The Credit Quality of a Corporate Bond Issuer

To illustrate how to evaluate the credit quality of a corporation, we will look at CVS, a US-based healthcare company. You will be in the shoes of a banker that needs to assess the creditworthiness of CVS. Using the financial statements information provided below, you need to report and interpret the following:

  • Profitability: Calculation of operating profit margin, EBITDA and Free cash flow after dividends. (Note that the company did not pay dividends during the years analyzed).
  • Leverage: Analysis of leverage ratios such as Debt/EBITDA, Debt/Capital, Free cash flow after Dividends / Debt.
  • Coverage: Calculation of the interest coverage ratio using both EBIT and EBITDA.

$$ \begin{array}{} \text{CSV Speciality Healthcare’s Financial Statements} \\ \end{array} $$

$$ \begin{array}{} \text{Consolidated Statement of Operations} \\ \text{Years ended December 31} \\ \end{array} $$

$$ \begin{array}{l|r|r|r} \begin{array}{l} \textbf{(Dollars in millions except} \\ \textbf{per share amounts)} \end{array} & \textbf{2014} & \textbf{2015} & \textbf{2016} \\ \hline \textbf{Net revenues} & \textbf{2,500.0} & \textbf{2,750.0} & \textbf{3,500.0} \\ \textbf{Operating expenses} & \text{} & \text{} & \text{} \\ \text{Cost of sales} & \text{1,500.0} & \text{1,600.0} & \text{2,000.0} \\ \text{Research and development} & \text{175.0} & \text{200.0} & \text{300.0} \\ \text{Selling and marketing} & \text{235.0} & \text{265.0} & \text{325.0} \\ \text{General and administrative} & \text{200.0} & \text{260.0} & \text{440.0} \\ \text{Amortization} & \text{80.0} & \text{90.0} & \text{180.0} \\ \text{Loss on asset sales and impairments} & \text{5.0} & \text{2.5} & \text{30.0} \\ \textbf{Total operating expenses} & \textbf{2,195.0} & \textbf{2,417.5} & \textbf{3,275.0} \\ \textbf{Operating Income} & \textbf{305.0} & \textbf{332.5} & \textbf{225.0} \\ \textbf{Other income/(expense)} & \text{} & \text{} & \text{} \\ \text{Interest expense)} & \text{(30.0)} & \text{(35.0)} & \text{(85.0)} \\ \end{array} $$

$$ \begin{array}{} \text{Consolidated Statements of Cash Flows} \\ \text{Years ended December 31} \\ \end{array} $$

$$ \begin{array}{l|r|r|r} \begin{array}{l} \textbf{(Dollars in millions except} \\ \textbf{per share amounts)} \end{array} & \textbf{2014} & \textbf{2015} & \textbf{2016} \\ \hline \textbf{Cash flows from operating activities} & \text{} & \text{} & \text{} \\ \text{Net income} & \text{250.0} & \text{220.0} & \text{180.0} \\ \begin{array}{l} \textbf{(Reconciliation to net cash provided} \\ \textbf{by operating activities:)} \end{array} & \text{} & \text{} & \text{} \\ \text{Depreciation} & \text{90.0} & \text{95.0} & \text{100.0} \\ \text{Amortization} & \text{80.0} & \text{90.0} & \text{180.0} \\ \text{…} & \text{} & \text{} & \text{} \\ \text{…} & \text{} & \text{} & \text{} \\ \begin{array}{l} \textbf{(Net cash flow provided by} \\ \textbf{operating activities:)} \end{array} & \textbf{425.0} & \textbf{375.0} & \textbf{575.0} \\ \textbf{Cash flows from investing activities} & \text{} & \text{} & \text{} \\ \text{Additions to property and equipment} & \text{(60.0)} & \text{(50.0)} & \text{(55.0)} \\ \text{Additions to product rights and other intangibles} & \text{(40.0)} & \text{(20.0)} & \text{(10.0)} \\ \text{Proceeds from sale of property and equipment} & \text{0.0} & \text{5.0} & \text{5.0} \\ \text{…} & \text{} & \text{} & \text{} \\ \text{…} & \text{} & \text{} & \text{} \\ \textbf{Net cash used in investing activities} & \textbf{(100.0)} & \textbf{(1,000.0)} & \textbf{(75.0)} \\ \end{array} $$

$$ \begin{array}{} \text{Consolidated Balance Sheets} \\ \text{Years ended December 31} \\ \end{array} $$

$$ \begin{array}{l|r|r|r} \begin{array}{l} \textbf{(Dollars in millions except} \\ \textbf{per share amounts)} \end{array} & \textbf{2014} & \textbf{2015} & \textbf{2016} \\ \hline \textbf{assets} & \text{} & \text{} & \text{} \\ \text{…} & \text{} & \text{} & \text{} \\ \text{…} & \text{} & \text{} & \text{} \\ \textbf{Liabilities} & \text{} & \text{} & \text{} \\ \begin{array}{l} \text{(Short-term debt and current} \\ \textbf{portion of long term debt)} \end{array} & \text{60.0} & \text{300.0} & \text{0.0} \\ \text{Long term debt} & \text{800.0} & \text{1,000.0} & \text{1,000.0} \\ \textbf{Equity} & \text{} & \text{} & \text{} \\ \text{Preferred stock} & \text{0.0} & \text{0.0} & \text{0.0} \\ \text{Common stock} & \text{0.4} & \text{0.4} & \text{0.4} \\ \text{Additional paid-in capital} & \text{995.9} & \text{1,686.9} & \text{1,771.8} \\ \text{Retained earnings} & \text{1,418.1} & \text{1,640.1} & \text{1,824.5} \\ \end{array} $$

Profitability ratios

$$ \begin{array}{l|r|r|r} \begin{array}{l} \textbf{(Dollars in millions except} \\ \textbf{per share amounts)} \end{array} & \textbf{2014} & \textbf{2015} & \textbf{2016} \\ \hline \begin{array}{l} \text{Operating profit margin (%)=} \\ \text{Operating income / Revenue} \end{array} & \text{12.2%} & \text{12.1%} & \text{6.4%} \\ \hline \begin{array}{l} \text{EBITDA = Operating income +} \\ \text{Depreciation + Amortization} \end{array} & \text{475.0} & \text{517.5} & \text{505.0} \\ \hline \begin{array}{l} \text{FCF after dividends = Cash flow from} \\ \text{operations – Capital expenditures -} \\ \text{Dividends} \end{array} & \text{325.0} & \text{310.0} & \text{515.0} \\ \end{array} $$

Where Capital expenditures = Additions to property and equipment + Additions to product rights and other intangibles + Proceeds from sale of property and equipment

The operating profit margin declined significantly even though EBITDA and FCF after dividends increased. As a good financial analyst, you might have to go back into the financial statements and look at the reason(s) why there has been such decrease in operating income.

Leverage ratios

$$ \begin{array}{l|r|r|r} \begin{array}{l} \textbf{(Dollars in millions except} \\ \textbf{per share amounts)} \end{array} & \textbf{2014} & \textbf{2015} & \textbf{2016} \\ \hline \text{Debt} & \text{860.0} & \text{1,300.0} & \text{1,000.0} \\ \text{Debt / EBITDA} & \text{1.8x} & \text{2.5x} & \text{2.0x} \\ \hline \text{Capital = Debt + Equity} & \text{3,024.4} & \text{4,407.4} & \text{4,416.7} \\ \text{Debt / Capital (%)} & \text{28.4%} & \text{29.5%} & \text{22.6%} \\ \hline \text{FCF after Dividends / Debt (%)} & \text{37.8%} & \text{23.8%} & \text{51.5%} \\ \end{array} $$

Where Total debt = Short-term debt and current portion of long-term debt + Long term debt

Leverage ratios imply volatility in the capital structure of the company. However, the creditworthiness in 2016 is higher than in 2015 and 2014. This has to do with the fact that the firm completely paid off its short-term debt in 2015, which is a good signal the company is sending to its debt holders.

Coverage ratios

$$ \begin{array}{l|r|r|r} \text{} & \textbf{2014} & \textbf{2015} & \textbf{2016} \\ \hline \text{EBIT / Interest expense} & \text{10.2x} & \text{9.5x} & \text{2.6x}\\ \hline \text{EBITDA / Interest expense} & \text{15.8x} & \text{14.8x} & \text{5.9x} \\ \end{array} $$

Here, we can see that the firm in 2016 is now able to repay a larger percentage of its interest payments with its earnings before interests and taxes. Again, this is a good sign if you were to issue a loan to CVS.

Reading 47 LOS 47h:

Evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial ratios of the issuer and the industry

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