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A company with a high ratio of assets to liabilities should, in theory, be better placed to service its debts than one with fewer assets supporting its obligations. However, the balance sheet – the primary record of an entity’s assets and liabilities – is rarely employed by credit analysts as a standalone indicator of credit risk.

The three main shortcomings which limit its usefulness are that:

  • Under the historical cost accounting convention, the amounts shown on the asset side are unlikely to be a good proxy for the real value of the entity’s resources;
  • Leased assets, and the related obligation to pay the lease rentals, are mostly off balance sheet; and
  • Pension obligations are not reported consistently.

However, these obstacles are not completely insurmountable because:

  • The value of the assets can be estimated by reference to the earning power of the business;
  • Off-balance-sheet leased assets can be factored in using either a multiple of the lease expense, or the estimated present value of the obligation to pay the lease rentals; and
  • Inconsistencies in the reporting of pension obligations can be rectified by including the actuarially-estimated defined benefit obligation as a liability, and by transferring pension assets to the asset side of the balance sheet where appropriate.

Using Western Europe’s 10 largest telecoms operators as an example, this report shows that it is possible to construct a metric – the ratio of total assets to total liabilities – which not only correlates nicely with our credit ratings for the telcos concerned, but also provides additional insight into the strength of their balance sheets. However, the adjustments required are not entirely robust, and Moody’s will continue to focus on metrics which compare the cash generating capability of the entity with the level of its debt.

Excerpted from Close, but No Cigar: Why Balance Sheets Fall Short as Indicators of Credit Risk (Premium)

Source: Why Balance Sheets Fall Short as Indicators of Credit Risk