024 10.938 1/(1+0.028)69/12 9.077
Oct. 2025 10.938 1/(1+0.028)69/12 8.830
Oct. 2026 260.938 1/(1+0.028) 81/12
204.926
£282.892
This bond value estimate of £282.9 million is close to 13 percent above par value. For comparison, in early 2018
Next’s £250 million bond traded at a price of between 109 and 111 percent of par value. The observed market
price and our fundamental estimates of debt value need not be equal, given that transaction prices are subject
to the influence of investor sentiment. In fact, a possible explanation for any observed differences may be that
on the valuation date, credit yield spreads of lower-rated bonds, such as those issued by Next, were temporarily
below or above their historical averages.
Summary
Debt financing is attractive to firms with high marginal tax rates and few non-interest tax shields, making
interest tax shields from debt valuable. Debt can also help create value by deterring management of firms with
high, stable profits/cash flows and few new investment opportunities from over-investing in unprofitable new
ventures.
However, debt financing also creates the risk of financial distress, which is likely to be particularly severe for
firms with volatile earnings and cash flows, and intangible assets that are easily destroyed by financial distress.
Prospective providers of debt use credit analysis to evaluate the risks of financial distress for a firm. Credit
analysis is important to a wide variety of economic agents – not just bankers and other financial intermediaries
but also public debt analysts, industrial companies, service companies, and others.
At the heart of credit analysis lie the same techniques described in Chapters 2 through 8: business strategy
analysis, accounting analysis, financial analysis, and portions of prospective analysis. The purpose of the analy-
sis is not just to assess the likelihood that a potential borrower will fail to repay the loan. It is also important
to identify the nature of the key risks involved, and how the loan might be structured to mitigate or control
those risks. A well-structured loan provides the lender with a viable “exit strategy,” even in the case of default.
Properly designed accounting-based covenants are essential to this structure.
Fundamentally, the issues involved in analysis of public debt are no different from those involved in evaluat-
ing bank loans or other private debt. Institutionally, however, the contexts are different. Investors in public debt
are usually not close to the borrower and must rely on other agents, including debt raters and other analysts,
to assess creditworthiness. Debt ratings, which depend heavily on firm size and financial measures of perfor-
mance, have an important influence on the market yields that must be offered to issue debt.
The key task in credit analysis is the assessment of the probability of default. The task is complex, difficult,
and to some extent, subjective. A few financial ratios can help predict financial distress with some accuracy. The
most important indicators for this purpose are profitability, volatility of profits, and leverage. While a number
of models predict distress based on financial indicators, they cannot replace the in-depth forms of analysis
discussed in this book.
Core concepts
Benefits of debt Two benefits of debt financing are:
1 The tax deductibility of interest payments creates a corporate tax shield.
2 Debt reduces the free cash flow that is available to management and, consequently, strengthens managerial
incentives for value creation.
Costs of debt Three potential costs of debt financing are:
1 Too much debt can lead to financial distress and costly debt restructurings.
2 Financial distress can make a firm forego valuable investment opportunities.
3 Financial distress creates conflicts between creditors, who wish to maximize the value of the firm’s assets, and
shareholders, who wish to maximize the value of equity.
Country differences in debt financing The use of debt financing differs across countries because of institu-
tional differences, such as differences in the legal protection of creditors’ interests. Institutional differences affect,
amongst others, the occurrence of multiple-bank borrowing, the use of supplier financing, the use of off-balance
sheet financing (such as factoring of receivables), and the development of public debt markets. The ultimate effect
of institutional differences on firms’ leverage ratios is complex and uncertain.
Credit analysis Credit analysis includes assessing the creditworthiness of a firm; determining the type of loan,
loan structure, and the necessity of security and/or loan covenants; and assessing whether the firm’s future growth
opportunities can be valuable to the lender. The credit analysis process consists of the following four steps:
1 Understanding why the firm applies for a loan and for what purpose the loan will be used.
2 Determining the type of loan on the basis of the purpose of the loan and the firm’s financial strength. This step
also includes determining the type of security that will be required to reduce the lender’s risk (and thereby the
cost of debt).
3 Analyzing the creditworthiness of the firm using ratio analysis and forecasting.
4 Determining the loan structure, including loan covenants and price (interest rate).
Debt rating prediction models Quantitative models explaining firms’ public debt ratings on the basis of observ-
able firm and debt characteristics. An example of a debt rating prediction model is the Kaplan-Urwitz model. The
primary firm characteristics used to predict debt ratings are: firm size, profitability, leverage, and interest coverage.
Financial distress prediction models Quantitative models predicting the likelihood that a firm will become finan-
cially distressed within a period of typically one year (on the basis of observable firm characteristics). An example of
a financial distress prediction model is the Altman Z-score model. Some firm characteristics used to predict financial
distress are: (cumulative) profitability, leverage, and liquidity.
Public debt ratings Scores assigned to the financial condition of firms issuing public debt by debt rating agencies
such as Fitch, Moody’s and Standard and Poor’s.
Suppliers of debt financing Major suppliers of debt financing are: commercial banks, non-bank financial institu-
tions such as finance and insurance companies, public debt markets, and suppliers of goods and services.
Questions
1 What are the critical performance dimensions food retailer. How may these three loans dif-
for (a) a retailer and (b) a financial services fer from each other in terms of loan maturity,
company that should be considered in credit required collateral, and loan amount?
analysis? What ratios would you suggest looking 7 Cambridge Construction plc follows the per-
at for each of these dimensions? centage-of-completion method for reporting
2 Why would a company pay to have its public long-term contract revenues. The percentage
debt rated by a major rating agency (such as of completion is based on the cost of materi-
Fitch, Moody’s or Standard & Poor’s)? Why als shipped to the project site as a percentage
might a firm decide not to have its debt rated? of total expected material costs. Cambridge’s
3 Some have argued that the market for original- major debt agreement includes restrictions on
issue junk bonds developed in the United States net worth, interest cover age, and minimum
in the late 1970s as a result of a failure in the working capital requirements. A leading analyst
rating process. Proponents of this argument sug- claims that “the company is buying its way out
gest that rating agencies rated companies too of these covenants by spending cash and buy-
harshly at the low end of the rating scale, deny- ing materials, even when they are not needed.”
ing investment-grade status to some deserving Explain how this may be possible.
companies. What are proponents of this argu- 8 Can Cambridge improve its Z score by behav-
ment effectively assuming were the incentives ing as the analyst claims in question 7? Is this
of rating agencies? What economic forces could change consistent with economic reality?
give rise to this incentive? 9 A banker asserts, “I avoid lending to companies
4 Many debt agreements require borrowers to with negative cash from operations because they
obtain the permission of the lender before are too risky.” Is this a sensible lending policy?
undertaking a major acquisition or asset sale. 10 A leading retailer finds itself in a financial
Why would the lender want to include this type bind. It doesn’t have sufficient cash flow from
of restriction? operations to finance its growth, and it is close
5 Betty Li, the finance director of a company to violating the maximum debt-to-assets ratio
applying for a new loan, states, “I will never allowed by its covenants. The marketing director
agree to a debt covenant that restricts my ability suggests, “We can raise cash for our growth by
to pay dividends to my shareholders because it selling the existing stores and leasing them back.
reduces shareholder wealth.” Do you agree with This source of financing is cheap since it avoids
this argument? violating either the debt-to-assets or interest
6 A bank extends three loans to the follow- coverage ratios in our covenants.” Do you agree
ing companies: an Italy-based biotech firm; a with his analysis? Why or why not? As the firm’s
France-based car manufacturer; and a UK-based banker, how would you view this arrangement?
Notes
1 Rahim Bah and Pascal Dumontier provide empirical Prices,” Journal of Financial Economics (September
evidence that R&D-intensive firms in Europe, Japan, and 1986): 57–90; and John Hand, Robert Holthausen,
the United States have lower debt and pay out lower div- and Richard Leftwich, “The Effect of Bond Rating
idends than non-R&D firms. See Rahim Bah and Pascal Announcements on Bond and Stock Prices,” Journal of
Dumontier, “R&D Intensity and Corporate Financial Finance (June 1992): 733–752.
Policy: Some International Evidence,” Journal of Business 14 See Corporate Financial Distress by Edward Altman
Finance and Accounting 28 (June/July 2001): 671–692. (New York: John Wiley, 1993).
2 Some arguments that have been raised in other countries 15 See Edward Altman, “Financial Ratios, Discriminant Anal-
against universal banking are the following. First, because ysis, and the Prediction of Corporate Bankruptcy,” Journal
of their investment banking activities, universal banks of Finance (September 1968): 589–609; Altman, Corporate
may incur greater risks than other commercial banks Financial Distress, op. cit.; William Beaver, “Financial
and, consequently, jeopardize the stability of a country’s Ratios as Predictors of Distress,” Journal of Accounting
financial system. Second, universal banks may become Research, Suppl. (1966): 71–111; James Ohlson, “Financial
too powerful because of their size and hold back competi- Ratios and the Probabilistic Prediction of Bankruptcy,”
tion in the banking industry. Third, universal banks could Journal of Accounting Research (Spring 1980): 109–131;
potentially misuse inside information about clients that and Mark Zmijewski, “Predicting Corporate Bankruptcy:
they obtained through their lending activities in securities An Empirical Comparison of the Extant Financial Distress
trading. In the United States, these concerns led to ban Models,” Working Paper, SUNY at Buffalo, 1983.
on universal banking until 1999. For a discussion of the 16 Zmijewski, op. cit.
potential advantages and disadvantages of universal bank- 17 Altman, Corporate Financial Distress, op. cit.
ing, see, for example, George J. Benston, “Universal Bank- 18 For private firms, Altman, ibid., adjusts the public model
ing,” Journal of Economic Perspectives (1994): 121–143. by changing the numerator for the variable X4 from the
3 See Sergei A. Davydenko and Julian R. Franks, “Do market value of equity to the book value. The revised
Bankruptcy Codes Matter? A Study of Defaults in model follows:
France, Germany and the UK,” Working Paper, Univer- Z 5 0.717(X 1 ) 1 0.847(X 2 ) 1 3.107(X 3 ) 1 0.420(X 4 ) 1 0.998(X 5 )
sity of Toronto and London Business School, 2005.
4 See Steven Ongena and David C. Smith, “What Determines where X1 5 net working capital/total assets
the Number of Bank Relationships? Cross-Country Evi- X 2 5 retained earnings/total assets
dence,” Journal of Financial Intermediation (2000): 26–56. X 3 5 EBIT/total assets
5 See Asli Demirgüç-Kunt and Vojislav Maksimovic,
X 4 5 book value of equity/book value of total liabilities
“Firms as Financial Intermediaries: Evidence from Trade
Credit Data,” Working Paper, World Bank and Univer- X 5 5 revenue/total assets
sity of Maryland, 2001. The model predicts bankruptcy when Z < 1.20. The
6 See Marie H.R. Bakker, Leonora Klapper, and Gregory F. range between 1.20 and 2.90 is labelled the “grey area.”
Udell, “Financing Small and Medium-Sized Enterprises 19 See E. Altman and P. Narayanan, “An International Sur-
with Factoring: Global Growth and Its Potential in East- vey of Business Failure Classification Models,” Financial
ern Europe,” Working Paper, World Bank and Indiana Markets, Institutions and Instruments (May 1997): 1–57,
University, 2004. for an extensive description of various non-US bank-
7 See Asli Demirgüç-Kunt and Vojislav Maksimovic, ruptcy prediction models.
“Institutions, Financial Markets, and Firm Debt Matu- 20 The Taffler model and tests of its predictive accuracy are
rity,” Journal of Financial Economics 54 (1999): 295–336. described in R. Taffler, “The Assessment of Company Sol-
8 See Mariassunta Giannetti, “Do Better Institutions vency and Performance Using a Statistical Model,” Account-
Mitigate Agency Problems? Evidence from Corporate ing and Business Research (1983): 295–307; and R. Taffler,
Finance Choices,” Journal of Financial and Quantitative “Empirical Models for the Monitoring of UK Corpora-
Analysis 38 (2003): 185–212. tions,” Journal of Banking and Finance (1984): 199–227.
9 Sergei A. Davydenko and Julian R. Franks, op. cit. 21 See, for example, E. Elton, M. Gruber, D. Agrawal, and
10 The same is true of preference dividends. However, when D. Mann, “Explaining the Rate Spread on Corporate
preference shares are cumulative, any dividends missed must Bonds.” Journal of Finance (2001): 247–277, P. Collin-
be paid later, when and if the firm returns to profitability. Dufresne, R. Goldstein, and J. Spencer Martin, “The
11 Other relevant coverage ratios are discussed in Chapter 5. Determinants of Credit Spread Changes,” Journal of
12 Robert Kaplan and G. Urwitz, “Statistical Models of Finance (2001): 2177–2207, and L. Chen, D. Lesmond,
Bond Ratings: A Methodological Inquiry,” Journal of and J. Wei, “Corporate Yield Spreads and Bond Liquid-
Business (April 1979): 231–261. ity,” Journal of Finance (2007): 119–149 for discussions
13 See Robert Holthausen and Richard Leftwich, “The of what factors explain corporate bond spreads.
Effect of Bond Rating Changes on Common Stock
CASE
Getronics’ debt ratings
Getronics NV is a Netherlands-based provider of Information and Communication Technology (ICT) services.

The company originates from a leveraged management buyout of Geveke Electronics NV and was taken public
by its privately held owner SHV Holdings NV in 1985. Following its initial public offering, the company adopted
a strategy of aggressive expansion through internal growth, acquisitions, and strategic investments. Between
1985 and 1999 Getronics managed to double its revenue and earnings every three years, on average. In 1999
the company turned from being a moderate player in the European ICT industry into one of the world’s largest
ICT service providers through its acquisition of US-based Wang Global. This acquisition more than doubled
Getronics’ revenues (from €1.5 billion to €3.7 billion) and almost tripled the company’s employee base.
To finance the acquisition of Wang Global, Getronics needed to issue new shares and attract a substantial
amount of new debt. Therefore the company entered into a €500 million syndicated revolving variable-rate
credit facility, which would mature on April 2004, and issued €350 million of subordinated convertible bonds.
The subordinated convertible bonds bore an annual interest rate of 0.25 percent but would be redeemed at
113.21 percent of their face value if they remained unconverted until the maturity date (April 2004). Hence the
yield to maturity of unconverted bonds was 2.75 percent. The bonds’ conversion price was €14.53 per ordinary
share, while Getronics’ share price on December 31, 1999, had reached €26.40.
At the end of fiscal year 1999, Getronics had 343,724,237 ordinary shares and 21,950,000 cumulative pref-
erence shares outstanding. The preference shares earned cumulative dividend, paid annually in arrears, at 5.7
percent and had been issued at €10.75 per share (€236 million in total).
During fiscal year 2000 Getronics issued €500 million of new subordinated convertible bonds (with an
annual interest rate of 0.25 percent, a redemption price of 116.01 percent, and a conversion price of €36.98),
maturing in March 2005, and reduced its debt under the revolving credit facility by €150 million. Getronics’
share price at the end of 2000 was €6.26; by the end of 2001 it had dropped further to €3.64.
During fiscal year 2001 Getronics temporarily lowered the conversion price of its subordinated convertible
bonds to persuade its bondholders to convert their bonds into ordinary shares. As a result, convertible debt
with a total book value €295 million was converted into equity, increasing the number of outstanding shares
with 61,078,827. In 2003 Getronics eventually redeemed its outstanding subordinated convertible bonds by
paying the bondholders €325 million in cash and agreeing to repay the remaining €250 million through quar-
terly installment payments during a five-year period. The interest rate on the new installment bonds equaled
13 percent. To finance the redemption, Getronics issued new unsubordinated convertible bonds, maturing in
five years, for an amount of €100 million (with an annual interest rate of 5.5 percent, a redemption price of 100
percent, and a conversion price of €1.58). At the end of 2003 Getronics’ share price was €1.66.
In 2004 and 2005 Getronics issued 100 million and 48.5 million new shares. The company used the proceeds
of the 2004 issue to redeem its installment bonds early. In addition, the company obtained a new €175 credit
facility in 2004 – which was replaced by a €300 credit facility in 2005 – to help finance the redemption as well
as replace a €100 credit facility and issued new unsubordinated convertible bonds (with an annual interest
rate of 5.5 percent and a redemption price of 100 percent) in 2005. As a consequence of the adoption of IFRS
Professor Erik Peek prepared this case. The case is intended solely as the basis for class discussion and is not intended to serve as an endorse-
ment, source of primary data, or illustration of effective or ineffective management.
411
Standards in 2005, Getronics reclassified its cumulative preference shares from equity to debt. The par value
and premium reserve of these shares (i.e., the book value of the new debt) amounted to €235 million.
Fiscal year 2006 was another challenging year for Getronics. The company incurred unexpected losses
in Italy and had to recognize an impairment charge of €65 million on goodwill relating to the Wang Global
acquisition and, consequently, reported a significant net loss. During 2006 Getronics did not change much of
its borrowings other than replacing maturing bonds with new unsubordinated convertible bonds. The losses
continued in 2007, when competitors started to consider the company as a takeover candidate. On July 31,
2007, Royal KPN NV announced its interest in acquiring Getronics. On October 22, 2007, KPN completed its
acquisition.
EXHIBIT 1 Getronics NV – summary of events
Date Event/announcement
May 5, 1999 Getronics acquires US-based industry peer Wang Global; the company finances the acquisition through a
mixture of new equity (€0.7 billion common and €0.3 billion preferred) and debt (€0.5 billion loans and
€0.3 billion convertible bonds). The amount of goodwill that Getronics recognized on the transaction is
close to €2.4 billion.
February 9, 2000 Getronics sells its ATM business, realizing a profit on the sale.
March 3, 2000 Annual results 1999 announcement. The acquisition of Wang Global boosts the company’s results. Getronics
announces ambitious growth plans.
March 16, 2000 Getronics issues €450 million in subordinated convertible debt (to replace maturing debt).
First half 2000 End of the dotcom bubble. Technology shares decline.
August 17, 2000 First half-year report.
November 22, 2000 Getronics announces that this year’s earnings will be below expectations. Getronics’ share price declines by
42 percent.
February 5, 2001 Getronics signs €75 million contract with Shell.
February 28, 2001 Annual results 2000 announcement.
June 1, 2001 Getronics’ CEO Cees van Luijk resigns and is succeeded by Peter van Voorst.
December 11, 2001 Getronics exchanges €295.3 million of subordinated convertible bonds for equity.
December 18, 2001 Getronics signs €90 million contract with Barclays.
March 5, 2002 Annual results 2001 announcement. Getronics decides to freeze wages of its employees after incurring a
record loss.
April 22, 2002 Getronics announces that it plans to repurchase some of its outstanding convertible bonds.
August 13, 2002 Getronics’ share price drops by close to 40 percent after rumours that the company is close to applying for
bankruptcy.
December 31, 2002 Getronics repays all its amounts outstanding under the €500 million credit facility.
February 12, 2003 Getronics offers (mostly institutional) subordinated convertible bondholders equity in exchange for their
bonds. Convertible bondholders deny the offer, resulting in a conflict between management and
bondholders.
(Continued)
EXHIBIT 1 Getronics NV – summary of events (Continued)
Date Event/announcement
February 21, 2003 CEO Peter van Voorst and CFO Jan Docter step down. The new CEO of Getronics is Klaas Wagenaar.
March 4, 2003 Annual results 2002 announcement.
March 21, 2003 Getronics announces to reduce debt by selling assets rather than offering bondholders equity.
April 22, 2003 Getronics sells Getronics HR Solutions for €315 million in cash (and realizes a profit on the sale of €270
million).
June 10, 2003 Getronics immediately repays bondholders €325 million (in cash) and agrees for the repayment of the
remaining €250 million in installments. The agreement resolves the company’s conflict with its convertible
bondholders.
July 1, 2003 Getronics obtains a loan of €100 million, which will be used to replace a €200 million credit facility.
October 13, 2003 Getronics issues €100 million in convertible debt (to replace maturing debt).
February 4, 2004 Getronics sells 100 million new shares to institutional investors (proceeds: €233 million). The proceeds are
used to repay €250 million in subordinated installment bonds on March 30, 2004.
April 19, 2004 Getronics obtains a new credit facility of €175 million from a consortium of banks.
November 1, 2004 Getronics announces the acquisition of industry peer PinkRoccade N.V for the amount of €350 million. The
company will obtain a new credit facility of €125 million that, together with the credit facility obtained in
April, will be used to finance the acquisition.
April 11, 2005 Getronics issues new shares (proceeds: €388 million).
September 29, 2005 Getronics issues €150 million in unsecured convertible debt (to replace maturing bonds).
March 2, 2006 Annual results 2005 announcement. Getronics also announces that its Italian subsidiary has committed
fraud, hiding €15 million in expenses.
April 20, 2006 Getronics receives four bids for its Italian subsidiary.
June 23, 2006 Getronics sells its Italian subsidiary to Eutelia for an estimated amount of €135 million, realizing a loss of
€50 million. The sale helps the company to meet its debt covenants again.
August 1, 2006 First half-year report. Disappointing results cause share prices to decline by close to 24 percent. Getronics
announces restructuring plans.
November 15, 2006 CFO Theo Janssen resigns unexpectedly. Two other Board Members follow his example.
December 14, 2006 Getronics issues €95 million in convertible bonds (to replace maturing bonds).
February 27, 2007 Annual results 2006 announcement. Getronics announces its annual results early. The company realized an
unexpected loss of €145 million.
July 30, 2007 Royal KPN acquires Getronics.
EXHIBIT 2 Getronics NV – financial information (in € mn)
414
2007 2007 2006 2006 2005 2005 2004 2004 2003 2003 2002 2002 2001 2001 2000 2000
H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1
Revenue 1,224 1,280 1,285 1,342 1,271 1,322 918 1,188 1,263 1,363 1,757 1,838 2,048 2,101 2,214 1,913
Cost of sales –996 –1,051 –1,007 –1,095 –988 –1,079 –740 –981 –1,044 –1,131 –1,463 –1,495 –1,703 –1,723 –1,768 –1,514
Gross profit 228 229 278 247 283 243 178 207 219 232 294 343 345 378 446 399
Selling expenses –91 –97 –96 –111 –95 –98 –68 –86 –85 –92 –124 –132 –135 –131 –131 –125
General and administrative –153 –108 –107 –110 –98 –106 –67 –94 –106 –128 –126 –151 –145 –162 –180 –161
expenses
Other expenses/income 0 –13 –2 –11 –30 –3 –3 6 –5 176 –33 –2 –15 –69 –29 37
Amortization/impairment –13 –88 –65 0 0 0 0 0 –22 –21 –403 –30 –983 –49 –50 –48
of intangible assets
Earnings before interest –29 –77 8 15 60 36 40 33 1 167 –392 28 –933 –33 56 102
and taxes (EBIT)
PART III Business analysis and valuation applications
Interest income 14 11 8 5 10 — 7 — 3 — 4 8 — — — —
Interest expense (including –43 –33 –48 –28 –33 –40 –13 –17 –35 –12 –30 –21 –30 –30 –37 –19
preferred dividends)
Earnings before taxes –58 –99 –32 –8 37 –4 34 16 –31 155 –418 15 –963 –63 19 83
(EBT)
Income taxes 6 –9 –38 24 24 0 60 –4 22 74 –9 –11 –12 –14 –26 –22
Income from discontin- 1 0 –34 –57 –53 0 –50 0 13 0 0 0 –1 1 1 –6
ued operations (net of
income taxes)
Group profit or loss –51 –108 –104 –41 8 –4 44 12 4 229 –427 4 –976 –76 –6 55
Intangible fixed assets 517 534 681 896 913 925 530 553 606 — 654 1,213 1,238 2,196 2,201 2,258
Tangible fixed assets 109 102 95 107 113 143 73 76 100 — 144 177 185 240 223 202
Other non-current assets 322 281 281 352 283 241 147 191 140 — 91 79 88 100 168 161
Total non-current 948 917 1,057 1,355 1,309 1,309 750 820 846 833 889 1,469 1,511 2,536 2,592 2,621
assets
EXHIBIT 2 Getronics NV – financial information (in € mn) (Continued)
2007 2007 2006 2006 2005 2005 2004 2004 2003 2003 2002 2002 2001 2001 2000 2000
Total current assets 701 714 793 841 907 963 889 872 1,083 1,042 1,287 1,564 1,752 1,805 1,882 1,604
– of which cash and cash 134 122 174 144 251 141 236 217 429 214 296 269 387 250 292 150
equivalents
Assets held for sale 0 161 90 22 181 — — — — — — — — — — —
Total assets 1,649 1,792 1,940 2,218 2,397 2,272 1,639 1,692 1,929 1,875 2,176 3,033 3,263 4,341 4,474 4,225
Shareholders’ equity 409 321 408 524 597 602 357 386 65 86 –112 288 298 975 1,023 1,083
Non-controlling interest 0 0 0 0 0 0 0 2 2 1 2 2 3 3 4 3
in equity
Preference shares — — — — — — — — 234 234 234 234 234 234 234 234
Subordinated — — — — — — — — — — 520 522 554 849 849 849
convertibles
Short-term interest bear- 67 223 137 85 100 10 6 2 105 38 15 12 24 20 15 15
ing debt
Long-term debt 347 340 323 551 337 453 197 199 330 301 80 367 427 542 435 395
Provisions — — — — — — — — — 286 337 391 411 413 458 452
Employee benefit plans 95 110 119 155 160 185 202 237 126 — — — — — — —
Provisions for liabilities 27 16 26 51 39 40 22 23 81 — — — — — — —
and charges
Deferred income tax 10 7 6 20 12 72 12 51 50 — — — — — — —
liabilities
Other non-current 13 29 24 6 15 0 4 0 0 — — — — — — —
liabilities
Chapter 10 Credit analysis and distress prediction
Non-current liabilities 559 725 635 868 663 760 443 512 692 625 432 770 862 975 908 862
and short-term debt (continued )
415
EXHIBIT 2 Getronics NV – financial information (in € mn) (Continued)
416
2007 2007 2006 2006 2005 2005 2004 2004 2003 2003 2002 2002 2001 2001 2000 2000
Current liabilities (excl. 681 684 862 814 888 910 839 792 936 929 1,100 1,217 1,312 1,305 1,456 1,194
short-term debt)
Liabilities from 0 62 35 12 249 — — — — — — — — — — —
discontinued
activities
Total equity and 1,649 1,792 1,940 2,218 2,397 2,272 1,639 1,692 1,929 1,875 2,176 3,033 3,263 4,341 4,474 4,225
liabilities
Cash flow from operations 12 –148 144 –142 95 –160 34 –141 96 –103 175 5 229 –27 –16 –13
Cash flow from capital 13 –26 65 –81 –28 –344 –19 –1 32 259 150 –17 22 –83 –29 –127
expenditures
Cash flow from financing –20 115 –203 127 48 403 9 –53 92 –231 –307 –97 –114 68 181 130
activities
PART III Business analysis and valuation applications
Market capitalization at 771 674 753 1,031 1,392 1,196 846 856 679 458 237 790 1,489 1,667 2,116 5,458
year end
Statutory tax rate (%) 25.50 25.50 29.60 29.60 31.50 31.50 34.50 34.50 34.50 34.50 34.50 34.50 34.50 34.50 34.50 34.50
Sources: 2000–2007 annual and semiannual reports of Getronics NV. Financial figures for the years 2004 through 2007 have been prepared using International Financial Reporting Standards (IFRS Standards); financial figures for the years 2000–2003
have been prepared using Dutch accounting standards.

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10 Credit analysis and distress

Why do firms use debt financing?

Debt Financing and Free Cash Flow

Interest-bearing debt-to-book equity

Computer programming and data processing 19% 27%

The market for credit

Non-bank financial institutions

Public debt markets

Sellers who provide financing

Country differences in debt financing

TABLE 10.2 Public debt issues in 12 European countries (2005–2014)

Average annual total proceeds Average annual total proceeds as a percentage

Belgium 2.89% 7.56%

Country factors and the optimal mix of debt and equity

Interest-bearing Cash and cash equivalents- Net interest-bearing Net interest-bearing

Portugal 124 20 108 121

The credit analysis process in private debt markets

Step 1: Consider the nature and purpose of the loan

Step 2: Consider the type of loan and available security

Step 3: Conduct a financial analysis of the potential borrower

Step 4: Assemble the detailed loan structure, including loan covenants

Writing loan covenants

Financial statement analysis and public debt

The meaning of debt ratings

Equivalent Percentage of Average (pre-tax)

AA Aa Nestlé, Novartis, Novo Nordisk, Roche, Sanofi 2.0% 3.5%

TABLE 10.5 Debt ratings: Median financial ratios by category

Median ratios for overall category between 1998 and 2017

S&P’s debt Return on Interest coverage Operating cash flow Debt to

Factors that drive debt ratings

TABLE 10.6 Factors used in quantitative models of debt ratings

Firm 1 Firm 2 Firm 3

TABLE 10.7 Kaplan-Urwitz models of debt ratings

Model intercept 5.67 4.41

Firm or debt characteristic Variable reflecting characteristic Coefficients

Model intercept 1.678

Prediction of distress and turnaround

Models for distress prediction

where X1 5 net working capital/total assets (measure of liquidity)

Fiscal 2017 Fiscal 2016

where X1 5 profit before tax/current liabilities

Investment opportunities in distressed companies

Credit ratings, default probabilities, and debt valuation

TABLE 10.9 European companies’ default probabilities by debt rating category

Cumulative probability (in %) that the firm defaults within . . . year(s)

S&P debt rating 1 2 3 4 5 6 7

Effective yield spreads(%)

AAA/AA 0.0 0.0 0.0

Intercept 1.678 1.000 1.678

Coupon (4.375% × £250)

Oct. 2018 10.938 1/(1+0.028)9/12 10.713

Getronics NV is a Netherlands-based provider of Information and Communication Technology (ICT) services.

EXHIBIT 1 Getronics NV – summary of events

EXHIBIT 1 Getronics NV – summary of events (Continued)

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