The Case of the Missing Bond Ratings

It’s probably safe to say that there’s nothing more important in determining a bod’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 be also 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)

Â	Company	Company	Company	Company	Company	Company
Financial Ratio	1	2	3	4	5	6
1. Current Ratio	1.13 x	1.39 x	1.78 x	1.32 x	1.03 x	1.41 x
2. Quick ratio	0.48 x	0.84 x	0.93 x	0.33 x	0.50 x	0.75 x
3. Net profit margin	4.6%	12.9%	14.5%	2.8%	5.9%	10.0%
4. Return on total capital	15.0%	25.9%	29.4%	11.5%	16.8%	28.4%
5. Long – term debt to total capital	63.3%	52.7%	23.9%	97.0%	88.6%	42.1%
6. Owner’s equity ratio	18.6%	18.9%	44.1%	1.5%	5.1%	21.2%
7. Pretax interest coverage	2.3 x	4.5 x	8.9 x	1.7 x	2.4 x	6.4 x
8. Cash flow to total debt	34.7%	48.8%	71.2%	20.4%	30.2%	42.7%
Notes:   1. Current ratio = current assets/current liabilities 2. Quick ratio = (current assets – inventory)/current liabilities 3. Net profit margin= net profit/sales; 4. Return on total capital= pretax income/ (equity +long – term debt); 5. Long – term debt to total capital= long – term debt/ (long term debt +equity); 6. Owner’s equity ratio= stockholders’ equity/total assets; 7. Pretax interest coverage= earnings before interest and taxes/interest expense; 8. Cash flow to total debt= (net profit +depreciation)/total liabilities.

 

The financial ratios shown above are often helpful in carrying out such analysis. The first 2 ratios measure the liquidity of the firm, the next 2 its profitability, the following 2 the debt load, and the final 2 the ability of the firm to service its debt load. (For ratio 5, the lower ratio, the better. For all the others, the higher the ratio, and the better.) The table lists each of these ratios for 6 companies.

Questions

1. Three of these companies have bonds that carry investment – grade ratings. The other 3 companies carry junk – bond ratings. Judging by the information in the table, which 3 companies have the investment – grade bonds and which 3 have the junk bonds? Briefly explain your selections.

2. One of these 6 companies is a AAA – rates firm and one is B – rated. Identify those companies. Briefly explain your selections.

3. Of the remaining 4 companies, 1 carries AA rating, 1 carries an A rating, and 2 have BB ratings. Which companies are they?