Just as financial ratios can be used in the analysis of common stocks, they can also be used in the analysis of bonds—a process we refer to as credit analysis. In credit analysis, attention is directed toward the basic liquidity and profitability of the firm,

Case Problem 10.1     Max and Veronica Develop a Bond Investment Program

Max and Veronica Shuman, along with their teenage sons, Terry and Thomas, live in Portland, Oregon. Max is a sales rep for a major medical firm, and Veronica is a personnel officer at a local bank. Together they earn an annual income of around $100,000. Max has just learned that his recently departed rich uncle has named him in his will to the tune of some $250,000 after taxes. Needless to say, the family is elated. Max intends to spend $50,000 of his inheritance on a number of long-overdue family items (like some badly needed remodeling of their kitchen and family room, the down payment on a new Porsche Boxster, and braces to correct Tom’s overbite). Max wants to invest the remaining $200,000 in various types of fixed-income securities.

 

Max and Veronica have no unusual income requirements or health problems. Their only investment objectives are that they want to achieve some capital appreciation, and they want to keep their funds fully invested for at least 20 years. They would rather not have to rely on their investments as a source of current income but want to maintain some liquidity in their portfolio just in case.

 

Case Problem 10.2  The Case of the Missing Bond Ratings

It’s probably safe to say that there’s nothing more important in determining a bond’s rating than the underlying financial condition and operating results of the company issuing the bond. Just as financial ratios can be used in the analysis of common stocks, they can also be used in the analysis of bonds—a process we refer to as credit analysis. In credit analysis, attention is directed toward the basic liquidity and profitability of the firm, the extent to which the firm employs debt, and the ability of the firm to service its debt.

             
Financial Ratio Company 1 Company 2 Company 3 Company 4 Company 5 Company 6
1. Current ratio 1.13 1.39 1.78 1.32 1.03 1.41
2. Quick ratio 0.48 0.84 0.93 0.33 0.50 0.75
3. Net profit margin 4.6% 12.9% 14.5% 2.8% 5.9% 10.0%
4. Return on total capital 15.0% 25.9% 29.4% 11.5% 16.8% 28.4%
5. Long-term debt to total capital 63.3% 52.7% 23.9% 97.0% 88.6% 42.1%
6. Owners’ equity ratio 18.6% 18.9% 44.1% 1.5% 5.1% 21.2%
7. Pretax interest coverage 2.3 4.5 8.9 1.7 2.4 6.4
8. Cash flow to total debt 34.7% 48.8% 71.2% 20.4% 30.2% 42.7%
Notes:

  1. Current ratio = current assets / current liabilities
  2. Quick ratio = (current assets – inventory) / current liabilities
  3. Net profit margin = net profit / sales
  4. Return on total capital = pretax income / (equity + long-term debt)
  5. Long-term debt to total capital = long-term debt / (long-term debt + equity)
  6. Owner’s equity ratio = stockholders’ equity / total assets
  7. Pretax interest coverage = earnings before interest and taxes / interest expense
  8. Cash flow to total debt = (net profit + depreciation) / total liabilities
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