Credit Quality Assessment and Equity Screening | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll discuss more applications of financial statement analysis, focusing on assessing credit quality for potential debt investments and screening potential equity investments.

Credit Quality Assessment

Analysts use forecasts based on past performance to assess the credit quality of potential debt investments. Credit risk evaluation involves examining a debt issuer’s ability to meet interest payments and principal repayment. Analysts often use the 3 ‘C’s as a guideline:

• Character – The company’s track record in meeting debt obligations and the management’s professional reputation.
• Capacity – The company’s ability to meet future debt obligations. This requires close examination of financial statements and ratios.
• Collateral – Assets offered to secure the loan, which can reduce the risk to the lender.

Large debt issuances often involve credit rating agencies, such as Moody’s and Standard & Poor’s, to assess the credit quality. The rating process considers four general categories:

1. Scale and diversification – Larger and more diverse companies have better credit risks.
2. Operational efficiency – Profitability ratios and the degree of vertical diversification indicate operational efficiency.
3. Stability of profitability margins – Low variability in margins indicates a higher probability of timely interest and principal repayment.
4. Degree of leverage – Firms with less debt and greater earnings relative to debt and interest expense have lower credit risk. Ratios like interest coverage ratio or free cash flow to interest expense can be used for evaluation.

Equity Screening

Portfolio managers use investment strategies to narrow down the list of potential equity investments, focusing on growth stocks, value stocks, or income stocks. Ratios and projections can help identify which category a stock belongs to. Some investment strategies are more specific, like low price-to-earnings (P/E) and low price-to-sales investing.

Criteria are seldom used in isolation, as a single-factor screen can include firms with other undesirable characteristics. For example, an analyst may look at debt levels in addition to a low P/E ratio to determine if high earnings are due to high leverage. In this case, the screen is further narrowed down by excluding firms with a high debt-to-equity ratio.

And that’s all for this lesson! Up next, we’ll learn about adjustments to improve the comparability of financial statements.