Financial Ratios in Corporate Credit Analysis

Financial ratios derived from quantitative factors enable credit analysts to gauge a company’s financial health, spot trends, and conduct comparisons within and across sectors. The focus is primarily on three critical areas: profitability, coverage, and leverage.

Profitability Ratios

EBIT Margin

It assesses a company’s operational efficiency before considering capital costs and taxes.

\[\text{EBIT Margin } = \frac{\text{ Operating Income }}{\text{ Revenue }}\]

A high EBIT margin suggests that a larger portion of sales revenue remains after paying for variable costs of production, indicating good profitability.

Coverage Ratios

EBIT to Interest Expense

This metric measures a company’s ability to cover its interest obligations using its operating profit.

\[\text{EBIT to Interest Expense } = \frac{\text{ Operating Income }}{\text{ Interest Expense }}\]

A higher value suggests that the company can easily meet its interest obligations from its operating profit, indicating lower credit risk.

Leverage Ratios

Debt to EBITDA

It evaluates the company’s leverage by comparing its total debt to its overall operating performance.

\[\text{Debt to EBITDA } = \frac{\text{ Debt }}{\text{ }\text{EBITDA}\text{ }}\]

A higher Debt to EBITDA is a red flag, indicating a higher degree of financial risk.

RCF to Net Debt

Assesses leverage by comparing cash retained in the business to net debt.

\[RCF\text{ to Net Debt } = \frac{\text{ Retained Cash Flow }(RCF)}{\text{ Debt } – \text{ Cash and Marketable Securi}\text{ties}\text{ }}\]

A higher RCF to Net Debt suggests the firm has retained more cash relative to its net debt, pointing toward better financial stability.

Cash Flow Measures

Cash flow measures such as Free Cash Flow (FCF), Funds From Operations (FFO), and Retained Cash Flow (RCF) are often used in credit analysis. They emphasize cash flows from operations over those from asset sales or financing. Some cash flow measures Include:

1. Free Cash Flow (FCF): Net income minus necessary investments in working capital and fixed assets and net interest paid.
2. Funds from Operations (FFO): Net income with added back non-cash expenses.
3. Retained Cash Flow (RCF): Operational cash flow minus dividends.

These measures are conservative because they adjust for cash used in core business activities or distributed to shareholders.

Additional Considerations

Debt and interest measures might undergo adjustments to account for operational leases or other fixed commitments, not on the balance sheet. The concepts and definitions provided for these ratios are among several usages and may not have official IFRS definitions.

Example: Credit Analysis

A credit analyst is evaluating the financial health of AlphaTech Inc. The company’s financials are given in the following table:

$$\begin{array}{l|c}
\textbf{Metric} & \textbf{Amount (\$ in millions)} \\
\hline
\text{Operating Income (EBIT)} & 50 \\
\hline
\text{Revenue} & 200 \\
\hline
\text{Interest Expense} & 10 \\
\hline
\text{Total Debt} & 150 \\
\hline
\text{EBITDA} & 70 \\
\hline
\text{Cash and Marketable Securities} & 30 \\
\hline
\text{Dividends} & 5 \\
\end{array}$$

Profitability Ratios

EBIT Margin \(= \frac{\text{Operating Income}}{\text{Revenue}} = \frac{50}{200} = 0.25\) or \(25\%\)

With an EBIT Margin of 25%, AlphaTech Inc. retains $0.25 for every dollar of revenue after covering variable production costs. This is a strong profitability indicator.

Coverage Ratios

EBIT to Interest Expense \(= \frac{\text{Operating Income}}{\text{Interest Expense}} = \frac{50}{10} = 5\)

An EBIT to Interest Expense ratio of 5 indicates that AlphaTech can cover its interest expense 5 times over with its operating profit, implying lower credit risk.

Leverage Ratios

Debt to EBITDA:

\[\text{Debt to EBITDA} = \frac{\text{Debt}}{\text{EBITDA}} = \frac{150}{70} = 2.14\]

The Debt to EBITDA ratio of 2.14 suggests that AlphaTech’s debt is slightly over twice its operational performance. A higher value here would be concerning.

RCF to Net Debt:

\(RCF\) (Net cash from operations – Dividends) \(= 50 – 5 = 45\)

Net Debt \(=\) Debt – Cash and Marketable Securities \(= 150 – 30 = 120\)

\[RCF\text{ to Net Debt} = \frac{RCF}{\text{Net Debt}} = \frac{45}{120} = 0.375\text{ or }37.5\%\]

The RCF to Net Debt ratio of 37.5% indicates that the company retains cash, equating to 37.5% of its net debt, which is a positive sign of financial stability.

Question

Company A and Company B operate in the same industry.

$$\begin{array}{l|c|c}
& \textbf{Company A} & \textbf{Company B} \\
\hline
\text{EBITDA margin} & 20\% & 18\% \\
\hline
\text{FCF} & (-15) & 10 \\
\hline
\text{FCF before dividends} & (-10) & 5 \\
\hline
\text{Debt/EBITDA} & 3.0 & 2.0 \\
\hline
\text{EBITDA/interest expense} & 2.5 & 3.0 \\
\end{array}$$

Based on the financial information above, which of the following statements Is most likely correct?

1. Company A has a lower credit risk than Company B.
2. Company B has a lower credit risk than Company A.
3. Both companies have the same credit risk.

The correct answer is B.

1. EBITDA margin: Company A has a higher EBITDA margin (20% vs. 18%), suggesting it is more profitable.
2. FCF: Company B has a positive FCF of 10, while Company A has a negative FCF of (15). This indicates that Company B is in a better cash flow position.
3. FCF before dividends: Company B also has a better position here with 5 compared to Company A’s (10).
4. Debt/EBITDA: Company B has a lower Debt/EBITDA ratio (2.0 vs. 3.0), suggesting it is less leveraged and, therefore, potentially less risky.
5. EBITDA/interest expense: Company B has a higher EBITDA/interest expense ratio (3.0 vs. 2.5), meaning it is better positioned to cover its interest expenses with its earnings.

Based on the evaluation: Company A has a higher EBITDA margin, but this advantage is offset by its negative FCF, higher leverage, and lower interest coverage. Company B has positive FCF, better FCF before dividends, lower leverage, and better interest coverage.