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:
- Operating Margin: Operating income divided by revenue. It measures how much profit a company makes on a dollar of sales.
- Net Income: Derived after accounting for all income and expenses, including non-recurring items.
Profit and Cash Flow Metrics
Let’s discuss four commonly used profit and cash flow metrics:
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.
- Debt-to-EBITDA Ratio: A higher ratio indicates higher leverage and higher credit risk.
- FFO-to-Debt Ratio: A higher ratio indicates more cash flow to service debt, and hence lower credit risk.
- Free Cash Flow-to-Debt Ratio: A higher ratio indicates more cash flow to service debt, and hence lower credit risk.
- Debt-to-Capital Ratio: A higher ratio indicates higher leverage, and higher credit risk.
- 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!