It’s probably safe to say that there’s nothing more important in determining a b
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Question
It’s probably safe to say that there’s nothing more important in determining a bond’s rating than the underlying financial condition and operating results of the company issuing the bond. Just as financial ratios can be used in the analysis of common stocks, they can also be used in the analysis of bonds—a process we refer to as credit analysis. In credit analysis, attention is directed toward the basic liquidity and profitability of the firm, the extent to which the firm employs debt, and the ability of the firm to service its debt.
A Table Of Financial Ratios (All ratios are real and pertain to real companies.)
The financial ratios shown in the preceding table are often helpful in carrying out such analysis. The first two ratios measure the liquidity of the firm; the next two, its profitability; the following two, the debt load; and the final two, the ability of the firm to service its debt load. (For ratio 5, the lower the ratio, the better. For all the others, the higher the ratio, the better.) The table lists each of these ratios for six companies.
Questions
Three of these companies have bonds that carry investment-grade ratings. The other three companies carry junk-bond ratings. Judging by the information in the table, which three companies have the investment-grade bonds and which three have the junk bonds? Briefly explain your selections.
One of these six companies is an AAA-rated firm and one is B-rated. Identify those companies. Briefly explain your selections.
Of the remaining four companies, one carries an AA rating, one carries an A rating, and two have BB ratings. Which companies are they?
Explanation / Answer
1)
Looking at the ratios, we can safely say that Companies 1,4, and 5 must have junk rated bonds. This is clear from their Quick ratios, Net Profit Margins and Debt to Capital ratios.
Quick ratio is quite low which means they have their inventory stuck and are not able sell it quickly. This is supplemented by their low profit margins and high debt to capital ratio further hampering their ability to service debt. The other Companies 2,3,and 6 must have investment rated bonds.
2)
Company 3 is clearly the AAA rated firm and Company 4 is the B- rated firm. Company 3 has the best ratios among the 6 and thus must have the highest rated bonds. Company 4 on the other hand is struggling with the finances as evident from its lowest Profit margin and high debt to capital and low interest coverage.
3)
Although companies 2 and 6 are both doing good as indicated by the given ratios, at closer observation we can make out that company 6 must be higher rated given its better interest coverage, lower debt to capital, and higher return on total capital. The other two companies 1 and 5 must be the BB rated ones, going by the arguments presented in the above two questions
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