Financial ratios for credit rating analysis usually focus on answering the question “how can the company generate sufficient cash flow to finance its obligations”. It compares two metrics: the company’s ability to generate cash and the company’s liabilities (interest and debt).
Before presenting what financial ratios are used, let’s discuss what a credit rating is and what credit risk is.
What is a credit rating?
The credit rating (credit rating) is a metric to reflect the feasibility and the credit quality of the issuer of debt securities. It is issued by credit rating agencies, of which the three world-famous ones are Standard & Poor’s, Moody’s, and Fitch. Meanwhile, the issuer of debt securities can come from companies, the national government or local governments. In this article, I focus on a company’s credit rating.
The ratings are divided into several categories. It may be for long term or short term ratings, each has its own code. Likewise, codes for credit tiers also vary between government agencies.
AAA or equivalent code is the highest rating. It shows the best creditworthiness. Meanwhile, D is the lowest rating, indicating the debt issuer is in default.
And, in general, credit ratings can be grouped into two broader classes:
- Investment grade includes a rating of BBB- to AAA or equivalent. The issuer has relatively good creditworthiness. Thus, when they issue debt securities, they can obtain a lower cost of funds than the non-investment grade rating.
- Non-investment grade includes ratings below BBB-. Debt securities or bonds with these ratings are often referred to as junk bonds, high-yield bonds, and speculative bonds.
What is credit risk?
Credit risk reflects uncertainty about the company’s ability and willingness to fulfill its contractual obligations. Meanwhile, for creditors or debt securities holders, the risk they bear if the borrower cannot make payments on time is called the risk of default. Thus, higher credit risk leads to a higher default risk. Borrowers with these characteristics will have a low rating.
The company’s credit risk comes from two aspects: business risk and financial risk. From these two aspects, credit analysts then describe them into several indicators to measure, both quantitatively and qualitatively.
Business risk (business risk) associated with the uncertainty in the realization of earnings and future cash flows due to factors other than financial leverage. Rather, it is related to the company’s business operating activities. Several factors influence this risk, including:
- Market position
- Income diversification
- Income diversification
- Competitive dynamics
- Macroeconomic conditions
Financial risks (financial risk) associated with the uncertainty in the realization of profits and cash flow due to factors associated with financial leverage. It involves financial loss or gain. It can usually be measured by several financial metrics to measure its capital structure, solvency, liquidity and profitability.
What are the financial ratios for a company’s credit rating analysis?
Credit analysts evaluate a company’s credit risk profile and creditworthiness to establish a credit rating. Creditworthiness indicates the company’s ability and willingness to fulfill its contractual obligations in the future.
From business and financial risks, analysts outline several indicators for analysis. In addition, for the global ranking, the country’s rating (sovereign rating) is also considered. And, this article does not cover all of those indicators. Instead, here, I will only review some financial ratios for company credit rating analysis, including:
- Debt to Capital
- FFO to debt
- Debt to EBITDA
- FFO to cash interest
- EBITDA to interest
- CFO to debt
- FOCF to debt
Debt to Capital
In financing its operations and growth, companies depend on capital. It comes from two sources: debt capital and equity capital.
Debt to capital tells us how dependent a company is on debt capital. High debt has implications for high financial leverage, which reflects high credit risk.
Debt capital has regular outflow consequences. The company must pay interest periodically. And, at maturity, they must pay the principal debt. Such payments they have to make even when they are not generating income.
Meanwhile, equity capital represents ownership in the company. We call the suppliers the shareholders or owners.
Then, we divide the total interest-bearing debt (short term and long term) by the total capital to calculate the debt to capital ratio. To get the total capital, we add up the total debt with the total shareholders’ equity. We can find both on the balance sheet. Meanwhile, the debt to capital formula is as follows:
- Debt to capital = Total debt / (Total debt + Total equity)
A higher debt to capital ratio indicates a higher credit risk. Therefore, it is frowned upon because it indicates the company is taking on more debt, which results in higher interest and principal payments. Conversely, a lower ratio means the company is less dependent on debt.
Credit analysts may still be able to tolerate high debt to capital if the company is able to generate sufficient and regular cash. Thus, they can pay their contractual obligations on time.
FFO to debt
Funds from operations (FFO) is an alternative to cash from operations (CFO). FFO measures the ability to generate recurring cash flows. However, compared to CFO, FFO is more subtle because it represents the cash flow available to the company before adjusting for expenses for routine operations and to grow the business in the future such as working capital, capital expenditures, and discretionary items such as dividends and acquisitions.
- FFO to debt (%) = FFO / Total debt
A higher FFO to debt ratio is preferable because the company posted a higher FFO relative to total debt. In other words, the company makes more money than it takes on debt.
Debt to EBITDA
EBITDA is a metric to measure company profits. However, analysts often use it to indicate the money a company is making. Different from net income, EBITDA adjusts earnings for non-cash items such as depreciation and amortization expenses. So, it can indicate the money the company makes before paying interest and taxes.
- Debt to EBITDA (x) = Total debt / EBITDA
So, debt to EBITDA(x) shows us how many times the company’s total debt is compared to the money it generates. For example, a debt to EBITDA ratio equal to 2x means the company has to raise twice the current amount to be able to pay off debt.
Since we use EBITDA as the denominator, a lower ratio is preferred, indicating the higher the company’s ability to pay off its debts. Usually, a ratio higher than 3xbecomes an alarm.
FFO to cash interest
FFO to cash interest compares the money a company makes from operations with interest payments. It shows us how many times the money made is compared to the money to pay interest.
Cash interest excludes non-cash interest paid on, for example, payment-in-kind instruments. So, it only covers cash interest payments.
- FFO to Cash interest (x) = FFO / Cash Interest
A higher ratio is more desirable. Companies make more money relative to money to pay interest expense.
EBITDA to interest
EBITDA to interest is similar to FFO to cash interest. Both measure how easily a company can pay interest on debt. But, instead of using a metric in the cash flow statement, we use a measure from the income statement , namely EBITDA, which is a proxy for how much money a company makes.
- EBITDA to interest (x) = EBITDA / Interest expense
A higher EBITDA to interest ratio is preferable because it indicates a better ability to pay interest. But, as with any ratio, the ideal ratio varies between industries.
In addition, some analysts may use EBIT instead of EBITDA. So, we calculate the ratio by dividing EBIT by interest expense.
- EBIT to interest expense = EBIT / Interest expense
Like EBITDA to interest, a higher ratio is more desirable because it indicates a better ability to pay interest.
CFO to debt
CFO to debt measures what percentage of the money generated from operations can cover the company’s total debt. Different from FFO, CFO is pure cash obtained from operations because it does not take into account capital expenditures. So, it assumes the company does not set aside funds to finance capital investment to grow the business in the future.
- CFO to debt (%) = CFO / Total debt
A higher CFO to debt is preferred. Since using CFO as the numerator, assuming both items increase, it means the company is making more money than its debt increases. Thus, the company generates more money to pay off debt.
FOCF to debt
Free operating cash flow (FOCF) measures money from operating activities after deducting capital expenditures. Sometimes we also refer to it as free cash flow (FCF). We calculate the ratio by dividing the FOCF by the total debt.
- FOCF to debt (%) = FOCF / Total debt
A higher FOCF is more desirable. It shows the company has cash remaining after paying expenses to finance operations and future growth, which can be used to pay off debt.