Credit Rating Determinants

When evaluating an organization, one of the important decisions concerns the target leverage, which affects the WACC (Weighted Average Cost of Capital) and consequently the valuation outcome (naturally, the rating also influences the cost of debt).

There are typically two main assumptions in this regard: first, that debt increases proportionally with the growth of the organization’s value; or second, that the amount of debt remains constant over the long term.

Since it is generally recognized that there exists an optimal leverage structure, the organization’s leverage should aim towards this optimal, which should be relatively stable within a specific industry.

An optimal structure is considered to be a rating between AA+ and BBB, as within this range, the organization maintains decision-making sovereignty while also benefiting from the tax savings created by the interest expenses on the debt.

Therefore, it is important to define the target financial structure based on ratings, accurately calculate the WACC, and set the balance according to the forecasts.

Empirical evidence shows that credit ratings primarily depend on two components – the size of the organization and coverage ratios.

The size of the organization is a less significant factor, as it mainly affects very large or very small organizations. The ratings of 71% of organizations with revenues exceeding $5 billion, and 60% of organizations with revenues exceeding $1 billion, fall within the A+ to BBB range.

Coverage ratios, specifically debt and interest coverage ratios, have a more significant impact on ratings:

It is also interesting that the relationship between coverage ratios and credit ratings varies across industries:

Finally, there is a clear correlation between the probability of bankruptcy and interest rates, which deteriorates with the worsening of the rating:

Source:

Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels