### Ratios used in Credit Analysis

Financial ratios are a means of evaluating a company’s performance or health using its financial statements. We will discuss few ratios which are predominantly used by credit rating analyst or credit rating agencies to gauge solvency and cash flow related aspects of a business/company. Even an equity investor can use this to test whether a company is effective managing its business. Ratios are classified into different variants. They are:

• Liquidity Ratio
• Asset Turnover Ratio
• Financial Leverage Ratio/Gearing Ratio
• Profitability Ratio
• Dividend Policy Ratio
• Cash Flow Ratio
• Investment Valuation Ratio

There may be more bifurcation. But for now let’s read above listed ratios. We won’t discuss the non-bold ratios.

• Liquidity Ratio: Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations.
1. Current Ratio:

The concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

Current Ratio = Current Asset / Current Liabilities

1. Quick Ratio:

Quick Ratio is also known as Acid Test Ratio. Quick Ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

Quick Ratio = (Cash Equivalents + Liquid Investment + Accounts Receivable) / Current Liabilities

• Gearing Ratio:

Financial Leverage Ratios provide an indication of the long term solvency of the firm unlike liquidity ratios which are concerned with short term assets and liabilities. It is also said to be a measure of financial leverage, demonstrating the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds.

1. Debt to Equity Ratio:

The most common Gearing ratio is  Debt-to-Equity ratio. A high Debt-to-Equity ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. In a business downturn, such companies may have trouble meeting their debt repayment schedules, and could risk bankruptcy.

Debt – Equity Ratio = Total Debt/ Total Equity

2. Times Interest Earned:

The Times Interest Earned ratio indicates how well the firm’s earnings can cover the interest payment on its debt. It is also known as Interest Coverage Ratio. Higher the ratio better is the business.

Interest Coverage = (EBIT)/Interest & Finance Charges

3. Debt-Asset Ratio:

Debt by Asset ratio here again indicates the level of leverage the business is facing. Higher the ratio more leveraged the business is.

Debt-Asset Ratio = Total Debt / Total Assets

4. Capitalization Ratio: Capitalization ratio again deciphers the financial leverage of a firm.

Capitalization Ratio = (LT Debt) / (LT Debt + Preferred Stock + Equity)

• Profitability Ratio:

This ratios show how profitable is the business. These ratios examine the profits made by a firm and compare these figures with the size of the firm, the assets employed by the firm or its level of sales.

1. Gross Profit margin: Gross profit is profit before indirect expenses.  High Margin is preferable.

Gross Profit Margin = Gross Profit / Operating Income

2. Net Profit Margin : This Margin indicates profitability after all cost have been included. High Margin is preferable.

Net Profit Margin = PAT (Profit After Tax) / Operating Income

3. Return on Capital Employed (ROCE) :

ROCE is the % return on the capital invested in the business. It is a ratio which looks at how effectively a company uses its capital. It is often seen as a prime ratio since it provides a direct measure of the main task of management i.e. to maximise the return on capital invested. High number is preferred.

ROCE = PBIT / (Total Debt +Tangible Net worth +Deferred Tax Liability –CWIP)

• Cash Flow Ratio :

Cash flow analysis uses ratios that focuses on cash flow and how solvent, liquid, and viable the company is. Here are the most important cash flow ratios with their calculations and interpretation.

1.Fund Flow From Operation / Interest

2.Fund Flow from Operations/Total Debt

3.Retained Cash Flows/Total Debt

The above ratio may vary from industry to industry.

They can be proper used to compare business in same industry as we know ratio of an Infra company would differ with FMCG in terms of above ratios. Higher the above cash flow ratio better the business.

Above note is a result of publicly available information!!

### Altman Z-Score / Zeta Model of Credit Analysis

The Altman zeta model is a formula that predicts whether a company will go bankrupt within the following two years. Generally speaking, any company with a score of 1.8 or lower is in trouble, while a score of 3.0 or higher means the company is safe. If the score is between 1.8 and 3.0, then it is in a danger area; depending on the company’s policies and market fluctuations it could go either way. Given the value of the five variables for a given firm, a Z-score is computed.

Z = 1.2X1 + 1.4X2+ 3.3X3 + 0.6X4 + 1X5

Z: Z score
X1: Working capital/Total assets (in decimal)
X2: Retained earnings/Total assets (in decimal)
X3: Earnings before interest and taxes/Total assets (in decimal)
X4: Market value of equity/Total liabilities (in decimal)
X5: Sales/Total assets (number of times)

Extensive testing has found this formula to be very accurate, as high as 90% in some cases. It works by weighting various aspects of a company’s assets and earnings in order to generate a final score. The original model was designed for certain manufacturing companies, but it has since expanded to cover other areas. In Altman’s original testing, the zeta model was found to have 72% accuracy with a false positive chance of 6%. These numbers made it far more accurate than any other model currently used. Since the initial testing, the model has been put up against a huge number of cases, and it is believed to have an 85% to 90% accuracy rate with a false positive rate of 15 to 20%, still far above other models.

Below is the calculated Z-score based on Zeta model dictated above of Few Indian Real Estate Companies: Note: Oberoi has zero debt but for some rational Z-Score I have taken a Debt figure of Rs.1crore.

There are said to be few drawback as well:

• There are only two extremes or say two states i.e. Default or no Default
• The second drawback is the constant factor weights which few analyst may agree with and few disagree.
• The model only considers five fundamental quantifiable variables. No Weight for Qualitative information.

Above note is a result of publicly available information!!

### Types and Shifts in a Yield Curve

Yield Curve is the graphical description of the relationship between yields on bonds of same credit quality but with different maturities. The typical yield curve is upward sloping, meaning short term to maturity notes have low interest rates and longer term to maturity notes have higher interest rates. Of course, one strategy to maximize investment return would be to invest in the longer term, higher yielding notes. The yields offered on Treasury securities represent the base interest rate or minimum interest rate that investors demand if they purchase a non-Treasury security. For this reason market participants continuously monitor the yields on Treasury securities, particularly the yields of the on-the-run(Recent) issues.

Shapes of Yield Curve Observed: 1.)    Normal Yield Curve:

A normal yield curve is yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. During such conditions, investors expect higher yields for fixed income instruments with long-term maturities that occur farther into the future. In other words, the market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. This is a normal expectation of the market because short-term instruments generally hold less risk than long-term instruments; the farther into the future the bond’s maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the principal. In other words, the difference in yields between a 1 year and 2 year bond will usually be greater than the difference in yield between a 10 year and a 11 year bond.

2.)    Flat Yield Curve :

A flat yield curve, where yields for bonds with short term and long term maturities are very similar, is seen when the market is uncertain about which way the economy will go. When investors are not sure whether interest rates will move up or go down, the yields for bonds with different terms tend to converge. In the rare instances wherein long-term interest rates decline, a flat curve can sometimes lead to an inverted curve. Also a flat curve indicates slowdown of economy. This usually happens when central banks try to contain inflation by increasing interest rates, thus increasing short term yields. However, with the actions taken, the expectations of high inflation begin to subside to moderate inflation and expectations of higher long term rates also fall.

3.)    Inverted Yield Curve:

The inverted yield curve, where yields for bonds with short term maturities are higer than those of long term bonds, is seen in very rare situations. Such a yield curve indicates that the market believes interest rates will soon go down. An inverted yield curve is a downward sloping curve. This type of yield curve is the rarest of the four main curve types and is considered to be a predictor of economic recession. Lower interest rates would lower the inflation expectations. Hence, here short term yields are higher than the longer term yields. Though short term yields are greater, few investors may still seek long term bonds as they expect a further economic slowdown where interest rates will further decline resulting in still lower yields.

4.)    Humped Yield Curve:

A type of yield curve that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments. Humped yield curves are also known as bell-shaped curves.

Now before we move forward to Yield Curve Shifts lets understand below two terms

Flattening of Yield Curve:

When the yield curve flattens, it means that the gap between the yields on short-term bonds and long-term bonds decreases, making the curve appear less steep. The narrowing of the gap indicates that yields on long-term bonds are falling faster than yields on short-term Treasury bonds or, occasionally, that short-term bond yields are rising even as longer-term yields are falling. A flattening yield curve can indicate that expectations for future inflation are falling. A flattening also can occur in anticipation of slower economic growth. And sometimes, the curve flattens when short-term rates rise on the expectation that the Federal Reserve will raise interest rates.

Steepening of Yield Curve:

When the yield curve steepens, the gap between the yields on short-term bonds and long-term bonds widens, making the curve appear less steep. The narrowing of this gap indicates that yields on long-term bonds are falling faster than yields on short-term bonds or, occasionally, that short-term bond yields are rising even as longer-term yields are falling.  Steepening yield curve typically indicates investor expectations for rising inflation and stronger economic growth.

Yield curve shift The relative change in the yield for each bond maturity is called the shift in yield curve. If the change in yield of all maturities is same, it is a parallel shift, while non equal changes in yield of all maturities bring about a non parallel shift in the yield curve. When there is a change in the shape of the yield curve, it implies that one needs to change his outlook on the economy.

Historically, two types of nonparallel yield curve shifts have been observed:

• A twist in the slope of the yield curve
• A change in the humpedness or curvature of the yield curve

A twist in the slope of the yield curve :

refers to a flattening or steepening of the yield curve.

A change in the humpedness or curvature of the yield curve :

This type of shift involves the movement of yields at the short maturity and long maturity sectors of the yield curve relative to the movement of yields in the intermediate maturity sector of the yield curve. Such nonparallel shifts in the yield curve that change its curvature are referred to as butterfly shifts. The name comes from viewing the three maturity sectors (short, intermediate, and long) as three parts of a butterfly. Specifically, the intermediate maturity sector is viewed as the body of the butterfly and the short maturity and long maturity sectors are viewed as the wings of the butterfly.

A positive butterfly means that the yield curve becomes less humped (i.e., has less curvature). This means that if yields increase, for example, the yields in the short maturity and long maturity sectors increase more than the yields in the intermediate maturity sector. If yields decrease, the yields in the short and long maturity sectors decrease less than the intermediate maturity sector.

A negative butterfly means the yield curve becomes more humped (i.e., has more curvature). So, if yields increase, for example, yields in the intermediate maturity sector will increase more than yields in the short maturity and long maturity sectors. If, instead, yields decrease, a negative butterfly occurs when yields in the intermediate maturity sector decrease less than the short maturity and long maturity sectors.

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Bearish vs. Bullish Yield Curve:

When we discuss yield curve changes from a bearish or bullish standpoint, we are describing if interest rate are rising(bearish) or falling(bullish).

Now that we are done with Bearish, Bullish Yield curves and curve shape (Steep, Flat, Inverted & Humped). We can combine and discuss the non parallel yield curve changes. ————————————

Current Scenario (India) Between the 6 month and 1 year rates we can see some inversion. This means that if the govt. had to borrow for 6 months, it could have to pay a higher yield than what it would pay if it had to borrow for 1 year. The short end of the yield curve is higher as a consequence of RBI’s hawkish stance (or say not dovish). We can also see that the Indian yield curve is flattish, since there is not much difference between the 1 year and ten year rates, as can be seen in the chart above (as range of yield is near 8-8.5%). As per the current data the difference is around 0.22%. Even if the government had to borrow for 30 years, yields would be around the 8.66%, while for 3 months it is at 8.20%.

If the spread between short and medium term steepens that shows signs of high expected inflation. If it flattens then probably inflation is expected to ease off. 0.25yrs yield comes at 8.20% and 1yr at 8.03% which gives an FRA 3×12 rate of 7.52%. Now this indicates that market is expecting a rate cut of near 50bps in coming 9months.