The letter ratings that the credit rating agencies provide on corporate bond issuers are the extremely short final conclusions of a long process of analysis. However, if you only look at the letter rating then you are missing out on important information, such as the key assumptions made by the analysts when formulating the rating.
This is why, in addition to issuing the letter rating for a bond, the rating agencies will also issue a full credit report. The credit report gives a more complete picture of the the thinking that went into the letter rating, and is important for two reasons:
Many brokerage firms provide corporate credit reports as part of their online research offering. For example, Fidelity Investments provides 2 or 3 page summary reports from Standard & Poors. The reports tend to have two different focuses: the company’s underlying business and their cash situation.
Business Risk Profile: This section of the credit report discusses issues that affect future earnings. Depending on the type of company, there may be a discussion of profit margins, sales, strategy, litigation, or the regulatory environment. A report about a company like Altria (which manufactures cigarettes and smokeless tobacco) might focus on declining cigarette sales, the ability to raise prices, or the cost of settling lawsuits. For example, the report might make the assumption that Altria will be able to offset lower sales with higher prices.
Financial Risk Profile: The focus of this section is to determine if the company has the cash on hand to pay interest or principal when due, or the ability to raise it. In particular it looks at the company’s cash position, access to additional credit (like revolving credit lines), and expected cash flows from operations. Then it looks at how these match up to its cash requirements.
Total Debt To EBITDA – This is a ratio which divides the total debt of a company by its EBITDA. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. EBITDA measures how much profit a firm is generating from operations. When looking at Total Debt to EBITDA, investors want to know how long it would take the company to pay off all its debt if all the operating profits went to pay debt holders. A total debt to EBITDA ratio measures how long this process would take in years. An EBITDA to debt ratio of between 2 and 3 is normal.
One major criticism is that the E (earnings) in EBITDA can be easily manipulated and its possible to generate earnings temporarily on paper, without the company receiving the cash.
EBITDA To Interest Coverage: This is a ratio which divides EBITDA by the interest payments a company must make on its debt. Many companies are able to regularly refinance their debt or have long-term debt, which means that principal repayment is less of a concern than interest payments.
FFO To Debt: FFO stands for Funds From Operations. FFO is earnings after interest payments and taxes, but it does not include charges related to depreciation or amortization. In other words, it focuses on net income without including the accounting related changes that don’t affect cash flow. FFO to debt tries to come closer to the real world than total debt to EBITDA, as firms have to pay interest and taxes with their earnings. Typically, FFO to debt is expressed as a percentage rather than a ratio.
For more on individual bond issues visit the corporate bonds section here at Learn Bonds.