Corporate and Project Financial
Analysis Programme
Background on Forecasting,
Ratios and Drivers of Value
Every Subject in Finance Boils Down to Two Subjects
Every decision in finance is in one way or another derived from
how much the outcome of the decision is worth. Valuation is
the single financial analytical skill that managers must master.
• Valuation analysis of debt or equity involves assessing
1. Future cash flow levels, (cash flow is reality) and
2. Risks in valuing those cash flows, whether it be the cash flow from
assets, debt or equity
• Measurement value – forecasting and risk assessment -- is a
very complex and difficult problem.
• Coming up with a measurement of risk is extremely difficult
and things like beta, value at risk and credit scoring have not
worked very well.
2
Project Finance versus Corporate Finance
Corporate Finance
Project Finance
• Analysis is founded on history and • Since there is no history a series of
evaluation of how companies will
consulting and engineering studies
evolve relative to the past.
must be evaluated.
• Financing is important but
• The bank assesses whether the
necessarily the primary part of the
project works (engineering report).
evaluation.
• Focus on cash flow. Equity IRR and
• Focus on earnings, P/E ratios,
DSCR
EV/EBITDA ratios and
Debt/EBITDA
3
History and Forecasts in Corporate Analysis
• History in Corporate Forecasts
– Project Finance versus Corporate Finance
– Example of Financial Ratio
• Interest Coverage Ratio
• Debt Service Coverage Ratio
– Formula to Interpret Financial Ratio
• Percent Reduction in Cash Flow = (ICR-1)/ICR or (DSCR-1)/DSCR
• Cash Flow = 150, Interest is 75: Percent Reduction is 50%
• Compute Interest Coverage Ratio for Case
• Problem with History
– Not available in project finance
– Sudden changes from historic numbers
4
Industry versus Firm and Management Analysis to
Evaluate Potential Cash Flow Variation
• Industry Analysis
–
–
–
–
–
Drivers of price and demand volatility
Cost Structure of industry, fixed and variable cost
Long-run and short-run marginal cost
Capitals expenditures required to sustain EBITDA
Product life cycle
• Company/Competitive Advantage Analysis
–
–
–
–
Competitive position
Drivers of market share
Customer tastes
Relative cost structure
Exercise:
Use INDEX function to see
the defaults by year and by
industry
• S&P - Industry Risk, Country Risk and Competitive
Position
5
Industry Risk: Cyclicality
• Companies where earnings show cycles of major rises
and declines
Examples:
Retail, property, paper, cars, chemicals,
• Characteristics:
–
–
–
–
airlines, steel, primary metals, houseCyclical downturn in recession
building, building materials, advertising,
Producers over-invest at peak
capital goods, shipping.
Supply rises
Prices fall sharply when demand declines because of surplus capacity
• Cash available for investment at peak
• Rational behavior to not invest is limited by desire to maintain
market share
• Example: Rates to move a 20 foot container from Hong Kong
to Northern Europe have fallen from about $12,0000 to roughly
$220, creating the deepest ever crisis in the industry. (FT 08).
6
Exercise on Cyclical Industry: Rates for Shipping
•
•
•
•
Go to St. Louis FRED data
Find the relevant URL’s
Copy the data to Excel Sheet
Create Macro to Download the Data
Key is to use the
WORKBOOKS.OPEN
statement in a macro together
with the INDEX Function
7
Country Risk, Macro-economic Factors and
Cyclicality
Macro Economic Policy
Result
Excessive Liquidity and Low
Interest Rates Leads to Overlending
U.S. Subprime Crisis, Spain
Construction
Higher Interest Rates to Slow
Down the Economy
U.S. Commercial Real Estate in
1980’s
Unemployment Increase Slows
Down Demand
U.S. Recession of 2008 and
Bankruptcy of GM Suppliers
8
Economics of Price Volatility in Industry Analysis
• Demand Volatility
– Technical Definition of Volatility
– Different Distributions
– Income Elasticity
Exercise: Compute volatility from
data that is downloaded from the
industry analysis sheet
• Capital Expenditure Changes
• Difference between Long-Run Marginal Cost and
Short-Run Marginal Cost – Driven by Capital
Intensity and Operating Leverage
• Capital Intensity of Assets
– Lifetime of Assets
– Revenues versus Operating Costs
• Operating Leverage
9
Operating Leverage
• Definition: Fixed Expenses that do not vary with sales
• Definition of Fixed and Variable Costs
–
–
–
–
–
Not in Financial Statements
COGS generally includes depreciation which is fixed
Administrative expenses are related to sales when many are fixed
Semi-fixed expenses that change after passage of time
Pension obligations and costs of employee reductions
Exercise:
Analysis of Fixed and Variable Expenses
Open a Financial Statement File
Use F11 to make graph of revenues and operating
expenses
Remove title and create scatter plot
10
Investment to Maintain Cash Flow and Profits
• To generate profits or cash flow, just about everything
requires some level of investment:
–
–
–
–
–
–
–
Personal: Invest in education
High Tech: Invest in research and investment
Start-up: Invest in marketing and service or product
Telecom: Invest in acquisitions and licenses
Retailing or Trading: Invest in Inventories
Banking: Invest in Loans
Manufacturing: Invest in Capital Expenditures
• If a company stops investing or makes bad investment
decisions, or pays too much for investments, it will have
problems in the future
11
Example of Industry Analysis – Peak to Trough
Percent (PTT)
12
Industry Default History
13
Moody’s Default Rates by Industry
14
Corporate and Project Financial
Analysis Programme
Qualitative Discussion of Risk
Qualitative Checklists
•
•
•
•
•
Economic and Demand Volatility Risks
Cost Input Risks
Obsolesce Risks
Regulatory Changes
Political Risks
16
Standard and Poor’s Check List for Business Risk
Key Industry Characteristics And Drivers Of Credit Risk
Credit risk impact: High (H); Medium (M); Low (L)
Risk factor
Industry
Airlines (U.S.)
Autos*
Auto suppliers*
High technology*
Mining*
Chemicals (bulk)*
Hotels*
Shipping*
Competitive power*
Telecoms (Europe)
Cyclicality
H
H
H
H
H
H
H
H
H
H
M
Competition
H
H
H
H
H
H
H
H
H
H
H
Does this help very much
Capital intensity Technology risk
H
L
H
M
H
M
M
H
H
M
H
L
H
L
H
L
H
L
M
L
H
H
Regulatory/Gov
ernment
M/H
M
M
L
M/H
M
M
L
L
H
H
Energy
sensitivity
H
H
M
L/M
H
L
H
M
M
H
L
Exercise:
Use Lookup function to rank
industries
17
Company and Industry Economic Factors – Really
Measuring the Demand Volatility
•
•
•
•
•
•
•
•
•
Home economy situation and trends
Overseas economies and trends
Seasonality/Weather Issues
Market and trade cycles
Specific industry factors
Market routes and distribution trends
Customer/end-user drivers
Interest and exchange rates
International trade/monetary issues
Combine these Factor with:
• Barriers to entry
• Capital Intensity
• Operating Leverage
• Construction Lag
Declining Demand
Difficult to Downsize
Rise in Input Costs
Inefficient vs. Competitors
Technical Problems
Reputational Damage
Working Capital Control
Customer Concentration
18
Demand Volatility Driven by Changes in Attitudes
•
•
•
•
•
•
•
•
•
•
•
Lifestyle trends
Demographics
Consumer Attitudes
Media Views
Brand, Company, Technology Change
Consumer Buying Patterns
Fashion and Role Models
Major Events
Buying Access and Trends
Advertising and Publicity
Ethical Issue
19
Examples of Risks – Economic Risks and Barriers to
Entry
• Definition: Prices fall because of surplus capacity; demand
falls because of economic volatility; competition increases;
• First Solar Case: Danger of Falling From Power House to
Capital Junkie
• Other cases: Solar companies, telecom companies, subprime crisis
20
Obsolescence, Technological Change and Regulatory
Changes
• Technical Obsolescence
– Polaroid, Kodak, Maps, Guidebooks, CD players, DVD
players
• Impact of Internet
– Retail, Newspapers, Music, Travel Agents
• Impact of EMG Competition
– Textiles, general manufacturing
21
Technology Risk
• Definition: Demand falls because of available new
technology; capital expenditures and/or costs for new
technology changes
Projected and Actual Revenues for Iridium
• Iridium Case
9,000,000
Actual
Salomon Smith Barney
8,000,000
Credit Suisse/First Boston
7,000,000
Lehman Brothers
6,000,000
Merrill Lynch
CIBC Oppenheimer
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
• Other cases: HP, RIM, Nokia, Kodak
22
Checklists – Political Risks
•
•
•
•
•
•
•
•
•
Ecological/environmental issues
Current and future legislation
Regulatory bodies and processes
Government term and change
Funding, and grants
International pressure groups
Austerity measures
Capital controls, wars and conflict
More licenses awarded, withdrawal of government
support, sharp price reductions mandated
23
Environmental Risks
• GDF Coal Plant in Italy
• Italian police have seized control of a coal-fired power plant in
Savona, shutting it down after a judge ruled in favor of arguments
that the plant was responsible for 442 premature deaths between
2000 and 2007, and a further 2,000 cases of heart and lung
disease. The owner of the plant, Tirreno Power, which is
controlled by France’s GDF Suez, was deemed to have exhibited
“negligent behavior” by the judge, who also said the emissions
data from the plant was “unreliable”. Emissions from coal-fired
plants pose well-known health risks, and GDF Suez is already
under fire for its involvement in a major coal disaster in Australia,
where an open cast coal mine caught fire and burned for over a
month, leading to evacuations and severe health impacts on
residents. The coal plant closure in Italy and mine fire in Australia
have exacerbated a bad start to the year for GDF Suez, which has
written down €14.9 billion in fossil assets on its books due to
strong competition from renewables.
24
Political/Legal Risks
• Definition: Will companies continue to honor uneconomic contracts
• Example: Dabhol Plant in India
• Other Examples
25
Risks and Causes of Project Failure
•
•
•
•
•
•
•
•
•
•
•
•
•
Delay in completion (increase in IDC)
Capital cost over-run
Technical Failure
Revenue Contract Default
Increased Price of Raw Materials
Loss of Competitive Position
Commodity Price Risk
Volume Risk
Overoptimistic Reserve Projections
Exchange rate
Technical Obsolescence of Plant
Financial Failure of Contractor
Uninsured Casualty Losses
•
•
•
•
•
•
•
•
•
•
•
•
US Nuclear Plants
Eurotunnel / Samsung Heavy Industries
Alstrom Combined Cycle
Dabhol; AES Drax
Austrian/California Wood Plants
Natural gas plants
Argentina Merchants
Pocantas Toll way; Subways
Philippines Project
PT Pation in Indonesia
Iridium
Hima Power Plant in India
26
Largest Defaults by Year
27
Selected Defaults including Lehman Brothers in 2008
28
Corporate and Project Financial
Analysis Programme
Assessing Commercial Risks and
Mitigation
Risk Matrix and Credit Memorandum
• Measuring Risks is Probability Impossible
• Discussion of Risks
– Classify Risks
– Define Risks
– Mitigation of Risks
– Probability and Magnitude
– Buffer to Accept Risks
30
Managerial Risk
• Growth Strategy and True Competitive Advantage
(First Solar)
• Power House Square to Capital Destruction Square
(Kalitta)
• Pricing Strategies and Risks (Iridium)
• Enron, VW, Constellation (Hiding Information)
• Re-financing in Corporate Finance after lack of
confidence in management
31
Cost Structure
• Understand Fixed and Variable Costs (UAL, GM)
• Required Maintenance Capital Expenditures
(Airlines, Nuclear Plants)
• Use of Historic Trends and Danger of Multi-year
Economic Expansion (1990’s, 2002-2006)
• Problem: How can you really assess fixed and
variable costs in financial reports
• Exercise: Scatter Plot
– Use F11 and eliminate the name of the X-axis
32
Short-term Risks
• Inventory Risk (Launer)
– Trading company buys gifts for sale to large retail stores. Tastes and
demand changes. Left with inventory that has a lot less value.
• Receivables Risk
– Sales made to customers who do not make payments because of
bankruptcy.
• Trade receivables age analysis
– Evaluate the accounts receivable as percent of sales
• Supplier Risk
• Example: Loss of $55 million related to the bankruptcy of one of our domestic
coal suppliers. During the first quarter of 2008, as a result of a default by the
supplier, we terminated our derivative contracts with the supplier, reclassified the
related asset to accounts receivable, and fully reserved the amount.
• Danger of exposure to single customer; Inventory holding risk
33
Corporate and Project Financial
Analysis Programme
Evaluating Cash Flow and Source
of Repayment
Primary Source of Repayment for Credit Analysis
• Project finance source of repayment is cash flow
– Cash flow after taxes and maintenance capital expenditures
– Examples
• Corporate finance
– When a company grows, it would be bad to repay all debt
– Source of repayment is strong enough financial ratios to refinance
– When markets loose confidence, companies go bankrupt
• Examples: Enron, Constellation Energy, Lehman Brothers
• How can you assess when re-financing becomes not possible
35
Cash Flow and Debt Repayment
• Primary source of repayment for:
– Project Finance
– Leverage Acquisitions
• Secondary source of repayment for:
– Corporate finance when stop discretionary capital
expenditures
– Related to financial ratios in corporate finance
36
EBITDA – General Discussion
• Definition as revenues related to basic operations
coming in versus cash expenses going out
• Computation of EBITDA and Measurement Issues
• Understanding and Dissecting Trends in EBITDA
• Acquiring Long-term data on EBITDA (read PDF)
• Adjusting EBITDA for Exploration Expenses,
Rental Expenses and Other Factors
37
Income Statement
• Review trends in EBITDA, EBIT, EBT and Net Income and explain what is
happening to the company
• EBITDA includes operating earnings and other income, but it does not
include foreign exchange gains or losses, minority interest, extraordinary
income or interest income.
– EBITDA is a rough proxy for free cash flow
– EBITDA is not generally shown on Income Statement
– Potential Adjustments for items such as exploration expense
– Compare EBIT to Net Assets and Net Capital
• Ratio of EBITDA to Revenues (EBITDA margin) should be shown for
historic and projected periods
• EBITDA is related to un-levered cash flow while Net Income and EPS are
after leverage
• NOPLAT is computed by EBIT less adjusted taxes, where taxes are
computed through adjusting income taxes.
38
Standard Computation of EBITDA
39
Exercise: Compute EBITDA
• Samsung and Chesapeake Energy
– Download PDF
– Use Read PDF file
– Use Arrange Titles with Union Function
– Use Match and Index to Arrange Data
– Compute EBITDA
40
EBITDA and Project Life
• If Project Life is 2 years, ROIC is 10% and Investment is 1000.
– EBIT = EBITDA – 500
– EBIT = 1000 * 10% = 100
– EBITDA = 600
• If Project Life is 2 years, ROIC is 10% and Investment is 1000.
– EBITDA = EBITDA – 50
– EBIT = 1000 * 10% = 100
– EBITDA = 150
• Debt to EBITDA and EV to EBITDA should be Different
41
Income Statement Analysis and
Adjustments to EBITDA
• Example of Adjustments to EBITDA
– Exploration Expenses (EBITDAX)
– Rental and Lease Payments (EBITDR)
• EBITDA Computation
– Top Down – move other income
– Bottom-up (Indirect)
• EBITDA Notes
– Interest Income out of EBITDA
– Interest Expense not in EBITDA
– Understand Non-cash Expenses
• Deferred Mining Costs
• Equity Income
• Minority Interest
42
Problems with EBITDA
• EBITDA is useful in its simplicity, and can be a good
reference for comparison of debt and value, but it has
weaknesses:
– EBIT is more important than DA, because must use cash for
replacing depreciation and amortization
– In credit analysis, EBITDA works better for low rated credits than
high rated credits. (Moody’s)
– EBITDA is a better measure for companies with long-lived assets
– EBITDA can be manipulated through accounting policies
(operating expenses versus capital expenditures)
– EBITDA ignores changes in working capital, does not consider
required re-investment, says nothing about the quality of
earnings, and it ignores unique attributes of industries.
43
S&P Definition of EBITA
•
•
•
Our definition of EBITDA is: Revenue minus operating expenses plus depreciation
and amortization (including noncurrent asset impairment and impairment
reversals). We include cash dividends received from investments accounted for
under the equity method, and exclude the company's share of these investees'
profits. This definition generally adheres to what EBITDA stands for: earnings
before interest, taxes, depreciation, and amortization.
However, it also excludes certain other income statement activity that we view as
nonoperating. Our definition of EBITDA aims to capture the results of a company's
core operating activities before interest, taxes, and the impact on earnings of
capital spending and other investing and financing activities. This definition links to
the cash flow statement because we use EBITDA to calculate FFO, which we use
as an accrual-based proxy for CFO (cash flow from operations).
Generally, this means that any income statement activity whose cash effects have
been (or will be) classified as being from operating activities (excluding interest
and taxes) are included in our definition of EBITDA. Conversely, income statement
activity whose cash effects have been (or will be) classified in the statement of
cash flows as being from investing or financing activities is excluded from EBITDA.
44
Corporate and Project Financial
Analysis Programme
Income Statement
Simplified Income Statement
•
•
•
•
•
•
•
•
•
•
Sales
=
+
=
=
=
=
COGS
Gross Margin
SG&A
Other Expenses
Other Income
EBITDA
Depreciation and Amortization
EBIT
Interest Expense (income)
EBT
Income Taxes
Minority Interest
Net Income
There is a debate about how to
handle other income from nonconsolidated subsidiary
companies.
One school of thought (McKinsey)
is that they should be valued
separately since they will have
different cost of capital etc.
In this case, do not include in
EBITDA and remove the asset
balance from the invested capital.
Must be consistent
NOPLAT = EBIT x (1-tax rate)
NOPLAT = Net Income + Interest Expense x (1-tax)
46
Analysis of Income Statement – Computation of
EBITDA, Minority Interest, Preferred Dividends,
Exploration Expense
47
Corporate and Project Financial
Analysis Programme
Cash Flow Statement
Cash Flow Statement
• Modern Cash Flow Statement has separation between
– Operations
– Capital expenditures (to maintain and grow operations) and
– Financing
• Operating Cash Flow
– Add back items from the income statement that do not use cash
(depreciation, dry hole costs etc.)
• Analyze how much cash flow the company generated and how it raised
funds or disposed funds
• Use Cash Flow statement as a basis to compute free cash flow although cash
flow not presented on the statement
• Problem: Interest Expense – related to financing and not operations – is
in the Net Income and is included in Cash From Operations
49
Cash Flow Statement
• A. Operating Cash Flows
•
1) Net Income including interest expense, interest income and taxes
•
2) Depreciation
•
3) Deferred Taxes
•
4) Working Capital Changes
•
5) Minority Interest on Income Statement and Other Items
• B. Investing Cash Flows
•
1) Capital Expenditure and Asset Purchases
•
3) Sale of Property, Plant, & Equipment
•
4) Inter-Corporate Investment
• C. Financing Cash Flows
•
1) Dividend Payments
•
3) Proceeds from Equity or Debt Issuance
•
4) Equity Repurchased
•
5) Debt Principal Payments
50
Cash Flow Statement Items that You Really Need
• Depreciation expense if it is not already in the
profit and loss statement
• Capital expenditures
• Maintenance capital expenditures (these are not
normally reported)
• Dividends (for computing the dividend payout
ratio)
51
S&P and Funds from Operations versus EBITDA
• Funds form Operations = Net Income from
Continuing Operations + Depreciation and
Amortization + Deferred Tax + Other Non-Cash Items
• Free Operating Cash Flow = FFO + (-) Increase in
Working Capital excluding changes in case
• Reconciliation of FFO and EBITDA
– EBITDA is NI + depreciation + interest + taxes
– FFO is NI + depreciation
– Difference is interest and taxes
52
Debt Repayment from EBITDA Analysis
• Cash Flow that is available to really pay debt service
– Begin with EBITDA
– Subtract working capital changes required to support
EBITDA
– Subtract maintenance expenditures required to keep up
equipment
– Reduce by taxes
– Account for Reduction in EBITDA from asset retirement
• Use Model with Cash Flow Analysis
• Create Data Table to Evaluate Debt to EBITDA
53
Evaluation of EBITDA in Credit Analysis
– Assessment of EBITDA in Different Analyses
• Sufficient to Repay all Debt in Project Finance Analysis
• Sufficient to Generate Financial Ratios for Refinance in
Corporate Analysis
• Sufficient to Limit Draws from Revolver in Acquisition
Analysis
– EBITDA Break-even
• Potential Reductions in EBITDA
• Probability of Default
• Loss on Debt
54
Short-term Cash Flow Analysis and Liquidity
• Seasonality versus trends in cash flows relative to current assets and current
liabilities
• Fixed and Variable Costs: how changes in revenues impact profit
• Cash Flows and revolving credit facilities
– Managing the working capital cycle Business cycles and businesses
• Stocking
• Selling
• Destocking
• Applying and evaluating the main ratios to understand and analyse
– the Cash Conversion Cycle
– the cash position of the business
• the credit-worth of the business
55
Corporate and Project Financial
Analysis Programme
Balance Sheet
Balance Sheet Adjustments
•
When analysing the balance sheet, various items should be adjusted and grouped
together:
– Net Debt
• Total short and long term debt minus liquid investments held and surplus
cash
– Cash Bucket
• For modelling, subtract short-term debt from surplus cash and liquid
investments
– Surplus Cash
• Include temporary investments and also include long-term investments
– Current Assets and Current Liabilities
• Separate the surplus cash from current assets and the debt from current
liabilities and relate remaining working capital items to revenue and expense
items
57
Balance Sheet Issues
• Treat surplus cash as negative debt and debt as negative
cash
– Rule of thumb – cash is 2% of revenues
– Example – when developing a basic cash flow model, group
the cash and the debt as one account and then separate this
account on the balance sheet.
– Unfunded pension expenses should be treated like debt –
they involve a fixed obligation and they can be replaced
with debt when they are funded.
– Deferred taxes depend on the way deferred taxes are
modelled for cash flow purposes. If you model future
changes in deferred taxes and take account of these in
projections, do not put deferred taxes as a component of
equity.
58
Problems with Equity Balance
• Would like the return on equity and the return on
invested capital to measure equity invested by
shareholders for return on investment and return on
equity
– Problems with using equity balance on the balance sheet
to measure equity investment
•
•
•
•
•
Write-offs of plant
Accumulated Other Comprehensive Income
Goodwill
Re-structuring losses
Employee Stock options
– Can make adjustments to equity balance
59
Corporate and Project Financial
Analysis Programme
Financial Ratios for Credit
Analysis
Liquidity and Solvency
Credit worthiness: Ability to honor credit obligations
(downside risk)
Solvency
Ability to meet long-term
obligations
Focus:
• Long-term economic risks
conditions
• Long-term cash flows
• Extended ability to make profit
Liquidity
Ability to meet short-term
obligations
Focus:
• Current Financial
conditions
• Current cash flows
• Liquidity of assets
61
Solvency Ratios
• Ratios are the center of traditional credit analysis that
assesses whether a company can re-pay loans. These
ratios should be compared to benchmarks.
• Debt Payback Ratios (Time to Repay)
– Funds from Operations to Total Debt
– Debt to EBITDA
• Leverage Ratios (Skin in the Game)
– Debt to Capital (Include Short-term Debt)
– Market Debt to Market Capital
• Payment Ratios (Buffer for Downside Repayment)
– Interest Coverage
– Debt Service Coverage [Cash Flow/(Interest + Principal)]
62
Liquidity
• Current Ratio
– Current Assets to Current Liabilities
– Current Assets less Inventory to Current Liabilities
• Model Working Capital
– Current Assets less Cash and Temporary Securities minus Current
liabilities less Short-term Debt
• Liquidity Assessment
– Debt Profile (Maturities)
– Bank Lines (Availability, amount, maturity, covenants, triggers)
– Alternative Sources of Liquidity (Asset sales, dividend flexibility,
capital spending flexibility)
63
Philosophy and Alternative Calculations for Debt
Service and Interest Coverage Ratio
• The specifics of the ratios are less important than
the general objective and the underlying
philosophy of the ratios
• The general idea is to see how low EBITDA or
cash flow can go down before the debt service or
interest cannot be paid
• For project finance use DSCR because debt service
is known from structuring debt repayments around
cash flow
• DSCR much less relevant in corporate finance
because of bullet debt repayments
64
DSCR Criteria in Different Industries in Project
Finance
•
•
•
•
•
•
Electric Power:
1.3-1.4
Resources:
1.5-2.0
Telecoms:
1.5-2.0
Infrastructure:
1.2-1.6
Minimum ratio could dip to 1.5
At a minimum, investment-grade merchant projects probably will have to
exceed a 2.0x annual DSCR through debt maturity, but also show steadily
increasing ratios. Even with 2.0x coverage levels, Standard & Poor's will
need to be satisfied that the scenarios behind such forecasts are defensible.
Hence, Standard & Poor's may rely on more conservative scenarios when
determining its rating levels.
• For more traditional contract revenue driven projects, minimum base case
coverage levels should exceed 1.3x to 1.5x levels for investment-grade.
65
Debt to Capital Ratio
• The debt to capital ratio has two general ideas
– The amount of investment made by equity holders –
they would not be stupid enough to put skin in the game
if they did not expect to be paid
– The amount by which the net assets of the company can
fall before which the value of the debt will be below the
collateral value
• Problems with debt ratio is that it depends on the
valuation of assets on the balance sheet
– Example of goodwill and mergers
– Example of stock price assumptions in mergers
66
Philosophy Behind Debt to EBITDA and FFO to Debt
• General philosophy is to compute the amount of
time that it takes to repay debt.
• Debt to EBITDA does not really measure to years
of EBITDA to repay debt
– Must account for interest
– Must account for replacement capital expenditures
– Must account for maintenance capital expenditures
– Does not account for asset life
• FFO to Debt
– Accounts for interest
– Does not account for other flaws
67
Banks or Rating Agencies Value Debt with Risk
Classification Systems
Map of Internal Ratings to Public Rating Agencies
Internal
Credit
Ratings
1
2
3
4
5
6
7
8
9
10
Code
Meaning
A
Exceptional
B
Excellent
C
Strong
D
Good
E
Satisfactory
F
Adequate
G
Watch List
H
Weak
I
Substandard
L
Doubtful
N
In Elimination
S
In Consolidation
Z
Pending Classification
Corresponding
Moody's
Aaa
Aa1
Aa2/Aa3
A1/A2/A3
Baa1/Baa2/Baa3
Ba1
Ba2/Ba3
B1
B2/B3
Caa - O
68
General S&P Benchmarks without Industry or
Company Risk Adjustments
69
Financial Ratios and Ratings - Updated
70
Ratios Depend on the Business Risk
71
Credit Rating Standards and Business Risk
Business Risk/Financial Risk
—Financial risk profile—
Business risk profile
Minimal Modest Intermediate Aggressive Highly leveraged
Excellent
AAA
AA
A
BBB
BB
Strong
AA
A
A-
BBB-
BB-
Satisfactory
A
BBB+
BBB
BB+
B+
Weak
BBB
BBB-
BB+
BB-
B
Vulnerable
BB
B+
B+
B
B-
Financial risk indicative ratios*
Minimal Modest Intermediate Aggressive Highly leveraged
Cash flow (Funds from operations/Debt) (%) Over 60
45–60
30–45
15–30
Below 15
Debt leverage (Total debt/Capital) (%)
Below 25 25–35
35–45
45–55
Over 55
Debt/EBITDA (x)
<1.4
3.0–4.5
>4.5
1.4–2.0 2.0–3.0
Key Industry Characteristics And Drivers Of Credit Risk
Credit risk impact: High (H); Medium (M); Low (L)
Risk factor
Industry
Airlines (U.S.)
Autos*
Auto suppliers*
High technology*
Mining*
Chemicals (bulk)*
Hotels*
Shipping*
Competitive power*
Telecoms (Europe)
Cyclicality
H
H
H
H
H
H
H
H
H
H
M
Competition
H
H
H
H
H
H
H
H
H
H
H
Capital intensity Technology risk
H
L
H
M
H
M
M
H
H
M
H
L
H
L
H
L
H
L
M
L
H
H
Regulatory/Gov
ernment
M/H
M
M
L
M/H
M
M
L
L
H
H
Energy
sensitivity
H
H
M
L/M
H
L
H
M
M
H
L
72
S&P Use of Ratios and Business Risk Profile to
Determine Credit Risk
Business Risk/Financial Risk
Business risk profile
Excellent
Strong
Satisfactory
Minimal
AAA
AA
A
Modest
AA
A
BBB+
Intermediate
A
ABBB
Aggressive
BBB
BBBBB+
Highly
leveraged
BB
BBB+
Weak
Vulnerable
BBB
BB
BBBB+
BB+
B+
BBB
B
B-
Financial risk indicative ratios*
Cash flow (Funds from operations/Debt) (%)
Debt leverage (Total debt/Capital) (%)
Debt/EBITDA (x)
Minimal
Over 60
Below 25
<1.4
Modest
45–60
25–35
1.4–2.0
Intermediate
30–45
35–45
2.0–3.0
Aggressive
15–30
45–55
3.0–4.5
Highly
leveraged
Below 15
Over 55
>4.5
FFO to Debt
Debt to EBITDA
Debt to FFO
60.00%
1.40
1.67
52.50%
1.70
1.90
37.50%
2.50
2.67
22.50%
3.75
4.44
15.00%
4.50
6.67
73
Example of Using Ratios to Gauge Credit Rating
• The credit ratios are shown next to the achieved
ratios. Concentrate on Funds from operations
ratios.
Note that based on business
profile scores published by
S&P
74
Debt Capacity and Interest Cover
• Despite theory of
probability of default
and loss given
default, the basic
technique to
establish bond
ratings continues to
be cover ratios.
• This analysis from
Damarodan is not
correct because it
does not account for
business conditions.
75
Computing Simulated Bond Ratings from Financial R
atios
Use File with S&P Bond Ratings
Enter the financial ratio
Then enter the business risk
1
2
3
4
5
6
7
8
9
Use excel functions:
INDEX
MATCH
LOOKUP
INTERPOLATE
INTERPOLATE REVERSE
Ratio
Business Risk
Row Number
Low Range
High Range
Interpolated
Bond Rating
Interpolated
Lowest FFO/Interest Acceptable
1
2
3
AA
A
BBB
2.50
1.50
1.00
3.00
2.00
1.00
3.50
2.50
1.50
4.20
3.50
2.50
4.50
3.80
2.80
5.20
4.20
3.00
6.50
4.50
3.20
7.50
5.50
3.50
7.00
4.00
2.80
5.61
5.00
4.50
5.20
4.92
BB
3.12
5.61
5.00
3.80
4.20
4.04
5.61
5.00
2.80
3.00
2.92
4
BB
1.00
1.50
1.80
2.00
2.20
2.50
2.80
5.61
5.00
1.80
2.00
1.92
76
DSCR and Credit Ratings in Project Finance
• Target rating of BBB• Target DSCR or LLCR
• Example of Toll-roads
77
Default Rates and Credit Spreads
78
Moody’s Forecast of Default Rates
Defaults versus Long-term Average
Moody's Speculative Grade Trailing 12-Month Default Rates
Actual Jan. 2000 to Aug. 2002 / Forecasted Sept. 2002 to Feb. 2003
12.0%
11.0%
10.5%
9.6%
10.0%
9.0%
8.5%
7.7%
8.0%
7.0%
7.7%
8.8%
10.7%
10.5%
10.3% 10.3%
10.5%
10.3%
9.8%
10.1% 10.0% 10.0% 10.0% 10.0% 9.8%
9.3%
9.0%
8.8%
7.9%
7.1%
6.7%
6.2%
% 6.0%
5.0%
4.0%
3.77%*
3.0%
2.0%
1.0%
Feb-03
Jan-03
Dec-02
Nov-02
Oct-02
Sep-02
Aug-02
Jul-02
Jun-02
May-02
Apr-02
Mar-02
Feb-02
Jan-02
Dec-01
Nov-01
Oct-01
Sep-01
Aug-01
Jul-01
Jun-01
May-01
Apr-01
Mar-01
Feb-01
Jan-01
0.0%
Months
Note: *Long run annual default rate is 3.77%
79
Probability of Default
• This chart shows rating migrations and the proba
bility of default for alternative loans. Note the in
crease in default probability with longer loans.
80
Probability of Default Updated
81
Credit Spread on Debt Facilities
• The spread on a loan is directly related to the
probability of default andS the loss, given default.
The Credit Triangle
S = P (1-R)
P

R
The credit spread (s) can be characterized as the default probability (P)
times the loss in the event of a default (R).
82
Expected Loss Can Be Broken Down Into Three
Components
Borrower Risk
EXPECTED
LOSS
$$
=
Probability of
Default
Facility Risk Related
Loss Severity
x
Given Default
Loan Equivalent
x
Exposure
(PD)
(Severity)
(Exposure)
%
%
$$
What is the probability
of the counterparty
defaulting?
If default occurs, how
much of this do we
expect to lose?
If default occurs, how
much exposure do we
expect to have?
The focus of grading tools is on modeling PD
83
Comparison of PD x LGD with Precise Formula
Case 1: No LGD and One Year
• .
84
Comparison of PD x LGD with Precise Formula
Case 2: LGD and Multiple Years
• .
Assumptions
Years
Risk Free Rate 1
Prob Default 1
Loss Given Default 1
5
5%
20.8%
80%
BB
5
7
20.80%
PD
Alternative Computations of Credit Spread
Credit Spread 1
3.88%
PD x LGD 1
16.64%
Proof
Opening
100
Closing
127.63
Value
127.63
Risky - No Default
100
Prob
Closing
0.95
153.01
Value
145.36
Risky - Default
100
Risk Free
Total Value
0.05
30.60
1.53
146.89
FALSE
Credit Spread Formula
With LGD
cs = ((1+rf)/((1-pd)+pd*(1-lgd))-rf)^(1/years)-1
85
Recovery Rates
86
Putting Things Together and Measuring the Risk
Adjusted Return on Capital
87
Corporate and Project Financial
Analysis Programme
Determining the Correct Ratio to
Use in Measuring Profit
Relevance of Measuring Profit for Credit Analysis
• Some would say that the credit ratios are more
important, but if there is no profit, there is no
ability to repay debt
• Long-term profitability should be assessed
• The most important item is the danger of high rates
of return
– Attract competitors
– Attract political risk
– Artificially inflated
– Subject to changes in tastes
89
Financial Indicators of Management Performance
• Evaluate Whether Management is Doing a Good Job with
Investor Funds (Not if the company is appropriately valued)
– Return on Invested Capital
– Return on Assets
– Return on Equity
– Market/Book Ratio
– Market Value/Replacement Cost
• Key Issue
– Evaluate relative to risk
• ROE versus Cost of Equity
• ROIC versus WACC
90
Basic Economic Principles,
ROIC and Financial Analysis
• When you measure value, you are gauging the ability of a firm
to realize economic profit. For example, when you compare
the equity IRR with the equity cost of capital.
• When you assess assumptions in a financial forecast, you must
assess whether economic profit implicit in the assumptions can
in fact be realized. For example, if the financial forecast has a
very high ROE, is that reasonable.
• When you interpret financial statistics, you are gauging the
strategy of the company in terms of whether economic profit is
being realized. In reviewing the return on invested capital,
does this demonstrate that the company has the potential to
earn economic profit.
91
Return on Invested Capital Analysis
• ROIC is not distorted by the leverage of the company
• ROIC can be used to gauge economic profit and whether the
company should grow operations
• ROIC can be used to assess the reasonableness of projections
– For example, if ROIC is very high and the company is in a competitive
business with few barriers to entry, the forecast is probably not realistic.
• ROIC can be computed on a division basis EBIT and allocation
of capital to divisions from net assets to gauge the profit of
parts of the company
• ROIC comes from sustainable competitive advantage and high
market share
92
Issues in Management Performance Evaluation
• Basic Formula: ROIC versus WACC
– How to compute ROIC
• NOPLAT/Average Invested Capital
• May or may not include goodwill – If goodwill is not included,
compute NOPLAT without subtracting goodwill write-off and
subtract net goodwill from invested capital
• Reduce the invested capital by surplus cash balances
• Some don’t include other income – then the invested capital should
be reduced by other investments
• Can compute with ratios
– EBIT Margin x (1-t) * Asset Turn
– Asset Turn = Sales/Assets; EBIT Margin = EBIT/Sales
– ROCE vs. ROIC
• ROCE is generally computed in an indirect way by starting with net
income, and adding net of tax interest and adding minorities
93
Exxon Mobil Return on Average Capital Employed
• Return on average capital employed (ROCE) is a performance measure
ratio. From the perspective of the business segments, ROCE is annual
business segment earnings divided by average business segment capital
employed (average of beginning and end-of-year amounts).
• These segment earnings include ExxonMobil’s share of segment earnings of
equity companies, consistent with our capital employed definition, and
exclude the cost of financing.
• The corporation’s total ROCE is net income excluding the after-tax cost of
financing, divided by total corporate average capital employed. The
corporation has consistently applied its ROCE definition for many years and
views it as the best measure of historical capital productivity in our capital
intensive long-term industry, both to evaluate management’s performance
and to demonstrate to shareholders that capital has been used wisely over
the long term. Additional measures, which tend to be more cash flow based,
are used for future investment decisions.
94
Exxon Mobil Return on Capital Employed – Where are
they making expenditures
95
Illustration of Invested Capital Computation
96
ROE and ROIC – Note how to compute growth rates
from ROE and Retention
97
Corporate and Project Financial
Analysis Programme
Financial Statement Analysis Liquidity, Solvency and Efficiency
Analysis
Evaluation of Ratios and Understanding Problems
with Ratios
• Importance of Different Ratios
– Limited use of liquidity ratios in long-term loans
– Problems with Debt to EBITDA and re-investment
requirement in capital expenditures
– Problems with Interest Coverage and Repayment of
Debt
– Problems with Debt to Capital and asset valuation on
balance sheet
– Problems with Return on Investment with write-offs, restructuring charges, asset sales
99
Limited use of liquidity ratios in long-term loans
• Accounts Receivable in different industries such as
telecom
• Valuation of inventories
• Cash and need for debt
100
Problems with Debt to EBITDA
•
•
•
•
•
Variation in EBITDA
Accounting for Asset Life
Reflecting Maintenance capital expenditures
Measuring Interest Expense
Case Study: Chesapake Energy
101
Problems with Interest Coverage and Repayment of
Debt
• Directly measures acceptable variation in EBITDA
• If the lifetime of assets is 5-years, must somehow a
ccount for the repayment over the lifetime of assets
• Use of LLCR and PLCR in project finance
102
Use of Different Ratios in Different Circumstances
• Explain why different ratios are typically applied:
– DSCR and LLCR in Project Finance with Contracts
• Break even cash flow
• Toll road cash flow patterns
– PLCR in Project Finance In Resource Projects
• Break-even commodity price over reserve life
– Debt to EBITDA in Leverage Buyouts
• Relates to EV/EBITDA
– Debt to Capital in Stable Industries with Market Based
Asset Value
– Interest Coverage in Highly Levered Transactions with
Cash Sweep
103
Items that Distort Financial Ratios
• Issues that Distort Financial Ratios
– Goodwill in Merger Transaction
– Share Valuation in Exchange Transaction
– Maintenance Expenditures in Debt to EBITDA
– Asset Impairment for Debt to Capital
– Re-structuring Charges
104
Corporate and Project Financial
Analysis Programme
Analyzing Statement of Other
Comprehensive Income
Valuation of Derivatives
• Example of Forward Contract
– Example of Oil Price Contract
– Term and Futures Price
– Valuation when Forward Price Changes over Time
• Example of Interest Rates
– Valuation of Debt with Changing Interest Rates
– Valuation of Interest Rate Swap
• Example of Option
– Using the Black Sholes Model
– Valuation of Band of Oil Prices
106
Accounting for Changes in Value of Derivatives
• Hedge Accounting versus Direct
– No effect on income statement if hedge accounting
• Example of oil price hedge
– Gains in value in profit and loss
• Should or should not be in be in EBITDA?
– Effects of income and investment on
• ROIC
• Debt to Capital
• Debt to EBITDA
107
Unrealized gains or losses on derivatives (S&P)
• If a company has not achieved the requirements of technical
hedge accounting (even though an effective economic hedge may
exist), it reports all mark-to-market gains or losses related to the
fair-valuing of derivative contracts in the income statement.
• Although the nature of the underlying activity is often integral to
EBITDA, FFO, or both, using mark-to-market accounting can
distort these metrics because the derivative contract may be used
to hedge several future periods. Therefore, when we have
sufficient information, we exclude the unrealized gains or losses
not related to current-year activity, so that the income statement
represents the economic hedge position achieved in the current
financial year (that is, as if hedge accounting had been used).
• This adjustment is common in the utilities and oil and gas sectors.
This means that hedge accounting does not result in EBITDA
being affected by the hedges.
108
Case Study of Problems with Derivatives –
Constellation Energy
Constellation Merchant Segments Reported in
2009 ($ millions)
2006
2007
2008
Gross margin:
Generation
Customer Supply
Global Commodities
1,490
764
656
1,700
889
654
1,956
765
260
Total
2,910
3,243
2,981
Generation Percent
51%
52%
66%
Valuation by Morgan Stanley
Low Range
High Range
Fair value of businesses other than global commodities
$12,000.00
$13,000.00
Less repayment of outstanding indebtedness
($6,000.00)
($6,000.00)
Less net loss (negative value) of global commodities business
($2,000.00)
($2,000.00)
Net equity value (before costs and expenses)
$4,000.00
$5,000.00
Shares
179.00
179.00
Net equity value per share (before costs and expenses)
$22.35
$27.93
109
Effects of Derivative Accounting
• Constellation Energy had stated that it was hedged. But:
– $282 million of lower gross margin related to our portfolio
of contracts subject to mark-to-market accounting.
– On October 31, 2008, we discontinued the use of hedge
accounting for derivative contracts that previously were
accounted for as cash-flow hedges within the international
commodities operation. From that date, subsequent changes
in fair value of those derivative contracts have been
recorded in earnings. We concluded that the combination of
the decline in value associated with the previously hedged
transactions together with the related balances remaining in
accumulated other comprehensive income, would lead to the
recognition of a net loss in one or more future periods. As
such, we recognized a loss of $42 million during the fourth
quarter of 2008.
110
Re-valuations of Assets and Liabilities
• Evaluating sensitivities for FX gains and losses
• Property: identifying cash and non-cash gains and
losses in value
• Hedging gains and losses: when do financial asset
revaluations impact the Income statement?
111
General Discussion of Profit and Distributions
• Consolidated net profit
• Funding dividends and distributions in alternative
financial structures
• Dividend policy and capital structure
• Dividends as mitigation in credit analysis
112
Shareholder Loans
• Effects of shareholder loans on ability to pay
dividends
• Effects on taxes of corporation
• Effects on taxes paid by debt and equity investors
• Analyzing a share buyback’s impact on EPS and
NAV
113
Corporate and Project Financial
Analysis Programme
Assessing Earnings Quality
Premature revenue recognition
• Examples
– WorldCom
• Caused bankruptcy
• Revenue instead of capital
– Mobily
• Pre-paid accounts
• Resulted in Major Stock Decline
– Enron
• Recognized Future Revenues on Contracts
• Allowance for doubtful accounts
115
Projecting and Analyzing Revenues
• Price vs. volume changes
– Often difficult from financial statements
– Requires industry data
– Danger of price and volume growth
•
•
•
•
•
•
Evaluation of price with marginal cost analysis
Potential for prices to decline to short-run marginal cost
Difficulty in projecting volumes for oligopoly
Real and nominal growth
Price versus margin analysis
Exercise with Simulation Model
116
Evaluating Costs and Discretionary Expenditures
• Cost flow assumption for inventory
–
–
–
–
Inventory restructuring (LIFO pools)
Inventory write downs and effect on gross margin
Shifting future expenses to the current period - provisioning
Identifying and adjusting for Inflation profits in inventory
• Analysing and evaluating the impact of
– capitalisation of expenses (World com)
– changing depreciation over (in)-appropriate periods (Shale o
il and gas)
– deferring expenses
– asset impairment and accelerated depreciations
117
Boosting Profits and Hiding Negative Trends
• Motivations
– Declining returns relative to past
– Declining returns relative to peers
• Techniques to hide problems
– Use sophisticated and confusing language
– Increase gearing and hide debt
– Capitalise future profits
– Combine risky activities with safe activities
118
Case Studies of Boosting Profits and Hiding Negative
Returns
• Constellation Energy
– Sophisticated language
– Lenders lose confidence and cannot re-finance
– Stock price decline
– VAR does not work
• LTCM
– Famous case of hedge fund
– Returns declined after methods copied
– Increased leverage
– Took risky positions instead of arbitrage
119