Understand the difference between financial risk and business risk, and how these critical factors contribute to credit rating calculation. Discover essential financial indicators such as Free Cash Flow, Debt to Capital ratio, and Interest Coverage Ratio that credit analysts use in evaluating a company's default risk.
Key Insights:
- Financial risk and business risk are two different types of warning signs that credit rating agencies consider. Financial risk involves a company's ability to manage its debt and financial leverage, while business risk has not been detailed in this content.
- To evaluate financial risk, several factors are considered such as the company's accounting policy, financial policy and governance, cash flow adequacy, capital structure, and liquidity.
- Free Cash Flow (FCF) is a significant financial indicator that shows how much cash a company has available for debt repayment after all necessary expenses. FCF near zero or negative often indicates higher default risk.
- The Debt to Capital ratio represents a company's debt as a percentage of its total capital. A higher debt-to-capital ratio usually indicates a higher default risk.
- The Interest Coverage Ratio analyzes the relationship between a company's earnings and its interest obligations. A higher ratio means lower default risk, while a ratio of 1.5 or below can raise doubts about the company's ability to fulfill its interest obligations.
- Combining Business and Financial risks helps the rating agencies to accurately determine the credit rating for industries and companies.
Financial Risk Categories
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Market Risk
Losses from price changes — equities, rates, FX, commodities.
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Credit Risk
Counterparty defaulting on obligations.
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Liquidity Risk
Unable to convert assets to cash without major loss.
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Operational Risk
Internal failures — people, processes, systems.
Financial risk and business risk are two different types of warning signs that are considered in credit rating calculation.
Financial risk refers to a company's ability to manage its debt and financial leverage. To evaluate the financial risk we consider:
- Accounting policy of this company
- Financial policy and governance
- Cash flow adequacy
- Capital structure
- Liquidity
Free cash flows, debt to capital ratio and interest cover ratio are all common financial indicators credit analysts rely upon to determine a borrower’s risk of default in the credit process
Free Cash Flow
Free cash flow (FCF) tells a bank exactly how much cash is available for a company to repay its debt after all necessary expenses are made.
FCF = EDITDA – Interest – Taxes +/- working capital +/- other operational liabilities – capital expenditure.
Free cash flows near zero or negative could indicate higher default risk. It is important to note in the above formula that interest is subtracted from EBITDA. This is different from unlevered free cash flows and provides more detail into how credit rating agencies review cash flows.
Debt to capital ratio
The debt to capital ratio shows a company’s debt as a percentage of its total capital. A higher debt-to-capital ratio indicates higher default risk.
In the example above, company A has a higher debt to capital ratio and consequently higher default risk than company B.
Interest Coverage Ratio
The interest coverage ratio analyzes the relationship between a company’s earnings and its interest obligations. It is calculated by dividing a company’s EBIT by its interest expenses for the period.
The higher the interest coverage ratio, the lower is the company’s default risk. An interest coverage ratio of 1.5 or below raises doubts about the company’s ability to fulfill its interest obligations. In the example above, the interest coverage ratio is 6.3, which is very comfortable.
Business and Financial Risk Combined help the rating agencies to come up with the accurate credit rating for the industry and companies.
