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Subject 2. Financial Ratios in Corporate Credit Analysis PDF Download

How does an analyst who has calculated a ratio know whether it represents good, bad, or indifferent credit quality? The analyst must relate the ratio to the likelihood that the borrower will satisfy all scheduled interest and principal payments in full and on time. In practice, this is accomplished by testing financial ratios as predictors of the borrower's propensity not to pay (to default).

For example, a company with high financial leverage is statistically more likely to default than one with low leverage, all other things being equal. Similarly, high fixed-charge coverage implies less default risk than low coverage. After identifying the factors that create high default risk, the analyst can use ratios to rank all borrowers on a relative scale of propensity to default.

The ratios can be categorized into four groups:

  • Profitability: focus on operating profits and recurring revenues.
  • Leverage: lower leverage is preferred.
  • Coverage: fixed debt obligations are serviced by income/cash flows.
  • Liquidity: availability of short-term resources to pay interest or principle?

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