Determinants of Bond Ratings

The bond ratings assigned by ratings agencies are primarily based upon publicly available information, though private information conveyed by the firm to the rating agency does play a role. The rating that is assigned to a company's bonds will depend in large part on financial ratios that measure the capacity of the company to meet debt payments and generate stable and predictable cashflows. While a multitude of financial ratios exist, table 3.2 summarizes some of the key ratios that are used to measure default risk:

Table 3.2: Financial Ratios used to measure Default Risk

Ratio

Description

Pretax Interest Coverage

= (Pretax Income from Continuing Operations + Interest Expense) / Gross Interest

EBITDA Interest Coverage

= EBITDA/ Gross Interest

Funds from Operations / Total Debt

=(Net Income from Continuing Operations + Depreciation) / Total Debt

Free Operating Cashflow/ Total Debt

= (Funds from Operations - Capital Expenditures - Change in Working Capital) / Total Debt

Pretax Return on Permanent Capital

= (Pretax Income from Continuing Operations + Interest Expense)

/ (Average of Beginning of the year and End of the year of long and short term debt, minority interest and Shareholders Equity)

Operating Income/Sales (%)

= (Sales - COGS (before depreciation) - Selling Expenses -Administrative Expenses - R&D Expenses) / Sales

Long Term Debt/ Capital

= Long Term Debt / (Long Term Debt + Equity)

Total

Debt/Capitalization

= Total Debt / (Total Debt + Equity)

There is a strong relationship between the bond rating a company receives and its

There is a strong relationship between the bond rating a company receives and its performance on these financial ratios. Table 3.3 provides a summary of the median ratios from 1998 to 2000 for different S&P ratings classes for manufacturing firms.

Table 3.3: Financial Ratios by Bond Rating: 1998- 2000
Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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Responses

  • Charles
    What are the determinants of bond ratings?
    8 years ago
  • anna nurmi
    What are the determinants of bond rating?
    8 years ago
  • Hannes
    Which financial ratio is used to determine debt and bond ratings?
    7 years ago

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