The term ‘credit risk’ has become a buzzword after some of the recent default episodes which have left a mark on the mutual fund industry. Let’s take a look at how credit rating agencies analyze and identify the credit worthiness of companies.
Credit analysis is performed by an investor or bond portfolio manager on companies or other debt issuing entities regarding the entity's ability to meet its debt obligations. The credit analysis seeks to identify the appropriate level of default risk associated with investing in that particular entity.
Credit analysis may relate to borrower’s credit risk in particular transaction or overall credit worthiness. One general approach is credit scoring like CIBIL rating.
Another general process is credit rating process by various companies. They assess the risk taking ability of company either on long term or short term period and express the probability of default by the issuer on its debt obligation.
What is credit risk?
It is the risk of loss of the counterparty or debtor’s failure to fulfill the promised payment. Credit risks are calculated based on the borrowers' overall ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).
Credit rating process
Credit rating process involves broad assessment of the company and not just the financial reports. It is done by an analyst of the credit-rating agency by:
- Meeting the CFO and CEO to discuss the industry outlook, business segments, goals both long term and short term and capital spending etc.
- Evaluating business risk: operating environment, industry characteristics, success factors etc.
- Financial risk which includes, evaluation of capital structure, interest coverage and profitability using profitability ratio analysis and debt covenants
- Evaluating the management.
While issuing the analysis the credit agencies emphasize the relation between the business risk profile and financial risk profile.
Credit ratios used by rating agencies
Interest coverage ratio: EBIT/Gross Interest
This ratio determines how easily a company can pay interest on outstanding debt. It can be calculated by dividing a company's earnings before interest and taxes (EBIT) during a given period by the amount a company must pay in interest on its debts during the same period.
EBITDA to interest coverage ratio: EBITDA/Gross Interest
The EBITDA-to-interest coverage ratio is used to assess a company's financial durability by examining whether it is at least profitable enough to pay off its interest expenses. A ratio greater than 1 indicates that the company has more than enough interest coverage to pay off its interest expenses.
ROACE (Return on Avg Capital Employed): EBIT/Avg Capital
Return on average capital employed is a useful ratio when analyzing businesses in capital-intensive industries such as oil. Businesses that are able to squeeze higher profits from a smaller amount of capital assets will have a higher ROACE than businesses that are not as efficient in converting capital into profit.
FFO to debt: FFO (interest paid-operating lease adjustments)/Total Debt
The funds from operations (FFO) to total debt ratio is a leverage ratio that a credit rating agency or an investor can use to evaluate a company’s financial risk. The lower the ratio the more leveraged the company.
Free operating cash flow to debt: CFO (capital expenditures)/Total Debt
This coverage ratio compares a company's operating cash flow to its total debt, which, for the purpose of this ratio, is defined as the sum of short-term borrowings, the current portion of long-term debt and long-term debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better is the company's ability to carry its debt.
Debt to EBITDA: Total Debt/EBITDA
Debt is the total of a company's long and short-term debts. EBITDA is the company's total earnings before excluding interest, taxes, depreciation and amortization. A high ratio of net debt to EBITDA reveals a company that's in deep debt.
Debt to Capital Raito: Total Debt/ Total debt + Total Equity
Companies can finance their operations through either debt or equity. The debt-to-capital ratio gives users an idea of a company's financial structure or how it is financing its operations, along with some insight into its financial strength. The higher the debt-to-capital ratio, the more debt the company has compared to its equity. This tells investors whether a company is more prone to using debt financing or equity financing.
Let us know if you require any more information.
