The relation of credit risk rating with financial ratios in Australia

Credit risk

A credit rating is an assessment of a borrower’s credit worthiness or their ability to repay a debt or their likelihood of defaulting.  Self-regulating organizations called credit rating agencies to evaluate borrowers to determine their credit rating. A credit rating may furnish an investor with one indicator as to the relative risk of investing in a bond or hybrid security. Simply put, lower the credit rating, greater the risk to the investor. When considering the credit rating on a bond or hybrid security, an investor should look at the following:

    • the credit rating of the issuer;
    • the complexity of the product; and
    • the credit rating of the security.

Australia Ratings allocates ratings to segregate the level of creditworthiness of companies and fixed income products existing in the Australian financial market to investors. Credit ratings are given on a different scale: a long-term and short-term rating scale. A long-term rating is assigned where the investment period of financial exposure is greater than 12 months. A short-term rating is assigned where the term of the debt security is less than 12 months.

Australia Ratings Product Complexity Indicator (PCI) is shown next to a credit rating to aid in separating debt securities which may have comparable credit characteristics. PCI assists to render investors with certain observations into a security’s terms and conditions that could possibly influence such an investment’s return.

Credit risk rating and financial ratios:

Cash Flow/Leverage
The form of cash flow generation, current and future, in context to cash obligations is the best gauge of a company’s financial risk. A variety of credit ratios, predominately cash flow-based, which complement each other by focusing on the different levels of a company’s cash flow waterfall in relation to its obligations. For instance, it could be before and after working capital investment, before and after capital expenditures or before and after dividends. For the analysis of companies with intermediate or stronger cash flow/leverage assessments (a measure of the relationship between the company’s cash flows and its debt obligations), cash flows are evaluated that reflect the considerable flexibility and discretion over outlays that such companies typically possess. For these entities, the starting point in the analysis is cash flows before working capital changes plus capital investments in relation to the size of a company’s debt obligations in order to assess the relative ability of a company to repay its debt. These “leverage” or “payback” cash flow ratios are a measure of how much flexibility and capacity the company has to pay its obligations. For entities with significant or weaker cash flow/leverage assessments, evaluation of cash flows is evaluated in relation to the carrying cost or interest burden of a company’s debt. This will help assess a company’s relative and absolute ability to service its debt. These “coverage”- or “debt service”- based cash flow ratios are a measure of a company’s ability to pay obligations from cash earnings and the cushion the company possesses through stressful periods.

Assessing cash flow/leverage
Cash flow/leverage is assessed as minimal, modest, intermediate, significant, aggressive or, highly leveraged. To arrive at these assessments, the assessments combine a variety of credit ratios, primarily cash flow-based, which complement each other by focusing attention on the different levels of a company’s cash flow waterfall in context to its commitments. The final cash flow/leverage assessment is derived for a company by determining the relevant core ratios, anchoring a preliminary cash flow assessment based on the relevant core ratios, determining the relevant supplemental ratio(s), adjusting the preliminary cash flow assessment according to the relevant supplemental ratio(s),and, finally, modifying the adjusted cash flow/leverage assessment for any material volatility.

Core and supplemental ratios

Core ratios
For each company, two core credit ratios are calculated –funds from operations (FFO) to debt and debt to EBITDA. These payback ratios are compared against benchmarks to derive the preliminary cash flow/leverage assessment for a company. These ratios are also useful in determining the relative ranking of the financial risk of companies.

Supplemental ratios
Supplemental ratios could either confirm or adjust the preliminary cash flow/leverage assessment. The confirmation or adjustment of the preliminary cash flow/leverage assessment will depend on the importance of the supplemental ratios as well as any difference in indicative cash flow/leverage assessment between the core and supplemental ratios. Five standard supplemental ratios are typically considered. The standard supplemental ratios comprise of three payback ratios–cash flow from operations (CFO) to debt, free operating cash flow (FOCF) to debt, and discretionary cash flow (DCF) to debt–and two coverage ratios, FFO plus interest to cash interest ratio and EBITDA to interest ratio.

For working-capital-intensive companies, EBITDA and FFO overstate financial strength, and CFO may be a more accurate measure of the company’s cash flow in relation to its financial risk profile. If a company has a working capital-to-sales ratio that exceeds 25% or if there are significant seasonal swings in working capital, generally it is considered to be working-capital-intensive. For these companies, the more emphasis is placed on the supplementary ratio of CFO to debt. Examples of companies that have working-capital-intensive characteristics can be found in the capital goods, metals and mining downstream, or the retail and restaurants industries. The need for working capital in those industries reduces financial flexibility and, therefore, these supplemental leverage ratios take on more importance in the analysis.

The other ratios that carry significant weight in the determination of credit ratings are Profitability, size and leverage ratios.

Size: Size is a variable that is correlated with many financial statements inputs and the quality of financial statements.

Profitability: The focus of most shareholders is on the profit of the company and ultimately the returns available to them.

Leverage: The capital structure of the firm is considered to be a key indicator of the fundraising capacity of the firm. It measures the ability to withstand unforeseen circumstances.

Interest Cover: The ability of the firm to service its debt on a timely basis out of the profit of the firm is very important in assessing its creditworthiness.

Growth: It is prudent to examine statistically whether the dynamics of the firm behaviour is related to future default behaviour.

Activity: The firm’s activity is measured by considering the stock turnover of the firm.

Liquidity: There may be many liquidity ratios, differing simply on the weight assigned to the different types of current assets.