As with my stock ratings, my gradation of credit ratings goes like this: Very Attractive -> Attractive -> Neutral -> Unattractive -> Very Unattractive, with a corresponding 1 to 5 numerical rating. The ratings are given based on three broad factors, “a firm’s “Leverage”, “Liquidity” and “Coverage” in the last twelve months (LTM). The final stock rating is based on the average numerical rating of the five ratings I assign under these three factors, rounded to the nearest whole number. When I release a spreadsheet, the prices in it are live, so the reader should be able to work out what the appropriate rating is. I may update the spreadsheet without necessarily issuing a credit update.
The table below shows the elements that go into a rating, based on New Constructs’ own work:
As implied in the table, a firm's credit rating is determined by its Debt to Capital, EBITDA/Debt, 3-Year Average Free Cash Flow (FCF), Cash to Debt, and Interest Coverage ratios. The accounting adjustments I make are adopted from the paper, “Core Earnings: New Data and Evidence”, by Ethan Rouen, Eric C. So, and Charles C.Y. Wang and New Constructs' research approach, and provide me with superior fundamental data, by reversing the impact of non-core and non-recurring items, whether they occur on or off the face of financial statements. Exploiting this data allows me to arrive at a clearer sense of a firm's credit worthiness compared to traditional ratings agencies. So, my estimate of these ratios uses adjusted, or scrubbed data, compared to traditional credit ratings agencies:
- Leverage, measured using Debt to Capital, has Adjusted Total Debt as the numerator, because it is a truer reflection of a firm's debt than debt as it appears on the balance sheet.
- Liquidity, measured using
- EBITDA to Debt, which is essentially the ratio between adjusted EBITDA, calculated as Total Operating Revenue + Total Operating Income - Total Operating Expense - Total Net Non-Operating Expense Hidden in Operating Earnings - ESO Expense (Employee Stock Options) + Goodwill Amortisation + Depreciation and Amortisation (Cash Flow); and Adjusted Total Debt.
- 3-Year FCF to Debt, which is the ratio between a 3-year average of FCF and Adjusted Total Debt.
- Coverage, measured using
- Cash to Debt and, which is essentially, cash and cash equivalents divided by Adjusted Total Debt.
- Interest Coverage, which is the ratio of adjusted EBIT to interest expense.
The table below shows the data that went into my "attractive" credit rating for CMC, a firm I recently discussed: