Hi all,
I need to review a company's credit position. This is from the point of view of a investor buying debt and holding until maturity.
What are the kinds of metrics I should look for? Besides profitability and leverage, what else is important in credit analysis of this sort?
Thanks in advance.
Investopedia has a list http://www.investopedia.com/university/ratios/#axzz1xcdN3yzE
You want to focus on:
1) Cash flow: - free cash flow / total debt - EBITDA / cash interest
2) Leverage: - total debt / EBITDA - total debt / (EBITDA - Capex)
If you're looking at holding to maturity you'd want to get a sense for how these metrics look going forward. If the debt is prepayable you want to figure out whether the company will have enough cash flow to prepay the debt before maturity. If not you need to get a sense for what the metrics will look like at maturity because you're relying on a refinancing to get your money back.
First I’d look at qualitative factors such as management and competitive advantage. This is very important and quite often overlooked by less experienced monkeys that get caught up in the financial “metrics”. Having an experienced, trustworthy management team that is willing to work with you will make all the difference in the world when a loan goes sour. By competitive advantage I’m talking about things such as barriers to entry, defensible business model/niche, etc… Make sure you understand the business, and the key risks facing the business. In lending the upside potential of the company does not matter to you, what matters is that you get paid back – and that means you are comfortable with all the risks facing the business.
Assuming you’re not talking about asset based lending, second thing I’d look at is cash flow. This is what will pay you back. Here you are looking for stability and predictability…. Preferably you want a nice cash flow cushion to absorb any hiccups. Also look at the kinds of things the company spends money on. CAPEX, distributions, etc…
Third is leverage as you already mentioned. There is absolutely no substitute for a strong balance sheet. A well capitalized balance sheet will allow a company to endure a down cycle and any other fuckups. Liquidity. You want to make sure a company has sufficient liquidity to get by day to day. Note: don’t just look at a company’s cash balance and assume they are liquid. Once things start going south, the company will burn through the cash like a hot knife through butter.
There are countless other things you’ll need to consider such as is the loan secured or unsecured? If you are unsecured, make sure you are getting compensated for the increased risk. Are there any guarantees from parent, subsidiary, owner, etc.? Is there any other debt? Also you want to think about the structure of the loan. Things you want to keep in mind is the position of your debt – subordinated or senior. You also want to think of appropriate covenants and the tenor of the debt….That’s just a gist of it but I think this should get you thinking in the right direction.
As far as metrics go some I’d look at are: balance sheet leverage, cash flow leverage, current ratio, debt service coverage / fixed charge coverage, and interest coverage.
For extra credit, arguably the most important factor when making an informed lending decision is probability of default and the resulting loss given a default.
Hope this helps.
SJ that is very helpful, I sincerely thank you for taking the time to write it up!
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