Using a Credit Analysis Framework to Look at Companies
Using a Credit Analysis Framework to Look At Companies
Disclaimer: I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand! Also if you have not read my article on credit ratings, check it out before reading this one, it is a prerequisite. Finally, this article will use a lot of jargon, so utilize the vocabulary section if you have any questions on definitions.
In this article I will explain a method of thinking about companies based on a basic credit analysis. According to Leveraged Financial Markets by William Maxwell and Mark Shenkman, “credit analysis is determining the ability and willingness of a borrower to meet its interest and principal obligations when due” (Maxwell and Shenkman 113). Put more simply, credit analysis is seeing if a company can and how likely a company will pay its debt. Credit analysis is typically used for debt investors to determine how likely they are to get their money back. It can be a useful framework for equity investors as well, since this method of looking at companies focuses on risk and mitigating risk is a good thing. This analysis is made for and best suited for companies that are considered non-investment grade. However, it can be applied to any company but it is important to keep in mind what type of company you are looking at. For example stress testing Microsoft’s cash flow to determine if it can pay back its debt may be futile. My goal is to provide a systematic methodical way to look at a company, to compare it to others, and to gauge a company’s ability to improve its financial position, thus making its stock more valuable.
I will share my personal methodology and thinking on this topic, however I should note that my foundation does come from the book Leveraged Financial Markets, and thus many of my methods are similar to those discussed in the book. In order to perform a thorough credit analysis you must attempt to understand the company. Just like in stock picking you want to consider things like the size of the company, the stage of growth a company is in, their market position, and diversification. I learned these four factors from Leveraged Financial Markets, which was made for looking at debt. However I still use many of the principals it teaches to look at and invest in companies. Before looking at the upside of owning a stock, I want to teach you to understand the downside, so you can avoid or limit it.
If you are attempting to maximize return an important aspect is relative value, meaning that if you over-pay for a good company, your return can be poor (for more information on relative valuation check out my comparable analysis of retailers).
Starting with size, if the company is larger it often has advantages. For example large companies have better access to the capital markets, have more assets, often have more capacity for debt, and better access to shorter term financing like revolving credit facilities. Sometimes smaller companies can have less competition and operate in a very small but profitable niche. It is important to understand the size of the company so you can be prepared and explore the risks associated with a company of that size. If a company is growing quickly, profitability can often be overlooked, however if a company is shrinking and has low profitability or no profits, this would be very concerning. Thus looking at sales growth of the past 5 years as well as net income growth can be very useful in understanding what type of company you are looking at. A more subtle thing to look at is market position. Market position is essentially how well a company fares against its competition. Looking at profitability, productivity of assets, and return on debt are common financial metrics to look at. Some non-financial indicators would be things like patents, unique products, and how easy to substitute a company’s product or service is. While this can be a lengthy exercise, especially looking at these non-economic items, a poor market position means a company is more likely to suffer in a recession, which is what you want to avoid. Diversification of revenue is also something you want to look at. If a company is getting most of its revenue from a small number of customers, they are over relying on those customers. What happens if one or two switch stop buying? You want to look at how specifically a company makes money, sometimes the methods and breakdown of revenue may surprise you even if you think you know the company. This may seem obvious but a company’s purpose is to generate cash. However there is not perfect way to measure how “good” at generating cash a company is. Net income is often reported on financial statements, you have probably seen EBITDA, EBIT, and many other methods for looking at “earnings” or cash flow. Net income is useful because it takes into account all expenses and is used for earnings per share. EBITDA is useful because it takes out non-cash expenses like depreciation as well as interest payments, so you can more easily compare different types of companies. EBITDA is important to look at how stable a company’s cash flow is. Wild swings from quarter to quarter could be risky if the company has a few bad quarters in a row. On this note, looking at the trend of EBITDA can provide helpful information also. Reading the MD&A section of previous financial statements can be good to see if management has been correct with their past projections, and what they are projecting for the future.
When looking to identify companies that can improve their financial position there are a few financial metrics that can be useful. In short, it is good to see progress in the financials, instead of taking management’s forward guidance as fact. Predictable cash flows, an upward trend in earnings and management achieving their goals are all good things to see. With more troubled companies leverage is a critical ratio, and it must go down. This means earnings must increase, or debt must decrease or ideally both. This is not to say that debt is bad, if a company is achieving a strong return on their debt, then it surely is advantageous. But too much debt often gets companies into trouble, so you should see some signs of progress before assuming a company will improve its financial position. Even then, there is always the risk that the company may not. In terms of being able to improve, having a decent quick ratio is always helpful. It would be good to see return on assets, return on debt and return on equity generally increasing. Increasing profitability and sales is always a good thing as well. Sometimes a company may improve some of these areas but stay the same or get worse in others. It is then the investor’s job to determine if these changes are good or bad. Seeing that a company is generally improving is a positive sign, and the longer the trend, usually the better. A final note on this, I specifically did not give target values for any of these ratios because these ratios differ wildly by industry. The best way to determine a “good” or “bad” ratio is to compare companies in the same industry like I did with retailers.
Looking at the economic and business factors while looking at financials is critical in an investment process. Keeping in mind size, growth, market position, and diversification is a good first step. For example if a company does not have stable cash flows, but is growing, has little competition, is smaller, but has a solid diversification of revenue then you may be prompted to look further. A hypothetical reason for this lack of stability in cash flow could be the company needs to fund growth, and has been using earnings and debt to do so. With an understanding like this, I could feel more comfortable considering an investment. By analyzing cash flow, ability to improve financial position and business factors, you can develop a more wholistic understanding of wether or not to invest. I personally like to make a list describing all these items because it is helpful seeing strong points and weak points together. Sometimes good things may outweigh the bad but not always. For example, if a company has fluctuating cash flows and a lot of short term debt, profitability, growth, and low competition likely won’t save it. If a company has a lot of debt that does not mature in the near term, and the company has strong profitability, as well as a solid market position, this seems ok on the surface. Thinking about a company this way can be a very helpful way to understand its strong areas and weak areas.
This next section may be beyond the scope of newer investors, however I wanted to provide insight into what practitioners are doing so newer investors may better understand what “professionals” are looking for. First and foremost, investors build a 3 statement financial model for the company, and attempt to predict future earnings. They then try to see what happens to the company’s earnings under certain scenarios. For example, what if costs increase 10%, they would as questions like “will the company be able to pay dividends? Will it be able to pay interest? How likely would this be?” The next step would be to see if under certain bad scenarios it breaks credit agreements called covenants. Covenants limit things like dividends, or how much debt a company can have relative to earnings, ect. If under bad scenarios a company still has solid earnings this indicates a high quality company. Investors also look for ability to deleverage or ability to pay down debt. They will look at how much cash a company has after all cash-expenses and after capital expenditures to see if a company has excess cash to pay down debt. They will also look at if the company has paid down debt in the past, and at what pace.
With riskier companies two critical ratios you have seen me use before are leverage and coverage (see vocab). How much debt a company has and how much cash a company has to pay interest are critical metrics especially for companies in worse financial positions. Next there are a few useful items analysts would look at. How much cash and short term debt can a company get to start a new project? How soon does a company have debt maturities or amortization coming up? For more distressed companies quality of assets comes into play, so how easily could assets be sold, and for how much could they be sold? There are a few more bond investor specific items practitioners look for but these are the most basic ones. My reason for walking you through this potentially challenging process is so you can understand better what kind of companies big investment firms like generally. What I just described are the first steps of a credit analysis. The entire article explains a framework for looking at companies that is based off a credit analysis. However this method should not be considered a credit analysis. I will walk you through a proper one in a future article. The purpose of this article is just to give new investors a methodical way to think about companies.
Capital markets: Publicly traded debt and equity markets. If a company has access to the capital markets it means they can issue debt or equity and have investors buy their securities.
EBIT: Earnings before interest and taxes.
EBITDA: Earnings before interest, taxes, depreciation, and amortization.
Leverage (Debt/EBITDA): Measures debt relative to earnings.
Coverage (Interest expense/EBITDA): Measures how many times a company can cover its interest expense with the most recent earnings.
Quick ratio: (link to article)
EBITDA margin (EBITDA/sales): Measure of profitability.
ROA (Net income/Average total assets): Return on assets measures how profitable a company’s assets are at producing revenue.