Corporate Credit Analysis (Ratios)

Corporate Credit Analysis: Understanding Ratios | CFA Level I Fixed Income

Welcome to our lesson on the calculations and interpretations of financial ratios used in credit analysis. Remember the 4 ‘C’s for credit analysis: capacity, collateral, covenants, and character. Today, we’ll focus on capacity, which is the borrower’s ability to repay its debt obligations on time.

Financial Ratios and Profitability

To assess a company’s capacity to repay its debt, credit analysts calculate ratios to evaluate a company’s financial health. They use ratios to identify trends over time and compare companies to industry averages and peers. But first, let’s quickly recap a typical income statement.

Some key figures in the income statement include:

Profit and Cash Flow Metrics

Let’s discuss four commonly used profit and cash flow metrics:

EBITDA (Earnings before interest, taxes, depreciation, and amortisation): A good approximation of the cash the company generates from its day-to-day operations available to repay its debts.

Funds from Operations (FFO): Net income from continuing operations plus depreciation, amortisation, and other non-cash items. Similar to cash flow from operations, but excludes changes in working capital.

Free Cash Flow: Net income from continuing operations plus depreciation and amortisation, and other non-cash items, adjusted for capital expenditures and working capital investments.

Free Cash Flow after Dividends: The free cash flow minus the dividends. This represents cash available to pay down debt or accumulate on the balance sheet.

Leverage Ratios

Leverage ratios compare the total outstanding debt held by the company against a profitability or investment figure. Some common leverage ratios include:

Coverage Ratios

Coverage ratios measure the borrower’s ability to generate cash flows to meet interest payments. Two commonly used coverage ratios are:

  • EBIT-to-Interest Ratio: A higher ratio indicates more cash flows to service interest costs, meaning lower credit risk.
  • EBITDA-to-Interest Ratio: A higher ratio indicates more cash flows to service interest costs, meaning lower credit risk. This ratio is used more often than the EBIT-to-interest ratio.

Applying Ratios in Credit Analysis

Now that we’ve calculated various figures and ratios for a company, how do they help in determining the appropriate credit rating? Ratings agencies publish benchmark values for financial ratios associated with each ratings classification. There is a set of benchmark ratios for every major industry. Credit analysts can evaluate the expected issuer credit ratings based on the company’s ratios relative to these benchmarks.

For example, if these are the benchmark ratios for bond issues of the industry that Company X is in, we can plot the ratios we have calculated for Company X on the benchmark scale. If the majority of the ratios meet at least the AA rating, the likely credit rating for Company X is AA.

And that concludes our lesson on corporate credit analysis with a focus on ratio analysis. Up next, we’ll examine some factors that affect yield spreads on corporate bonds. Stay tuned!

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