Problem 6-8 Assigning credit ratings using financial ratios (LO6-7) Exhibit 6.5

Question

Problem 6-8 Assigning credit ratings using financial ratios (LO6-7)

Exhibit 6.5 describes the key financial ratios Standard & Poor’s analysts use to assess credit risk and assign credit ratings to industrial companies. The same financial ratios for three firms follow.

Required:

What credit rating would be assigned to Firm 1?

What credit rating would be assigned to Firm 2?

Does Firm 3 have more or less credit risk than Firm 2?

Firm 1 Firm 2 Firm 3 EBIT interest coverage 2.7 12.8 16.7 EBITDA interest coverage 3.7 18.7 24.6 FFO/Total debt (%) 19.8 80.2 135.1 Free operating cash flow/Total debt (%) 8.2 40.6 87.9 Total debt/EBITDA 4.0 1.0 0.3 Return on capital (%) 9.9 29.2 32.7 Total debt/Capital (%) 54.8 30.2 8.1

Explanation / Answer

Firm 1 riskier than Firm 2 and Firm 2 is riskier than Firm 3

Answer 1. Firm 1 should have A Rating

Answer 2 Firm 2 should have AA Rating

Answer 3 Firm 3 has less credit risk than Firm 2

(Firm 3 should have AAA Rating)

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