Module 7: Credit Analysis & Credit Ratings

Learning Objectives

  • Interpret credit ratings and key inputs used by rating agencies and FICO scores.
  • Explain how financial statement changes impact credit ratings.
  • Evaluate a company using financials and industry characteristics.

FICO Scores vs. Corporate Credit Ratings

  • FICO Scores (for individuals):

    • Payment History: 35%
    • Credit Utilization: 30%
    • Length of Credit History: 15%
    • Types of Credit Used: 10%
    • Recent Credit Searches: 10%

  • Corporate Credit Ratings (assigned by Moody's, S&P, Fitch):

    • Evaluate probability of default and severity of loss in case of default.
    • Investment Grade: AAA to BBB
    • Non-Investment Grade (Junk): BB and below
    • Lower ratings mean higher borrowing costs and stricter loan terms.

Key Factors in Credit Ratings

  1. Size of the Firm: Larger firms are generally safer.
  2. Financial Resources: More cash and liquid assets lead to better ratings.
  3. Profitability: Higher and consistent profits improve ratings.
  4. Earnings Stability: Less volatility equates to lower risk.
  5. Interest Coverage Ratio: Higher ratio indicates stronger debt repayment ability.
  6. Long-Term Debt-to-Equity Ratio: Lower ratio suggests less financial risk.

Credit Spreads

  • Difference in yield over Treasuries indicates risk premium:
    • AAA: ~0.8-0.9% spread
    • BBB: ~1.75% spread
    • BB: ~3.25% spread

Altman Z-Score Model

  • Formula: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X_5 Where:
    • X_1 = \text{Working Capital / Total Assets}
    • X_2 = \text{Retained Earnings / Total Assets}
    • X_3 = \text{EBIT / Total Assets}
    • X_4 = \text{Market Value of Equity / Total Liabilities}
    • X_5 = \text{Sales / Total Assets}
  • Interpretation:
    • Z < 1.8 implies high bankruptcy risk;
    • Z > 3.0 implies low bankruptcy risk.