R 3 = Ratios, Ratings, & Reference

Disclaimer

BRASS Program, ALA Annual Conference
June 26, 1995


Using Financial Ratios in the Credit Rating Process

M. Alexander Simic
Director, European Corporate Ratings



Goal of Credit Analysis

Determine if projected cash flow is sufficient to make timely:

  • Interest payments
  • Principal payments


Analyze Cash Flow Along Four Parameters

Strength

  • The amount of cash thrown off by core operations.
  • Refers to the ability of the firm to generate excess internal cash for investments, debt reduction and dividend payments.


Volatility

  • Sensitivity of cash flow to changes in the economy and interest rates.
  • Identify the potential range of cash flow and anticipate when the highest and lowest levels are likely to occur.


Predictability

  • Cash flow variation above and beyond what is expected from typical business cycles.


Restrictions

  • Debt covenants
  • Regulatory requirements
  • Government laws


Factors Impacting Projected Cash Flow

  • Management
  • Operating strategy
  • Financial condition


Management

  • Exposure to a bus accident
  • Honeymoon period
  • Experience and skills


Operating Strategy

Competitive Strategy

  • Low cost
  • Differentiation
  • Focus


Industry Threats

  • New entrants
  • Substitution
  • Supplier power
  • Buyer power
  • Industry rivalry


Financial Position

Trends in revenues and sources
(Sustainability of cashflows)

  • % Revenue growth
  • Source of revenue growth or decline


Profitability
(Ability to control expenses)

  • Gross margin
  • Operating profit margin
  • Net margin


Liquidity
(Ability to meet short-term obligations)

  • Current ratio
  • Quick ratio
  • Amount of balance sheet cash
  • Availability under committed bank lines


Working Capital Management
(Management of trade accounts and financing)

  • Days receivable
  • Days inventory
  • Days payable
  • Days accrual


Other

  • Return on assets
  • Return on equity
  • Dividend policy


Leverage
(Fixed payment obligation and access to capital)

  • Magnitude of debt size
    • Debt equity
    • Debt capital
    • Debt/Free cash flow
  • Debt Burden
    (Ability to repay interest with internally generated cash flow.)
    • Interest coverage
    • Fixed charge coverage


Why Calculate Financial Ratios?

  • Comparison to peer group
  • Historical time series analysis


Limitations of Financial Ratios

  • Subject to accounting distortions
  • Restrictions
  • Timing Issues
  • Business cycle
  • Product life cycle
  • Point in time
  • Historical focus
  • Indirect measurement


Misperceptions about Repayment Ability

The Kroger Company
$ in millions 1990 1991 1992 1993
Debt 4,654.3 4,488.0 4,553.5 4,206.0
Equity -2.9 -2.7 -2.7 -2.5
Debt/Equity -162,712% -163,250% -168,649% -171,002%
Debt/Capital 100.1% 100.1% 100.1% 100.1%
Free Cash Flow* 842 775 766 631
Interest 564 535 475 390
*Before interest expense and non-recurring items.

Distortion caused by firms with negative equity balances.

Historical Inconsistency

General Motors Corp.(with GMAC on an equity Basis)
$ millions 1991 1992
Debt 8,817 8,253
Equity* 27,328 6,226
Debt/equity 32% 133%
Debt/capital 24% 57%
*The 1992 equity balance include a $20.8 billion charge related to SFAS No. 106.

Distortion caused by adoption of SFAs no. 106 Employers Accounting for Post Retirement Benefits Other than Pensions.

Competitive Non-Comparability

Dayton Hudson Sears
Consol. Retail
1992 1992 1992
Debt 4,724 18,343 12,638
Equity 2,486 10,773 3,110
Debt/Equity 190% 170% 406%
Debt/Capital 66% 63% 80%


Distortion caused by the adoption of SFAS No. 94 Consolidation of all Majority-Owned Subsidiaries.

Limitations of Financial Ratios

Subject to accounting distortions

  • Restrictions
  • Timing issues
  • Business cycle
  • Product life cycle
  • Point in time
  • Historical focus


Summary

  • Ratios are widely used to gain insights to the financial condition of a firm
  • Subject to limitations
  • Not a substitute for a thorough credit analysis



bulletR 3 = Ratios, Ratings, & Reference
BRASS Program, ALA Annual Conference, June 26, 1995



Disclaimer: This publication has been placed on the web for the convenience of BRASS members. Information and links will not be updated. Posted 23 May 1997.