CHAPTER 22

CORPORATE BOND CREDIT ANALYSIS

CHAPTER SUMMARY
Since the credit rating companies (Moodys Investors Service, Standard & Poors, and Fitch
Ratings) have well-developed methodologies for analyzing the default risk of a corporate bond,
we will describe factors that they consider in this chapter. The framework for analysis that we
describe in this chapter is referred as traditional credit analysis.

OVERVIEW OF CORPORATE BOND CREDIT ANALYSIS

In the analysis of the default risk of a corporate bond issuer and specific bond issues, there are
three areas that are analyzed by bond credit analysts. These are: the protections afforded to
bondholders that are provided by covenants limiting managements discretion; the collateral
available for the bondholder should the issuer fail to make the required payments; and, the ability
of an issuer to make the contractual payments to bondholders.

Analysis of Covenants

An analysis of the indenture is part of a credit review of a corporations bond issue. The indenture
provisions establish rules for several important areas of operation for corporate management.
These provisions are safeguards for the bondholder. Indenture provisions should be analyzed
carefully. There are two general types of covenants. Affirmative covenants call upon the
corporation to make promises to do certain things. Negative covenants, also called restrictive
covenants, require that the borrower not take certain actions. There are an infinite variety of
restrictions that can be placed on borrowers in the form of negative covenants.

Some of the more common restrictive covenants include various limitations on the companys
ability to incur debt. Consequently, bondholders may want to include limits on the absolute dollar
amount of debt that may be outstanding or may require some type of fixed charge coverage ratio
test. The two most common tests are the maintenance test and the debt incurrence test. The
maintenance test requires the borrowers ratio of earnings available for interest or fixed charges to
be at least a certain minimum figure on each required reporting date (such as quarterly or annually)
for a certain preceding period.

The debt incurrence test only comes into play when the company wishes to do additional
borrowing. In order to take on additional debt, the required interest or fixed charge coverage figure
adjusted for the new debt must be at a certain minimum level for the required period prior to the
financing. Debt incurrence tests are generally considered less stringent than maintenance
provisions. There could also be cash flow tests (or cash flow requirements) and working capital
maintenance provisions.

Some indentures may prohibit subsidiaries from borrowing from all other companies except the
parent. Restricted subsidiaries are those considered to be consolidated for financial test purposes;

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unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded
from the covenants governing the parent.

Analysis of Collateral

A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a
corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority
rule. What is typically observed is that the corporations unsecured creditors may receive
distributions for the entire amount of their claim and common stockholders may receive some
distribution, whereas secured creditors may receive only a portion of their claim. The claim
position of a secured creditor is important in terms of the negotiation process.

Assessing an Issuers Ability to Pay

The ability of an issuer to generate cash flow goes considerably beyond the calculation and analysis
of a myriad of financial ratios and cash flow measures that can be used as a basic assessment of a
companys financial risk. An evaluation of an issuers ability to pay involves analysis of business
risk, corporate governance risk and financial risk

ANALYSIS OF BUSINESS RISK

Business risk is defined as the risk associated with operating cash flows. Operating cash flows are
not certain because the revenues and the expenditures comprising the cash flows are uncertain. An
analysis of industry trends is important because it is only within the context of an industry that
company analysis is valid. Industry consideration should be considered in a global context. The
need for many companies to become globally competitive increases as the barriers to international
trade are broken down.

The analysis of business risk begins with an understanding of how a company makes money. It is
so basic that many experienced investors cannot wait to skip this very first step and dive into
more in-depth analysis. But without a good grasp of how a companys business model works,
conclusions drawn upon further analysis are often very shaky.

It has been suggested that the following areas will provide a credit analyst with a sufficient
framework to properly interpret a companys economic prospects: economic cyclicality, growth
prospects, research and development expenses, competition, sources of supply, degree of
regulation, and labor. These general areas encompass most of the areas that the rating agencies
have identified for assessing business risk.

One of the first areas of analysis is investigating how closely the industry follows gross domestic
product (GDP) growth. This is done in order to understand the industrys economic cyclicality.
Related to the analysis of economic cyclicality are the growth prospects of the industry. This
requires an analysis as to whether the industrys growth is projected to increase and thereafter be
maintained at a high level or is it expected to decline. To assess the growth prospects, a credit
analyst will have to investigate the dependence on research and development (R&D) expenditures
for maintaining or expanding the companys market position.

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With respect to regulation, the concern should not be with its existence or absence in an industry
per se. Rather, the focus with respect to regulation should be on the direction of regulation and its
potential impact on the current and prospective profitability of the company. Regulation also
encompasses government intervention in nonU.S. operations of a company.

A key component in the cost structure of an industry is labor. In analyzing the labor situation, the
credit analyst will examine if the industry is heavily unionized. In nonunionized companies, the
credit analyst will look at the prospect of potential unionization.

CORPORATE GOVERNANCE RISK

Corporate governance issues involve (1) the ownership structure of the corporation, (2) the
practices followed by management, and (3) policies for financial disclosure. The underlying
economic theory regarding many of the corporate governance issues is the principal-agency
relationship between the senior managers and the shareholders of corporations. The agent, a
corporations senior management, is charged with the responsibility of acting on behalf of the
principal, the shareholders of the corporation.

There are mechanisms that can mitigate the likelihood that management will act in its own
self-interest. The mechanisms fall into two general categories. The first is to more strongly align
the interests of management with those of shareholders. This can be accomplished by granting
management an economically meaningful equity interest in the company. Also, manager
compensation can be linked to the performance of the companys common stock.

The second category of mechanism is by means of the companys internal corporate control systems,
which can provide a way for effectively monitoring the performance and decision-making behavior
of management. What has been clear in corporate scandals is that there was a breakdown of the
internal corporate control systems that lead to corporate difficulties and the destruction of
shareholder wealth. Because of the important role played by the board of directors, the structure and
composition of the board are critical for effective corporate governance. The key is to remove the
influence of the CEO and senior management on board members.

Several organizations have developed services that assess corporate governance and express their
view in the form of a rating. Generally, these ratings are made public at the option of the company
requesting an evaluation. One such service is offered by S&P, which produces a Corporate
Governance Score based on a review of both publicly available information, interviews with
senior management and directors, and confidential information that S&P may have available from
its credit rating of the corporations debt.

FINANCIAL RISK

Having achieved an understanding of a corporations business risk and corporate governance risk,
the analyst is ready to move on to assessing financial risk. This involves traditional ratio analysis
and other factors affecting the firms financing. Some of the more important financial ratios are:

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interest coverage, leverage, cash flow, net assets, and working capital. Once these ratios are
calculated, it is necessary to analyze their absolute levels relative to those of the industry.

Before performing an analysis of the financial statement, the analyst must determine if the industry
in which the company operates has any special accounting practices, such as those in the insurance
industry. If so, an analyst should become familiar with industry practices.

Interest Coverage

An interest coverage ratio measures the number of times interest charges are covered on a pretax
basis. Typically, interest coverage ratios that are used and published are pretax as opposed to after-
tax because interest payments are a pretax expense. Pretax interest coverage ratio is calculated by
dividing pretax income plus interest charges by total interest charges. The higher this ratio, the
lower the credit risk, all other factors the same. A calculation of simple pretax interest coverage
would be misleading if there are fixed obligations other than interest that are significant. In this
case, a more appropriate coverage ratio would include these other fixed obligations, and the
resulting ratio is called a fixed charge coverage ratio.

A calculation of simple pretax interest coverage would be misleading if there are fixed obligations
other than interest that are significant. A more appropriate coverage ratio is the fixed-charge
coverage ratio. An example of a significant fixed obligation is lease payments. Additionally, a net
interest expense number understates the true interest payment obligation of companies. It is more
prudent to use the gross interest expense than net interest expense when calculating the interest
coverage ratio. Rather than use pretax income, cash flow can be used, and the computed ratio is
called a cash flow ratio.

Leverage

Although there is no one definition for leverage, the most common one is the ratio of total debt to
total capitalization. The higher the level of debt is, the higher the percentage of operating income
that must be used to satisfy fixed obligations.

In addition to the ratio of total debt to total capitalization, two other ratios are commonly used in
assessing a companys leverage: (1) total debt to EBITDA and (2) total debt to EBIT. In analyzing
a highly leveraged company (i.e., a company with a high leverage ratio), the margin of safety must
be analyzed. The margin of safety is defined as the percentage by which operating income could
decline and still be sufficient to allow the company to meet its fixed obligations. Recognition must
be given to the companys operating leases. Such leases represent an alternative to financing assets
with borrowed funds.

Cash Flow

The statement of cash flows is required to be published in financial statements along with the
income statement and balance sheet. The statement of cash flows is a summary over a period of
time of a companys cash flows broken out by operating, investing, and financing activities.

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Analysts reformat this information, combining it with information from the income statement to
obtain what they view as a better description of the companys activities.

S&P calculates what it refers to as funds from operations (defined as net income adjusted for
depreciation and other noncash debits and credits). Operating cash flow is funds from operations
reduced by changes in the investment in working capital (current assets less current liabilities).
Subtracting capital expenditures gives what S&P defines as free operating cash flow. It is from
this cash flow that dividends and acquisitions can be made. Deducting cash dividends from free
operating cash flow gives discretionary cash flow. Adjusting discretionary cash flow for
managerial discretionary decisions for acquisition of other companies, the disposal of assets (e.g.,
lines of business or subsidiaries), and other sources or uses of cash gives prefinancing cash flow.
As stated by S&P, prefinancing cash flow represents the extent to which company cash flow from
all internal sources have been sufficient to cover all internal needs.

Cash flow measures can then be used to calculate various cash flow ratios. The ratio used often
depends on the type of company being analyzed.

Net Assets

A fourth important ratio is net assets to total debt. In the analysis of this ratio, consideration should
be given to the liquidation value of the assets. Liquidation value will often differ dramatically from
the value stated on the balance sheet. Consideration should be given to several other financial
variables including intangible assets, pension liabilities, and the age and condition of the plant.

Working Capital

Working capital is defined as current assets less current liabilities. Working capital is considered
a primary measure of a companys financial flexibility. Other such measures include the current
ratio (current assets divided by current liabilities) and the acid test (cash, marketable securities,
and receivables divided by current liabilities). The stronger the companys liquidity measures, the
better it can weather a downturn in business and reduction in cash flow.

THE INVESTMENT DECISION

Any investment has to be done at a certain price. And it often determines the final action. In high-
yield investing, the rule-of-thumb is: dont trade safety for yield. Credit risk is not linear and
investors are rarely compensated enough to give up safety when risk and reward are asymmetric
in high-yield investing. A typical high-yield debt investor benefits more from acquiring high-
quality assets at sensible prices. In the end, investing is a combination of art and science, but maybe
more of an art than a science.

CORPORATE BOND CREDIT ANALYSIS AND EQUITY ANALYSIS

The analysis of business risk, corporate governance risk, and financial risk involves the same type
of analysis that a common stock analyst would undertake. Many fixed income portfolio managers
strongly believe that corporate bond analysis, particularly high-yield bond analysis, should be

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viewed from an equity analysts perspective. If analysts think about whether they would want to
buy a particular high yield companys stock and what will happen to the future equity value of that
company, they have a useful approach because, as equity values go up, so does the equity cushion
beneath the companys debt.

CASE STUDY: CREDIT ANALYSIS OF SIRIUS XM HOLDINGS INC.

This case study look at Sirius XMs 5.25% 2022 bonds (referred to as 2022 bonds hereafter) due
to their much superior covenant protections compared to the companys other bonds. Covenants
are the single most important driver of the 2022 bonds significant outperformance relative to the
companys other bonds.

Conclusion

Sirius XM utilized a combination of covenant suspension and limitation on liens to successfully

relief itself from most restrictive covenants as a high-yield issuer. Covenants are among the most
important credit considerations for bondholders. In Sirius XMs case, covenants are the key
differentiator of the bond performance between the 5.25% 2022s and the rest of its bonds. That
said, covenants alone are far from sufficient to protect bondholders. The quality of an issuers
business remains to be the most important factor in credit analysis. Weak covenants, in many cases,
can be a deal breaker for prudent investors. But strong covenants cannot justify commitment of
capital in weak businesses. Successful investments require careful examination of all important
factors.

CASE STUDY: SINO-FOREST CORPORATION

Sino-Forest Corporation is a commercial forestry company in China. It began operations in 1994

and was listed on the Toronto Stock Exchange (TSX) under the symbol TRE in 1995. It was
among the earliest Chinese companies that went public in foreign stock markets. The purpose of
the case study is to elaborate on the credit analysis framework.

KEY POINTS

Corporate bond credit analysis involves an assessment of bondholder protections set forth in
the bond indenture, the collateral available for the bondholder should the issuer fail to make the
required payments, and the capacity of an issuer to fulfill its payment obligations.
Covenants contained in the bond indenture set forth limitations on management and, as a result,
provide safeguard provisions for bondholders.
Although collateral analysis is important, there is a question of what a secured position means
in the case of a reorganization if the absolute priority rule is not followed in a reorganization.
In assessing the ability of an issuer to service its debt, analysts look at a myriad of financial
ratios as well as qualitative factors such as the issuers business risk and corporate government
risk.
In assessing the ability of an issuer to service its debt, analysts assess the issuers business risk,
corporate governance risk, and financial risk.

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 Business risk is the risk associated with operating cash flows and begins with an understanding
of a companys business model.
In assessing business risk, some of the main factors considered are industry characteristics and
trends, the companys market and competitive positions, management characteristics, and
national political and regulatory environment.
Corporate governance risk involves assessing (1) the ownership structure of the corporation,
(2) the practices followed by management, and (3) policies for financial disclosure.
Assessing financial risk involves traditional ratio analysis and other factors affecting the firms
financing. The more important financial ratios analyzed are interest coverage, leverage, cash
flow, net assets, and working capital.
Some fixed income portfolio managers strongly believe that corporate bond analysis should be
viewed from an equity analysts perspective. This is particularly the case in analyzing high-
yield bonds.

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 ANSWERS TO QUESTIONS FOR CHAPTER 22
(Questions are in bold print followed by answers.)

1. Answer the below questions.

(a) What is the difference between a positive and negative covenant?

There are two general types of covenants. Positive (or affirmative) covenants call upon the
corporation to make promises to take certain actions. Negative (or restrictive) covenants differ
because they require that the borrower not take certain actions. There are an infinite variety of
restrictions that can be placed on borrowers in the form of restrictive covenants. More details are
given below on these restrictive covenants.

Some of the more common restrictive covenants include various limitations on the companys
ability to incur debt since unrestricted borrowing can be highly detrimental to the bondholders.
Consequently, bondholders may want to include limits on the absolute dollar amount of debt that
may be outstanding or may require some type of fixed charge coverage ratio test. The two most
common tests are the maintenance test and the debt incurrence test. There could also be cash flow
tests (or cash flow requirements) and working capital maintenance provisions.

Some indentures may prohibit subsidiaries from borrowing from all other companies except the
parent. Indentures often classify subsidiaries as restricted or unrestricted. Restricted subsidiaries
are those considered to be consolidated for financial test purposes; unrestricted subsidiaries (often
foreign and certain special-purpose companies) are those excluded from the covenants governing
the parent. Often, subsidiaries are classified as unrestricted in order to allow them to finance
themselves through outside sources of funds.

(b) What is the purpose of the analysis of covenants in assessing the credit risk of an issuer?

An analysis of covenants found in a bond indenture is part of assessing the credit risk of a bond
issuer. The purpose of analyzing the covenants (or provisions) is to examine the procedures for
areas of corporate management operatives. These covenants are safeguards for the bondholder.
Covenants must also be analyzed for ambiguity. Thus, analyst must pay careful attention to the
definitions in indentures because they vary from indenture to indenture.

2. Answer the below questions.

(a) What is a maintenance test?

A maintenance test is a check and balance measure to help the bondholder monitor the company.
In particular, the bondholder wants to make sure the covenants are being followed. The
maintenance helps achieve this by requiring the borrowers ratio of earnings available for interest
or fixed charges to be at least a certain minimum figure on each required reporting date (such as
quarterly or annually) for a certain preceding period.

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(b) What is a debt incurrence test and when does it come into play?

The debt incurrence test only comes into play when the company wishes to do additional
borrowing. In order to take on additional debt, the required interest or fixed charge coverage figure
adjusted for the new debt must be at a certain minimum level for the required period prior to the
financing. Debt incurrence tests are generally considered less stringent than maintenance
provisions.

3. Some credit analysts place less emphasis on collateral compared to covenants and business
risk. Explain why.

Some analysts place less emphasis on collateral compared to covenants and business risk due the
observation that bankruptcy often only allows secured creditors to receive part of their claim in
terms of assets pledged by a borrower to secure a loan. Thus, the both covenants found in the
indenture and also the business risk (under which the company operates) takes on added
significance. More details are given below.

A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a
corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority
rule. In contrast, seldom do the absolute priority rules hold in a reorganization. What is typically
observed in such cases is that the corporations unsecured creditors may receive distributions for
the entire amount of their claim and common stockholders may receive some distribution, while
secured creditors may receive only a portion of their claim. Secured creditors are willing to allow
distribution to unsecured creditors and common stockholders in order to obtain approval for the
plan of reorganization, a plan that requires approval of all parties.

The question is then, what does a secured position mean in the case of a reorganization if the
absolute priority rule is not followed in a reorganization? The claim position of a secured creditor
is important in terms of the negotiation process. However, because absolute priority is not followed
and the final distribution in a reorganization depends on the bargaining ability of the parties, some
analysts place less emphasis on collateral compared to covenants and business risk.

4. Why do credit analysts begin with an analysis of the industry in assessing the business risk
of a corporate issuer?

An analysis of the industry (and its trends) is important for credit analysts because it is only within
the context of an industry that company analysis is valid. All proper analysts have to take into
consider both some standard and how that standard changes over time or might be influenced by
global competition. For example, suppose that the growth rate for a company over the past three
years was 20% per year. In isolation, that may appear to be an attractive growth rate. However,
suppose that over the same time period, the industry in which the company operates has been
growing at 45% over the same period. While there could be many factors to explain the
discrepancy in the relative performance, one might conclude that the company is competitively
weak. As an example of the need to look at an industry within a global contexts consider the
automobile industry. For this industry, it is not sufficient for a company to examine its competitive
position in its industry but also investigate its competitive position from a global perspective.

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5. What is the purpose of a credit analyst investigating the market structure of an industry
(e.g., unregulated monopoly, oligopoly, etc.)?

A credit analyst will look at the market structure of an industry (e.g., unregulated monopoly,
oligopoly, etc.) because of its implications regarding factors such as price, supply, product quality,
distribution capabilities, image, product differentiation, or service. With respect to pricing, the
credit analyst will look at the market structure of an industry because of its implications on pricing
flexibility. As concerns supply, a credit analyst should examine whether or not a company is self-
sufficient in its factors of production. For example, the analyst will want to know if the firm is
sufficiently powerful in its industry to pass along increased costs.

6. What should be the focus of an analyst with respect to the regulation of an industry?

In regards to regulation, a credit analysts concern should not be with just the existence or absence
of regulation in an industry. Rather, the focus with respect to regulation should be on the direction
of regulation and its possible impact on the current and prospective profitability of the company.
Regulation also encompasses government intervention in non-U.S. operations of a company.

7. In analyzing the labor situation in an industry in which a corporate issue operates, what
should the credit analyst examine?

Because labor is a key component in the cost structure of an industry, a credit analyst will want to
know the affect that labor can have a firms profitability through its ability to manage cost. In
analyzing the labor situation in an industry in which a corporate issue operates, the credit analyst
will examine if the industry is heavily unionized. If so, the analyst will examine: whether
management has the flexibility to reduce the labor force; when does the prevailing labor contract
come up for renewal; and, the historical occurrence of strikes. In nonunionized companies, the
credit analyst will look at the prospect of potential unionization. Also in analyzing an industry, the
requirements for particular specialists are examined.

8. The underlying economic theory regarding many corporate governance issues is the principal-
agency relationship between the senior managers and the shareholders of corporations. Explain
this relationship.

Standard agency theory advocates that principals must monitor agents to insure that they will
properly carry out their duties. In our situation, the agent is senior managers who are charged with
the responsibility of acting on behalf of the principal (who are the shareholders of the corporation).
There is the potential for the senior managers not to pursue the best interest of the shareholders,
but instead pursue a policy in their own self-interest. This policy may include a variety of behaviors
including the use of company resources for their own enjoyment, doctoring the books to achieve
a stock price to maximize their benefits through a salary increase or exercise of expiring stock
options. To help alleviate this problem, the principals try to align incentives so as to maximize
stockholder value. This cannot be done without costs. The costs of monitoring the agents behavior
are called agency costs.

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9. With respect to corporate governance, what are the mechanisms that can mitigate the
likelihood that management will act in its own self-interest?

The mechanisms (that can mitigate the likelihood that management will act in its own
self-interest) fall into two general categories. The first category involves strongly aligning the
interests of management with those of shareholders. This can be accomplished by granting
management an economically meaningful equity interest in the company. Also, manager
compensation can be linked to the performance of the companys long-run common stock price.
The second category involves the companys internal corporate control systems, which can
provide a way for effectively monitoring the performance and decision-making behavior of
management. For example, it would allow the timely removal of the CEO by the board of directors
who believe that a CEOs performance is not in the best interest of the shareholders. In general,
there are several critical features of an internal corporate control system that are necessary for the
effective monitoring of management. What has been clear in corporate scandals is that there was
a breakdown of the internal corporate control systems that lead to corporate difficulties and the
destruction of shareholder wealth. More details are given below.

Because of the important role played by the board of directors, the structure and composition of
the board are critical for effective corporate governance. The key is to remove the influence of the
CEO and senior management on board members. This can be done in several ways. First, although
there is no optimal board size, the more members there are, the less likely the influence of the
CEO. With more board members, a larger number of committees can be formed to deal with
important corporate matters. At a minimum, there should be an auditing committee, a nominating
committee (for board members), and a compensation committee.

Second, the composition of the committee should have a majority of independent directors, and
the committees should include only independent directors. There are two classes of members of
the board of directors. Directors who are employees of management or have some economic
interest as set forth by the SEC (for example, a former employee with a pension fund, the relative
of senior management, or an employee of an investment banking firm that has underwritten the
companys securities) are referred to as inside directors. Board members who do not fall into the
category of inside directors are referred to as outside directors or independent directors.

Finally, there are corporate governance specialists who believe that the CEO should not be the
chairman of the board of directors because such a practice allows the CEO to exert too much
influence over board members and other important corporate actions. This is a position that has
been taken by the Securities and Exchange Commission.

10. Answer the below questions.

(a) What are corporate governance ratings?

Corporate governance ratings refer to the ratings received by corporation in regard to their
adherence to the standards and codes of best practice for effective corporate governance. The
standards of best practice that have become widely accepted as a benchmark to rate companies on
corporate govern are those set forth by the Organization of Economic Cooperation and

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Development (OECD) in 1999. Other entities that have established standards and codes for
corporate governance are the Commonwealth Association for Corporate Governance, the
International Corporate Governance Network, and the Business Roundtable. Countries have
established their own code and standards using the OECD principles. The standards and codes of
best practice go beyond applicable securities law. The expectation is that the adoption of best
practice for corporate governance is a signal to investors about the character of management. There
is empirical evidence supporting the relationship between corporate governance and bond ratings
(and hence bond yields).

(b) Are corporate governance ratings reported to the investing public?

Several organizations have developed services that assess corporate governance and express their
view in the form of a rating. Generally, these ratings are made public at the option of the company
requesting an evaluation. One such service is offered by S&P, which produces a Corporate
Governance Score based on a review of both publicly available information, interviews with senior
management and directors, and confidential information that S&P may have available from its
credit rating of the corporations debt.

(c) What factors are considered by services that assign corporate governance ratings?

For a look at the factors considered by services that assign corporate governance ratings, consider
S&Ps Corporate Governance Score. This score is based on information attained both privately
and publicly and includes interviews with managers and knowledge attained from its credit rating
of the corporations debt. The score takes into consider the following factors. First is the ownership
structure and external influences. This factor includes the transparency of ownership structure and
the concentration and influence of ownership and external stakeholders. Second factor involves
shareholder rights and stakeholder relations. This factor consists of shareholder meetings and
voting procedures, ownership rights and takeover defenses and stakeholder relations. The third
factor is transparency, disclosure, and audit that include content of public disclosure, timing of and
access to public disclosure, and the audit process. The fourth factor is the board structure and
effectiveness that consists of the board structure and independence, the role and effectiveness of
the board, and the director and senior executive compensation.

Based on S&Ps analysis of these four key factors, its assessment of the companys corporate
governance practices and policies and how its policies serve shareholders and other stakeholders
is reflected in the Corporate Governance Score. The score ranges from 10 (the highest score) to 1
(the lowest score). In addition to corporate governance, credit analysts look at the quality of
management in assessing a corporations ability to pay.

Although difficult to quantify, management quality is one of the most important factors supporting
an issuers credit strength. When the unexpected occurs, it is a managements ability to react
appropriately that will sustain the companys performance. Assessment of managements plans in
comparison with those of their industry peers can also provide important insights into the
companys ability to compete, how likely it is to use debt capacity, its treatment of its subsidiaries,
its relationship with regulators, and its position vis--vis all fundamentals affecting the companys
long-term credit strength.

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In assessing management quality, Moodys tries to understand the business strategies and policies
formulated by management. The factors Moodys considers are: strategic direction, financial
philosophy, conservatism, track record, succession planning, and control systems.

11. Explain what a credit analyst should do in preparation for an analysis of the financial
statements.

Before performing an analysis of the financial statement, the credit analyst must determine if the
industry in which the company operates has any special accounting practices, such as those in the
insurance industry. If so, an analyst should become familiar with industry practices. Moreover,
the analyst must review the accounting policies to determine whether management is employing
liberal or conservative policies in applying generally accepted accounting principles (GAAP). An
analyst should be aware of changes in GAAP policies by the company and the reason for any
changes. Because historical data are analyzed, the analyst should recognize that companies adjust
prior years results to accommodate discontinued operations and changes in accounting that can
hide unfavorable trends. This can be done by assessing the trends for the companys unadjusted
and adjusted results.

12. Answer the below questions.

(a) What is the purpose of an interest coverage ratio?

The purpose of an interest coverage ratio is to measure the number of times interest charges are
covered by earnings.

(b) What does an interest coverage ratio of 1.8 mean?

If a company has a pretax interest ratio that is 1.8 , it means it does not need to borrow or use
cash flow or proceeds from the sale of assets to meet its interest payments. It has a cushion of
safety since a company with a pretax interest ratio that is equal to 1 would have just enough so
that it would not have to borrow or use cash flow or proceeds from the sale of assets to meet its
interest payments. Although a precise interpretation must take into account a norm or standard
(such as the industry average), the general understanding is that a company must consistently
maintain a ratio greater than one to avoid financial distress that could eventually lead to default.

(c) Why are interest coverage ratios typically computed on a pretax basis?

Interest coverage ratios are typically computed on a pretax basis because interest payments are a
pretax expense. Because interest payments lower a companys taxes there is no need to adjust the
interest payment for taxes to get an after-tax accounting of its effect. Pretax interest coverage ratio
is calculated by dividing pretax income plus interest charges by total interest charges. The higher
this ratio, the lower the credit risk, all other factors the same.

(d) Why would a fixed charge coverage ratio be materially different from an interest coverage
ratio?

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A fixed charge coverage ratio would be materially different from an interest coverage ratio
calculation of simple pretax interest coverage if there are fixed obligations other than interest that
are significant. If there are other fixed obligations, a more appropriate coverage ratio would include
these other obligations, and should compute a fixed charge coverage ratio. An example of other
significant fixed obligations is lease payments. An analyst must also be aware of any contingent
liabilities, such as a companys guaranteeing another companys debt.

13. Answer the below questions.

(a) What is the purpose of a leverage ratio?

The purpose of a leverage ratio is to determine what proportion of a firms financing is composed
of debt. While there is no one definition for leverage, the most common one is the ratio of long-
term debt to total capitalization. The higher the level of debt, the higher the percentage of operating
income that must be used to satisfy fixed obligations. Everything else equal, a higher leverage ratio
indicates a greater the probability of default.

(b) What measures are used in a leverage ratio for total capitalization?

In addition to the ratio of total debt to total capitalization, two other ratios are commonly used in
assessing a companys leverage: (1) total debt to EBITDA and (2) total debt to EBIT. In calculating
a leverage ratio for total capitalization, it is common to use the companys capitalization structure
as stated in the most recent balance sheet. To supplement this measure, the analyst should calculate
capitalization using a market approximation for the value of the common stock.

(c) What is the margin of safety measure?

The margin of safety is defined as the percentage by which operating income could decline and
still be sufficient to allow the company to meet its fixed obligations. The degree of leverage and
margin of safety varies dramatically among industries. It is especially important to know the
margin of safety if the company is believe to be highly leveraged company relative to some
standard like an industry norm. More details are given below.

In computing a margin of safety, recognition must be given to other factors to make sure the margin
of safety is accurately calculated. For example, one must see if the company has operating leases.
Such leases represent an alternative to financing assets with borrowed funds. The existence of
material operating leases can therefore understate a companys leverage causing the margin of
safety to be overestimated. Thus, operating leases should be capitalized to give a true measure of
leverage.

Two other factors should be considered: the maturity structure of the debt and bank lines of credit.
With respect to the first, the one would want to know the percentage of debt that is coming due
within the next five years and how that debt will be refinanced. For the latter, a companys bank
lines of credit often constitute a significant portion of its total debt.

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14. Why do analysts investigate the bank lines of credit that a corporation has?

Analysts investigate the bank lines of credit because a firms bank lines of credit often constitute
a significant portion of its total debt. These lines of credit should be closely analyzed in order to
determine the flexibility afforded to the company. The lines of credit should be evaluated in terms
of undrawn capacity as well as security interests granted. The analysis also involves a
determination as to if the line contains a material adverse change clause under which the bank
may withdraw a line of credit.

15. Answer each of the below questions.

(a) Explain the meaning of funds from operation.

Funds from operation are the net income adjusted for depreciation and other noncash debits and
credits. From this definition, we see that the meaning involves trying to get a true picture of the
cash generated by the companys operations for the period being considered.

(b) Explain the meaning of operating cash flow.

Operating cash flow is funds from operations reduced by changes in the investment in working
capital (current assets minus current liabilities). If a company has undergone a change in working
capital for the period being considered, the operating cash flow will give a better picture of the
cash generated by the companys operations.

(c) Explain the meaning of free operating cash flow.

Free operating cash flow is operating cash flow minus capital expenditures. If a company has
undergone a change in capital expenditures for the period being considered, the free operating cash
flow will give an improved picture of the cash generated by a firms operations.

(d) Explain the meaning of discretionary cash flow.

The discretionary cash flow is free operating cash flow minus cash dividends. If the company pays
dividends, the discretionary cash flow will reveal how much cash is available to spend on sources
or uses of cash determined by the company.

(e) Explain the meaning of prefinancing cash flow.

Adjusting discretionary cash flow for managerial discretionary decisions for acquisition of other
companies, the disposal of assets (e.g., lines of business or subsidiaries), and other sources or uses
of cash gives prefinancing cash flow. As stated by S&P, prefinancing cash flow represents the
extent to which company cash flow from all internal sources have been sufficient to cover all
internal needs.

16. In the analysis of net assets, what factors should be considered?

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In the analysis of net assets (and any financial ratio involving net assets such as net assets to total
debt), consideration should be given to the liquidation value of the assets. Liquidation value will often
differ dramatically from the net asset value stated on the balance sheet. If the liquidation value per
share for a company is less than the current share price, then it usually means that the company should
go out of business. A company with a high percentage of its assets in cash and marketable securities is
in a much stronger asset position than a company whose primary assets are illiquid real estate. Finally,
consideration should be given to several other financial variables including intangible assets, pension
liabilities, and the age and condition of the plant. Companies with greater intangible assets will
typically have a lower liquidation value. Pension liabilities are a major concern if a companys pension
fund is underfunded. Plants that are in poor condition will have lower liquidation value.

17. Answer the below questions.

(a) What is meant by working capital?

Working capital is considered a primary measure of a companys financial flexibility. It is defined

as current assets less current liabilities. Working capital measures include the current ratio (current
assets divided by current liabilities) and the acid test (cash, marketable securities, and receivables
divided by current liabilities). The stronger the companys liquidity measures, the better it can
weather a downturn in business and reduction in cash flow.

(b) Why is an analysis of working capital important?

An analysis of working capital is important in order to determine a firms capacity to meet current
obligations. In analyzing working capital, the normal working capital requirements of both a
company and industry should be considered. In addition, the components of working capital (such
as accounts receivable, accounts payable and so forth) should be assessed. For example, although
accounts receivable are considered to be liquid, an increase in the average days receivables (which
is accounts receivable divided by annual sales on credit times 365) that are outstanding may be an
indication that a higher level of working capital is needed for the efficient running of the operation.
In addition, companies frequently have account receivable financing, some with recourse
provisions. In this scenario, comparisons among companies in the same industry may be distorted.

18. Why do analysts of high-yield corporate bonds feel that the analysis should be viewed
from an equity analysts perspective?

For high-yield bonds, the analysis of business risk, corporate governance risk, and financial risk
all involve the same type of analysis that a common stock analyst would undertake. Thus, many
fixed income portfolio managers strongly believe that corporate bond analysis, particularly
high-yield bond analysis, should be viewed from an equity analysts perspective. Using an equity
approach, especially for high yield debt, can be used to verify the findings of traditional credit
analysis. If analysts think about whether they would want to buy a particular high yield companys
stock and what will happen to the future equity value of that company, they have a useful approach
because, as equity values go up, so does the equity cushion beneath the companys debt.

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