Financial Ratios Used in Credit Analysis

Key credit analysis measures fall into 4 different groups:

Profitability and Cash Flows

It is from operating cash flows that companies can service their debt payments. The operating income can be obtained by subtracting operating expenses from operating revenues, and it is commonly referred to as “earnings before interest and taxes” (EBIT). Below are other cash flow measures that are equally important and analysts should look at:

• earnings before interest, taxes, depreciation, and amortization (EBITDA);
• funds from operations (FFO): FFO as Net income from continuing operations plus depreciation, amortization, deferred income taxes, and other non-cash items;
• free-cash flow before dividends: net income plus depreciation and amortization excluding non-cash working capital and capital expenditures; and
• free-cash flow after dividends: free cash flow before dividends minus the dividends paid to shareholders.

Leverage Ratios

• Debt/Capital: where capital is total debt plus shareholder’s equity. A higher ratio implies more leverage and thus higher credit risk.
• Debt / EBITDA: this is a very common leverage measure. A higher ratio implies more leverage and thus higher credit risk.
• FFO / Debt: credit rating agencies often use this leverage ratio. Since debt is in the denominator here, a higher ratio means a greater ability to pay debts.

Coverage Ratios

Coverage ratios measure the issuer’s ability to meet or “cover” its interest payments.

• EBITDA/Interest expense
• EBIT/Interest expense: EBIT does not include depreciation and amortization, and it is considered a more conservative measure of interest coverage.

The Issuer’s Liquidity

While assessing an issuer’s liquidity, credit analysts tend to also look at the following:

• cash on the balance sheet
• net working capital
• operating cash flow
• committed bank lines
• debt coming due and committed capital expenditures

Question

Which of the following is a conservative coverage measure in credit analysis?

1. FFO/Debt.
2. EBIT/Interest expense
3. Free cash flow before interest

Solution

The correct answer is B.

Coverage ratios measure the issuer’s ability to meet or “cover” its interest payments. EBIT/Interest expense is a conservative measure of interest coverage since at times it does not account for the repayment of capital and excludes depreciation and amortization.