This paper sets forth the key financial ratios and the definitions of some key financial terms used in TRIS Rating’s credit analyses for corporate issuers. This paper also explains the adjustments TRIS Rating makes to some of the accounting items reported in the financial statements of corporate issuers.
We adjust the financial results reported by some corporate issuers to improve the comparability and to ensure the consistency of the financial ratios across companies. The adjustments cover significant items that affect the key financial ratios. The adjustments better reflect the underlying economic condition of the company.
The financial ratios and accounting adjustments described in this report are applicable to most corporate issuers, except for issuers in some specific industries or a selected number of companies. The adjustments are not applicable to financial institutions, non-bank lending institutions, project finance companies, or special purpose vehicles.
I. KEY FINANCIAL RATIOS
The key financial ratios that TRIS Rating uses in the rating process can be classified into three groups: profitability, leverage, and efficiency.
1. Profitability ratios: The key profitability ratios include earnings before interest and taxes margin (EBIT margin), earnings before interest, tax, depreciation and amortization margin (EBITDA margin), operating income margin, and pretax return on permanent capital. The supplemental ratios include gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity.
2. Leverage ratios: The key ratios include debt to capitalization, funds from operations (FFO) to debt, and debt to EBITDA. We also focus on interest coverage ratios like EBIT interest coverage and EBITDA interest coverage. The supplemental ratios include cash flow from operations (CFO) to debt, free operating cash flow (FOCF) to debt, and discretionary cash flow (DCF) to debt.
3. Efficiency ratios: The key ratios include days receivables, days inventory, days payables, and cash cycle days. The supplemental ratios include current ratio, quick ratio, total asset turnover, and fixed asset turnover.
The appendix contains the formulae of the key financial ratios
II. FINANCIAL TERMS
TRIS Rating has specific definitions of some of the financial terms we use frequently when calculating our key financial ratios. Our definitions may be different from the definitions set by others. These financial terms are derived mainly from accounting items in the balance sheet, income statement, and cash flow statement.
BALANCE SHEET:
Adjusted debt. TRIS Rating uses the financial debts as reported on an issuer’s balance sheet. In addition, we include in the debt calculations some debt-like financing or financial obligations that may or may not appear on the balance sheet. The sum of these other items plus financial debts yields total debt. Total debt is then netted with excess cash to arrive at the adjusted debt value. TRIS Rating uses adjusted debt to calculate the leverage ratios.
Adjusted equity. We adjust the value of equity reported on the balance sheet to reflect the equity content of hybrid securities, preferred shares, or convertible debentures.
Capitalization. TRIS Rating defines capitalization as the sum of adjusted debt and adjusted equity.
Excess cash. Excess cash includes cash and cash equivalents, and short-term investments. However, for short-term investments, TRIS Rating applies a minimum haircut rate of 25% before subtracting the value of the short-term investments from total debt. We apply a haircut because we believe there could be a time lag or some limitations that could prevent an issuer from obtaining the full amount of the proceeds if the short-term investments must be liquidated at a time of need. We also exclude from excess cash any short-term investments in equity securities.
Permanent capital. TRIS Rating defines permanent capital as the sum of adjusted equity and adjusted debt before deducting excess cash.
INCOME STATEMENT:
Operating profit. Operating profit is equal to total operating revenues minus total operating expenses minus selling, general, and administrative (SG&A) expenses.
Operating income. Operating income is equal to operating profit with depreciation and amortization expenses added back.
Earnings before interest and taxes (EBIT). EBIT is defined as operating profit plus or minus other recurring income (expenses) and all applicable adjustments. Some examples of recurring income (expenses) are interest income, dividend income, any share of the profit (loss) from investments accounted for using the equity method, and foreign exchange gains (losses) from operations, among others.
Earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is equal to EBIT plus depreciation and amortization (D&A) expenses, minus the share of any profit (loss) from investments accounted for using the equity method, plus dividends received from investments accounted for under the equity method, plus or minus all other applicable adjustments (if any).
Adjusted interest expense. TRIS Rating includes several costs related to liabilities, either on-balance sheet or off-balance sheet, as part of interest expense. The items may include, but are not limited to, debt issuance costs, capitalized interest, the portion of interest expense in the rental payment of an operating lease contract, the portion of interest expense in hybrid securities, convertible debentures, preferred shares (if applicable), and interest cost in the asset retirement obligations and postretirement benefit obligations.
CASH FLOW STATEMENT:
Funds from operations (FFO). Previously, we derived FFO from cash flow from operations before changes in working capital. However, companies may use different methodologies when reporting cash flow from operating activities in the cash flow statement. Our old definition may not yield values that are comparable across companies. Thus, in this paper, we define FFO as EBITDA minus adjusted interest expense, minus tax expenses (as shown in the income statement). The new definition incorporates the same adjustments we make to EBITDA; the adjustments can be cash items or non-cash items.
Cash flow from operations (CFO). CFO is the reported cash flow from operating activities, adjusted for dividends received and interest paid or received, whether a company reports these items as investing cash flows or financing cash flows.
Free operating cash flow (FOCF). FOCF is CFO minus capital expenditures on fixed assets and intangibles.
Discretionary cash flow (DCF). DCF is FOCF minus cash dividends paid on common shares, preferred shares, and hybrid securities.
III. STANDARD ADJUSTMENTS
In general, TRIS Rating will make standard adjustments to the financial data of all entities, especially for companies in the same industry. However, in some cases, data limitations may make the adjustments imperfect. Some examples of the adjustments that we make include but are not limited to:
• Operating leases. An operating lease is generally treated as an expense in a particular accounting period and reported on the income statement. We hold the view that an operating lease is considered a financial obligation. Thus, we normally adjust total debt to include operating leases.
To make the adjustment, we add to total debt the present value of the minimum lease commitments. A discount rate of 7% (we used a 10% discount rate previously) is used to derive the net present value (NPV) of the lease commitments. The notes to the financial statements normally disclose the annual lease expenses in the first year, a single amount combining the lease payments payable in year two through year five, and a lump sum combining all lease payments made after year five. Unless the company provides details, we assume the same annual payment amounts in years two through year five; the annual payment from year six onward will be the same as year five.
In addition, the annual rent paid under the operating lease is allocated to interest expense and depreciation expense. Interest expense is calculated by using the 7% discount rate times the average NPV of the lease payments for the current year and the previous year. Depreciation expense is the amount remaining after deducting interest expense. Therefore, when calculating EBIT, we include the interest expense portion of the annual lease payment. When calculating FFO, we only add back the depreciation expense portion of the annual lease payment. Lastly, when calculating EBITDA, we add back the entire annual lease payment.
• Guarantees. For an issuer that provides a financial guarantee to a separate entity, we may include the guaranteed debt as part of the issuer’s total debt if the debt has not been consolidated onto the financial statements of the issuer. However, we do not include the interest expense on the guaranteed debt in the adjusted interest expense of the issuer.
• Non-recourse debt of affiliates/joint ventures. Generally, in a non-recourse structure, a company has no legal obligation to bail out its ailing affiliates or joint ventures (JVs). In accounting practice, the debt of an affiliate or JV is usually not consolidated with the debt of the company. However, if we believe that the company has the potential to provide financial support to an ailing affiliate or JV due to the reputational risk of the company, we include the debts of the affiliate or JV as part of the debts of the company, based on the percentage of shareholding in the affiliate or JV. Conservatively, if we believe that the other shareholders of the affiliate or other JV partner(s) may not be able to service their portions of the debt, we include all of debt owed by the affiliate or JV as part of the company’s total debt.
• Hybrid securities. Based on accounting standards, hybrid securities are regarded as equity. However, from our perspective, hybrid securities have characteristics of both debt and common equity. Thus, the treatment of hybrid securities will be based on the equity content we assign to the securities. Under TRIS Rating criteria, the equity content is one of three levels: “high”, “intermediate”, and “minimal”.
Hybrid securities with “high” equity content (100% equity credit) will be treated as equity, with coupon payments treated as dividends. For hybrid securities with “intermediate” equity content (50% equity credit), TRIS Rating treats 50% of the face value of the hybrid securities as equity and the other 50% as debt. Half of the coupon payment will be treated as dividends; the other half as interest expense. For hybrid securities with “minimal” equity content (0% equity credit), we treat all of the hybrid securities as debt; all of the coupon payments are considered interest expense. However, the maximum equity credit given to all outstanding hybrid securities will be limited to one-third of the company’s total equity before including the equity content from any outstanding hybrid securities.
• Accrued interest on debt and accrued dividends on hybrid securities: Accrued interest payable on debt and accrued dividends on hybrid securities are added to total debt.
• Preferred shares. Preferred shares are classified as hybrid securities and are treated as debt or equity based on the assigned equity content.
• Net asset retirement obligations. In some industries, like the oil & gas industry and power industry, a company is liable for the restoration costs or removal costs for dismantling or decommissioning the operating assets after a concession ends. The costs are recorded as liabilities on a pretax basis as the costs are not related to the production of oil and gas or related to the cash flows generated from the use of the assets. TRIS Rating adjusts the item by adding the obligations (net of any tax benefits and funds reserved for the obligations) to the total debt of the issuer. As the obligations increase over time, the incremental change should reflect the time value of money.
• Debt issuance costs (on balance sheet). Debt issuance costs, when recorded on the balance sheet as a contra liability item instead of an asset, are added back to total debt.
• Convertible debentures (CD). TRIS Rating treats CDs as debt, unless the CDs carry a forced conversion provision. With a forced conversion provision, the CDs are treated as equity and deducted from total debt. However, the coupon payments (including the conversion cost) are normally be treated as interest expense.
• Post-retirement employee benefits. TRIS Rating reclassifies post-retirement employee benefits as financial obligations that must be paid over time. Thus, when calculating debt-related ratios, we include these obligations as debt, net of any prefunded amount. For employee benefit expenses recorded on the income statement, only the service cost will be treated as an operating expense item; the interest cost is treated as interest expense.
• Impairment costs on the diminution in value of current assets. TRIS Rating treats as operating expenses the impairment loss or mark-to-market loss on obsolete inventory and provisions for bad debt or bad accounts receivable. Conversely, any reversals are deducted from operating expenses.
• Capitalized interest: A company may capitalize a portion of interest expense by recognizing the amount on the balance sheet instead of booking all of the interest paid on the income statement. Such treatment reduces the actual amount of interest incurred during the period. Thus, we add to interest expense (on the income statement) the interest payment capitalized in the period when we calculate adjusted interest expense. For some industries like homebuilders and real estate developers, we use interest paid in the cash flow statement as a proxy for interest incurred during the period.
• Foreign currency exchange gains (losses). Previously, TRIS Rating classified the gains (losses) from foreign exchange as an extraordinary item and did not include the items in the assessment of the operating performance of the issuer. However, as more Thai companies expand abroad, foreign currency gains (losses) are becoming more like recurring operating transactions rather than extraordinary items.
In our view, foreign exchange gains (losses) that are related to operations should be included in the calculation of EBIT, EBITDA, and FFO. In contrast, currency gains (losses) that result from borrowing or lending in a foreign currency may be excluded when calculating normal operating performance ratios. However, companies may not report foreign exchange gains (losses) separately for operating and non-operating transactions. Therefore, we may not make adjustments if the data are not available or the amount is immaterial.
• Extraordinary items. Unusual and non-recurring items are classified as extraordinary items and are not included when calculating financial ratios used to measure the financial profile of the issuer. Examples of these items are:
o Gains (losses) on disposals of fixed assets, intangible assets, and other assets. For most companies, the disposals of fixed assets are non-recurring and are treated as extraordinary items. However, for property-related businesses, net gains (losses) from selling assets to a property fund, a real estate investment trust (REIT), or an infrastructure fund are classified as other income and included in the calculation of EBIT, EBITDA, and FFO.
o Gains (losses) on fair value adjustments of investments or investment properties
o Gains (losses) from business restructuring
o Reversal of impairment (impairment loss) of fixed assets, intangibles, or goodwill
o Discontinued operations
IV. INDUSTRY SPECIFIC/NON-STANDARD ADJUSTMENTS
In addition to the standard adjustments, TRIS Rating may apply specific adjustments to the financial statements of some industries and/or companies if we believe the adjustments are needed in order to make a more accurate credit analysis. Examples of industry specific adjustments are shown below.
• Capitalized interest charged to cost of goods sold. For homebuilders, a significant amount of interest expense is usually capitalized as part of real estate inventory. Thus, a portion of capitalized interest will be charged to cost of goods sold in the following periods when the company transfers the completed housing units to the customers. Since the capitalized interest charged to cost of goods sold has already been included in adjusted interest expense in the prior periods, therefore, we add back the amount of capitalized interest (which had been charged to the cost of goods sold) in the calculation of EBIT, EBITDA, and FFO.
• Debt of affiliates or joint ventures. It is quite common for homebuilders to develop projects jointly with partners. Under the current accounting treatment, these affiliates are generally accounted for using the equity method if the shareholding of the company in the joint venture is less than or equal to 50%. Thus, the debt of a joint venture is not consolidated with the debt of the company. However, if we believe the inclusion of the debt of a joint venture better reflects the status of the company, we will include the debt of a joint venture as part of adjusted debt.
Generally, the amount of debt added is based on the portion of the joint venture owned by the company. We also adjust the income statement to reflect pro rata earnings and interest expense. However, if the company develops projects through several joint ventures, we may use the share of profit (loss) from investments in affiliates/joint ventures as a proxy for the earnings of the joint ventures. In this case, we include in EBITDA the share of profit (loss) from investments in affiliates/joint ventures, instead of dividends received from affiliates/joint ventures, when calculating financial ratios.
• Program development and acquisition costs. For companies in the media and entertainment industry, we classify the amount of cash paid for program development and acquisition as an operating cash flow. The normal accounting treatment in this industry shows these expenditures as an investing cash flow on the statement of cash flows. We also treat the amortization of these assets as an operating cost and do not add back the amortized amount in the calculations of EBTIDA and FFO.
In addition, TRIS Rating may make non-standard adjustments to the financial statements of some companies. These adjustments are not made to a large number of companies. The non-standard adjustments are subject to the decision of the rating committee.
Appendix – Key Financial Ratios
TRIS Rating Co., Ltd. Silom Complex Building, 24th Floor, 191 Silom Road, Bangkok 10500, Thailand Tel: 0-2098-3000 ? Copyright 2018, TRIS Rating Co., Ltd. All rights reserved. Any unauthorized use, disclosure, copying, republication, further transmission, dissemination, redistribution or storing for subsequent use for any purpose, in whole or Any unauthorized use, disclosure, copying, republication, further transmission, dissemination, redistribution, or storing for subsequent use for any purpose, in whole or in part, in any form or manner or by any means whatsoever, by any person, of the credit rating reports or information is prohibited, without the prior written permission of TRIS Rating Co., Ltd. The credit rating is not a statement of fact or a recommendation to buy, sell or hold any debt instruments. It is an expression of opinion regarding credit risks for that instrument or particular company. The opinion expressed in the credit rating does not represent investment or other advice and should therefore not be construed as such. Any rating and information contained in any report written or published by TRIS Rating has been prepared without taking into account any recipient’s particular financial needs, circumstances, knowledge and objectives. Therefore, a recipient should assess the appropriateness of such information before making an investment decision based on this information. Information used for the rating has been obtained by TRIS Rating from the company and other sources believed to be reliable. Therefore, TRIS Rating does not guarantee the accuracy, adequacy, or completeness of any such information and will accept no liability for any loss or damage arising from any inaccuracy, inadequacy or incompleteness. Also, TRIS Rating is not responsible for any errors or omissions, the result obtained from, or any actions taken in reliance upon such information. All methodologies used can be found at www.trisrating.com/rating-information/rating-criteria