Question about Cash Flow!
Hello, I'm a student new to the world of credit trying to understand how you all determine if the cash flow profile of a business can support the debt they're adding to their structure. I understand this is most of the job but any walk throughs or resources would be greatly appreciated. Thank you in advance.
The main metric you want to look at is cash flow available for debt service. This is the cash generated by the firm before paying any debt obligations (interest/principal) and is calculated as EBITDA - Cash taxes - Chg. NWC - Capex. Now obviously you can't pay new debt with historical cash flow so you'll need to take a view on what cash flow looks like going forward which will be informed by your model.
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For this you’d want to determine free cash flows available to all shareholders so EBIT(1-tax)-DA-change in NWC- CAPEX. From this you make a debt schedule that determines the amount owed and then the amount you have left. Look at LBO models to see this all workout.
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To be clear, more goes into determining debt capacity than just using the right formula for unlevered free cash flows. Quality of cash flows is probably more important. You want to ensure you're not inadvertently capitalizing unsustainably high cash flows. For example, cash flows of a cyclical business look great at top of the cycle; but, it would not be unusual for cash flows to be zero or even a burn at the cyclical bottom so you'll need to ensure the capital structure is setup to withstand that pressure. Working capital can also result in unsustainably high cash flows. For another example, stretching vendor payables results in increased cash flows because less cash goes out the door to pay suppliers, etc. The flip side of this is that those vendor terms typically reverse, fairly quickly, when the business starts to experience stress. So I would spend more time thinking about the durability of cash flows and how they fluctuate in various scenarios. Hope that is helpful.
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What you could do is include a button or a switch in your model that automatically changes the assumptions for your bear, moderate and best case projections.
Sure you can have base, bull and bear case scenarios in your model. As with all things, if your inputs are garbage your output will be useless. It is sort of redundant with credit because the output of your base and bull case should be the same, you get par + accrued. It is a little more relevant if your security has fancy features like above par cash flow sweeps, you anticipate a make whole or other early redemption at a premium, or your security has equity-linked features. Most people, even credit analysts, are too generous with their bear case analyses. If you're not looking at a scenario where you're impaired or need to put more money into the Company you haven't given the downside enough thought.
^^ this always pay close attention to NWC items!
Levered free cash flow. Pick an interest rate and then solve for a 5% yield (lfcf / debt) is usually a good way to do it. Somewhat circular but if it’s less than that, it needs to be a business with low volatility or a business that has a high growth prospect
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