GF510 Unit 5 Dealer Credit Exposure Analysis Example

$4.2 Million on Open Terms: A Unit 5 Credit Exposure Analysis of a Pool Maker's Largest Dealer

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Purdue University Global

GF510: Risk Analysis and Management

Unit 5 Credit Exposure Analysis

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[Date]

Ledgerwood Pools, Sabal Creek Pools and every figure are composite; the model, study and texts cited are real.

The Exposure in Context

Sabal Creek is a composite pool builder with fourteen branches in Texas and Florida and sales of about $96 million. It buys about $14 million of shells a year from Ledgerwood, 6 percent of Ledgerwood's sales, on net sixty-day terms with a credit limit of $4.2 million. At the latest month end it owed $3.1 million. Ledgerwood earns a gross margin of about 25 percent on these sales, roughly $3.5 million a year, so the relationship is worth protecting as well as measuring.

What the Statements Show

Three annual reports supplied by the dealer give the following picture.

Debt. Total debt of $27.5 million against EBITDA of $6.7 million, or 4.1 times. Two years ago the ratio was 2.9 times.

Interest coverage. Operating profit covered interest 3.8 times two years ago and 2.2 times last year, as rates on the dealer's floating credit line rose and sales slowed.

Liquidity. A current ratio of 1.3, adequate but thin for a business whose customers pay in stages.

Payment behavior. The dealer's average days to pay Ledgerwood have lengthened from 41 to 63, past the sixty-day terms.

Each measure on its own is a caution rather than an alarm. Together they describe a firm that borrowed to expand when demand was strong and is now carrying that debt into a slower market.

The Private-Firm Z-Score

Altman's original model predicted bankruptcy from five ratios using the market value of equity (Altman, 1968). For a private firm, a revised version substitutes book equity and re-estimates the weights, and a later review across many countries found that it keeps useful accuracy (Altman et al., 2017). For Sabal Creek, with total assets of $48 million:

1. Working capital to total assets: $6.0 million over $48 million, 0.125, times 0.717 gives 0.090.

2. Retained earnings to total assets: $7.0 million over $48 million, 0.146, times 0.847 gives 0.124.

3. Operating profit to total assets: $5.3 million over $48 million, 0.110, times 3.107 gives 0.342.

4. Book equity to total liabilities: $12 million over $36 million, 0.333, times 0.420 gives 0.140.

5. Sales to total assets: $96 million over $48 million, 2.0, times 0.998 gives 1.996.

The total is about 2.69. Scores above 2.90 fall in the safe zone and below 1.23 in the distress zone, so Sabal Creek sits in the gray zone, nearer its top.

Exposure at Default

If the dealer fails, it is likely to have drawn its whole limit first, since struggling firms stretch trade credit before they stop paying. Exposure at default is therefore the current balance of $3.1 million plus the $1.1 million still available, at a conversion factor of 100 percent: $4.2 million.

Probability and Loss Given Default

A gray-zone score near the top of the band corresponds roughly to a low speculative-grade borrower. S&P's long-run default studies put one-year default rates for issuers rated in the single-B-plus range at around 2 percent (S&P Global Ratings, 2024), and that figure is used as the probability of default.

Loss given default is set at 60 percent. Ledgerwood is an unsecured trade creditor with no claim on installed pools, and unsecured creditors typically recover well under half of what they are owed (Hull, 2023).

Expected Loss

Expected loss equals exposure times probability times severity: $4.2 million times 0.02 times 0.60, or about $50,400 a year. Against $3.5 million of annual gross margin, the base-case cost of carrying this dealer is small.

The base case says the dealer is a sound customer, but the same three numbers move together in a downturn, because a housing slowdown raises the dealer's chance of failing, pushes it to draw its whole limit and lowers what creditors recover, so the stress case matters more than the base case here.

Stress Case

Suppose the dealer's sales fall 25 percent, to $72 million, as pool orders did in earlier rate cycles. Operating profit would drop to about $1.3 million because branch costs are largely fixed, and working capital would shrink to about $4 million. The Z-score would fall to about 1.90: still gray, but closer to distress. Under those conditions a probability of default near 6 percent and a loss given default of 70 percent are reasonable, since recoveries fall when many builders fail at once. Expected loss rises to $4.2 million times 0.06 times 0.70, or about $176,000, three and a half times the base case.

Recommendation

Keep selling to Sabal Creek, but on tighter terms. First, reduce the unused limit from $1.1 million to $0.5 million, lowering exposure at default to $3.6 million. Second, take a purchase-money security interest in shells delivered but not yet installed, which would give Ledgerwood a claim on its own product and lower severity to about 45 percent in the base case and 55 percent under stress. Base-case expected loss would then fall to about $32,400 and stressed expected loss to about $119,000. Third, review the dealer's statements every quarter and cut the limit further if the Z-score drops below 2.0.

References

Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609. https://doi.org/10.1111/j.1540-6261.1968.tb00843.x

Altman, E. I., Iwanicz-Drozdowska, M., Laitinen, E. K., & Suvas, A. (2017). Financial distress prediction in an international context: A review and empirical analysis of Altman's Z-score model. Journal of International Financial Management & Accounting, 28(2), 131-171. https://doi.org/10.1111/jifm.12053

Hull, J. C. (2023). Risk management and financial institutions (6th ed.). Wiley.

S&P Global Ratings. (2024). Default, transition, and recovery: 2023 annual global corporate default and rating transition study. S&P Global.