FI 16 Credit Analysis for Corporate Issuers
The creditworthiness of a corporate borrower rests mainly on one question: can the company generate enough profit and cash flow, reliably and on time, to pay the interest and principal it owes. Credit analysts approach that question from two angles. Qualitative work reads the business itself: its model, its industry, its competitive position, and the character of the people running it. Quantitative work turns the financial statements into ratios and forecasts. Both feed into two risk components that drive every credit decision but that cannot be observed directly: the probability of default (POD), the chance the borrower fails to pay, and the loss given default (LGD), the share of the exposure a lender would fail to recover if default occurs.
A useful contrast is with equity analysis. An equity analyst values every future cash flow that could accrue to shareholders. A fixed-income analyst cares instead about whether cash flows arrive in the right size and at the right time to cover a claim that has a fixed maturity. Because debt has a defined life, the credit view is anchored to a horizon, and creditworthiness can look very different for a claim maturing in six months than for one maturing in fifteen years.
| Category | What the analyst weighs |
|---|---|
| Business model | Stability and predictability of demand, revenue, and margins; asset quality; concentration; long-term demand outlook |
| Industry and competition | Cyclicality, rivalry, life-cycle stage, and the competitive forces the issuer faces |
| Business risk | How far actual demand, revenue, and margins may deviate from expectations; external shocks from the macroeconomy, technology, demographics, government, geopolitics, and ESG |
| Corporate governance | Appropriate use of proceeds, treatment of debtholders, and compliance with legal, tax, accounting, and covenant obligations |
Governance stands in for the “character” element that consumer credit analysis assesses directly.
Business model and cash flow stability
A company whose demand, revenue, and margins are steady and predictable, whose business risk is low, and which faces limited competitive pressure can safely carry more debt and is less likely to default. Weak, volatile cash flows, high business risk, or intense competition push in the opposite direction. From a debtholder’s seat the test is not only whether the firm earns a return above its cost of capital, but whether the timing and size of its cash flows are enough to cover fixed obligations as they fall due.
Industry and competitive position
Industry structure sets much of the ceiling on how much debt a borrower can support. Higher barriers to entry mean fewer new competitors and less price pressure, which supports more stable cash flows and a greater capacity to carry debt. Conversely, intense rivalry, powerful suppliers, or powerful buyers erode margins and reduce that capacity. The economic cycle and the credit cycle are linked, so an analyst also asks how a downturn would flow through a cyclical issuer’s revenue and profit.
Business risk
Business risk captures the chance that outcomes diverge from the plan. A strategic pivot is a classic source: a change in technology or product mix can raise execution risk sharply, shift bargaining power toward suppliers, and expose the issuer to faster-moving rivals. The longer a debt claim runs, the more exposed its holders are to that risk playing out.
Bright Wheel Automotive (BRWA) is an investment-grade car maker whose lineup runs on internal combustion engine (ICE) technology. Two years ago it launched its first electric vehicle, which now accounts for 5% of revenue, and management intends, across the next ten years, to make more than half the range fully electric while shifting the remainder to hybrid powertrains. BRWA has three debt instruments outstanding: commercial paper with a 150-day tenor, notes maturing in five years, and notes maturing in fifteen years.
A credit analyst assesses Mojofon Holdings, a niche smartphone maker with roughly a 3% global share in a market dominated by a few firms that together hold close to 70%. Rivalry is intense with short product cycles; core chips and operating licenses sit with a few high-margin suppliers; customers have little pricing power and defer purchases; substitutes and new niche entrants are limited threats.
| Competitive force | Intensity | Capacity to support debt |
|---|---|---|
| Threat of new entrants | Low | High |
| Bargaining power of suppliers | High | Low |
| Bargaining power of customers | Low | High |
| Threat of substitutes | Low | High |
| Industry rivalry | High | Low |
Corporate governance and character
Character is harder to read for a company than for an individual borrower, yet it matters a great deal. Because debtholders lack the voting rights of shareholders, they protect themselves at issuance by specifying how proceeds may be used and by imposing restrictions. Highly rated unsecured issuers usually face only affirmative covenants: obey the law, keep the existing lines of business running, insure and maintain assets, and pay taxes. High-yield secured issuers face tighter terms, often including limits on dividends and additional debt plus financial covenants that trip if the borrower’s condition worsens.
Management’s track record signals character. Strategies that led to major downgrades, such as an overleveraged debt-funded acquisition, a large debt-funded special dividend, or a big debt-funded buyback, are warning signs about how debtholders will be treated relative to shareholders. Accounting policy is another window. Aggressive choices can hide the true performance and risk of a business: heavy off-balance-sheet financing, a preference for capitalizing rather than expensing, and early or premature revenue recognition are examples. Frequent changes of auditor or chief financial officer are among the most telling red flags, and any hint of fraud should prompt a hard look at the borrower’s character.
Wirecard, a German payments processor, climbed quickly after listing in 2005, entered the DAX (Germany’s index of its 30 most valuable listed companies), and topped a market value above EUR27 billion during 2018, only to seek insolvency protection in June 2020. Warning signs about character were there beforehand: a murky and needlessly complicated business model; supposed expansion concentrated in a mere three outside partners rather than the many thousands of customers management described; assets sitting in offshore trust accounts; and an in-house bank lending to the same fintech partners that were booked as revenue sources. Collapse came once auditors could not verify EUR1.9 billion of supposed cash, the bulk of reported profit. Carrying liabilities of EUR3.2 billion at insolvency, the equity lost more than 70% and the unsecured bonds sank to roughly 20 cents on the euro. The episode ranked as the biggest corporate accounting fraud and failure in Germany since the Second World War.
Collateral: secured versus unsecured debt
General corporate debt is unsecured: repayment depends on the company’s cash flows and its holders have only a general claim. Secured debt adds a second line of defense by pledging specific assets as collateral, which the lender can seize and sell if the borrower defaults. Secured lenders prefer tangible, or hard, collateral (property, plant, equipment, inventory, cash, and marketable securities) over intangible, or soft, collateral (patents, intellectual property, and goodwill). Collateral matters most for weaker credits: its value becomes decisive precisely when the borrower’s probability of default has climbed to the point where the lender may actually need it. Pledging assets can lower the cost of borrowing versus an unsecured alternative, or open a debt market that would otherwise be closed.
When the pandemic halted Royal Caribbean Cruises (RCL) operations in March 2020, the company moved quickly to raise cash. In May 2020 it privately placed USD3.3 billion of senior secured notes due 2023 and 2025, backed by 28 of its more than 60 vessels plus material intellectual property, and applied part of the proceeds to retire a 364-day senior secured term loan of USD2.35 billion. Even though the pandemic had raised RCL’s probability of default, investors were willing to lend because the pledged assets reduced the loss given default on the secured notes.
Quantitative credit analysis is a financial-statement model that expresses the analyst’s expectations for a company’s future performance. The inputs come from an understanding of the firm’s fundamental drivers and a view of the risks and opportunities ahead. Unlike an equity model, which values the stock from all cash flows available to owners, a credit model aims to estimate how likely the company is to keep meeting its debt obligations. Four families of measures do most of the work.
The four factor families
- Profitability. Strong, stable earnings generate the cash that is the primary source of repayment. Analysts favor operating profit and recurring revenue over one-time gains, and they watch for macro threats such as a downturn hitting a cyclical issuer or an erosion of market share.
- Leverage. Leverage gauges how much a company leans on debt. It usually compares total debt to a resource base: assets, capital, or a measure of profit or cash flow. Debt investors prefer lower leverage (more resources per unit of debt); equity investors often benefit from more.
- Coverage. Coverage compares a periodic income or cash-flow measure to debt service (interest and principal), interest alone, or debt-like payments such as leases. Higher coverage means more income available to meet fixed obligations.
- Liquidity. Liquidity asks whether short-term resources exist to pay near-term interest or principal. A firm can be solvent (assets exceed liabilities) yet still miss a payment if it lacks cash or assets that convert quickly to cash. Committed bank facilities count as liquidity when the borrower has a contractual right to draw them.
Top-down, bottom-up, and hybrid approaches
Model inputs are derived in three broad styles, often combined.
| Approach | Starting point and focus |
|---|---|
| Top-down (macro) | Begins with a macroeconomic forecast: growth relative to GDP, the issuer’s addressable market and market share, cyclicality, and adverse events tested through scenario analysis |
| Bottom-up (issuer-specific) | Forecasts the company’s own revenue drivers and balance-sheet positions directly |
| Hybrid | Blends expected cyclicality with changing issuer-specific features to project cash flows |
The aim throughout is to isolate the factors that drive the issuer’s probability of default and to see how they shift across the credit cycle. Investors in senior unsecured investment-grade debt focus almost entirely on the probability of default. High-yield investors, who deal with subordination and collateral, also weigh historical loss given default, the subject of the final section.
Ratios turn the quantitative factors into numbers an analyst can track over time and compare across peers. Credit work centers on profitability, coverage, and leverage, and it favors cash flow from operations over cash raised by selling assets or issuing securities. A short set of representative ratios does most of the job.
The core credit ratios
Because leverage ratios sometimes put debt in the numerator and sometimes in the denominator, always check whether a larger number means more or less leverage before drawing a conclusion.
Cash flow measures used in credit analysis
Credit analysts lean on conservative cash-flow measures that strip out cash needed to run the business or paid to shareholders. Three appear repeatedly.
Debt and interest figures may also be adjusted for operating leases and other fixed off-balance-sheet obligations. None of these measures has an official IFRS definition, so the names and formulas here are one common usage among several.
An issuer reports net income from continuing operations of 180, depreciation and amortization of 30, deferred income taxes of 18, and other non-cash items of 28. Working capital rose by 52, dividends paid were 60, capital expenditure was 100, and total debt is 1,280.
Watching ratios move: a stress scenario
Ratios matter most as a trajectory. A financial model can show how they migrate as the business weakens. Bowstream Corporation is a mid-sized, investment-grade consumer durables company whose latest results show 10% sales growth and a 35% operating margin. An analyst stresses it: sales growth slows to 5% while cost of goods sold climbs as a share of sales and interest rates rise.
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| Sales growth | 10% | 5% | 5% | 5% | 5% | 5% |
| Cost of goods sold / Sales | 65% | 70% | 75% | 80% | 85% | 85% |
| Interest rate on debt | 6% | 7% | 7% | 7% | 8% | 8% |
| Debt growth rate | 10% | 10% | 10% | 10% | 10% | 10% |
Running the three-statement model on these assumptions produces the profit, cash-flow, and ratio path below. All figures are in the model’s reporting units.
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| EBIT | 930 | 655 | 373 | 86 | -212 | -189 |
| EBITDA | 1,330 | 1,122 | 890 | 633 | 347 | 363 |
| FFO | 978 | 866 | 729 | 568 | 376 | 377 |
| RCF | 861 | 785 | 685 | 563 | 376 | 377 |
| EBIT margin | 25% | 20% | 15% | 10% | 5% | 5% |
| EBIT to interest expense | 51.9 | 32.9 | 23.0 | 14.4 | 5.8 | 5.2 |
| Debt to EBITDA | 0.47 | 0.61 | 0.85 | 1.32 | 2.77 | 3.04 |
| RCF to net debt | 379% | 271% | 191% | 130% | 67% | 54% |
Every dimension deteriorates together: profitability falls (EBIT margin from 25% to 5%), coverage thins (EBIT to interest from about 52 to about 5), and leverage builds (Debt to EBITDA from 0.47 to 3.04, RCF to net debt from 379% to 54%). That combination is the classic setup for wider credit spreads and a possible downgrade.
Bowstream carries debt of 627 in Year 0 and 1,104 in Year 5, with cash and marketable securities of 400 in both years. EBITDA is 1,330 in Year 0 and 363 in Year 5; retained cash flow (RCF) is 861 in Year 0 and 377 in Year 5.
Analysts read such a path against rating-agency benchmarks for the same industry. As a ratio drifts down through the bands mapped to Aa, A, Baa, Ba, and B, the implied rating migrates with it.
Comparing an issuer with its peers
Ratios only mean something in context. Analysts benchmark an issuer against industry and rating peers, and they read the whole panel rather than any single number.
Mojofon Holdings, the niche smartphone maker, reports total debt of 100 and total equity of 100 in the current year. Its EBITDA to interest coverage is 20 / 8 = 2.5 in the current year, down from 27 / 5 = 5.4 the prior year, and its bonds carry a covenant requiring the ratio to stay at or above 3.0. Peer companies average EBITDA to interest of 55 / 10 = 5.5.
Not all of an issuer’s debt is equal. A seniority ranking sets the priority of payment: the most senior claim has the first call on the issuer’s cash flows and assets. Some companies keep a simple structure with one operating entity and a single class of debt. Others, shaped by acquisitions, divestitures, or regulation, run many subsidiaries and a parent holding company, each issuing debt at different seniority levels. Where a claim sits in that order drives what its holders recover in default or restructuring.
Secured versus unsecured
Secured debt pledges specific assets and their cash flows to the lender, who can take and sell them to offset a loss, which is why secured debt tends to carry a lower loss given default. First mortgage and first lien debt rank highest among secured creditors: a first mortgage pledges specific property such as a power plant, while a first lien can cover buildings, equipment, licenses, patents, brands, or inventory. Second lien debt has a claim on pledged assets that ranks below first lien in both collateral protection and payment priority, though most second lien loans still rank above junior secured obligations.
Unsecured bondholders hold only a general claim and, in default, rank behind secured creditors under the priority of claims. Senior unsecured debt is the most common corporate bond, ranking below senior secured but above subordinated debt. Subordinated and junior subordinated debt sit lowest and often recover little or nothing, an effective loss given default near 100%. These layers exist because they serve both sides: issuers minimize their cost of capital by offering secured debt where investors demand it, or subordinated debt where it is cheaper than equity and does not dilute owners.
| Rank | Class | Type |
|---|---|---|
| 1 | First lien / first mortgage | Secured (lower LGD) |
| 2 | Senior secured | Secured (lower LGD) |
| 3 | Junior secured | Secured (lower LGD) |
| 4 | Senior unsecured | Unsecured (higher LGD) |
| 5 | Senior subordinated | Unsecured (higher LGD) |
| 6 | Subordinated | Unsecured (higher LGD) |
| 7 | Junior subordinated | Unsecured (higher LGD) |
Secured holders have a direct claim on pledged assets and their cash flows; unsecured holders have only a general claim.
An issuer has five bonds outstanding: senior unsecured debt, first lien debt, junior subordinated debt, second lien debt, and subordinated debt.
How claims are settled in default
All creditors at the same seniority level form one class and rank pari passu, so a senior unsecured holder whose bond matures in 30 years shares the same pro rata claim as one whose bond matures in six months; maturity does not change the ranking. A secured creditor has first call on the value of its specific collateral. If that value falls short of the secured claim, the shortfall becomes a senior unsecured claim and lines up with the other senior unsecured creditors. Senior unsecured creditors rank ahead of all subordinated creditors, who in turn must be paid in full before shareholders receive anything.
In practice the process is messier than the strict ladder suggests. Bankruptcy takes time, and legal and accounting fees mount while the business loses employees, customers, and value to competitors. To speed resolution, senior creditors sometimes agree to pay junior creditors and other claimants more than their strict legal entitlement. Outcomes also vary by country: the United States leans toward reorganizing and preserving companies, while many other jurisdictions lean toward liquidation to maximize value for senior and bank lenders. Because bankruptcy law is complex and country-specific, it is hard to generalize how creditors will fare.
A company reports the simplified balance sheet below and then books a USD90 impairment against the net current assets (other than cash) line.
| Assets | USD | Liabilities and equity | USD |
|---|---|---|---|
| Cash | 40 | Secured bank loans (cash collateral) | 30 |
| Net current assets (other than cash) | 100 | Unsecured bonds | 90 |
| Net fixed assets | 60 | Subordinated bonds | 10 |
| Common shares | 40 | ||
| Retained earnings | 30 | ||
| Total assets | 200 | Total liabilities and equity | 200 |
Vivivyu (VIVU) has 6.5% seven-year notes that are secured and unsubordinated, backed by a pledge of certain assets and ranking pari passu with its other secured, unsubordinated debt (USD400 million). It also has 10.0% ten-year notes that are direct, unsecured, and subordinated (USD300 million). In an insolvency the 6.5% secured notes rank highest, backed by their collateral; if that collateral falls short of the pari passu secured debt, the balance ranks alongside senior unsecured creditors. The 10.0% subordinated notes rank below both senior secured and senior unsecured debt (above only junior subordinated debt and shareholders) and typically show the lowest recovery.
Recovery rates put numbers on what different seniority levels tend to get back. Defaulted debt often trades near its expected recovery as a company heads into bankruptcy or liquidation, and long histories of defaults give statistically meaningful averages by ranking. Among North American non-financial issuers, to take one year, holders of defaulted senior secured debt got back 45.9% during 2019, whereas holders of defaulted senior unsecured issues salvaged just 31.3%.
| Emergence year | Default year | |||||
|---|---|---|---|---|---|---|
| Priority position | 2020 | 2019 | 1987-2020 | 2020 | 2019 | 1987-2020 |
| Term loans | 48.5 | 58.1 | 72.6 | 50.1 | 52.7 | 86.3 |
| Senior secured bonds | 34.8 | 45.9 | 61.4 | 34.8 | 44.6 | 61.4 |
| Senior unsecured bonds | 8.6 | 31.3 | 46.9 | 8.6 | 40.5 | 46.9 |
| Subordinated bonds | 0.9 | 24.7 | 27.9 | 0.9 | 24.7 | 27.9 |
Term loans include first, second-lien, and unsecured. Emergence year is when the company emerges from bankruptcy; default year is when the debt defaulted. North American non-financial companies. Source: Moody’s Investors Service (2021).
Three cautions apply to any recovery figure. It varies widely by industry, it depends on when in the cycle default occurs, and it is an average across many industries and companies. Firms failing in industries in secular decline recover less than those hit by a merely cyclical downturn, and a strong economy that supports robust markets for pledged collateral lifts recoveries, while a weak one depresses them. The mix of an issuer’s own capital structure matters too: a large stock of secured debt leaves smaller recoveries for lower-ranked claims.
| Industry group | 1st lien bond | Senior unsecured bond | Subordinated bond |
|---|---|---|---|
| Automotive | 57.94 | 46.08 | 49.46 |
| Capital equipment | 62.34 | 36.69 | 45.48 |
| Energy: electricity | 81.48 | 58.24 | 39.45 |
| Energy: oil and gas | 56.55 | 36.33 | 39.10 |
| Environmental | 13.00 | 29.73 | 5.44 |
| Finance | 47.60 | 45.68 | 27.80 |
| High-tech industries | 53.51 | 33.08 | 23.71 |
| Retail | 57.78 | 36.30 | 21.68 |
| Services: business | 71.14 | 46.83 | 46.22 |
| Telecommunications | 56.80 | 26.22 | 31.61 |
| Average recovery rate | 53.04 | 41.80 | 34.69 |
| Highest recovery rate | 96.25 | 92.00 | 63.56 |
| Lowest recovery rate | 7.00 | 22.18 | 1.47 |
Measured by trading prices before default; averages, highest, and lowest cover all 33 industries Moody’s identifies. Source: Moody’s Investors Service (2021).
Recovery rates and expected loss
Recovery feeds straight into expected loss, since loss given default is one minus the recovery rate.
An automotive issuer has a one-year forward default rate of 0.8%. Historical recovery assumptions are 58% for its senior secured bond, 46% for its senior unsecured bond, and 23% for its subordinated bond.
Issuer ratings, issue ratings, and notching
Rating agencies publish two kinds of rating. An issuer rating, also called a corporate family rating or corporate credit rating, addresses the borrower’s overall creditworthiness and is usually mapped to the senior unsecured level for consistency across issuers. An issue rating applies to a specific obligation and reflects factors such as seniority. Because of cross-default provisions, the probability of default is often the same across an issuer’s obligations, yet issue ratings differ because loss given default differs by seniority, subordination, and source of repayment. Moving an issue rating up or down from the issuer rating to reflect that difference is called notching.
The lower an issuer’s senior unsecured rating, the larger the notching tends to be. For a strong credit the default risk is small, so the potential loss difference between priority levels barely moves the rating. For a weak credit, default is more likely, so the loss difference from ranking higher or lower carries much more weight and the agencies apply larger adjustments. A related concept is structural subordination: when a holding company and its operating subsidiaries both issue debt, the subsidiary debt is serviced from subsidiary cash flows first, and only the residual can be upstreamed to service parent debt, so holding-company debt effectively ranks behind subsidiary debt.
In March 2021, as cruising resumed, Royal Caribbean issued USD1.5 billion of seven-year unsecured notes, mainly to refinance debt. It held a Moody’s B1 corporate family rating, while the new unsecured issue was rated B2, one notch lower. Its senior secured notes, backed by vessels and intellectual property, were rated Ba2, three notches higher than the family rating. Same issuer, same default risk, very different issue ratings, driven by collateral and expected loss.
Agencies differ in emphasis. Moody’s frames credit risk as the risk of missing contractual obligations plus any loss in default, so its scale principally reflects expected loss and it weighs recovery, especially for speculative-grade debt. S&P Global Ratings assigns ratings that primarily reflect probability of default and issues separate recovery ratings that capture seniority and loss severity, which can inform its notching. Fitch takes a similar route, assigning Issuer Default Ratings for the probability-of-default view and then notching issue ratings for recovery expectations.