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.
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.
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.
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 55 LOS 55h:
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