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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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WHAT METRICS MATTER MOST?

Investors and agencies evaluate a company’s ability to withstand financial stress operating on concepts and guidelines rather than on rigid rules. Because of the importance of qualitative factors, it is difficult to reduce such a holistic view to a set of financial ratios. Quantitative analysis is an important part of the evaluation of a credit but cannot fully capture the facets of a company’s financial risk.

Nonetheless, we do observe correlations between ratings and ratios with a significant and increasing degree of statistical explanatory power. Though coefficients of determination (R2) have remained relatively stable, t-statistics for individual metrics have improved across the time period.

And agencies view ratio analysis as an important part of the rating process, especially when they believe that financial data are reliable. Furthermore, from a policy perspective, ratios rather than ratings represent more manageable targets to manage toward.

In statistical tests of correlation between credit ratios and senior issuer bond ratings, there is a general trend of increased statistical significance over the prior decade for most metrics, and across most ratings categories and industry sectors. Notwithstanding recent high-profile incidents that might seem to suggest the opposite, the data show that, on average, quantitative methods have become a more reliable tool to evaluate credit profiles. This may be due to improved financial reporting consistency ...

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