Standard and Poor’s Uses Financial Ratios in Its Credit Ratings Standard and Poor’s (S&P) is a widely
known credit rating agency. S&P describes its ratings as an “opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors.” S&P uses letters of the alphabet for its ratings; for example, AAA is the highest rating, followed by AA, A, BBB, and so forth. Here, S&P reports the median of key financial ratios of U.S. industrial corporations.
20-Year Cumulative Default Rates of Debt Initially Rated in Category
AAA AA A bbb bb b CCC
Default rate. . . 0.2% 1.4% 3.3% 9.4% 31.8% 54.7% 83.4%
Average of 3-Year Medians
Key Financial Ratios of U.S. Industrials by Rating Category
AAA AA A bbb bb b CCC
Operating margin (before D&A) (%) . . . 22.2% 26.5% 19.8% 17.0% 17.2% 16.2% 10.5% Return on capital (%) . . . 27.0% 28.4% 21.8% 15.2% 12.4% 8.7% 2.7% EBIT interest coverage (x) . . . 26.2 16.4 11.2 5.8 3.4 1.4 0.4 EBITDA interest coverage (x) . . . 32.0 19.5 13.5 7.8 4.8 2.3 1.1 Free cash flow to debt (%) . . . 155.5% 79.2% 54.5% 35.5% 25.7% 11.5% 2.5% Free operating cash flow to debt (%). . 129.9% 40.6% 31.2% 16.1% 7.1% 2.2% −3.6% Debt to EBITDA (x) . . . 0.4 0.9 1.5 2.2 3.1 5.5 8.6 Debt to debt + equity (%). . . 12.3% 35.2% 36.8% 44.5% 52.5% 73.2% 98.9%
Number of observations. . . 6 14 111 213 306 354 22
S&P uses these ratios as part of a complex credit rating process, which includes using various finan- cial ratios in conjunction with the company’s business risk as guidelines. Not surprisingly, as the rating deteriorates from AAA to CCC, coverage ratios decline, leverage ratios increase, and profitability measures decline. S&P also reports default rates for debt initially rated in specific categories. The default rates are consistent with lower debt rating classes having higher default rates. The default rates reported here are the cumulative default rates over 20 years.
Source: Table 1 in Lugg, D., A. Balasubramanian, N. Pradhan, and V. Vishwanathan, “CreditStats: 2007 Adjusted Key U.S. Industrial and Utility Financial Ratios,” September 10, 2008, Standard & Poor’s, a division of the McGraw-Hill Companies, reprinted with permission.
Analysts typically do not include required principal repayments in fixed charges because with a sufficiently high coverage ratio, a company can likely refinance itself to repay the principal. If the com- pany’s ability to refinance its debt is in doubt, you may want to include required principal payments in the denominator. As with all financial ratios, we should make sure that our numerators and denominators are consistent, regardless of which way we measure them. If we include a fixed charge in the denominator, we should make sure that we do not deduct it from the numerator. Basic formulas for some of the common coverage ratios appear below (it is also common to use income from continuing operations instead of net income in the following formulas). We divide the preferred stock dividend by one minus the income tax rate because preferred stock dividends are not tax deductible.
EBIT/1INT1PSDiv25 Net Income1Interest1Income Taxes
Interest1Preferred Stock Dividends/112Income Tax Rate2 (2.25) EBITDA/1INT1PSDiv25Net Income1Interest1Income Taxes1Depreciation1Amortization
GAP does not have any preferred stock or debt financing outstanding at the end of fiscal 2010, but it had a small amount of debt outstanding during the year, resulting in $6 million of interest in 2010. The coverage ratios for GAP for 2010 are
EBIT/INTGAP, 20105 $1,2041$61$778 $61$0/1120.3932 5331.3 EBITDA/INTGAP, 20105 $1,2041$61$7781$648 $61$0/1120.3932 5439.3
Our calculations of EBIT and EBITDA for GAP above assume that the interest income is from operations and not from excess assets. If they were from excess assets, an alternative treatment that some analysts use is to reduce the EBIT and EBITDA for the interest income, but then to pay down the debt with the excess assets and calculate a revised interest amount.
Making additional adjustments to our calculations for GAP is beyond the scope of this chapter; however, in a more detailed analysis of GAP, we would consider capitalizing GAP’s operating leases as well as those of its competitors. GAP uses a significant amount of operating leases. Most of its stores are leased and GAP also leases most of its offices and distribution facilities. GAP’s leases are, for the most part, not capitalized on its balance sheet; rather, GAP recognizes the lease payments as rent expense on its income statement. In GAP’s case, capitalizing operating leases will increase financial leverage ratios. In addition, capitalizing those leases would affect its coverage ratios, as would the alternative treatment of including the lease payments as a fixed charge in the denominator if not capitalized.
U.S. Securities and Exchange Commission
The SEC requires a company to disclose its coverage ratio (earnings to fixed charges) in registration state- ments (prospectuses) for both debt and preferred stock issuances. The SEC provides a specific definition of both fixed charges and earnings. The definition of fixed charges includes “(a) interest expensed and capitalized, (b) amortized premiums, discounts and capitalized expenses related to indebtedness, (c) an estimate of the interest within rental expense, and (d) preference security dividend requirements of con- solidated subsidiaries,” and the definition of earnings is, in essence, earnings from continuing operations adjusted for the fixed charges and income taxes.14 The SEC requires companies to disclose a coverage ratio of less than 1.0 as a “deficiency.”
Valuation Key 2.7
Coverage ratios measure the ability of a company to pay its fixed charges (for example, interest). We measure coverage ratios as the ratio of a measure of income or cash flow to a measure of fixed charges (payments to non-equity security holders).
2.14 DISAggREgATINg THE RETURN oN (CommoN)
EQUITY
We can disaggregate the return on equity into three components. The first two components are similar to the components in the return on assets—(levered) profit margin and asset utilization. We measure profit margin using net income to common equity in the numerator, called the levered profit margin, for we are disaggregating the return on equity. The third component is a financial leverage factor that considers the impact of using non-equity financing—the average of total assets to the average equity. We show the basic formula to disaggregate the return on equity in Equation 2.27.
14 See Regulation S-K, Part 229 — Standard Instructions for Filing Forms Under Securities Act of 1933, Securities Exchange
Act of 1934 and Energy Policy and Conservation Act of 1975. You can find the definition of the coverage ratio and related disclosures at http://www.sec.gov/divisions/corpfin/forms/regsk.htm#ratio.
2.15 ASSESSINg ComPETITIvE ADvANTAgE
As we discussed briefly in Chapter 1, assessing a company’s competitive advantage is part of the valuation process. A company’s competitive advantage affects the forecasts we use in our valuation. A competitive advantage is any characteristic that allows a company to compete within its industry so that it performs better than its rivals perform and allows a company to earn a return higher than its cost of capital. Michael Porter identified two primary types of competitive advantage: cost leadership and differentiation.15 It is
15 See for example, Porter, Michael E., Competitive Advantage: Creating and Sustaining Superior Performance, The Free
Press (1985). lo5 Assess a company’s competitive advantage
REvIEW ExERCISE 2.5
the Gap, Inc. Return on Equity Forecasts for 2011 and beyond
Use the information in Exhibit 2.1 to calculate GAP’s return on equity for one or more of the years in the fore- casts (F2011 through F2016). How is GAP’s return on equity in the forecasts changing relative to 2010?
Solution on page 79.
ROE5 Levered Profit Margin 3 Asset Utilization 3 Financial Leverage Factor
ROE5 Net Income2Preferred Stock Dividends
Revenue 3
Revenue
Average Total Assets 3
Average Total Assets
Average Equity (2.27)
The decomposition of the return on equity for GAP using the numbers from 2010 is ROEGAP, 20105 $1,2042$0 $14,664 3 $14,664 1$7,9851$7,0652/23 1$7,9851$7,0652/2 1$4,8911$4,0802/250.268 ROEGAP, 201050.08231.9531.6850.268
Return on assets and return on equity are algebraically related to each other. The return on equity is equal to the return on assets multiplied by a non-equity financing leverage factor. The non-equity financ- ing leverage factor has two components. The first component is a leverage factor for earnings, and the second is a financial leverage factor that measures the amount of non-equity financing in the balance sheet. We show the relation between the return on assets and return on equity in Equation 2.28.
ROE5ROA3 Non-Equity Financing Leverage Factor
ROE5ROA3 3 Leverage Factor for Earnings 3 Financial Leverage Factor4
ROE5ROA3 c Income to Common Equity
Net Income1 112Income Tax Rate23Interest Expense 3
Average Total Assets
Average Equity d (2.28) The relation between the return on assets and return on equity for GAP is as follows:
ROEGAP, 201050.1603 c $1,2042$0 $1,2041 1120.3932 3$63 1$7,9851$7,0652/2 1$4,8911$4,0802/2d 50.268 ROEGAP, 201050.1603 30.99731.68450.268 ROEGAP, 201050.16031.6750.268
In Exhibit 2.6 (which is in Section 2.9), we depict the decomposition of GAP’s return on equity, just as we presented the decomposition of the return on assets.
also possible for a company to have a competitive advantage via government or legal avenues by means of patents, licenses to do business, subsidies, and tariffs.
In order to have a competitive advantage, a company has to have the resources and the capabilities or competencies to achieve that competitive advantage. By understanding those capabilities, management and valuation experts are able to understand the nature of a company’s competitive advantage and, more importantly, to make predictions about the sustainability of a company’s competitive advantage. In the end, we want to forecast a company’s free cash flows. Those free cash flows are affected by a company’s competitive advantage, the returns associated with that competitive advantage, how long the competitive advantage is sustainable, and the likelihood the company can create new sources of competitive advan- tage in the future.
A company generally develops a competitive advantage by being a low-cost provider or by differen- tiating its product or service from those of its competitors. Differentiation can come in the form of spe- cific attributes of the product, servicing of the product, speed of delivery, or perceived and actual quality (brand differentiation). A company can be a low-cost provider by either using its assets more efficiently than its competitors (effectively delivering more sales per dollar of invested assets) or by keeping costs of production, marketing, and distribution lower. While some companies are considered to be low-cost producers, their product offering is still somewhat differentiated.