Analysing a company's credit · RiskAtoms Academy

By the end you will be able to

1Use the five Cs to organise a credit judgement on a company.
2Calculate and read leverage, interest cover, gearing and the current ratio from a company's accounts.
3Turn EBITDA into free cash flow, and estimate debt capacity and the years needed to repay.
4Compute covenant headroom and test it under a fall in earnings and a rise in rates.

Why it matters

Thornvale Engineering Ltd and Larkhollow Freight Ltd both borrow from RiskAtoms Bank, both make about the same EBITDA margin, and the bank has lent each of them similar amounts. Yet the bank rates the first grade 4 and the second grade 7, a PD 8 times higher. A 20% fall in earnings would leave the engineer comfortably inside its covenants and push the haulier through both of them. Credit analysis is how a bank sees that difference before it lends.

Core explanation

Can they pay, and will they?

L3.3.01: The credit lifecycle placed analysis at the second stage of the credit lifecycle. For a company, the analyst's question is simple to state: will the business generate enough cash, for the life of the loan, to pay interest and repay principal, even when things go wrong? The raw material is the company's accounts (L1.8.01: Accounting basics), its plans, and the analyst's view of the industry and the people.

Illustrative dataRiskAtoms Bank plc's credit book

One made-up lending book, in pounds, at one made-up year end: twelve invented corporate borrowers (exposure at default £587m, expected loss £2.81m a year), 152,100 retail accounts in mortgages, personal loans and cards (exposure £4.485bn), a ten-grade master scale and an illustrative rating transition matrix. No firm or person in it is real. The same book runs through every lesson in Module 3.3, so the figures agree from lesson to lesson.

This lesson adds the borrowers' own summary accounts for the last financial year, in £m, for Thornvale Engineering Ltd (grade 4) and Larkhollow Freight Ltd (grade 7). They are invented, like the companies. Each company's debt includes what it has drawn from the bank in the book: £45m and £26m.

The five Cs

Lenders have long organised their judgement under the five Cs. Character: the integrity, track record and willingness to pay of the people in charge. Capacity: the cash flow available to service debt. Capital: the owners' equity cushion beneath the lenders. Collateral: the assets the lender can claim if all else fails. Conditions: the purpose and terms of the loan, the industry and the economy. Capacity comes first: collateral reduces the loss if a borrower defaults, but a loan that can only be repaid by seizing the security should not be made.

Sort itWhich C is it?

Facts from the files on Thornvale Engineering Ltd and Larkhollow Freight Ltd. Which of the five Cs does each one inform?

Thornvale Engineering Ltd's management has met every covenant and reporting deadline for twelve years.
Larkhollow Freight Ltd turns £25.2m of EBITDA into £5.0m of free cash flow after interest.
Thornvale Engineering Ltd has £210m of equity against £120m of debt.
The bank's loan to Thornvale Engineering Ltd is secured on its factories, valued at £30m.
UK road haulage margins are thin and fuel prices are volatile.

The ratios

Ratios turn accounts into comparable numbers, using the percentages of M-A01: Percentages. Start from EBITDA (L1.5.04: Valuation multiples), the cash-like operating profit. Four families matter most:

Leverage: net debt over EBITDA, the most widely used single measure. It is roughly the years of EBITDA needed to clear the debt. Gearing (debt over equity) shows the same thing from the balance sheet.
Interest cover: EBITDA or EBIT over interest. Below about 2 times, a modest dip in earnings leaves the interest unpaid.
Liquidity: the current ratio, current assets over current liabilities. Below 1, the company depends on its bank lines to pay next year's bills.
Cash flow: free cash flow after tax, capital expenditure, working capital and interest, and how many years of it would repay the net debt.

Last year, £m	Thornvale Engineering Ltd	Larkhollow Freight Ltd
Revenue	£420m	£210m
EBITDA	£63.0m	£25.2m
Depreciation	£18.0m	£14.0m
Interest paid	£6.3m	£5.6m
Total debt	£120m	£92m
Cash	£15m	£4m
Equity	£210m	£38m
EBITDA margin	15.0%	12.0%
Net debt	£105.0m	£88.0m
Net debt / EBITDA	1.67×	3.49×
EBITDA / interest	10.00×	4.50×
EBIT / interest	7.14×	2.00×
Debt / equity	0.57×	2.42×
Current ratio	1.60	1.05
Free cash flow after interest	£24.8m	£5.0m
Years to repay net debt	4.2	17.6

The margins are similar (15% and 12%). Almost everything else differs. Larkhollow Freight Ltd carries 3.49× of net debt to EBITDA against 1.67×, its EBIT covers interest only 2.0×, and its lorries need constant replacing, so £25.2m of EBITDA leaves just £5.0m of free cash. At that pace repaying its net debt would take 17.6 years, longer than the life of the lorries. Thornvale Engineering Ltd could repay in 4.2 years.

Thornvale Engineering Ltd: EBITDA to free cash flow

Larkhollow Freight Ltd: EBITDA to free cash flow

Debt capacity and covenants

Debt capacity asks the question the other way round: how much debt could this EBITDA carry? RiskAtoms Bank uses two tests, the same ones written into each loan as covenants: net debt at most L times EBITDA, and EBITDA at least c times interest, with interest computed at today's average rate plus 2 points. The smaller answer binds. For Thornvale Engineering Ltd (L = 3, c = 4) the leverage test allows £189m and the cover test £217m, so capacity is £189m against net debt of £105m: £84m to spare. Larkhollow Freight Ltd (L = 4, c = 3) has £12.8m to spare.

Covenants turn the analysis into an early-warning system. The useful number is the headroom: how far EBITDA can fall before a covenant breaks. Thornvale Engineering Ltd has 44% on leverage; Larkhollow Freight Ltd only 12.7%.

The formal version

Ratios, headroom and capacity

With $D$ total debt, $K$ cash, $E$ EBITDA and $I$ interest:

\begin{aligned} \ell &= \frac{D - K}{E} \quad \text{(net leverage)} &\qquad \kappa &= \frac{E}{I} \quad \text{(interest cover)} \\ \text{FCF} &= E - \text{tax} - \text{capex} - \Delta\text{WC} - I &\qquad \text{payback} &= \frac{D-K}{\text{FCF}} \end{aligned}

With Larkhollow Freight Ltd's numbers ( $\ell = 3.4921$ , $L = 4$ , $\kappa = 4.50$ , $c = 3$ ):

\begin{aligned} h_{\text{lev}} &= 1 - \frac{\ell}{L} = 1 - \frac{3.4921}{4} = 12.7\% \\ h_{\text{cover}} &= 1 - \frac{c}{\kappa} = 1 - \frac{3}{4.50} = 33.3\% \end{aligned}

Rates move interest too. If a share $f$ of the debt floats and rates rise by $\Delta r$ , interest becomes $I + fD\,\Delta r$ , and the cover covenant breaks at a smaller fall in EBITDA:

\begin{aligned} \frac{(1-h)E}{I + fD\,\Delta r} &= c \\ h &= 1 - \frac{c\,(I + fD\,\Delta r)}{E} = 1 - \frac{3 \times (5.6 + 1 \times 92 \times 0.02)}{25.2} = 11.4\% \end{aligned}

Debt capacity is the smaller of the two tests, at a stressed rate $r_s$ :

\begin{aligned} D^{\max} &= \min\!\Big(L\,E,\ \frac{E}{c\,r_s}\Big) \\ &= \min\!\Big(4 \times 25.2,\ \frac{25.2}{3 \times 0.0809}\Big) = \min(100.8,\ 103.9) = \text{£}100.8\text{m} \end{aligned}

Here $r_s$ is the average rate today, 6.09%, plus 2 points. Debt capacity is compared with net debt, so Larkhollow Freight Ltd could add about £12.8m before failing the bank's tests, and the cash-flow view says even that would take years to repay.

Try it

Choose a company and stress it. How large a fall in EBITDA does Thornvale Engineering Ltd survive? Now switch to Larkhollow Freight Ltd and add a 2-point rise in rates: watch the cover covenant go first, then leverage.

Try itStress a borrower's ratios

Company

Fall in EBITDA0% (EBITDA £25.2m)

Rise in interest rates+0.00 points on 100% of debt

Net debt / EBITDA3.49×

Covenant: at most 4.0×headroom 13%

Gross debt / EBITDA3.65×

Current ratio1.05

EBITDA / interest4.50×

Covenant: at least 3.0×headroom 33%

Free cash flow after interest£5.0m

Years to repay net debt from it17.6

Tax, capital expenditure and working capital are held at last year's levels; only EBITDA and interest move. Amber means less than 15% headroom left.

Worked example

The annual review of Larkhollow Freight Ltd

Larkhollow Freight Ltd: grade 7, EAD £29.0m

Step 1 of 7

1
Character, conditions, collateral
Family-owned, competent management with a clean payment record. Road haulage is cyclical, with thin margins and volatile fuel costs. The bank's loan is secured on lorries worth £18m before a 40% haircut, so the book's LGD on it is 35.1%.

What the credit paper says

Larkhollow Freight Ltd: net debt / EBITDA 3.49× (covenant 4.0×, headroom 13%), EBITDA cover 4.5×, free cash flow £5.0m, 17.6 years to repay. Fails both covenants under a 20% EBITDA fall with rates +2 points. Recommend: maintain, do not increase; grade 7 confirmed.

Regulatory lens

Supervisors expect this analysis to be done and documented. In the EU, the European Banking Authority's Guidelines on loan origination and monitoring (May 2020, applying to loans granted from 30 June 2021) ask lenders to use metrics of the borrower's ability to repay, to take a forward-looking view, and to test creditworthiness under adverse scenarios, much like the stress above. Under the internal ratings-based approach (M4.2: Credit risk capital), the ratios feed the rating models whose PDs set the bank's capital. Statistical models of default built on ratios are covered in M6.4: Credit risk modelling.

Spark Atoms

Spark Atom“The first thing is character”

Testifying to a US congressional committee on 19 December 1912, J. P. Morgan was asked whether commercial credit is based primarily on money or property. “No, sir; the first thing is character,” he replied. “Before money or anything else. Money cannot buy it.”

Spark AtomFive ratios and a score

In 1968 Edward Altman combined five financial ratios (working capital, retained earnings, EBIT, market value of equity and sales, each scaled by assets or liabilities) into one score that separated manufacturers that went bankrupt from those that did not. His Z-score is still quoted today, and it was an early step from ratio analysis to rating models.

Key takeaways

The five Cs: character, capacity, capital, collateral, conditions. Capacity to repay from cash flow comes first.
Net debt / EBITDA measures leverage; EBITDA / interest measures cover; the current ratio measures short-term liquidity.
Free cash flow after tax, capex, working capital and interest is what repays debt; EBITDA alone flatters.
Covenant headroom h = 1 − ℓ/L is the fall in EBITDA a borrower can take before breaching; rate rises shrink it.
Debt capacity is the smaller of L × EBITDA and EBITDA / (c × stressed rate).

Reaction

Check what stuck

Question 1 · objective 2

A company has £300m of debt, £60m of cash and EBITDA of £80m. What is its net debt to EBITDA (two decimals)?

×

Question 2 · objective 4

A borrower's net debt is 2.4 times EBITDA and its covenant allows at most 3.0 times. By what percentage can EBITDA fall before the covenant breaks?

%

Question 3 · objective 3

A company has EBITDA of £50m and pays £8m of interest on £160m of floating-rate debt. If rates rise by 1.5 points, what is its EBITDA interest cover (two decimals)?

×

Question 4 · objective 1

The founder of a borrower has twice before run companies that defaulted on bank loans. Which of the five Cs does this bear on most?

ACapacityBCapitalCCharacterDConditions

Question 5 · objective 3

Why does a credit analyst not stop at EBITDA when judging whether a loan can be repaid?

AEBITDA includes interest incomeBTax, capital expenditure, working capital and interest all come out of it before any cash is left to repay debtCEBITDA is always smaller than free cash flowDAccounting rules forbid it

Glossary

Five Cs of credit: A checklist for judging a borrower: character, capacity, capital, collateral and conditions.
EBITDA: Earnings before interest, tax, depreciation and amortisation: operating profit before non-cash charges, a rough measure of the cash the business generates.
Net debt: Total borrowings minus cash. The debt the company could not repay from cash in hand today.
Net leverage: Net debt divided by EBITDA: how many years of EBITDA it would take to repay the debt.
Interest cover: EBITDA (or EBIT) divided by interest paid: how many times earnings cover the interest bill.
Gearing: Debt divided by equity: how much of the business is funded by lenders rather than owners.
Current ratio: Current assets divided by current liabilities: whether short-term assets cover bills due within a year.
Free cash flow: Cash left after tax, capital expenditure, working capital and interest. What is actually available to repay debt.
Debt capacity: The most debt a borrower can carry and still pass the lender's tests, such as leverage and interest cover.
Covenant: A promise in the loan agreement, tested on each set of accounts. A breach lets the lender renegotiate or demand repayment.
Headroom: How far a ratio can move, usually as a fall in EBITDA, before a covenant is breached.

Deep Dives & Origins

Deep Dives

J. B. Caouette, E. I. Altman, P. Narayanan and R. Nimmo, Managing Credit Risk, 2nd ed., Wiley, 2008, the chapters on credit analysis. Intermediate.
B. Ganguin and J. Bilardello, Fundamentals of Corporate Credit Analysis, McGraw-Hill, 2005. Intermediate.

Origins

E. I. Altman, “Financial ratios, discriminant analysis and the prediction of corporate bankruptcy”, Journal of Finance 23(4), September 1968, pp. 589–609.
US House of Representatives, Subcommittee of the Committee on Banking and Currency (the Pujo Committee), testimony of J. P. Morgan, 19 December 1912.
European Banking Authority, Guidelines on loan origination and monitoring (EBA/GL/2020/06), May 2020.

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