An important part of assigning credit risk is to use accounting ratios to assess a company's ability to service its debt. There are many ratios used, some general accounting ratios, such as the one here on the slide, and others which are more industry specific. The numbers presented here are indicative of what ratios could be expected for different credit ratings. They've been sourced from S&P, and of course they tend to move around in time and in industry and so they should be used with caution.
The first ratio EBITDA interest could be thought of as interest cover. Using EBITDA as a proxy for cash flows, this ratio helps to understand the kind of buffer or comfort the company has in its EBITDA, in its ability to cover its interest obligations. FFO over total debt where FFO's funds from operation, it helps to measure how long the company would take to repay its debt from its funds from operation, which is a cash flow. A higher number is better if we imagine a hundred of debts, the triple-A company has funds from operations of 55 and so it would more quickly repay the debt in about two years or so, whereas the double-A company, if it had debt of a hundred, it would only have FFFO of 25, and so it would take roughly four years to repay the debt, if FFO was purely used to repay the debt which isn't that realistic. Total debt over capital, sometimes called leverage or gearing, examines the capital structure of the company. The more debt there is in the capital structure the higher the likelihood that they're going to default. Total debt of EBITDA is another measure of leverage and it's another measure of how quickly debt could be repaid. It's got a lot in common with the second one, FFO over total debt. But notice that now the income has been flipped to the bottom of the equation. If EBITDA seen again as a proxy for cash, this could be seen as the amount of time it would take for that proxy to repay the debt. What we've just seen is more the financial risk side of things.
Moving on, we could take a look at the business risk, which is as important as for financial risk in assessing the credit quality of a borrower to ensure all relevant aspects of both, business and financial risk, are taken into account. The CAMEL's framework acts as a useful tool analysts can use to assess the credit risk of financial institutions. CAMELs, which is the first letter of each of the items on the slide, stands for, firstly, capital. This is like gearing again, and banks want to ensure their counterparties are adequately capitalized. The better the quality of the capital the lower the probability of default.
The second item is assets. Banks want their counterparties to have high quality assets on their balance sheet and to avoid concentration risk. A bank which via their clients is exposed to one product or geography is at greater risk of loss, should that product or geography come under stress.
The next item is management. Banks want to ensure that management teams of their counterparties have the right level of expertise and skill to make sound judgment. And this becomes especially important in times of stress. Earnings, it's critical that the lender considers how a counterparty is able to afford to make future interest payments. And one of the key ways that companies can assess this is through profits. A bank should focus on the quality, diversity and consistency of earnings, in order to provide comfort in the borrower's ability to meet their long-term obligations. The last item is liquidity. Banks should only really want to do business with counterparties that have sufficient liquid cash and other assets that can be easily converted into cash.
