The link between keyfinancial ratios and ratings
Tags: Financial ratios | GDP | MARC | ratings
Written by A report by MARC
Monday, 14 June 2010 11:02
Introduction and sample description
This statistical report by MARC Fixed Income Research explores the degree of correlation between a set of financial ratios and assigned credit ratings based on available financial information from 2004 to 2009. We used the same financial information used by rating analysts in their credit rating process.
Since the majority of the 2009 financial information used in this analysis is unaudited and incomplete at the point of writing this report, caution must be exercised when going through the median ratios.
Our sample is limited to corporate debt and project finance issuers with long-term ratings and sufficient financial data. Companies lacking financial information are excluded from the sample. The data of these companies are available consistently throughout the period under analysis.
Median financial ratios along this time horizon are presented to eliminate the number of distortions that would have otherwise resulted from a reading of averages.
Moreover, the medians are derived under three different scenarios in which we first estimated the long-run median financial ratios using data from between 2004 and 2009.
The ratio medians vary throughout the six years, which could be due to various reasons such as change in sample size, economic cycles and changes in rating methodology.
The impact of cycles on companies’ performance is established using estimates of three-year medians for two periods: 2004-2006, which can be characterised as a boom period when real gross domestic product (GDP) grew at 6% on average, and 2007-2009, when average real GDP growth halved to 3% amidst a steep decline in global economic activity in 2008 and 2009.
This statistical study features the median ratios across three major rating bands, namely “AAA”, “AA” and “A & Lower” among rated corporate, excluding financial institutions. The lower rated institutions are grouped under “A & Lower”, due to the extremely small number of ratings belonging to that segment of the rating universe.
Medians of financial ratios reported in this study cannot be used on their own to benchmark issuers across different rating bands, as the judgmental credit scoring model used by credit rating analysts incorporates non-financial and qualitative considerations.
Nevertheless, historical financial measures may complement analysis undertaken in respect of an issuer’s business and industry risks.
Linear relationship between selected median financial ratios and the spectrum of long-term corporate ratings
During the period 2004-2009, we found a consistent pattern in the relationship between financial ratios and rating bands, with the strongest ratios witnessed among issuers positioned at the highest end of the rating scale.
For instance, median operating margins — which are used as a gauge of corporate profitability — stand at 30.3% for AAA-rated companies, 22.5% for AA-rated companies and 10% for A & Lower-rated companies.
While our rating analysts rely on debt-to-equity to evaluate the gearing level in assessing corporate credit quality, we added debt-to-Earnings before interest, taxes, depreciation and amortisation (Ebitda), which provides a rough measure of how many years of Ebitda would be necessary to repay all debt (assuming both the levels of debt and Ebitda are constant).
It is worth noting here that the usage of debt-to-Ebitda in this study does not indicate that this ratio is superior to debt-to-equity; indeed, rating analysts may have their own considerations for using debt-to-equity such as volatility in reported year-to-year Ebitda in evaluating debt servicing capacity from another angle.
The debt-to-Ebitda for AAA-rated companies stands at 2.5 times — and as we move down the ratings scale, the “AA” and “A & Lower” rating bands have a reading of 3.8 times and 7.1 times, respectively.
Other median financial ratios related to debt servicing capacity, namely the cash flow from operations-to-total debt (CFO), free cash flow-to-total debt (FCF) and debt service coverage ratio (DSCR), are also consistent with the credit strength of companies in our sample as depicted in Exhibit 2.
We measure interest coverage in terms of Ebit and Ebitda, and both ratios indicate a higher coverage among highly-rated credits with a reading of Ebitda interest coverage of 6.4 times for “AAA”, 2.5 times for “AA” and two times for “A & Lower bands”.
To supplement this analysis further, we also incorporate other statistics such as the three-year credit risk premiums, corporate default rates and corporate rating stability along those rating bands. The corporate default rates and rating stability measures are derived from our annual corporate default study.
Median financial ratios for contrasting points in economic cycle: the boom of 2004-2006 vs the gloom of 2007-2009
The cyclical component of corporate performance derives directly from business cycle, which — in turn — is generally correlated with the level of economic activity. The median ratios under the two contrasting points in the economic cycle; the boom of 2004-2006 and the downturn of 2007-2009 are set out below in Exhibits 3 and 4.
The 2004-2006 period is characterised as the boom period, with low market volatility and normal corporate risk premium levels.
The 2007-2009 period, on the other hand, is categorised as a downturn triggered by a significant global recession. It was during this period that we saw a sharp rise in market volatility and risk premiums alongside declining aggregate demand in the domestic economy and compressed profit margins.
The downturn in the economic cycle took a visible toll on corporate profitability which was evidenced by the retreat in operating margins from 21.4% during 2004-2006 to 17.8% during 2007-2009.
Nevertheless, the linear relationship between margin compression and our ordinal credit ranking system remains consistent, with issuers in highly rated bands continuing to exhibit relatively favourable ratios compared to issuers in the lower rated bands.
Other median ratios measuring interest coverage and debt servicing capacity also deteriorated in the 2007-2009 business cycle.
Another significant finding from our analysis is that cash from operations can be quite volatile during a downturn cycle, even for companies in the higher rating bands.
As can be seen from Exhibit 4, the differences in CFO-to-total debt along the rating bands become less significant compared to the period of stable operations in the 2004-2006 business cycle.
The volatility of free cash flow is even more extreme where the median FCF-to-total debt for the AA-rated companies which stood at 4.2% in 2004-2006 fell to -0.4% in 2007-2009, hence eliminating the linear relationship seen in the period of stable operations.
The behaviour of the median financial ratios under boom and downturn scenarios appears to justify the apparent increasing downward rating momentum seen, particularly in 2009.
There was a weakening of corporate balance sheets during the economic downturn. Again, as can be seen in Exhibits 3 and 4, the average corporate default rate rose from 0.6% in 2004-2006 to 2.2% in 2007-2009, and during the same period, credit risk premiums also widened considerably across all rating bands.
Rating stability of the overall corporate portfolio was notably affected, but then again, the resilience of issuers positioned in higher rating bands during the period of downturn is borne out in the consistent linear relationship between each of two variables and rating bands.
This article appeared in The Edge Financial Daily, June 14, 2010.
