Page 41 - FINAL CFA I SLIDES JUNE 2019 DAY 9

Session Unit 9:
LOS 33.c: Describe the role of financial statement 33. Financial Statement Analysis: Applications

analysis in assessing the credit quality of a potential
debt investment., p.324

Credit involves establishing three Cs of potential debtor:
• Character -credibility/reputation of management;

• Collateral -asset base and security to reduce default risk;
• Capacity - to repay (financial ratio analysis)
tanties

Credit rating agencies such as Moody’s and Standard and Poor’s employ formulas that are essentially
weighted averages of several specific accounting ratios and business characteristics:
• Scale and diversification -Larger companies and those with a wider variety of product lines and greater
geographic diversification are better credit risks;
• Operational efficiency - Operating ROA, operating margins, and EBITDA margins fall into this category;

along with greater vertical diversification, high operating efficiency is better debt ratings;
• Margin stability - Stability of the relevant profitability margins indicates a higher probability of

repayment (leads to a better debt rating and a lower interest rate);
• Leverage -Ratios of operating earnings, EBITDA, or some measure of free cash flow to interest expense
or total debt make up the most important part of the credit rating formula. Firms with greater earnings
in relation to their debt and in relation to their interest expense are better credit risks.