Introduction to Credit Management

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.