Credit Quality of a Potential Debt Investment

The analysis of a company’s historical and projected financial statements is an integral part of the credit evaluation process. It helps determine a company’s ability to meet its debt obligations.

Several financial ratios may be computed from these financial statements. The ratios help to assess the credit quality of a potential debt investment based on the issuer’s perceived ability to honor its debt obligations, i.e., repaying the principal and making interest payments.

The Role of Financial Statement Analysis in Assessing Credit Quality

A company’s financial statements, both historical and projected, are important sources of information for assessing credit quality. Whereas computation of a company’s financial ratios is useful in the determination of its creditworthiness, the company’s relative creditworthiness may be determined by comparing its financial ratios with those of its peers. Commonly used financial ratios for this purpose include EBITDA/Average assets; Debt/EBITDA; Retained cash flow to debt; and Free cash flow to net debt.

Additionally, credit analysis, or the evaluation of credit risk, involves the projection of a company’s period-by-period cash flows. It uses return measures related to operating cash flow because this represents the cash that is generated internally and is available for the payment of creditors.

Four groups of quantitative factors are used in credit analysis:

• scale and diversification: this relates to a company’s sensitivity to adverse events or economic conditions, and other factors such as access to capital markets, that may affect its debt-paying ability;
• tolerance for leverage: this relates to a company’s ability to service its indebtedness;
• operational efficiency: this relates to a company’s cost structure. Companies that have lower costs are better positioned to deal with financial stress; and
• margin stability: this relates to the past volatility of profit margins. Higher margin stability is associated with lower credit risk.

Question

Two companies have the same size. One of them operates in a more diversified market. The company in the more diversified market would most likely have:

1. The same credit score, since the size of the company is all that matters.
2. A higher credit score, since diversification creates a steady stream of cash flows.
3. A lower credit score, since its business is fragmented and this makes it harder to manage.

Solution

The correct answer is B.

The company in a diversified market would have a better credit score. A higher degree of diversification would enhance the stability of the company’s stream of cash flow. This would, in turn, boost its capacity to pay the principal and interests of its debt.