Corporations and analysts turn to scores of metrics—return on assets, working capital and others—to determine a company’s financial health. Another, the ratio of debt to internal funds, is one of the most widely used benchmarks. But a new study suggests that the debt-to-funds ratio isn’t all that accurate in predicting or explaining default risk.
According to the research, which was conducted by Moody’s Analytics’ John Lonski, analysts would be better off comparing corporate debt to pretax profits. In his analysis, Lonski first calculated the ratio of corporate debt to internal funds, using the Federal Reserve’s Financial Accounts of the US, better known as the Flow of Funds. This aggregate estimate of US internal funds equals the book value of pretax profits less corporate income taxes and net dividends, plus depreciation.
Lonski then compared this ratio to the high-yield default rate. The analysis revealed that the metric “is not a particularly accurate gauge of the near-term direction of the default rate,” he wrote. Case in point: During the year leading up to August 2007—when the economy began to erode—the measure “failed to consistently warn of an impending collapse by credit quality.” In fact, the benchmark dropped from 500% in the fourth quarter of 2006 to 474% in the second quarter of 2007, indicating lower odds that non-investment-grade companies would miss a loan payment.
In reality, the high-yield default rate jumped from 1.1% in the fourth quarter of 2007 to 4.2% a year later. It then spiked to 14.5% in the last quarter of 2009.
A more accurate predictor of a company’s health, Lonski contends, is the ratio of corporate debt to pretax profits from current production—what’s also known as core profits. This measure, found in the Bureau of Economic Analysis’s national income and products accounts, has several advantages over other metrics, he says. It’s not directly affected by changes in tax laws, and it excludes capital gains and losses, deductions for bad debt, and dividend income. “It’s a better estimate of recurring earnings,” Lonski contends.
In fact, the ratio shows a .86 correlation with the high-yield default rate three-quarters ahead, Lonski found. “It picks up fundamental deterioration or improvements in America’s earning performance.”