Volume 4 — Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 5 Table 1. Financial Metrics for Establishing Credit Limits Most Recent FYE – S&P_ 100 Financial Ratio Medians AAA A+ A- BBB+ BB+ B+ Pretax Interest Coverage (x) 25.5 7.6 3.1 1.2 1.7 (19.2) EBITDA Interest Coverage (x) 36.5 9.4 7.6 5.4 3.4 (5.0) Total Debt / EBITDA (x) 0.8 1.8 2.1 3.5 4.5 4.3 Long Term Debt / Capital (%) 18.7 42.9 27.9 44.8 46.4 55.4 Total Debt /Capital (%) 37.8 52.3 30.5 57.9 53.3 65.2 There are universal principles of credit strength that allow credit managers to tailor the standards on which they would grant credit. Among these are company size, industry characteristics and trends, profitability, liquidity, cash flow, interest and fixed-charge coverage, and capital structure. Credit ratings, whether from ratings agencies or internally developed (see “Scoring Model” below), are meant to capture all the universal principles and provide a common basis for expressing the credit strength of the portfolio. As a best practice, however, rather than relying solely on published credit ratings, we believe that credit managers should employ thorough financial analysis in deciding whether to extend or deny unsecured credit. Financial risk analysis is performed to determine the underlying creditworthiness of the counterparty and assess its capacity to perform financial and nonfinancial obligations. This involves taking into account the direct credit risk based on the counterparty’s financial profile and the indirect industry risks. Hence, credit analysis involves assessing the financial condition of the counterparty through the analysis of its underlying financial performance, as exemplified by its financial statements (income statement, balance sheet, statement of cash flow), an analysis of the industry, and an understanding of how subjective factors influence capability to financially perform. The following points should be included in a best practice approach to credit analysis (as discussed above, these should be adjusted to reflect a counterparty’s specific characteristics): Financial Statement Analysis • Income Statement Analysis − Historical revenue, costs, and earnings trends − Degree of operating leverage, and thus a basic understanding of the fixed and variable cost structure of the counterparty − Gross profit, EBIT, and EBITDA margins and trends − Coverage ratios, including EBITDA/interest and EBITDA/(principal and interest). • Balance Sheet Analysis − Asset efficiency ratios − Working capital position, including the liquid nature of its current assets and available cash