It’s probably safe to say that there’s nothing more important in determining a bond’s rating than the underlying financial condition and operating results of the company issuing the bond. Just as financial ratios can be used in the analysis of common stocks, they can also be used in the analysis of bonds—a process we refer to as credit analysis. In credit analysis, attention is directed toward the basic liquidity and profitability of the firm, the extent to which the firm employs debt, and the ability of the firm to service its debt.
A Table Of Financial Ratios (All ratios are real and pertain to real companies.)
Financial Ratio Company 1 Company 2 Company 3 Company 4 Company 5 Company 6 1. Current ratio 1.13 1.39 1.78 1.32 1.03 1.41 2. Quick ratio 0.48 0.84 0.93 0.33 0.50 0.75 3. Net profit margin 4.6% 12.9% 14.5% 2.8% 5.9% 10.0% 4. Return on total capital 15.0% 25.9% 29.4% 11.5% 16.8% 28.4% 5. Long-term debt to total capital 63.3% 52.7% 23.9% 97.0% 88.6% 42.1% 6. Owners’ equity ratio 18.6% 18.9% 44.1% 1.5% 5.1% 21.2% 7. Pretax interest coverage 2.3 4.5 8.9 1.7 2.4 6.4 8. Cash flow to total debt 34.7% 48.8% 71.2% 20.4% 30.2% 42.7% Notes: Current ratio = current assets / current liabilities Quick ratio = (current assets – inventory) / current liabilities Net profit margin = net profit / sales Return on total capital = pretax income / (equity + long-term debt) Long-term debt to total capital = long-term debt / (long-term debt + equity) Owner’s equity ratio = stockholders’ equity / total assets Pretax interest coverage = earnings before interest and taxes / interest expense Cash flow to total debt = (net profit + depreciation) / total liabilities
The financial ratios shown in the preceding table are often helpful in carrying out such analysis. The first two ratios measure the liquidity of the firm; the next two, its profitability; the following two, the debt load; and the final two, the ability of the firm to service its debt load. (For ratio 5, the lower the ratio, the better. For all the others, the higher the ratio, the better.) The table lists each of these ratios for six companies.
Questions
Three of these companies have bonds that carry investment-grade ratings. The other three companies carry junk-bond ratings. Judging by the information in the table, which three companies have the investment-grade bonds and which three have the junk bonds? Briefly explain your selections.
One of these six companies is an AAA-rated firm and one is B-rated. Identify those companies. Briefly explain your selections.
Of the remaining four companies, one carries an AA rating, one carries an A rating, and two have BB ratings. Which companies are they?