Financial ratios in credit analysis

Which ratios tell you whether a company can carry its debt?

Credit analysts boil a company down to three questions and a small set of ratios. Is it profitable enough? Do its earnings cover the interest? Is the debt a reasonable multiple of what it earns or generates in cash? The ratios below answer those three questions, using figures from the income statement, balance sheet and cash flow statement.

Credit ratiosprofitability, coverage, leverage

• Profitability Memorize higher is better
  • EBIT margin Memorize EBIT ÷ revenue
• Coverage Memorize higher is better
  • EBIT to interest expense Memorize EBIT ÷ interest expense
• Leverage Memorize read the direction of each ratio
  • Debt to EBITDA Memorize debt ÷ EBITDA; LOWER is better
  • RCF to net debt Memorize (CFO − dividends) ÷ (debt − cash); higher is better
  • FFO to debt Use it FFO ÷ debt; higher is better

Two cautions apply to all of them. These are not measures defined by International Financial Reporting Standards (IFRS): names and definitions vary between analysts and agencies, so check the definition before comparing sources. And debt and interest are often adjusted to include operating leases and other debt-like obligations. Always compare a ratio with industry and rating peers, because acceptable levels differ widely across industries.

How do you measure profitability and coverage?

EBIT margin shows how much operating profit each unit of revenue produces. Analysts use EBIT, earnings before interest and taxes, because it is the profit available before paying lenders (interest comes out before tax is calculated). Higher margins leave more profit to service debt.

$$\text{EBIT margin} = \dfrac{EBIT}{\text{Revenue}}$$

EBIT to interest expense is the coverage ratio: how many times operating profit covers the interest due. The higher it is, the lower the credit risk. A variant uses earnings before interest, taxes, depreciation and amortization (EBITDA) in the numerator, or adds lease payments to the denominator, but the base version is EBIT over interest.

$$\text{Coverage} = \dfrac{EBIT}{\text{Interest expense}}$$

How do you measure leverage?

Leverage ratios put debt on one side and earnings or cash flow on the other. Read the direction carefully: with debt on top, a higher number means more leverage.

EBITDA adds the non-cash charges back to EBIT, giving a broader measure of operating earnings:

$$EBITDA = EBIT + D\&A$$

D&A is depreciation and amortization.

Debt to EBITDA says how many years of EBITDA it would take to pay off the debt. Rating agencies often use it as a trigger for rating actions, and banks write it into loan covenants. A higher ratio is worse. It can be very volatile for cyclical companies and those with high fixed costs, because EBITDA swings.

$$\dfrac{\text{Debt}}{EBITDA} = \dfrac{\text{Debt}}{EBIT + D\&A}$$

What are the cash-flow measures?

Earnings can be flattered by accounting choices. Cash-flow measures are more conservative because they subtract cash the business must spend or pay out. Three appear in the curriculum.

Cash-flow measuresmore conservative than earnings

• Funds from operations (FFO) Use it net income from continuing operations + D&A + deferred tax + other non-cash items
• Retained cash flow (RCF) Memorize cash flow from operations − dividends
• Free cash flow (FCF) Know the idea net income − working capital increase − fixed-asset investment − net interest paid

Retained cash flow (RCF) is cash flow from operations less dividends: the cash left in the business. Net debt is debt less cash and marketable securities, because that cash could repay debt.

$$RCF = CFO - \text{dividends paid}$$

$$\text{Net debt} = \text{Debt} - \text{cash and securities}$$

RCF to net debt divides one by the other. Unlike debt to EBITDA, a higher figure means lower leverage.

$$\dfrac{RCF}{\text{Net debt}} = \dfrac{CFO - \text{dividends}}{\text{Debt} - \text{cash}}$$

Funds from operations (FFO) starts from net income from continuing operations and adds back the non-cash items. FFO to debt uses gross debt, and again higher is better.

$$FFO = NI_{cont} + D\&A + DT + NC$$

Here $NI_{cont}$ is net income from continuing operations, DT is deferred income tax and NC is other non-cash items.

$$\dfrac{FFO}{\text{Debt}}$$

Free cash flow (FCF) appears in the curriculum as net income less working capital increases, investment in fixed assets and net interest paid. Know the idea (cash left after running and maintaining the business); you are unlikely to compute it here.

$$FCF = NI - \Delta WC - \text{capex} - I_{net}$$

Here $\Delta WC$ is the increase in working capital, capex is investment in fixed assets and $I_{net}$ is net interest paid.

Worked example: Calderon Tools

Exam tip Put the answer’s direction in your head before you calculate: coverage, margin and cash-flow ratios up is good; debt to EBITDA up is bad.

What happens in a downside case?

Analysts do not stop at today’s numbers. They model a downside case and watch which ratios break first.

Go deeper Leases, EBITDAR and lease-adjusted debt

A company that rents its aircraft, stores or ships carries fixed obligations that look like debt. To compare it fairly with a company that owns them, analysts may add capitalized leases to debt, add lease payments to interest, or use EBITDAR (EBITDA before rental expense) in the numerator. The adjustments change every ratio, which is another reason to check definitions before comparing two sources.

Go deeper Why debt to EBITDA is volatile for cyclical companies

A cyclical company with high fixed costs sees profits swing sharply with sales. EBITDA may halve in a recession while debt stays the same, so debt to EBITDA can double within a year. Analysts therefore look at the ratio through a full cycle, and covenants set on it can be tripped by a downturn.

Go deeper How agencies turn ratios into ratings

Rating agencies publish ranges for each ratio by industry and rating category, and weigh them alongside business risk, governance and the other qualitative factors. A ratio that looks strong for one industry can be average for another, which is why the exam asks you to compare companies in the same industry and why you should not memorize universal cut-offs.