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.

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.