Credit risk is risk due to uncertainty about a counterparty's ability to meet its obligation. Credit analysis is the evaluation of credit risk. It focuses on debt-paying ability and cash flow rather than accrual-income returns.

Moody's ratings focus primarily on four factors:

1. Company profile - Scale and diversification.

These elements are indicative of other characteristics that mitigate risk and are a good indicator of market leadership, purchasing power, operational flexibility, the potential for enhanced access to financing and the capital markets, etc.

2. Financial policies - Tolerance for leverage.

Cash flow available to service indebtedness is considered the most fundamental measure of credit stature. Various solvency ratios are used for that purpose:

• Retained Cash Flow (RCF)/ Total Debt (TD)
• (RCF - CapEx) / TD
• TD / EBITDA
• (EBITDA - CapEx) / Interest
  *CapEx: Capital expenditure
• EBITDA / Interest

3. Operational efficiency.

This factor is analogous to operating leverage. Since they can generate larger levels of cash flow, companies with low operating leverage (i.e., superior profit margins) can afford to have larger debt loads. Owing to the fact that debt loads can be restructured, low-cost companies have better prospects than high-cost companies when faced with financial stress/distress and forced reorganizations.

4. Margin stability.

Lower volatility in margins would imply lower risk relative to economic conditions.

Practice Question 1

Which of the following is the most useful to an analyst assessing the creditworthiness of a company? Information related to ______.

A. operating cash flow
B. the scale and diversity of a company's operations
C. efficiency of a company's operations

Correct Answer: A

Credit analysis is concerned with a company's debt-paying ability. Returns to creditors are normally paid in cash, so the company's ability to generate cash internally is the most important factor in credit analysis.