Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer's financial ratios. The key ratios used to evaluate safety are:
1. Coverage ratios. Ratios of company earnings to fixed costs. For example, the times-interest-earned ratio is the ratio of earnings before interest payments and taxes to interest obligations. The fixed-charge coverage ratio adds lease payments and sinking fund payments to interest obligations to arrive at the ratio of earnings to all fixed cash obligations. Low or falling coverage ratios signal possible cash flow difficulties.
2. Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds.
3. Liquidity ratios. The two common liquidity ratios are the current ratio (current assets/current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the firm's ability to pay bills coming due with cash currently being collected.
4. Profitability ratios. Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm's overall financial health. The return on assets (earnings before interest and taxes divided by total assets) is the most popular of these measures. Firms with higher return on assets should be better able to raise money in security markets because they offer prospects for better returns on the firm's investments.
5. Cash flow-to-debt ratio. This is the ratio of total cash flow to outstanding debt.
Standard & Poor's periodically computes median values of selected ratios for firms in several rating classes, which we present in Table 9.3. Of course, ratios must be evaluated in the context of industry standards, and analysts differ in the weights they place on particular ratios. Nevertheless, Table 9.3 demonstrates the tendency of ratios to improve along with the firm's rating class.
The document defining the contract between the bond issuer and the bondholder.
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