Assessing the Credit Quality

An investor will generally analyse a company for an equity investment or a potential debt investment. With respect to debt investment, the investor is interested in assessing the credit quality, i.e., the ability of the company to meet its interest and principal repayments on schedule. The investor would be interested in positive future cash flows. The investor will also be interested in understanding how these cash flows may vary and how the company will manage in situations of cash crunch.

The “four C’s of credit” provide an analytical framework evaluating the credit quality of a company.

  • Character: This is an interpretation of managerial ability.  Does the company have a sound strategy?  Is the company financially conservative?  Does leadership respond effectively to a changing business environment?  Etc.
  • Capacity: This is an evaluation of the company’s ability to generate sufficient cash flows to service debt on time.
    • In analyzing “capacity”, an analyst will look at profitability ratios, liquidity ratios and solvency ratios (including interest coverage ratios).
    • Discretionary Cash Flow = Cash Flow from Ops – CapEx – Cash Dividend
    • Analysts will also want to look for off-balance sheet financing techniques, such as the use of operating leases, and also understand the frequency and application of short term debt financing.
  • Collateral: This is an evaluation of the quality of a company’s assets.  Are the assets sufficiently valuable and liquid enough to serve as borrowing collateral?  Can the assets be sold in order to return funds in the event of default?

  • Covenants: The analyst will need to ensure that the bond indenture contains terms that will facilitate debt payment.

    • Affirmative covenants: Borrower promises to lenders.
    • Negative covenants: Constrain borrow activities.
    • Common tests included in bond covenants include:
  • Maintenance test: Specifies minimum interest coverage ratios.

  • Working capital requirements: Specify minimum levels of working capital.

  • Cash flow test: Specify minimum cash flow levels.

  • Debt incurrence test: Restricts a company from issuing new debt unless interest coverage exceeds a specified level.

  • Restricted subsidiaries are subsidiaries must be consolidated with the parent for the above covenant tests.

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