A high-yield bond and an investment-grade bond from the same issuer can sit notches apart purely because of where they rank in the capital stack. Credit analysis prices that difference.
You evaluate a corporate borrower's creditworthiness with two kinds of evidence. Quantitative factors are the numbers: profitability, cash flow, leverage, coverage and liquidity. Qualitative factors describe the business and the people running it. The Four Cs organize both.
- Capacity: ability to generate cash to service debt. The most heavily weighted factor.
- Collateral: asset quality and value pledged or available to bondholders.
- Covenants: affirmative and negative protections in the indenture.
- Character: management track record, strategy, ethics, and bondholder treatment.
KEY: Capacity combines the ratios and cash-flow forecasts with a qualitative read of the business and its industry. Character and Covenants are mainly qualitative. Collateral straddles both: the legal pledge is qualitative, the asset value is quantitative.
Qualitative factors describe risks the ratios cannot see yet. They reach the numbers only after the damage is done.
Common mistakes
- Conflating issuer rating with bond rating. Issuer rating reflects default probability; bond ratings are notched for recovery. A BB issuer can have a BB+ secured bond and a B+ subordinated bond.
- Reversing leverage direction. Debt/EBITDA lower is stronger; FFO/Debt higher is stronger. Both are leverage measures but invert in formula. Trap: ranking the high-Debt/EBITDA issuer as stronger.
- Treating EBITDA as cash flow. EBITDA ignores interest, taxes, capex and working capital. In Example 1, $800M ÷ $3,200M = 25% is the trap for FFO/Debt; the correct figure is $600M ÷ $3,200M = 18.75%.
Bottom line
- Four Cs: Capacity (cash flow, weighted most heavily), Collateral (asset value), Covenants (legal protections), Character (management and financial policy)
- Ratio families: leverage (Debt/EBITDA, Debt/Capital) is lower-is-stronger; coverage (EBITDA/Interest, EBIT/Interest), cash flow (FFO/Debt, FCF/Debt), profitability (EBIT margin) and liquidity (current ratio) are higher-is-stronger. FFO = net income + D&A + deferred taxes
- Qualitative factors can reveal a weak credit despite strong ratios. A profitable firm in a declining industry can be the weaker credit once leverage and liquidity are compared
- Cash flow strictness rises EBITDA, then FFO, then FCF. FCF is the proxy closest to the cash that actually services debt
Exam shortcut
For FFO, start from net income and add back only the non-cash charges (D&A and deferred taxes), never total tax or interest. If a question gives EBITDA and EBIT, D&A is the difference. For ratio direction: leverage is "Debt over something" (lower better); coverage and cash-flow-to-debt are "something over Interest or Debt" (higher better).
The full lesson (about 2,366 words, 16 min read) adds 3 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- credit analysis corporate issuers
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