Introduction to Credit Management

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.

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.