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Kick the tires: analyzing financial risk

Our discussion of financial analysis highlights how reported results can sometimes be subject to misleading presentation or, worse, accounting improprieties. We focus on cash flows and cash availability and point out shortcomings of more traditional credit metrics. We help investors identify and quantify existing and potential cash obligations, including those not listed on the balance sheet.

Only as strong as the foundation

Often, companies with strong operations fail to achieve a strong credit profile because of an unsound capital structure. Such companies are vulnerable during downturns. We show how to evaluate capital structures to determine long-term sustainability, and how to use this analysis to determine downside potential in an investment opportunity.

Assess intangibles: analyzing non-financial risk

Non-financial analysis covers the intangibles associated with business risk — the non-financial factors behind weakening credit profiles. Common reasons include poor management, changes to competitive position within an industry and industry cyclicality. We look at recent examples of situations in which non-financial risk led to deterioration in credit quality, and show models to assist investors in assessing such risk.

Read the fine print

Investors must be aware of underlying legal arrangements that can have a material adverse impact on credit quality. We discuss legal issues such as bank and bond covenants, subordination and related party transactions to show how to approach these when calculating credit risk.

Not all sectors are the same

We draw on Citigroup analysts to outline specific factors required to analyse specific sectors to help provide an understanding of the relative value within and across sectors. We provide a separate comment on bank analysis.

Credit markets have developed

Credit markets have developed significantly in the last few years through increased interest in the credit default market and structured products. We include introductions to credit default swaps, collateralised debt obligations and asset-backed securities. We also include a write-up on absolute return strategies as a source of volatility and trading opportunities. We briefly introduce a variety of cross-credit strategies that today’s credit market offers.

Current markets now require credit diligence

While underlying credit quality remains good, we are now entering a period when both CFOs and private equity are beginning to embrace leverage. Combined with slowing economic metrics in Europe, we believe that the time to focus on credit fundamentals is upon us once again.

Ultimately, assessing credit quality is an attempt to quantify risk in relation to other assets. The goal of this publication is to assist in measuring risk to help locate undervalued or overvalued assets within the market. In addition, we challenge conventional wisdom in measuring credit risk across sectors and provide some of the strategies we find useful in establishing credit quality.

Cash flows come first

In our third edition of the Credit Primer, we again emphasize that there is no substitute for thorough cash flow analysis; this remains paramount in assessing corporate credit quality. We give our preferred means of conducting that analysis and provide with a key tool: a simple flowchart showing the importance of the combination of liquidity and free cash flow.

Non-financial analysis remains key

We also focus on non-financial aspects of credit analysis. Understanding the business models of a company and assessing management capabilities and the implications of their strategies remains paramount. While the markets are happy to focus on financial ratios, we draw particular attention to the fact that most credit downgrades are driven by non­financial factors. In the event of credit deterioration, a full understanding of capital structures is needed; we develop this theme and introduce some main concepts of distressed analysis, drawing on case studies.

Don’t head into battle without a strategy

In today’s low volatility and tight spread environment, a direct consequence of corporate deleveraging since the end of 2002, investors are turning to absolute return strategies as a source of volatility and trading opportunities. In this piece, we briefly introduce a variety of cross-credit strategies that today’s credit market offers.

We will now focus on 3 main sections:

1.Analysis basics and must know

2.Industry Analysis with many subsections to disect every single aspect of a given industry

3.Products Analysis

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