Profits and Cash Flows
Profits and cash flows are needed to service debt. Here we examine four profit and cash flow metrics commonly used in ratio analysis by credit analysts.
- Earnings before interest, taxes, depreciation, and amortization (EBITDA): EBITDA is a commonly used measure that is calculated as operating income plus depreciation and amortization. A drawback to using this measure for credit analysis is that it does not adjust for capital expenditures and changes in working capital, which are necessary uses of funds for a going concern. Cash needed for these uses is not available to debt holders.
- Funds from operations (FFO): Funds from operations are net income from continuing operations plus depreciation, amortization, deferred taxes, and noncash items. FFO is similar to cash flow from operations (CFO) except that FFO excludes changes in working capital.
- Free cash flow before dividends: Free cash flow before dividends is net income plus depreciation and amortization minus capital expenditures minus increase in working capital. Free cash flow before dividends excludes nonrecurring items.
- Free cash flow after dividends: This is free cash flow before dividends minus the dividends. If free cash flow after dividends is greater than zero, it represents cash that could pay down debt or accumulate on the balance sheet. Either outcome is a form of deleveraging, a positive indicator for creditworthiness.