No credit rating? No problem. Use a synthetic rating instead.

 

1) what is the basic measure of debt repayment capacity? and

 

The answer to the first question is the Interest Coverage Ratio: EBIT versus Interest Expense. In other words, how much in pre-tax earnings (interest is usually a tax-deductible expense) are available to cover interest payments.

 

The second was answered by Prof. Damoradan who took a listing of all U.S. firms with a bond rating and sorted them by the rating while noting the firms’ corresponding Interest Coverage Ratios. He then eliminated outliers and overlaps to establish cutoffs and a range for each rating level. For example, he observed that firms with an A3/A- minus bond rating had Interest Coverage Ratios between 4.5x and 6.0x.

 

To summarize, what he did was use real-world observations to work backward to map what the fully-researched credit agency rating should be.

 

Some modifications needed

While the base method works for U.S. companies in markets similar to the U.S., modifications need to be made for project finance and/or in emerging markets.

We usually do the following:

1. Work on a cash basis (usually IPSAS). Many sponsors will use a cash basis for entity accounting. (This to a large extent is better, as debt can only be paid back with real cash, not accruals!) As such, instead of comparing versus EBIT, compare versus Operating Cash Flows.

2. Adjust the Interest Coverage Ratio table to reflect the local market risk. The original Synthetic Rating model was based on U.S. non-financial firms and ratings, and, as such, they are based on a U.S. interest regime. If the local market has interest rates which are significantly higher than that of the U.S., then relative coverage ratios need to reflect this by being adjusted upward by the ratio of the local long-term risk-free rate versus the U.S. treasury bond rate. Alternatively, if known at the time, the project’s loan financing rate may be used.

3. Add in principal repayments. The original model is based on nonfinancial firms and the assumption for them is that debt is a permanent part of the balance sheet; it is never really fully paid back, but always refinanced. For a project loan, this is a bad assumption as the vast majority of multilateral development bank (MDB) project loans are amortized (i.e., the loan principal is paid down over time). So, reflect the same and use principal and interest (P&I), instead of just interest.

4. Be careful with currencies. Loans, and thus interest and principal payments, are usually in foreign currencies (e.g., USD, EUR, JPY, RMB) but project and sponsor cash flows are in local currency. This creates a mismatch that can turn disastrous if the value of the local currency declines while foreign currency payments are fixed.

5. To model even more conservatively, subtract Growth Capital Expenditures (Growth Capex) from the Operating Cash Flows. To avoid the risk that the addition of the project and its loan endangers the sponsor’s ability to stay on mission and expand, subtract planned growth-related capex (i.e., capital improvements) from operating cash flows before comparing them to P&I payments.

6. Calculate the synthetic rating for the duration of the loan. Interest coverage ratios may vary greatly over time due to front-loaded project costs coupled with delayed project cash inflows. As such, net cash flows (and interest coverage ratios) may be strained at the beginning of the project. Somewhat mitigating this, MDB loans usually have a grace period where only interest payments are due; only later full P&I must be repaid.

 

Applying the process