Analyzing Corporate Bond IssuersBond Instruments
While investing in equities, your analysis and valuation needs to take a wide array of factors into consideration. Equity investor’s essential goal is determining how quickly the company’s growth rate is for the long term, and relating that information to the firm’s value. The stability of the firm is also taken into account. When analyzing corporate bond issuers, you essentially care solely about the firm’s financial stability. You don’t care about the growth rate beyond its ability to ensure the firm will repay you. Will the firm still exist when the maturity date comes for the bonds? Are there any specific events which will result in your firm not being able to make interest payments or principle repayments? You are essentially playing the role of a bank lender, making the same judgments from the same position.
You are primarily investing the firm’s debt management, liquidity, and financial sustainability. Avoid firms with debt that is too high, low levels of liquidity, and unsustainable finances. If it seems like the firm is falling back on debt in order to survive their business situation, you should avoid purchasing their bonds. If the firm appears like it could have its credit rating downgraded, you should look elsewhere unless you are holding the firm to maturity. Even if you are, you should know that you will be receiving reduced reward in comparison to risk after the downgrade. If you are interested in purchasing the bonds of a firm which has either possibility, the interest you are earning should be phenomenal relative to similar bonds available. After purchase you remain aware of credit risk and downgrade possibilities due to identified financial hazards.
You need to ensure the firm has sensible debt management. An intense amount of debt does not bode well for a company. The higher the debt the firm has, the more likely they are to be bankrupted by a downturn in business or the economy. To analyze the firm, focus on these ratios on a year by year basis. Remember that trends mean more than numbers in a vacuum. Trends will affect the firm if they continue into the future, and will notify you if the firm’s survivability is decreasing over the course of your prospective bond’s maturity.
The following ratios can assist you in learning how the firm manages debt. As a note, you should realize firms do not necessarily have to reduce debt to change these numbers. They can manipulate their finances to change the appearance of these ratios, resulting in the appearance of a change in their situation. As an example, if they want to reduce costs, they can stop purchasing assets and instead rent them, or purchase the services of others. This reduces the total assets column, affecting the debt ratio. On an overall level, these ratios will still give you some crucially needed information about the firm’s debt management.
The debt ratio relates total liabilities to total assets. If this percentage is high, the firm is focusing on using debt to grow assets, as opposed to using equity or retained earnings. The closer this number is to 100%, the more dangerously the firm is utilizing debt. Above 50% is hazardous, but above 75% is especially dangerous. This ratio is best used for manufacturing firms, since service firms typically do not need as many hard assets.
The debt to equity ratio is a better measure of service firm’s debt management, since they have low asset bases. Instead of measuring Total Liabilities to assets, liabilities are compared with shareholder’s equity. Assets can be purchased with Debt or Equity. A number significantly under 1 is preferable. The higher this number is, the more dangerous the firm is as an investment. If this number is above one, pay attention to the liquidity, expenses, and growth rate of the service firm. This will help inform you if the firm will be around at maturity.
Times Interest Earned displays the amount of times a firm could pay the interest on its debts. The larger this number is, the less likely the firm is to default on interest payments. If this number is high and increasing over time the firm may be able to support longer term bonds. If the firm’s sales are volatile, you will need to pay attention to their cost structure before Earnings before Interest and Taxes. Costs will need to be low to ensure they have enough profit to meet their interest expenses. Barely being able to pay interest fees is not a good sign. The closer this is to one, or below one, the higher the bond issuer’s risk.
Interest Coverage informs you how many times the firm could pay its annualized interest expenses. The formula itself is highly similar to times interest earned. Higher is better, indicating that the firm can afford more debt and make bond payments easier. If this number is narrowing or a low to mid-single digit number, it’s a bad sign. If it’s both, it’s a really bad sign.
The financial leverage ratio will inform you how the company is funding its growing assets. Assets are purchased either with equity or debt. The larger this number is, the more debt the firm has. If the financial leverage ratio is at a 1:1 level, all assets were paid for with equity. If the ratio is 5 to 1, equity was used for only 20% of their assets. The rest of the assets were funded with debt. Higher numbers increase the risk of the firm during downturns and the likeliness the firm may default at a later date. Pay attention to financial leverage levels rising over time, especially if this number is in the double digits.
As a lender, you are also concerned about the liquidity of the bond’s issuer. If the firm has profit scheduled but no actual cash which can pay your interest payments, you will not be getting paid. Likewise, if a firm’s sales were completely accounts receivables, you wouldn’t be paid until it actually became cash. Focusing on the trend of liquid, or cash, financials is wise. Is liquidity decreasing or expanding over the long term? The following ratios can assist you in learning how the firm manages liquidity.
The current ratio will tell you the firm’s short term liquidity, for less than a year. This will tell you if the firm has enough liquidity to consistently meet its short term debts. Pay attention to this trend. Decreasing amounts of current ratios are bad, especially if it’s already close to one. If it’s below one, a bankruptcy or default may be imminent and you should consider skipping the firm’s bonds.
The quick ratio removes Inventory, which must be sold to ensure that the firm can meet current assets. They may be worth less than they’re marked on paper, so the firm needs to be able to clear this hurdle without relying on sales of inventory. The higher this number is the better. If below one, you should be careful and potentially check inventory turnover, to be sure they can meet short term liquidity requirements. If this number’s trend is decreasing over time, you should be wary of owning these bonds.
You can modify the quick ratio to remove or adjust accounts receivable. Many firms have a historically based estimate of the percentage of accounts receivable that will not be paid. This ratio is usually given in the footnotes. Multiplying this estimate by accounts receivable will give you a more realistic expectation of the amount of cash the firm will actually obtain. If you want to only measure cash, look at the cash ratio found below.
This modification removes both inventory and accounts receivable. To some degree, this is overkill, since it’s unlikely the firm will have a ratio above 1 without inventory or receivables. Everyone who owes the firm money in accounts receivable will not default. If they can survive even if all accounts receivables default, it’s a good sign. The firm neither has to sell inventory which may not sell or rely on collecting debts which might not be paid.
Financial sustainability derives from the various trends displayed by the firm. The basic question is: If the firm continued on the trending path it is on financially, where would it end up? Would it be in bankruptcy over the term of my bond, or would it be alive to repay me? To this degree, your analysis factors in the trajectory of sales, costs, and debts. You don’t particularly care about the actual growth rate, but whether or not the firm will stay afloat with a reasonable margin of profits during the time period of your bond. The trends from these ratios will inform you if the firm can maintain sustainability.
Return on Assets measures the profitability of the firm. You don’t care specifically about profit, but you do care about the ability to pay their debts. The higher a firm’s profitability, the more likely they can afford to repay obligations. Return on equity could also be used, but you don’t necessarily care about equity based returns as a bond investor. Higher is better for this ratio. The closer to one the ratio is, the better the firm’s ability to pay its debts.
If assets are equal to equity, the ratio has an output of one, which is the lowest it can go. This means the company is paying for all of its assets with shareholder investments and has no debt. If the ratio is higher than one, this means that the firm has more assets than equity. Since assets can only be paid for with debt or equity, the firm must be using debt to pay for assets. The closer this number is to one, the safer the firm is, but moderate amounts of debt are ok. High amounts of debt will devour the firm during downturns and result in potential defaults or bankruptcies.
Cash Flow to Debt displays the amount of cash flow incoming which it can use to pay down its debts. Clearly, higher abundances of liquid cash enable a firm to pay down debts. The higher this number is the better. It indicates the firm is more likely to have the steady cash flows necessary to overcome their needs.
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