Posts Tagged income
The ratio of credit earnings before tax, interest depreciation
Posted by admin in Companies, Investment Opportunities, budget, fixed costs, management skills, manufacturing, market demand, production cycles, profit margin on October 27th, 2009
A second metric for profitability is the ratio of earnings before tax, interest depreciation and amortization (EBITDA) to total assets. Using data from the national accounts of the United States we define earnings before tax and interest as pre-tax profits with inventory valuation and capital consumption adjustment plus net interest. This metric follows a similar path as the ratio of retained earnings to total assets, although on a higher level and with a higher volatility.
Measuring the extent to which a firm’s value can decline before its book value becomes negative and a firm becomes insolvent, the ratio of market value of equity to total debt represents the inverse of leverage. We have defined the value of equity as the market value of outstanding equities, total debt is defined as total credit market instruments. The tremendous equity bubble of the late 1990s has collapsed, but nevertheless the equity-to-debt ratio stays above the level reached in the 1970s and 1980s. Because of its higher volatility, the ratio is largely driven by the equity performance. As a result the equity-to-debt ratio usually rises at the end of a recession because equity markets already
anticipate stronger economic growth while many companies still deleverage their balance sheets. Here again, the 2001 recession makes an exception.
About one-and-a-half years after the end of the recession in November 2001 equity markets finally marked their lows.
Changes in credit quality
Posted by admin in Financial Advice, bonds, business, communication, consulting, economy, expenditures on October 22nd, 2009
With regard to the above-mentioned problems, rating migrations seem to be a more reliable indicator of changes in credit quality than default rates. Given that the risks of downgrade as well as default vary over time, the question is whether credit spreads compensate investors adequately.
Since the sample for the calculation of rating transition matrices is much broader than for default rates, they are less likely to be biased by changes of the rating agencies’ universe. To measure changes of credit quality over time, the ratings drift, that is the number of upgrades minus the number of downgrades, as a proportion of the total number of entities rated, can be a valuable indicator. A sample of high-quality issuers, however, will tend to have more downgrades than upgrades, and vice versa. Hence, variations of the ratings drift partly reflect changes in average credit quality over time.
As one would expect, credit spreads tend to rise when the ratio of upgrades to downgrades becomes worse.
The question, however, is, whether the credit spreads widen enough to compensate investors sufficiently for the deterioration of average credit quality that is reflected by a falling ratings drift. While predicting the direction of spread changes may help to make money on a mark-to-market basis, it is not adequate for buy-and-hold investors. They have to estimate the magnitude of the spread widening that corresponds to an observed deterioration of credit quality. Hence, the focus is purely on credit risk, while credit spreads also incorporate liquidity premia, and are influenced by technical factors and market sentiment.