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5.3 Financial Ratios Used in Corporate Debt Analysis

5.3.1 Financial Ratios Used in Credit Analysis

Credit measures are used to calculate an issuer's creditworthiness, as well as to compare its credit quality with that of peer companies. Key credit ratios focus on leverage and interest coverage and use such measures as EBITDA, free cash flow, funds from operations, interest expense, and balance sheet debt.

In analysis and understanding a company's fundamentals, a number of financial measures derived from the company's principal financial statements are examined.

They can be grouped into 2 categories:

  • Profitability and Cash flow measures: – they include EBITDA, FFO, FCF before dividends and FCF after dividends. These measures tell us the company's ability to service its debt and in time.
  • Leverage Measures: – They include Debt/Capital, Debt/EBITDA, FFO/Debt and FCF after Div/Debt. These measures (ratios) are indicator of financial risk.
  • Coverage Measures (ratios): – They measure an issuer's ability to meet – to "cover" – its interest payments. These ratios include, EBITDA/Interest Expense and EBIT/Interest Expense.

5.3.2 Credit Quality of a Corporate Bond Issuer and a Bond of that Issuer, Given Key

Financial Ratios of the Issuer and the Industry 5.3.2.1 Profitability and Cash Flow Measures There are several measures of cash flow used in credit analysis, including the following:

  • Earnings before interest, taxes, depreciation, and amortization (EBITDA): is equal to operating income plus depreciation and amortization expense. EBITDA is a somewhat crude measure of cash flow because it excludes certain cash-related expenses of running a business, such as capital expenditures and changes in (non- cash) working capital.
  • Funds from operations (FFO): is equal to net income from continuing operations plus depreciation, amortization, deferred income taxes, and other non-cash items.
  • Free cash flow before dividends (FCF before dividends): can be calculated as net income (excluding non-recurring items) plus depreciation and amortization minus increase in non-cash working capital minus capital expenditures. FCF measures excess cash flow generated by the company (excluding non-recurring items) before payments to shareholders or that could be used to pay down debt or pay dividends. Companies that have negative free cash flow before payments to shareholders will be consuming cash they have or will need to rely on additional financing-from banks, bond investors, or equity investors. This obviously represents higher credit risk.
  • Free cash flow after dividends (FCF after dividends): is equal to free cash flow before dividends minus dividend payments.

5.3.2.2 Leverage Ratios

  • Debt/Capital – Capital is calculated as total debt plus shareholders equity. This ratio shows the percent of a company's capital base that is financed with debt. A lower percentage of debt indicates lower credit risk. The debt/capital ratio is generally used for investment-grade corporate issuers. Where goodwill or other intangible assets are significant (and subject to obsolescence, depletion, or impairment), it is often informative to also compute the debt/capital ratio after assuming a write-down of the after-tax value of such assets.
  • Debt/EBITDA – A higher ratio indicates more leverage and thus higher credit risk. The debt/EBITDA ratio can be very volatile for companies with high cash flow variability, such as those in cyclical industries and with high operating leverage (fixed costs).
  • FFO/Debt – A higher ratio indicates a greater ability to pay debt by funds from operations, thus lower credit risk.
  • FCF after Dividends/Debt – A higher ratio indicates that a greater amount of debt can be paid off from free cash flow after dividend payments.

5.3.2.3 Coverage Ratios The two most common coverage ratios are the following:

  • EBITDA/Interest expense – This measurement of interest coverage is a bit more liberal than the one that uses EBIT because it does not subtract out the impact of (non-cash) depreciation and amortization expense. A higher ratio indicates higher credit quality.
  • EBIT/Interest expense – Because EBIT does not include depreciation and amortization, it is considered a more conservative measure of interest coverage.

This ratio is now used less frequently than EBITDA/interest expense.

5.3.2.4 Access to Liquidity Cash holdings provide the greatest assurance of having sufficient liquidity to make promised payments.

Committed but untapped lines of credit provide contingent liquidity in the event that the company is unable to tap other, potentially cheaper, financing in the public debt markets.

Analysts will compare the sources of liquidity with the amount of debt coming due as well as with committed capital expenditures to ensure that companies can repay their debt and still invest in the business if the capital markets are somehow not available.

Lesson Wrap-Up

This lesson should leave you able to explain the financial ratios used in corporate debt analysis in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain financial ratios used in credit analysis in your own words.
  2. Explain credit quality of a corporate bond issuer and a bond of that issuer, given key in your own words.
  3. State one exam-style risk, valuation, or market implication of the financial ratios used in corporate debt analysis.