The optimal debt/equity ratio depends on many variables like capital costs of other companies in the industry, the access for further debt financing and the stability of earnings. Another important measure for the company’s financial situation which can be drawn from the balance sheet is the working capital need, defined as the difference between current assets and current liabilities. Working capital must be related to other financial statement elements such as sales or total. The management of working capital is important for cash flows because it shows how efficiently a company manages its cash. It is defined as:

Working capital = Accounts receivable + inventory – accounts payable.

The amount of cash, marketable securities and noncore assets help to assess the liquidity situation and the financial flexibility of the company as well.

Property, Plant and Equipment are of particular interest to bondholders in case of financial distress, because the proceeds from asset sales are used to service the debt obligations.

Pension liabilities are an important topic in the analysis of corporate balance sheets and hence play an important role in the evaluation of corporate bonds. The two main pension schemes are:

Defined contribution: the employer pays into a designated pension fund for the benefit of the employee. After the contribution the employer has no further obligation to the employee.
Defined benefit: the employer agrees to pay to the employee an annuity (or lump sum) of a defined amount at retirement. This pension represents an ongoing liability for the employer.

Every balance sheet is grouped by assets, liabilities and stockholder’s equity. The balance sheet information is a basis for analyzing the sources of earnings. If assets are overstated, earnings will also be overstated because they will not include those charges required to reduce the assets to their proper valuations. Consequently, when liabilities are understated, earnings will be overstated. The asset quality depends on factors like changes in industry and economic conditions, and changes in the operations of the firm.

Assets can be divided into different risk classes, for example, the future realization of accounts receivable has a higher degree of probability (lower risk) than the future realization of goodwill. A current asset is expected to be converted into cash during the operating cycle of a business. By analyzing the balance sheet one has to be aware of the existence of off-balance-sheet items. They are not disclosed in the balance sheet but have an effect on the financial situation of a company.

EBITDA can be a good determinant of cash flows and it is the most commonly used measure for a company’s credit quality, for example, by computing coverage and leverage ratios. However, the use of EBITDA as a single measure of cash flows can be misleading, hence other factors have to be considered. The following are some critical points:

EBITDA ignores changes in working capital and overstates cash flows in periods of working capital growth.

EBITDAsays nothing about the quality of earnings and can be a misleading measure of a company’s liquidity.

EBITDA can be manipulated through aggressive accounting policies relating to revenue and expense recognition, asset write-downs, excessive adjustments in deriving “adjusted pro-forma EBITDA” and by timing asset sales.

EBITDA does not take into consideration the many unique attributes of different industries.

If some start-up companies (e.g. most of the noninvestment gradeEuropean telecommunications companies) have negative EBITDA, the computation of current financial ratios becomes almost meaningless and one has to focus on the growth trend, for example, whether the EBITDA loss narrows or widens over time. When computing the leverage ratio for these companies EBITDA can be replaced by PP&E (Property, Plant and Equipment). The ratio (Total Debt/PP&E) is a limited measure for leverage, hence debt protection.

The income statement shows the revenues, expenses and income of a company for a certain period of time. Important positions from the income statement are used to compute the profitability ratios and most importantly EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of cash flows from operations. It is important to assess whether net income has been determined based on conservative accounting policies or on liberal accounting policies which might not reflect economic reality and hence result in lower quality of earnings. High nonrecurring income as well as nonrecurring costs will bias the trend in earnings. An overstatement of revenues will distort profits. Revenue recognition practices vary across industries.

The financial analysis uses the information from the income statement, the balance sheet and the cash flow statement to compute various financial ratios. The purpose of the financial statement analysis is to evaluate the firm’s financial decision-making process and operating performance.

Nevertheless, we have to recognize that the information value of individual data items from the financial statements is quite limited. Financial ratios have to be examined in the context of the firm’s history, the industry, major competitors and the state of the economic cycle.

Furthermore, it has to be pointed out that the assessment of the financial situation of a company should not be static, but a dynamic analysis has to support the investment process. Financial numbers of a company have to be forecasted by the implementation of scenario analysis (e.g. worst case – base case – best case). By this means it can be shown whether a company will succeed in future and sales-, investment- and financing-plans will help to assess the dynamic liquidity position of a company.

Credit investors also face other event risks which are out of control for management and we will discuss this topic later. The subjective assessment of a credit analyst can provide valuable information about future changes of an issuer’s credit quality and hence the performance of bonds.

As the next step the capital structure and covenants have to be analyzed which is particularly important for high-yield issues. Sometimes bonds of issuers with a negative credit trend have coupon step-up language which means that bondholders will receive, for example, 25 bp in the case of 1 notch downgrade by one rating agency. This way a company can show committment to its current rating and bondholders have some protection in the case of a downgrade.

In a final step a relative value analysis has to be conducted in order to make a final investment decision based on the fundamental analysis results. Analysts and portfolio managers are used to express their views relative to a chosen average, for example, statements like bond X should trade 15–20 bp wide to bond Y are quite common. At this point spread volatility and the liquidity of single bonds have to be considered in the final decisionmaking process.

The evaluation of a company’s future prospects of being a profitable business and the ability and willingness to improve the financial risk profile is a very important part in the investment decision process. The quality and experience of management is of particular interest because the compatibility of the business strategy with the financial profile of a company is fundamental for successful companies. Financial and nonfinancial factors like strategic management decisions (feasibility of the business plan) and the competitive environment set the parameters for the improvement of credit quality in the future. Management has always the option to surprise market participants with the announcement of unexpected company actions which will alter the capital structure. The change of a previously announced strategy is a major component of the event risk. It is impossible to quantify event risk for a company hence it is a subjective factor in the valuation process.

Typical examples are:

Mergers and Acquisitions
Share buyback programs
Focus on new business segments
Leveraged Buy-outs
All actions which result in an increased leverage.

As the first step the financial risk of a company has to be assessed. As the next step the business risk has to be defined and its effect on the financial risk has to be explained because various business strategies will result in different finanical profiles. The third component is event risk which is partly influenced by management, but also external factors which are out of the control of management. The trend in a company’s financial risk profile is determined to a large extent by the underlying business. The analysis of business risk deals with the stability, quality and predictability
of a company’s business throughout the entire economic cycle, for example, cash flows and earnings of car manufacturers depend to a large extent on the economy and investors will require higher risk premia in weak economic periods which results in the spread widening for bonds issued by car manufacturers. In this case a comparable analysis of an issuer’s market position versus its peers and the ability to manage weak economic periods in the past should be incorporated in the dynamic part of the credit analysis.

The various steps of the analysis do not apply to banks and financial institutions; these differ from other companies, because they are highly leveraged due to the nature of their business, as their main business is to manage their assets. An indepth analysis of the credit risk of banks will follow later.

There are several documents which can be used to assess the credit quality of a company. These are the 10K (Annual Statement), 10Q (Quarterly Statement) and the annual report and quarterly financial report presented to the shareholders. If a company has a public offering of a new security it has to provide a prospectus. Every prospectus has a section where all current and potential risks to the company have to be disclosed.

Regulated companies like utilities and banks must also prepare documents for regulators. Besides useful financial data, the annual report contains the shareholder’s letter where the management discusses business strategies.

The main anchors of credit analysis are cash flows, asset value, profitability, management assessment and covenants. Every company has to be able to generate positive cash flows in the long run. Companies with permanently negative cash flows will face liquidity constraints at some point in future. Another focus lies on balance sheet strength. The value of assets is very important for bondholders because they can be pledged against liabilities. For particularly high leveraged companies a situation might evolve where asset sales are the last option for deleveraging. The management assessment is another important factor for credit analysis particularly for assigning probabilities to various event risks. Finally, covenants have the main purpose of limiting event risk in terms of a company undertaking bondholder-unfriendly actions. Another focus lies on the equity-market performance and the implied volatility of a company’s stock. We can identify periods where equity and corporate bonds move in the same direction and times where they decouple; in distressed cases the decoupling will be permanent because equity will have no value and the remaining value will reside with debt.