Credit Analysis for Corporate Issuers

Fixed Income

Assessing Corporate Creditworthiness

Learning Outcome Statement:

describe the qualitative and quantitative factors used to evaluate a corporate borrower’s creditworthiness

Summary:

The assessment of corporate creditworthiness involves both qualitative and quantitative factors. Qualitative factors include the business model, industry dynamics, competitive forces, and corporate governance, which influence a company's ability to meet debt obligations. Quantitative factors involve financial statement analysis and forecasting, focusing on profitability, liquidity, leverage, and coverage metrics to evaluate the company's capacity to service its debt.

Key Concepts:

Business Model and Industry

The business model and industry in which a company operates determine its revenue stability and growth prospects. Factors such as demand predictability, asset quality, and industry competition impact the company's ability to generate consistent cash flows to cover debt obligations.

Competitive Forces and Business Risks

A company's competitive position and the risks it faces from market and technological changes affect its creditworthiness. Companies in industries with high barriers to entry and less competition are generally seen as having lower credit risk.

Corporate Governance

Effective corporate governance, including management's treatment of debt holders and adherence to covenants, plays a crucial role in assessing credit risk. Management's track record and transparency are critical factors.

Financial Ratios

Key financial ratios such as debt-to-EBITDA, EBIT margin, and coverage ratios like EBITDA/interest are used to quantitatively assess a company's financial health and its ability to service debt.

Seniority of Debt

The priority of debt claims in the capital structure affects the loss given default. Senior secured debt has lower credit risk compared to junior or subordinated debt due to its higher claim on assets.

Formulas:

Debt-to-EBITDA Ratio

\text{Debt-to-EBITDA Ratio} = \frac{\text{Total Debt}}{\text{EBITDA}}

This ratio measures a company's ability to pay off its incurred debt and is a common measure of leverage and financial health.

Variables:

$Total Debt$ :: Total borrowings of the company
$EBITDA$ :: Earnings before interest, taxes, depreciation, and amortization

Units: dimensionless

EBITDA to Interest Coverage Ratio

\text{EBITDA to Interest Coverage Ratio} = \frac{\text{EBITDA}}{\text{Interest Expenses}}

This ratio indicates how easily a company can pay interest on its outstanding debt with its earnings before interest, taxes, depreciation, and amortization.

Variables:

$EBITDA$ :: Earnings before interest, taxes, depreciation, and amortization
$Interest Expenses$ :: Total interest expenses for the period

Units: dimensionless

Financial Ratios in Corporate Credit Analysis

Learning Outcome Statement:

calculate and interpret financial ratios used in credit analysis

Summary:

This LOS focuses on the use of financial ratios to assess the creditworthiness of corporate issuers. It covers the calculation and interpretation of key financial ratios such as profitability, coverage, and leverage, which help in evaluating a firm's ability to service its debt. The content also discusses the impact of various business and economic factors on these ratios and their implications for credit risk assessment.

Key Concepts:

Profitability Ratios

These ratios, such as EBIT Margin, measure a company's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period. A higher profitability ratio indicates a more financially healthy company capable of meeting debt obligations.

Coverage Ratios

Coverage ratios, like EBIT to Interest Expense, assess a company's ability to meet its debt obligations. They compare income or cash flows to debt service requirements. Higher coverage ratios signify lower credit risk.

Leverage Ratios

Leverage ratios, such as Debt to EBITDA, evaluate the degree of a company's financial leverage relative to its earnings. These ratios help understand how much the company relies on debt to fund its operations. A higher leverage ratio indicates higher credit risk.

Formulas:

EBIT Margin

\text{EBIT Margin} = \frac{\text{Operating Income}}{\text{Revenue}}

This ratio indicates the percentage of revenue that remains after covering operating expenses, excluding interest and taxes.

Variables:

$Operating Income$ :: Income from operations before interest and taxes
$Revenue$ :: Total revenue generated from sales

Units: Percentage (%)

EBIT to Interest Expense

\text{EBIT to Interest Expense} = \frac{\text{Operating Income}}{\text{Interest Expense}}

This ratio measures how many times a company can cover its interest expense with its operating income. Higher values indicate better ability to service debt.

Variables:

$Operating Income$ :: Income from operations before interest and taxes
$Interest Expense$ :: Total interest expenses

Units: Times

Debt to EBITDA

\text{Debt to EBITDA} = \frac{\text{Debt}}{\text{EBITDA}}

This ratio shows how many years it would take for a company to pay back its debt if EBITDA and debt are held constant. Higher ratios indicate higher leverage and greater credit risk.

Variables:

$Debt$ :: Total debt
$EBITDA$ :: Earnings before interest, taxes, depreciation, and amortization

Units: Ratio

Seniority Rankings, Recovery Rates, and Credit Ratings

Learning Outcome Statement:

Describe the seniority rankings of debt, secured versus unsecured debt and the priority of claims in bankruptcy, and their impact on credit ratings.

Summary:

This LOS explores the concepts of seniority rankings, secured versus unsecured debt, recovery rates, and credit ratings. It explains how the priority of claims in bankruptcy affects the recovery rates and credit ratings, illustrating the differences in risk and potential recovery associated with various types of debt.

Key Concepts:

Seniority Rankings

Seniority rankings determine the order in which creditors are paid in the event of a borrower's default. Secured debts, such as first lien and senior secured debts, have higher priority and thus lower loss given default (LGD) compared to unsecured debts like senior unsecured or subordinated debts.

Secured versus Unsecured Debt

Secured debt is backed by collateral, giving lenders a direct claim on specific assets, which provides a higher recovery rate in default scenarios. Unsecured debt lacks this collateral backing, resulting in a lower recovery rate and higher credit risk.

Recovery Rates

Recovery rates indicate the percentage of the principal amount that creditors recover in the event of default. These rates vary significantly based on the seniority of the debt and the industry of the issuer. Secured debts generally have higher recovery rates than unsecured debts.

Credit Ratings

Credit ratings assess the creditworthiness of issuers and individual debt issues, reflecting the likelihood of default and potential losses. Ratings consider factors like the type of debt (secured or unsecured), seniority, and structural subordination within the issuer's capital structure.

Formulas:

Expected Loss (EL)

EL = POD \times LGD

This formula calculates the expected credit loss by multiplying the probability of default by the loss given default. It is used to estimate potential losses on debt instruments based on their credit risk characteristics.

Variables:

$EL$ :: Expected loss
$POD$ :: Probability of default
$LGD$ :: Loss given default

Units: percentage

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