Level 1 CFA® Exam:
Credit Quality of Debt Investments

Last updated: December 09, 2022

Introducing Credit Quality to CFA Candidates

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Credit risk is the risk of incurring a loss as a result of the issuer not being able to make full and timely payments of interest and/or principal.

Credit analysis is the evaluation of credit risk.

The issue credit rating (aka. CCR = corporate credit rating) doesn’t have to be exactly the same as the issuer credit rating (aka. CFR = corporate family rating). The issuer credit rating usually applies to the issuer’s senior unsecured debt, whereas the issue credit rating depends on the terms like the priority of payments, etc. for a given issue.

When doing the credit analysis focus on:

  • adverse events that might occur and impact the company,
  • cash flows rather than income,
  • operating cash flows because they stem from the company’s operations.
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Z-Score & Leverage Ratios

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Z-Score by Altman
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\(Z=1.2\times\frac{\text{current assets }-\text{ current liabilities}}{\text{total assets}}+\\+1.4\times\frac{\text{retained earnings}}{\text{total assets}}+\\+3.3\times\frac{\text{EBIT}}{\text{total assets}}+\\+0.6\times\frac{\text{market value of stock}}{\text{book value of liabilities}}+\\+1.0\times\frac{\text{sales}}{\text{total assets}}\)

  • \(Z\) - Z-score by Altman

Z-score by Altman is used for predicting bankruptcy. The score lower than 1.81 indicates possible failure.

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Debt-to-Capital Ratio
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\(DTC = \frac{\text{debt}}{\text{debt} + \text{equity}}\)

  • \(DTC\) - debt-to-capital ratio
  • \(\text{debt}\) - total debt
  • \(\text{equity}\) - total shareholders' equity

Measures: what percentage of the company's capital is financed with debt.

Interpretation, relations, and usage:

the higher the ratio >> the higher the financial risk >> the weaker the solvency

'total debt' is defined as interest-bearing short-term debt + interest-bearing long-term debt

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Debt to EBITDA Ratio
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\(D_{EBITDA} = \frac{\text{total debt}}{EBITDA}\)

  • \(D_{EBITDA}\) - debt to EBITDA ratio
  • \(EBITDA\) - earnings before interest, taxes, depreciation, and amortization
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FFO to Debt Ratio
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\(\text{FFO-to-Debt} = \frac{FFO}{\text{total debt}}\)

  • \(\text{FFO-to-Debt}\) - funds from operations to debt ratio
  • \(FFO\) - funds from operations

FFO = funds from operations = EBITDA – net interest expense – current tax expense

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Free Operating Cash Flow to Debt Ratio
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\(\text{FOCF-to-Debt} = \frac{CFO - \text{ capital expenditures}}{\text{total debt}}\)

  • \(\text{FOCF-to-Debt}\) - free operating cash flow to debt
  • \(CFO\) - cash flow from operations
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Interest Coverage
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\(\text{interest coverage} = \frac{EBIT}{\text{interest payments}}\)

  • \(EBIT\) - earnings before deducting interest and taxes

Measures: how many times EBIT is higher than interest payments

Interpretation, relations, and usage:

the higher the ratio >> the higher the solvency

the higher the ratio >> the easier for the company to service its debt from its operating earnings

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EBITDA Interest Coverage
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\(IC_{EBITDA} = \frac{EBITDA}{\text{interest expense}}\)

  • \(IC_{EBITDA}\) - EBITDA interest coverage
  • \(EBITDA\) - earnings before interest, taxes, depreciation, and amortization
  • \(\text{interest expense}\) - interest expense (including non˗cash interest on conventional debt instruments)
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Operating Profit Margin
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\(OPM=\frac{OP}{R}\)

  • \(OPM\) - operating profit margin
  • \(OP\) - operating profit
  • \(R\) - revenue
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Return on Capital
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\(ROC = \frac{EBIT}{\text{average capital}}\)

  • \(ROC\) - return on capital
  • \(EBIT\) - earnings before interest and taxes

capital = debt + noncurrent deferred taxes + equity

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Level 1 CFA Exam Takeaways: Credit Quality of Debt Investments

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  1. Credit risk is the risk of incurring a loss as a result of the issuer not being able to make full and timely payments of interest and/or principal.
  2. Credit analysis is the evaluation of credit risk.
  3. When doing the credit analysis focus on operating cash flows rather than income.
  4. Z-score by Altman is used for predicting bankruptcy. The score lower than 1.81 indicates possible failure.
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