Level 1 CFA® Exam:
Four Cs of Credit Analysis & Credit Ratios

Last updated: January 04, 2023

CFA Exam: 4 Cs of Credit Analysis

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The 4 Cs of credit analysis include:

  1. capacity,
  2. collateral,
  3. covenants, and
  4. character.

Capacity

Capacity is the ability of the issuer to make debt payments according to the payment schedule.

To analyze the capacity of the issuer to service its debt, the credit analysts use the following process:

  1. Analyzing industry structure (e.g. using Porter's five forces).
  2. Analyzing industry fundamentals (e.g. growth prospects, cyclical vs non-cyclical, etc.).
  3. Analyzing company fundamentals (e.g. competitive position, operating history, management’s strategy & execution, ratio analysis, etc.)

Collateral

Collateral is the quality and value of the assets that serve as collateral for the issued debt.

Assets of a company vary in value, e.g. intangible assets like goodwill should be perceived as assets of lower quality. What is more, for publicly traded companies, if the market value is below the book value, it should be perceived as a warning sign.

Covenants

Covenants are terms and conditions of lending agreements, introduced to protect creditors, that the borrower has to comply with.

We distinguish between negative covenants which state what the issuer cannot do and affirmative covenants which state what the issuer must do.

Character

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CFA Exam: Financial Ratios Used in Credit Analysis

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Here are 4 financial ratios used in credit analysis that you should know in your level 1 CFA exam:

Leverage Ratios

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

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

Coverage Ratios

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

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)

Credit Quality of Issuer/Bond in Comparison to Industry

In your CFA exam, you might be asked to compare the credit quality of a company in comparison to the industry using different ratios. To do this right, always pay attention to the form of a given ratio, i.e. what’s in the numerator and what’s in the denominator.

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Level 1 CFA Exam Takeaways: Four Cs of Credit Analysis & Credit Ratios

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  1. The 4 Cs of credit analysis include capacity, collateral, covenants, and character.
  2. Capacity is the ability of the issuer to make debt payments according to the payment schedule.
  3. Collateral is the quality and value of the assets that serve as collateral for the issued debt.
  4. Covenants are terms and conditions of lending agreements, introduced to protect creditors, that the borrower has to comply with.
  5. We distinguish between negative and affirmative covenants.
  6. Character is the quality of the issuer’s management.
  7. For debt ratios if debt is given in the denominator of the ratio, then the higher the ratio, the higher the credit quality, and vice versa. If debt is given in the numerator of the ratio, then the higher the ratio, the lower the credit quality.
  8. For coverage ratios, the higher the ratio, the higher the credit quality.