5. Credit analysis
Important to consider
A credit analysis differs from an equity analysis in several respects. A credit analysis focuses on stability and a company’s ability to handle future payments while an equity analysis focuses on profit development and growth. The key factors in a credit analysis are the company’s debt level, its ability to generate positive cash flows and the sustainability of the business concept.
Below we have listed the most important factors that a good credit analysis should contain. If you can tick them off, you will increase the probability of making a good analysis and investment.
BUSINESS CONCEPT AND MANAGEMENT
The first thing to consider is whether the company has a competitive business concept and if the existing management is capable of implementing the business concept. If the issuer fails to pass on this, it is not worth analyzing the rest of the factors.
COUNTRY AND SECTOR RISK
There are risks associated with specific industries and countries. The issuer may be creditworthy, but if the company operates in a sector that is facing problems or in countries with political uncertainty, this will have an adverse impact on the investment’s conditions.
CASH FLOW ANALYSIS
Cash flow is a company’s lifeblood. A strong cash flow from operations that exceeds interest expenses by a good margin is a sign of good health. Positive cash flows of an extraordinary nature are always positive, but it is the cash flow generated in the underlying business that shows whether or not the company has a sound business concept. It is often a lack of liquidity that forces companies to throw in the towel.
High equity increases the chance that a company will be able to cope with a weak period. High indebtedness can cause a liquidity crisis and make borrowing more expensive if the company has to be refinanced. The ideal situation is a comfortable level of equity coupled with a good cash flow.
Fluctuations in earnings are a result of a company’s business risk and give an indication of how tough a recession will be on the company’s cash flow.
If the earnings do not fluctuate much over a business cycle, the credit risk will be lower. Examples of industries that are less sensitive to business cycles are pharmaceuticals and food producers.
This is a more important variable than many think. An ownership circle that has financial muscle, well established contacts with the financial markets as well as a long term perspective is a good owner from a credit perspective. There is a risk that an owner with limited capital will be unable to inject more capital in the event of an unforeseen downturn. Venture capitalists often have financial muscle but are not always as long term as investors would like.
The bond indenture gives the investor protection if the company runs into problems. The priority and collateral of a bond can be crucial to its value in the event of a default. In addition, it is important to understand that bonds can be structurally subordinated to each other. In complex corporate structures it is important that the bond is close to the operating company. A bond from a holding company is structurally subordinated to the operating company. Such a relationship can be improved by a parent company guarantee. Another factor is maturity. If you own the longest bond that the company has outstanding, timewise you are subordinated in relation to the other bondholders.
The same factors as above apply to a credit analysis for bonds issued to finance a project. Generally speaking cash flow is never positive during the first period. The investor has to assess the probability and stability of future cash flows as this affects the value of the project. There are often greater risks associated with project financing, which investors should be compensated for in the form of a higher coupon.