Forecasting Default: Ratio of Corporate Debt to EBITDA No Longer Good Predictor

It’s no longer a good idea to rely the ratio of corporate debt to EBITDA as a measure of financial leverage and predictor of default, according to credit-rating agency Moody’s. Use the ratio of debt to pretax operating profits instead.

“The ratio of debt to pretax operating profits for all US non-financial corporations has performed much better than the median ratio of debt to EBITDA for US high-yield issuers,” writes John Lonski, chief economist at Moody’s Capital Markets Research.

In an analysis of the actual and predicted high-yield default rate and the median ratio of interest expense to pretax operating profits of high-yield non-financial issuers in the US from the first quarter of 2006 to the first quarter of 2019, he found that the quarterly default rate generates a meaningful correlation of roughly 0.83 with the ratio of debt to pretax operating profits from two to three quarters earlier.

Worryingly, the median ratio of corporate debt to pretax operating profits has more than tripled since the first quarter of 2015, when it stood at 2%. But at nearly 6.5%, the ratio in the second quarter of 2018 is still lower than the 9.5% median ratio in the first quarter of 2008

In contrast, the quarterly default rate’s correlation with the median ratio of debt to EBITDA “is a relatively weak 0.12,” Lonski reports. He dates the poor performance from the end of 2005. Thus, the economist concludes. “a still historically high median ratio of corporate debt to EBITDA for high-yield issuers may not be reason enough to question forecasts of slide by the default rate into the summer of 2019.”

The findings are useful for macro-economic analysis and forecasts of the high-yield default rate. Worryingly, the median ratio of corporate debt to pretax operating profits has more than tripled since the first quarter of 2015, when it stood at 2%. But at nearly 6.5%, the ratio in the second quarter of 2018 is still lower than the 9.5% median ratio in the first quarter of 2008, at the start of the last global financial crisis.

CFOs and treasurers can also consider applying the same the test when screening potential counterparties as suppliers, customers, joint venture partners and M&A targets, among others. The higher the ratio of corporate debt to pretax operating profit, the more risk your company may be taking on when doing business with that entity.

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