{"id":3504,"date":"2019-09-06T12:00:00","date_gmt":"2019-09-06T12:00:00","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=3504"},"modified":"2025-05-28T09:35:56","modified_gmt":"2025-05-28T09:35:56","slug":"evaluate-credit-quality-corporate-bond","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/fixed-income\/evaluate-credit-quality-corporate-bond\/","title":{"rendered":"The Credit Quality of a Corporate Bond Issuer"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n\n  \"name\": \"Fundamentals of Credit Analysis (2025 Level I CFA\u00ae Exam \u2013 Fixed Income \u2013 Module 6)\",\n  \"description\": \"This video lesson covers credit risk in corporate bonds, including default probability, loss severity, and seniority rankings. It explains credit ratings, the four Cs of credit analysis, financial ratio evaluation, and risks of over-relying on rating agencies. It also discusses factors influencing yield spreads and considerations for high-yield and sovereign debt.\",\n\n  \"uploadDate\": \"2022-06-02T00:00:00+00:00\",\n  \"thumbnailUrl\": \"https:\/\/img.youtube.com\/vi\/zSl9z7qQB00\/hqdefault.jpg\",\n  \"contentUrl\": \"https:\/\/www.youtube.com\/watch?v=zSl9z7qQB00\",\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/zSl9z7qQB00\",\n  \"duration\": \"PT41M06S\"\n}\n<\/script>\n\n\n\n<p>[vsw id=&#8221;zSl9z7qQB00&#8243; source=&#8221;youtube&#8221; width=&#8221;611&#8243; height=&#8221;344&#8243; autoplay=&#8221;no&#8221;]<\/p>\n<p>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:<\/p>\n<ul>\n<li><strong>profitability<\/strong>: calculation of operating profit margin, EBITDA and free cash flow after dividends. (Note that the company did not pay dividends during the years analyzed).<\/li>\n<li><strong>leverage<\/strong>: Analysis of leverage ratios such as Debt\/EBITDA, Debt\/Capital, Free cash flow after dividends\/debt.<\/li>\n<li><strong>coverage<\/strong>: calculation of the interest coverage ratio using both EBIT and EBITDA.<\/li>\n<\/ul>\n<p>$$<br \/>\n\\begin{array}{}<br \/>\n\\text{CSV Speciality Healthcare&#8217;s Financial Statements} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>$$<br \/>\n\\begin{array}{}<br \/>\n\\text{Consolidated Statement of Operations} \\\\<br \/>\n\\text{Years ended December 31} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>$$<br \/>\n\\begin{array}{l|r|r|r}<br \/>\n\\begin{array}{l} \\textbf{(Dollars in millions except} \\\\ \\textbf{per share amounts)} \\end{array} &amp; \\textbf{2014} &amp; \\textbf{2015} &amp; \\textbf{2016} \\\\<br \/>\n\\hline<br \/>\n\\textbf{Net revenues} &amp; \\textbf{2,500.0} &amp; \\textbf{2,750.0} &amp; \\textbf{3,500.0} \\\\<br \/>\n\\textbf{Operating expenses} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{Cost of sales} &amp; \\text{1,500.0} &amp; \\text{1,600.0} &amp; \\text{2,000.0} \\\\<br \/>\n\\text{Research and development} &amp; \\text{175.0} &amp; \\text{200.0} &amp; \\text{300.0} \\\\<br \/>\n\\text{Selling and marketing} &amp; \\text{235.0} &amp; \\text{265.0} &amp; \\text{325.0} \\\\<br \/>\n\\text{General and administrative} &amp; \\text{200.0} &amp; \\text{260.0} &amp; \\text{440.0} \\\\<br \/>\n\\text{Amortization} &amp; \\text{80.0} &amp; \\text{90.0} &amp; \\text{180.0} \\\\<br \/>\n\\text{Loss on asset sales and impairments} &amp; \\text{5.0} &amp; \\text{2.5} &amp; \\text{30.0} \\\\<br \/>\n\\textbf{Total operating expenses} &amp; \\textbf{2,195.0} &amp; \\textbf{2,417.5} &amp; \\textbf{3,275.0} \\\\<br \/>\n\\textbf{Operating Income} &amp; \\textbf{305.0} &amp; \\textbf{332.5} &amp; \\textbf{225.0} \\\\<br \/>\n\\textbf{Other income\/(expense)} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{Interest expense)} &amp; \\text{(30.0)} &amp; \\text{(35.0)} &amp; \\text{(85.0)} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>$$<br \/>\n\\begin{array}{}<br \/>\n\\text{Consolidated Statements of Cash Flows} \\\\<br \/>\n\\text{Years ended December 31} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>$$<br \/>\n\\begin{array}{l|r|r|r}<br \/>\n\\begin{array}{l} \\textbf{(Dollars in millions except} \\\\ \\textbf{per share amounts)} \\end{array} &amp; \\textbf{2014} &amp; \\textbf{2015} &amp; \\textbf{2016} \\\\<br \/>\n\\hline<br \/>\n\\textbf{Cash flows from operating activities} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{Net income} &amp; \\text{250.0} &amp; \\text{220.0} &amp; \\text{180.0} \\\\<br \/>\n\\begin{array}{l} \\textbf{(Reconciliation to net cash provided} \\\\ \\textbf{by operating activities:)} \\end{array} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{Depreciation} &amp; \\text{90.0} &amp; \\text{95.0} &amp; \\text{100.0} \\\\<br \/>\n\\text{Amortization} &amp; \\text{80.0} &amp; \\text{90.0} &amp; \\text{180.0} \\\\<br \/>\n\\text{&#8230;} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{&#8230;} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\begin{array}{l} \\textbf{(Net cash flow provided by} \\\\ \\textbf{operating activities:)} \\end{array} &amp; \\textbf{425.0} &amp; \\textbf{375.0} &amp; \\textbf{575.0} \\\\<br \/>\n\\textbf{Cash flows from investing activities} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{Additions to property and equipment} &amp; \\text{(60.0)} &amp; \\text{(50.0)} &amp; \\text{(55.0)} \\\\<br \/>\n\\text{Additions to product rights and other intangibles} &amp; \\text{(40.0)} &amp; \\text{(20.0)} &amp; \\text{(10.0)} \\\\<br \/>\n\\text{Proceeds from sale of property and equipment} &amp; \\text{0.0} &amp; \\text{5.0} &amp; \\text{5.0} \\\\<br \/>\n\\text{&#8230;} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{&#8230;} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\textbf{Net cash used in investing activities} &amp; \\textbf{(100.0)} &amp; \\textbf{(1,000.0)} &amp; \\textbf{(75.0)} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>$$<br \/>\n\\begin{array}{}<br \/>\n\\text{Consolidated Balance Sheets} \\\\<br \/>\n\\text{Years ended December 31} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>$$<br \/>\n\\begin{array}{l|r|r|r}<br \/>\n\\begin{array}{l} \\textbf{(Dollars in millions except} \\\\ \\textbf{per share amounts)} \\end{array} &amp; \\textbf{2014} &amp; \\textbf{2015} &amp; \\textbf{2016} \\\\<br \/>\n\\hline<br \/>\n\\textbf{assets} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{&#8230;} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{&#8230;} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\textbf{Liabilities} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\begin{array}{l} \\text{(Short-term debt and current} \\\\ \\textbf{portion of long term debt)} \\end{array} &amp; \\text{60.0} &amp; \\text{300.0} &amp; \\text{0.0} \\\\<br \/>\n\\text{Long term debt} &amp; \\text{800.0} &amp; \\text{1,000.0} &amp; \\text{1,000.0} \\\\<br \/>\n\\textbf{Equity} &amp; \\text{} &amp; \\text{} &amp; \\text{} \\\\<br \/>\n\\text{Preferred stock} &amp; \\text{0.0} &amp; \\text{0.0} &amp; \\text{0.0} \\\\<br \/>\n\\text{Common stock} &amp; \\text{0.4} &amp; \\text{0.4} &amp; \\text{0.4} \\\\<br \/>\n\\text{Additional paid-in capital} &amp; \\text{995.9} &amp; \\text{1,686.9} &amp; \\text{1,771.8} \\\\<br \/>\n\\text{Retained earnings} &amp; \\text{1,418.1} &amp; \\text{1,640.1} &amp; \\text{1,824.5} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<h2><strong>Profitability Ratios<\/strong><\/h2>\n<p>$$<br \/>\n\\begin{array}{l|r|r|r}<br \/>\n\\begin{array}{l} \\textbf{(Dollars in millions except} \\\\ \\textbf{per share amounts)} \\end{array} &amp; \\textbf{2014} &amp; \\textbf{2015} &amp; \\textbf{2016} \\\\<br \/>\n\\hline<br \/>\n\\begin{array}{l} \\text{Operating profit margin (%)=} \\\\ \\text{Operating income \/ Revenue} \\end{array} &amp; \\text{12.2%} &amp; \\text{12.1%} &amp; \\text{6.4%} \\\\<br \/>\n\\hline<br \/>\n\\begin{array}{l} \\text{EBITDA = Operating income +} \\\\ \\text{Depreciation + Amortization} \\end{array} &amp; \\text{475.0} &amp; \\text{517.5} &amp; \\text{505.0} \\\\<br \/>\n\\hline<br \/>\n\\begin{array}{l} \\text{FCF after dividends = Cash flow from} \\\\ \\text{operations &#8211; Capital expenditures -} \\\\ \\text{Dividends} \\end{array} &amp; \\text{325.0} &amp; \\text{310.0} &amp; \\text{515.0} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p class=\"Text001\"><em><span lang=\"EN-US\" style=\"background: white;\">Where Capital expenditures = Additions to property and equipment + Additions to product rights and other intangibles + Proceeds from sale of property and equipment<\/span><\/em><\/p>\n<p class=\"Text001\">The operating profit margin declined significantly even though EBITDA and FCF increased after dividends. As a good financial analyst, you might have to go back into the financial statements and look at the reason(s) behind the decrease in operating income.<\/p>\n<h2><strong>Leverage Ratios<\/strong><\/h2>\n<p>$$<br \/>\n\\begin{array}{l|r|r|r}<br \/>\n\\begin{array}{l} \\textbf{(Dollars in millions except} \\\\ \\textbf{per share amounts)} \\end{array} &amp; \\textbf{2014} &amp; \\textbf{2015} &amp; \\textbf{2016} \\\\<br \/>\n\\hline<br \/>\n\\text{Debt} &amp; \\text{860.0} &amp; \\text{1,300.0} &amp; \\text{1,000.0} \\\\<br \/>\n\\text{Debt \/ EBITDA} &amp; \\text{1.8x} &amp; \\text{2.5x} &amp; \\text{2.0x} \\\\<br \/>\n\\hline<br \/>\n\\text{Capital = Debt + Equity} &amp; \\text{3,024.4} &amp; \\text{4,407.4} &amp; \\text{4,416.7} \\\\<br \/>\n\\text{Debt \/ Capital (%)} &amp; \\text{28.4%} &amp; \\text{29.5%} &amp; \\text{22.6%} \\\\<br \/>\n\\hline<br \/>\n\\text{FCF after Dividends \/ Debt (%)} &amp; \\text{37.8%} &amp; \\text{23.8%} &amp; \\text{51.5%} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p class=\"Text001\"><em><span class=\"Style2AltBaslikChar\"><span lang=\"EN-US\">Where Total debt = Short-term debt and current portion of long-term debt + Long term debt<\/span><\/span><\/em><\/p>\n<p class=\"Text001\">Leverage ratios imply volatility in the capital structure of the company. However, the creditworthiness in 2016 is the highest compared to 2015 and 2014. This is attributable to the fact that the firm completely paid off its short-term debt in 2015. This should send a good signal to its debtholders.<\/p>\n<h2><strong>Coverage Ratios<\/strong><\/h2>\n<p>$$<br \/>\n\\begin{array}{l|r|r|r}<br \/>\n\\text{} &amp; \\textbf{2014} &amp; \\textbf{2015} &amp; \\textbf{2016} \\\\<br \/>\n\\hline<br \/>\n\\text{EBIT \/ Interest expense} &amp; \\text{10.2x} &amp; \\text{9.5x} &amp; \\text{2.6x}\\\\<br \/>\n\\hline<br \/>\n\\text{EBITDA \/ Interest expense} &amp; \\text{15.8x} &amp; \\text{14.8x} &amp; \\text{5.9x} \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>The lower the coverage ratio, the greater the company\u2019s debt and the possibility of bankruptcy. A lower ratio indicates that the firm has less operating profits to meet interest payments.<\/p>\n<p>Note that both coverage ratios have decreased from 2014 to 2016. We can, therefore, deduce that the firm\u2019s creditworthiness has declined between 2014 and 2016.<\/p>\n<p>The decline in the ratios indicates that the growth in EBIT and EBITDA are not keeping pace with the rising interest expense.<\/p>\n<p>Therefore, the firm is repaying a larger portion of interest expenses in 2016 compared to the previous two years and is as such more prone to bankruptcy.<\/p>","protected":false},"excerpt":{"rendered":"<p>[vsw id=&#8221;zSl9z7qQB00&#8243; source=&#8221;youtube&#8221; width=&#8221;611&#8243; height=&#8221;344&#8243; autoplay=&#8221;no&#8221;] 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&#8230;<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[9],"tags":[],"class_list":["post-3504","post","type-post","status-publish","format-standard","hentry","category-fixed-income","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Evaluate Creditworthiness of a Company | CFA Level 1<\/title>\n<meta name=\"description\" content=\"Learn how to evaluate the credit quality of a corporate bond. 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