Publication Date: Jun 14, 2006 10:00 Australia/Sydney
Financial ratios are a key dimension of Standard & Poor's credit risk analysis both in Australia and internationally. For a given rating category, expected levels of financial ratios vary with the business or operating risk profile of a company. Companies with a stronger competitive position, more favorable business prospects, and more predictable cash flows can undertake added financial risk for a given credit rating than companies with weaker business profiles. Interpreted with care and a forward-looking perspective, financial analysis is a useful means of comparing and predicting the relative default risk of both similar and dissimilar companies.
In general, key ratios measure either the performance or the risk of the financial structure, or a combination of both. The performance of a company can be assessed using the return on permanent capital and operating margin ratios. In an absolute sense, earnings performance ratios measure the ability of a company to both cover its operating costs and provide a return to debt and equity investors; and, in a relative sense, these ratios give some indication of a company's performance and market position compared with those of its peers. The prudential measures of interest cover, cash flow-to-debt, and leverage indicate management's willingness to undertake financial risk and the desired level of asset protection and debt capacity.
It is important to note that the ratio medians Standard & Poor's publishes annually in CreditStats (which collates the historical financial data for the population of rated industrial and nonfinancial services companies) and its more industry-focused Global Sector Reviews are not rating benchmarks. This is because the ratio medians ignore the critical link between a company's financial risk, its business risk position, and management's strategic ambitions and financial policies. Furthermore, since ratings are designed to be maintained over the expected business cycle, ratios for a particular company at any point in the cycle may appear out of line for its assigned debt ratings. Cross-border comparisons should be treated with caution, because of differences in accounting principles, financial practices, and business operations. There also are many nonnumeric distinguishing characteristics that determine fundamental riskiness of a company's debt, which often outweigh the financial results.
The following definitions are some of the key ratios used by Standard & Poor's in analyzing the credit strength of industrial companies in Australia, and may help readers to more fully understand references to these ratios in Standard & Poor's Australian Corporate Reports. Special thought has been given to the treatment of items such as minority interests, equity accounted associated companies, abnormal items, nonrecurring gains or losses, and the capitalization of noncancelable operating leases. The objective of these adjustments is to generate ratios that reflect the ongoing operational profitability and capital structure of the firm analyzed and to make comparisons more valid and useful. No standard set of definitions can anticipate all the unique aspects of individual company finances, so additional adjusted ratios and statistics will often be included in the body of the reports to better explain financial performance or risk. Discretionary items like dividend reinvestment plans need to be interpreted in context. In addition, industry-specific statistical measures may be included.
For hybrid securities which are categorized as having intermediate equity content:
The outstanding principal amount will be divided, so that half is allocated to equity and half to debt.
Each period’s distributions will be divided, so that half is treated as a dividend and half as interest.
The resulting data will apply to the income statement, cash flow statement and balance sheet ratios, and to all ratios with components that are interest, debt and equity.
Hybrid securities categorized as having minimal equity content are treated as 100% debt in ratio calculations, and hybrid securities categorized as having high equity content are categorized as 100% equity for ratio calculations.
Earnings Performance and Coverage Ratios
The interest coverage ratios measure the ability of the company to meet its fixed financial obligations (sourced from pretax income from continuing operations). The pretax interest cover ratio is defined as earnings before interest and tax (EBIT) divided by gross interest. Adding back depreciation and amortization charges to EBIT provides a pretax operating cash flow measure of interest coverage. Thus, the earnings before interest, tax, depreciation and amortization (EBITDA) cover ratio is defined as EBITDA divided by gross interest. Also, interest capitalized is added to interest expense for interest cover calculations.
The return on permanent capital measures overall profitability against the average capitalization, or asset utilization. The definition of this ratio is EBIT divided by permanent capital. The operating income-to-sales ratio, also referred to as the operating margin, indicates the company's relative cost-competitiveness and market position.
Cash Flow Ratios
Cash flow ratios measure the ability of the company to generate cash from its operations to service outstanding debt principal and other obligations. Cash flow measures tend to overcome distortions that can be caused by differences in accounting for noncash charges. The two measures Standard & Poor's uses are: free operating cashflow (FOC)-to-total debt, and funds from operations (FFO)-to-total debt.
Capital Structure Ratios
Capital structure ratios, commonly referred to as debt-to-capital, gearing, or leverage ratios, are used to indicate the extent to which the company is funded by debt or equity. As some Australian companies carry large cash balances, net debt-to-net capital leverage ratios are also published, net of cash balances. The structure of a company's debt is also evaluated (current debt-to-total debt and secured debt-to-total debt), which reveals the presence of refinancing risks and the risks facing various categories of debt holders.
Treatment of Operating Leases
Standard & Poor's operating lease model improves the comprehensiveness and comparability of companies' financial ratios, by considering more de facto assets and liabilities, whether they are accounted for on or off the balance sheet. Again, the specific nature of a company's lease obligations (e.g. term, asset type, residual values, matching customer leases, and contracts) often requires a number of subjective analytical decisions to be made, but the operating lease model establishes parameters that serve as a starting point for such decisions. Under the financial ratios section of an Australian Corporate Report, Key Financial Ratios - Operating Lease Adjusted, adjusted ratios are presented for pretax and EBITDA interest coverage, return on permanent capital, operating margin, FOC-to-debt and FFO-to-debt, and debt-to-capital ratios.
In capitalizing the noncancelable operating lease commitments, a present value (PV) is calculated by discounting the future lease commitments at a standard discount rate, currently 10%. This method converts a stream of payments tied to temporary assets to a debt-financed purchase of property, plant and equipment. Standard & Poor's reallocates the average of the current and previous year's minimum first-year lease commitment to interest and depreciation. The average commitment is used, rather than the actual payment, as Standard & Poor's does not capitalize short-term operating leases.
The average lease commitment is split between:
Interest expense, which is the average of the current and previous year's PV multiplied by the interest factor (10%); and
Depreciation, which is the remainder of the average lease commitment.
Each ratio is then adjusted according to the following new values:
Pretax interest cover is adjusted by adding the additional interest expense to both EBIT and gross interest;
EBITDA cover is adjusted by adding the additional interest expense to both EBITDA and gross interest, and adding additional depreciation to EBITDA;
Return on permanent capital is adjusted by adding the additional interest expense to EBIT, and adding the average PV of the current and previous annual operating lease commitments to permanent capital (via total debt);
Operating income-to-sales is adjusted by adding both the additional interest and additional depreciation expenses back to operating income;
Free operating cash flow-to-total debt is adjusted by adding the PV of operating leases to total debt;
Funds from operations-to-total debt is adjusted by adding additional depreciation to FFO and the PV of operating leases to total debt; and
Debt-to-capital is adjusted by adding the PV of operating leases to total debt in both the numerator and denominator.
GLOSSARY OF RATIO DEFINITIONS
Sales are defined as net sales.
Operating profit is net profit before tax (after significant items), less equity profit from associates and joint ventures, plus dividends from associates and joint ventures.
Operating income is operating profit before interest income, interest expense, depreciation and amortization.
EBITDA is operating income plus interest income.
EBIT is EBITDA less depreciation and amortization.
Interest expense includes finance lease interest and discount on bills payable. Gross interest is interest expense plus capitalized interest.
Permanent Capital is the average of the past and present years' permanent capital (equity plus the provision for deferred tax plus total debt less future tax benefits).
Equity consists of paid-up capital, capital reserves, certain hybrid securities, unappropriated profits, and minority interests, less treasury stock. Redeemable preference shares and subordinated convertible notes and bonds are excluded from equity.
Total debt includes (current and noncurrent, secured and unsecured debt) bank overdrafts, loans including those loans from related companies, finance lease liabilities, redeemable preference shares, nonrecourse debt, debenture stock, promissory notes, convertible notes, and bills payable (nontrade).
Funds from operations (FFO) is defined as operating profit plus depreciation and amortization less income tax paid, plus/(minus) net noncash abnormal losses/(gains), plus/(minus) net losses/(gains) on the sale of assets.
Movement in noncash to nondebt working capital is defined as the difference between the current and past year's noncash current assets less nondebt current liabilities.
Free operating cashflow (FOC) is defined as FFO less fixed assets purchases less movement in noncash-to-nondebt working capital.
Capital Capital is total debt plus equity.
Cash and deposits includes government securities and negotiable securities.
