Ratios and ratio analysis attempt to standardize a company’s financial position and performance to enable intra-industry comparison and trend analysis. Financial ratios relevant for credit analysis include profitability and cash flow ratios, leverage ratios and coverage ratios.
Profitability and cash flow ratios
Profitability and cash flow ratios are useful for credit analysis because they provide information about the cash-flow-generating capacity of a company. Credit analysts focus on operating income (EBIT) instead of net income. Several measures of cash flow may be used in different ratios, some more conservative than others, depending primarily on the availability of information and accuracy:
Earnings before interest taxes, depreciation, and amortization (EBITDA) are frequently quoted as a proxy for operating cash flow but it ignores working capital changes and capital expenditures, hence other measures of cash flow must also be used.
Funds from operations (FFO) equals net income from continuing operations plus depreciation and amortization, deferred taxes and other non-cash items. Some analysts prefer it to cash flows from operations (FFO), because they believe that working capital changes which are reflected in the CFO even out over time.
Free cash flow before dividends refers to net cash flow available for repayment of debt and payment of dividends. It equals recurring net income plus depreciation and amortization minus increase (plus decrease) in working capital minus capital expenditures. It can be approximated by CFO minus capital expenditures. It is a useful measure because if FCF before dividends is negative, a company must use up its cash reserves or raise financing to make debt-related payments.
Free cash flow after dividends equals free cash flow before dividends minus dividends. Some analysts also subtract share buybacks. It represents the increase in cash reserves available for deleveraging which reduces credit risk.
Leverage ratios include debt/capital, debt/EBITDA and cash flow to debt. Many also include other debt-line liabilities such as an underfunded pension, operating leases, etc. in the definition of debt.
Debt/capital ratio represents the percentage of debt in the capital structure. Capital equals debt plus shareholders’ equity. It is predominantly used for analysis of investment-grade debt. One version of this ratio assumes the write-down of goodwill and other intangible assets.
Debt/EBITDA ratio is used both as a snapshot and for trend analysis and projections. This ratio is volatile for companies with high cash flow variability such as cyclical companies having high operating leverage (higher proportion of fixed costs in cost structure).
FFO/Debt ratio is often used and published by credit rating agencies to give an indication to analysts which a company is given a specific rating and how the rating might change.
FCF after dividends/debt, a higher ratio means more debt can be paid off.
Coverage ratios measure an issuer’s ability to pay/cover its interest payments:
- EBITDA/Interest expense: A higher ratio indicates better credit quality.
- EBIT/Interest expense: A more conservative ratio. Higher is better.
Other financial analysis
Since credit risk and liquidity risk are interrelated, analysts also assess a company’s overall liquidity:
- Cash on the balance sheet: the safest assurance of liquidity
- Working capital: very high negative working capital can dry up liquidity in recessions.
- Operating cash flow: an analyst needs to make sure they are not overstated.
- Committed bank lines provide contingent liquidity if other sources dry up.
- Debt coming due and committed capital expenditures in the next 2 years: an analyst compares these known cash outflows expected in the next 1-2 years with operating cash inflows.