Corporate Bonds Credit Risk Analysis - Example

Executive summary

Nike and Adidas refer to two multinational sportswear firms based in two countries but faced with same problems. Nike and Adidas offer a wide range of products across the globe and they have a god reputation for offering high quality products. The companies faces a change in consumer taste and preferences, however, the experiences a rise in the number of fans for sport-related products. The paper attempts to present an in-depth analysis of Nike and Adidas. The analysis shows the comparison and contrast of financial performance of both the companies using ratio analysis and probability of financial distress using Altman’s Z-score and Option pricing model.

• [Ratio analysis] Compute the ratios provided in the lecture slides

Ratio analysis refers to a tool of financial analysis widely utilized by companies in comparing relationship between risk and returns of firms of different sizes. It refers to a systematic utilization of ratios to interpret the firm’s financial statements so as to determine its weaknesses and strengths, financial health as well as its current performance and historical performance. Categories of ratios used are solvency, liquidity and operating profitability.

• • Liquidity

Liquidity ratios show the ability of the firm to meet its short-term obligations as it is the basic measure of the financial health of a company. The current ratio, cash ratio and quick ratio of Nike have been fluctuating over the past five years. The current ratio was 2.85 in 2012, increased to 2.98 in 2013 and 3.47 in 2013 but decreased to 2.72 in 2014 and to 2.52 in 2015. This indicates a decrease in the ability of the firm to meet its short term obligations. The quick ratio was 1.94 in 2012, decreased to 1.82 in 2013 and increased to 2.31 in 2013 but decreased to 1.71 in 2014 and to 1.47 in 2015. This indicates a fluctuation in the ability of Nike to meet their current assets using very liquid assets. On the other hand, the cash ratio decreased from 1.1465 in 2011 to 0.9678 in 2012 and the increased to 1.5056 in 2013 and decreased to 1.023 and then to 0.9353. This indicates a reduction in the ability of the firm to meet their current obligations using cash and cash equivalent. However, from the ratios, it is clear that Nike is very liquid because the current ratio and quick ratio is greater than one. This is indicated in the following graphs.

Nike ratios

The current ratio, cash ratio and quick ratio of Adidas have been fluctuating over the past five years. The current ratio increased from 1.5 in 2011 to 1.57 in 2012, decreased to 1.45 in 2013 and 1.68 in 2014 but decreased to 1.4 in 2015. This shows a fluctuation in the ability of the firm to meet its short term obligations using current assets. The quick ratio was 0.79 in 2011, increased to 0.87 in 2012 and decreased to 0.77 in 2013 but increased to 0.92 in 2014 and decreased to 0.71 in 2015. This indicates a fluctuation in the ability of Nike to meet their current assets using very liquid assets. Adidas is not able to meet its short term obligations using the most liquid assets. On the other hand, the cash ratio increased from 0.1861 in 2011 to 0.2153 in 2012 and then decreased to 0.1340 in 2013, then increased to 0.1601 and then increased to 0.2067. This indicates a fluctuation in the ability of the firm to meet their current obligations using cash and cash equivalent. From the ratios, it is clear that Adidas is not able to meet their short term obligations using very liquid assets. This is indicated in the following graphs

Adidas ratios

However, Nike is more liquid than Adidas. The values of Nike’s cash ratio, quick ratio and current ratio are higher than those of Adidas. Nike has more ability to meet their short term obligations using current assets.

Nike

The cash flow ratio also measures the short term liquidity of the company. It shows the ability of the firm to meet its current liabilities using their cash flow from operations. The cash flow ratio of Nike increased from 0.4578 in 2011 to 0.4699 in 2012 and to 0.7653 in 2013 and decreased to 0.5994 and then increased to 0.7389. This indicates a fluctuation in the ability of Nike to cover its current obligations using cash flow from their operations.

Defensive interval ratio measures the number of days a firm is able to take without accessing long term assets. Defensive interval ratio of Nike decreased from 4629.4 in 2011 to 4415.7 in 2012, increased to 9184.2 in 2013, then decreased to 8893.6 in 2014 and finally increased to 12848 in 2015. Although it fluctuated, the company will take more days before using its non-current assets.

Cash flow to capital expenditure refers to a ratio measuring the company’s ability of acquiring long term assets utilizing free cash flow. Cash flow to capital expenditure of Nike increased from 1.8816 in 2011 to 2.0727 in 2012, increased to 5.0702 in 2013, then increased to 5.3517 in 2014 and finally increased to 10.833 in 2015.the CF to CAPEX ratio shows an upward trend which is a positive sign as the company did not go through cycles of small and large capital expenditures. This is indicated in the following graphs.

Nike ratios

Adidas

The cash flow ratio of Adidas increased from 0.1861 in 2011 to 0.2153 in 2012 and decreased to 0.134 in 2013 and increased to 0.1601 and then increased to 0.2067. This indicates a fluctuation in the ability of Adidas to cover its current obligations using cash flow from their operations.

The Defensive interval ratio of Adidas increased from 5.944 in 2011 to 6.472 in 2012, increased to 6.533 in 2013, then increased to 18.347 in 2014 and finally decreased to 7.855 in 2015. Adidas is less liquid and will take very few days before using its non-current assets.

Adidas’ Cash flow to capital expenditure increased from 1.474 in 2011 to 1.598 in 2012, decreased to 1.145 in 2013, then increased to 3.188 in 2014 and finally decreased to 2.301 in 2015. The CF to CAPEX ratio shows a fluctuating trend which imply that the company goes through cycles of small and large capital expenditures. This is indicated in the following graphs.

Adidas ratios

With regards to the cash flow ratio, Defensive interval ratio, and Cash flow to capital expenditure, Nike has a higher performance than Adidas. Nike has higher ability to meet its current liabilities using their cash flow from operations than Adidas. Secondly, it takes more days without accessing long term assets. Finally, the CF to CAPEX ratio shows an upward trend which is a positive sign as the company did not go through cycles of small and large capital expenditures.

• • Solvency

Solvency ratios illustrate how leveraged the companies are. They measure the ability of the companies to meet their debt as well as other obligations. They indicate if the cash flow of the company is enough to meet their long term and short term liabilities. The total debt to total assets of Nike increased from 1.48 in 2011 to 1.58 in 2012 to 1.72 in 2013, then decreased to 1.70 in 2014 and finally increased to 1.71 in 2015. The debt to equity ratio of Nike decreased from 0.07 in 2011 to 0.04 in 2012 to 0.12 in 2013, then increased to 0.13 in 2014 and finally decreased to 0.10 in 2015. The long term debt ratio of Nike was o.o2 in 2011 and 2012, increased to 0.07 in 2013, decreased to 0.06 in 2014 and to 0.05 in 2015. The interest coverage, fixed charge coverage and CFO to debt also fluctuate. However, the values are relatively low indicating that Nike uses relatively lower amount of debts. This is indicated in the following graphs.

Nike ratios

Adidas

The total debt to total assets of Adidas increased from 2.14 in 2011 to 2.2 in 2012, decreased to 2.11 in 2013, then increased to 2.21 in 2014 and finally increased to 2.35 in 2015. The debt to equity ratio of Nike decreased from 0.19 in 2011 to 0.28 in 2012, decreased to 0.24 in 2013, then increased to 0.34 in 2014 and finally decreased to 0.32 in 2015. The long term debt ratio of Nike was 0.09 in 2011, increased to 0.1 in 2012, decreased to 0.06 in 2013, increased to 0.13 in 2014 and finally decreased to 0.11 in 2015. The interest coverage, fixed charge coverage and CFO to debt also fluctuate. However, the values are relatively low indicating that Adidas uses relatively lower amount of debts. This is indicated in the following graphs.

Adidas ratios

When compared to Adidas, Nike uses relatively fewer debts than Adidas. All the long term solvency ratios for Nike are lower than those of Adidas. Hence, it is less leveraged and can effectively meet ist long term obligations.

• • Operating profitability

This category of financial ratios determines the firm’s bottom line as well as the returns it offers to its investors. They show the firm’s overall performance and efficiency. Return ratios shows the ability of the company to measure its overall efficiency in generating returns or earnings for its shareholders. Therefore, ROA ratio assesses the efficiency with which the companies manage their investment in assets and utilizing them to generate profit. The ROA gauges the amount of profit that a company earns relatively to their investment level in total assets. Generally, a greater percentage is better since it implies that the company is using its total assets efficiently to generate sales. The Nike’s ROA increased from 14.5% in 201 to 14.59% in 2012, it then increased to 15.04% and then decreased to 14.89% and then increased to 16.29%. Although, the profitability fluctuated, the fluctuation was minimal and the company is still profitable. The company is effective at using it total assets in generating revenue.

Operating profit margin measures the operating efficiency and pricing strategy of a company. It is the proportion of the revenue of a company that remains after meeting its variable cost of production. The operating profit margin of Nike also fluctuated. It decreased from 13.63 in 2011 to 12.36% in 2012; it then increased to 12.93% in 2013 then decreased to 12.75% in 2014 and finally increased to 13.74% in 2015. Although it fluctuated, Nike is very profitable. Nike is well suited to satisfy their creditors and create value for their shareholders by generating operating cash flow. Nike has a healthy operating margin and is able to meet its fixed costs and hence has less financial risk.

Sales growth metrics helps in measuring the pace at which the sales revenue of the company is increasing or decreasing. The sales revenue of the company increased at different rates; in 2011 it increased by 9.72%, in 2012 it increased by 15.66%, in 2013 it increased by 4.91%, in 2014 it increased by 9.82% and in 2015 it increased by 10.08%. The company had a positive growth in all the years implying an increase in the effectiveness of its operations.

Nike ratios

The Adidas’s ROA decreased from 6.1% in 2011 to 4.57% in 2012, it then increased to 6.77% and then decreased to 4.08% in 2013 and then increased to 4.92% in 2015. Although, the profitability fluctuated, the fluctuation was minimal and the company is still profitable. The company is relatively effective at using it total assets in generating revenue.

The operating profit margin of Adidas also fluctuated. It decreased from 7.58% in 2011 to 6.18% in 2012; it then increased to 8.29% in 2013 then decreased to 6.08% in 2014 and finally increased to 6.26% in 2015. Although it fluctuated, Adidas is very profitable as it is well suited to satisfy their creditors and create value for their shareholders by generating operating cash flow.

The sales revenue of the company increased at different rates; in 2011 it increased by 11.29%, in 2012 it increased by 11.53%, in 2013 it decreased by 2.63%, in 2014 it increased by 0.29% and in 2015 it increased by 16.38%. The company had a positive growth in all the years except for in 2013 implying an increase in the effectiveness of its operations.

Adidas ratios

In overall, Nike is more profitable than Adidas. Firstly, it is more efficient in managing their investment in assets and utilizing them to generate profit. It has a ROA than Adidas which implies that the company is using its total assets efficiently to generate sales. Secondly, it has a greater proportion of its revenue that remains after meeting its variable cost of production. Nike is well suited to satisfy their creditors and create a higher value for their shareholders by generating operating cash flow than Adidas. Nike has a healthy operating margin and is able to meet its fixed costs and hence has less financial risk. Finally, the company has a higher pace at which the sales revenue of the company is increasing. Nike has a positive growth in all the years implying an increase in the effectiveness of its operations.

• [Probability of financial distress]

Financial distress refers to the difficulty of a firm in meeting their debt obligations. Probability of default refers to the situation where the firm fails to meet its required principal and interest payments. Altman’s Z-score assesses the likelihood of bankruptcy of a company.

Nike

The Altman’s Z-score of Nike was higher than 3 indicating that it is less likely to go bankrupt. The probability of default in the first instance is less than 1% hence it is less likely to fail to meet its principal and interest payments. The probability fluctuated between 0.05% and 0.01%. This is indicated in the table below.

Nike Altman’s Z-score

Altman Z-score

7.6946

9.1355

8.2782

8.2422

8.7732

On the other hand, the Altman’s Z-score New is less than three hence it is more likely to go bankrupt. This is indicated by the high probability of default. The new probability is more than 10 percent as indicated by the table below. The probability fluctuated between 10% and 16%.

Adidas Altman’s Z-score

Altman Z-score

3.2132

3.681

4.3029

3.2477

3.6264

With regards to Option pricing model, Nikes distance to default is 5.96847 and the probability of default is 0.15%.

Adidas

The Altman’s Z-score of Adidas was also higher than 3 indicating that it is less likely to go bankrupt. The probability of default in is relatively high however it is less likely to fail to meet its principal and interest payments. The probability fluctuated between 1% and 4%. This is indicated in the table below.

On the other hand, the Altman’s Z-score New is less than one indicating that it is more likely to go bankrupt. This is indicated by the high probability of more than 30% as indicated in the table below. The probability fluctuated between 38% and 43%.

With regards to Option pricing model, Adidas’ distance to default is 3.99754 and the probability of default is 0.21%.

In overall, it is evident that Nike is not in any financial distress. It has an Altman’s Z-score of more than 3 and low probability of default compared to Adidas.

Conclusions

Nike is the best company to invest it according to the analysis. Nike is more liquid than Adidas and more ability to meet their short term obligations using current assets. Nike has a higher performance than Adidas and will take more days without accessing long term assets. Nike’s CF to CAPEX ratio shows an upward trend which is a positive sign as the company did not go through cycles of small and large capital expenditures. Nike uses relatively fewer debts than Adidas and is also more profitable than Adidas. It is more efficient in managing their investment in assets and utilizing them to generate profit. Also, it has a positive growth in all the years implying an increase in the effectiveness of its operations.Nike is not in any financial distress. It has an Altman’s Z-score of more than 3 and low probability of default compared to Adidas.