Particularly in assessing the quality of bank lines the presence of “material adverse change” clauses is important. Such a provision enables the lender to hold back or cancel earlier committed bank lines if the borrower’s financial condition or operational position has deteriorated significantly and the circumstances which led to the new situation were previously unknown.
The following factors have to be considered in the analysis:
- The issuer’s cash flows matched against its short-term debt maturity profile
- The issuer’s ability to manage its working capital and capital spending
- Funding diversity through regular global market access and/or securitizations.
The rating agencies emphasize the liquidity situation of an issuer in their credit rating assessment. Especially cyclical companies can experience short-term liquidity problems, which can lead to financial distress, particularly if a company relies heavily on short-term debt. An appropriate cash management is an important factor for the success of a company. In general, every company has to find a match between its investment function and financing function.
Liquidity is a measure of a company’s financial flexibility. It has to be acknowledged that liquidity profiles can vary significantly across different industries. In general a company has four options to repay maturing debt:
- Cash position
- Operating cash flow
- Refinancing
- Asset sales.
The following points have to be considered when evaluating the liquidity position of an issuer:
- Cash position and marketable securities and the strength and availability of cash flows
- Ability to raise capital (equity and debt) in the short term
- Undrawn bank facilities (focus on covenants, material adverse change clauses)
- Available vendor financing
- Ability to control working capital as a means of improving cash flows (especially under a stress scenario)
- The scaleability of the business plan in order to reduce or postpone CAPEX
- Value of non-strategic assets which can be sold (timing and asset value under a stress scenario)
- Asset securitization
- Direct and contingent obligations of a company.
Countless numbers of financial ratios were used to determine the probability of financial distress. This effort is complicated by the fact that various reasons for financial distress are reflected in different financial ratios. The deterioration in the following ratios proved to be a good indicator – several months before the occurrence of default:
? Cash flow/total debt
? Net income/total assets
? Debt/total assets
? Sales/total assets
? Working capital/total assets
? Current assets/current liabilities.
It is almost impossible to standardize an approach for detecting financial distress by monitoring a set of financial ratios due to the fact that every industry has its own dynamics and every default case is unique by itself. Credit trends like the evolution of leverage, coverage, EBITDA growth and the growth of operating margins proved to be very reliable indicators of the performance of companies and also the performance of whole industry sectors. Deteriorating margins are equivalent with problems in the core business and will result in weaker debt protection measures (coverage + leverage) over the course of time. The trend in the ratio cash flows/total debt proved to be a very good indicator of financial distress as well.
There is no valid scoring model for the exact evaluation of financial risk, which implies that the probability of default or development of credit quality is a nonquantifiable process. Generally, the default probability rises with increasing financial risk and decreasing rating class. The evaluation of the financial situation of a company should be a synthesis out of the following factors:
? Financial flexibility;
? variability of CAPEX; working capital intensity
? Profitability
? Liquidity; cash position; lines of credit; vendor financing
? Access to capital markets under a stress scenario
? Refinancing risk; debt maturity
? Balance sheet structure (leverage, capital structure, coverage)
? Financial decisions and risk appetite
? Financial profile (dividend policy; share buybacks; IPOs)
? Merger and acquisition potential
? Nonstrategic assets
? Accounting approach (aggressive or conservative).
An in-depth analysis of the whole capital structure is thus required prior to computing the leverage ratios. Many issuers (all rating classes) have convertible bonds outstanding. Especially when a company’s stock price is falling, a redemption of the convertible bond will be the most likely scenario (conversion option expires worthless). Under such circumstances the convertible bonds have to be considered as “pure” debt instruments.
Leverage will decline when cash flow growth from earnings outpaces debt growth. There is a relationship between leverage (here, total debt/EBITDA) and spreads for selected European investment grade bonds ex financials. Generally, it can be said that an increasing leverage is accompanied by wider spread levels.
The rating agencies Standard & Poor’s, Moody’s and Fitch Ibca use some of the financial ratios from previous examples as a basis for their rating decision when evaluating the credit quality of a company. There is a variation in the average ratio size across the various industries so that a company’s ratios should be compared only with the peer group. The main financial ratios can be divided into the following categories:
- Coverage
- Leverage
- Profitability
- Cash flows/liquidity.
Profitability ratios explore the causes of a change in earnings. The way a company manages its assets and debt has a direct effect on its profitability. By understanding the causes one can better project future profitability and hence the ability to service debt. In the long run, every company has to generate free cash flows from operations. Short-term liquidity is essential for every company to stay in business.
Every company has to generate enough operating cash flows in the long run in order to grow and continue its business. The operating cash flows should be adjusted by the following positions in order to make them comparable over time and to other companies:
Cash flows from interest rate expenses are included in the operating cash flows even though they should belong to the cash flows from financing.
Income taxes are included in operating cash flow. Correctly, they are affected by financing decisions (e.g. deductibility of interest rate expenses of debt-financed projects) and investing decisions (e.g. tax credits for certain investment projects).
Interest income and dividend income are considered as operating cash flow but they are the result of investment activities.
The cash flows from investing activities can be a measure of management’s risk appetite and also the current phase of the business plan. Cash flows from financing give an insight into the company’s ability to access the capital markets or alternative financing sources. It can be stated that bonds of companies which generate permanent positive free cash flows will on average outperform bonds of companies with negative free cash flows.
The development of cash flows from operating, investing and financing activities should be monitored on a quarterly basis and the cash position at the beginning of the period is compared to the cash position at the end of the period. A projection of the cash flows will help to determine the future liquidity situation of a company.
The FASB (Federal Accounting Standards Board) has listed the following as examples for cash flows from operating, investing and financing activities.
Noncash investing and financing activities must be distinguished from activities that involve cash receipts and payments and reported separately because they might have a significant effect on future cash flows of a company.
These are for example:
- Acquiring an asset through a capital lease
- Conversion of debt to equity
- Exchange of noncash assets or liabilities for other noncash assets or liabilities
- Issuance of stock to acquire assets.
A statement of cash flows has to provide information about the cash receipts and cash payments of a company during a period. Furthermore, it will provide insight into the investing and financing activities of the company. The cash flow statement is a central tool in credit analysis for corporate bonds because it will help creditors to assess:
- the ability to generate future positive cash flows;
- the ability to meet obligations and pay dividends;
- reasons for differences between income and cash receipts and payments;
- both cash and noncash aspects of a company’s investing and financing transactions.
A main focus is on future operating cash flows because the debt service capability, CAPEX and working capital needs have to be covered by operating cash flows, particularly if a short-term financing on the capital markets proves to be problematic. The uncertainty of projected future cash flows is higher for companies with a more volatile earnings trend. Overall, companies with high leverage will experience a high increase in their credit risk and widening in spreads when only a minor decrease in their cash flows occurs. The short-term refinancing risk increases with increasing short-term debt, increasing working capital needs and a higher CAPEX. An improvement of operating cash flows reduces the refinancing risk.
Credit risk is associated with rising pension expenses, cash contribution and rising unfunded pension liabilities. Falling asset returns increase pension costs because unfunded pension plans require cash contributions.
Therefore, less cash is available for investments and deleveraging. While dealing with pension schemes we have to consider jurisdictional differences which create discrepancies in financial flexibility and different accounting standards. Unfunded pension plans became an issue for the capital markets in 2002 due to a multiyear equity bear market that significantly lowered the value of pension assets. At the same time historically low bond yields increased pension liabilities. Finally, rating downgrades associated with pension liabilities highlighted the credit risk inherent in unfunded pension plans. The main points which have to be considered in credit analysis are summed up below:
Unfunded pension liabilities have earnings, cash flow and balance sheet consequences dependent on the jurisdiction.
Unfunded pension liabilities have debt-like characteristics.
Company characteristics have an impact on the size of liabilities. Mature companies and workforces will cause higher cash outflows as well as heavily unionized workforces.
The actuarial assumptions made to calculate pension liabilities can misrepresent the funding status. It is in the interest of a company to keep discount rates (for future pension obligations) higher and assume also higher expected returns on pension assets in order to inflate earnings.