Problem 6-10 Making credit-rating changes (LO6-7) Exhibit 6.5 describes the key
ID: 2820967 • Letter: P
Question
Problem 6-10 Making credit-rating changes (LO6-7)
Exhibit 6.5 describes the key financial ratios Standard & Poor’s analysts use to assess credit risk and assign credit ratings to industrial companies. Those same financial ratios for a single company over time follow. The company was assigned a AAA credit rating at the beginning of 2013.
Required:
Did the company’s credit risk increase or decrease over these six quarters?
What credit rating should be assigned to the company as of Q2 in 2017?
Which is the quarter from the table above that Standard & Poor's would first consider downgrading this company's credit rating?
2016 2017 Q1 Q2 Q3 Q4 Q1 Q2 EBIT interest coverage 23.8 22.1 21.6 20.8 20.6 12.4 EBITDA interest coverage 25.3 26.4 25.6 23.2 22.9 16.5 FFO/Total debt (%) 167.8 150.8 130.7 128.4 80.2 76.2 Free operating cash flow/Total debt (%) 104.1 107.3 103.7 98.6 61.5 45.3 Total debt/EBITDA 0.2 0.2 0.2 0.6 0.8 1.0 Return on capital (%) 35.1 34.3 30.6 28.1 25.9 24.7 Total debt/Capital (%) 6.2 6.8 7.5 15.4 27.2 35.6Explanation / Answer
1. To evaluate credit risk, total debt to income ratio is considered. As it is quite evident that the credit risk has increased substantially as the ratio become 1 towards the end of the 6th quarter stated(2nd are of 2017) from just 0.2 in the 1st qtr of 2016.
2. In the 2nd qtr of 2017 almost all ratios indicates unfavourable credit position of the company. Already the company has so much debt liability to be met. The rating would be changed to C, CC or CCC as the condition is quite vulnerable for the company
Further worsened situations can make the company bankrupt/ default some of it commitments.
3. The 4th qtr of 2016 will be the prime consideration to downgrade the company. Things were quite good till then, the risks were nominal and within the allowable limits but steadily after that the debt in the capital mix has almost doubled making the company prone to various financial burden and this is clearly seen in the worsened ratios after that.