Capacity to pay is an important element while analysing a company for credit ratings. Usually Traditional Ratio analysis is done to check the capability of a company meet its short term and long term debt obligations. Interestingly Traditional Ratios can give a deceived view. To counter that, eminent credit rating agencies do the cash flow analysis in order to truly judge the capacity of firms meeting their debt obligations.

Knowing the sources for cash of a firm is an important consideration in this regard. A firm must be able to generate cash flows from its operations to have future prosperity and the ability to meet its obligations. Standards and Poors utilizes the criteria in which it adds depreciation and plus/minus other non cash items to Net Income in order to get

**. They are adjusted for working capital to get operating cash flows which are further netted against capital expenditures (operating cash flow - capital expenditure) to get***Funds from Operations***. After subtracting cash dividends from Free Operating Cash flows they get***Free Operating Cash Flows***. As its name implies these cash flows are on the discretion of the management to use. Netting these cash flows against acquisitions, adding asset disposals and adding (subtracting) other sources (uses) result in***Discretionary Cash flows**Pre-financing Cash Flows.*The flow can be illustrated as:

Net Income

Plus Depreciation

Plus/Minus: Other non cash items

**Funds from Operations**

Decrease (increase) in non cash current assets

Increase (decrease) in non debt current liabilities

**Operating Cash Flow**

Minus Capital expenditure

Free Operating Cash flow

Minus Cash dividends

**Discretionary Cash flow**

Minus acquisitions

Plus Asset Disposals

Plus (minus) other sources (uses)

**Pre-financing Cash Flow**

S&P uses the following cash flow ratios in order to analyse a company

1. Funds from Operations / Total debt (netted against off-balance sheet liabilities, leases etc.)

- Higher the ratio, the stronger the issuer's capacity to pay

2. (Free Operating Cash flow + interest) / Interest

- The higher the ratio, the stronger the issuer's capacity to pay.

3. Debt Service Coverage Ratio = (Free Operating Cash Flow + Interest) / (interest + Annual Principal Repayment Obligation)

- The higher the ratio, the stronger the issuer's capacity to pay

4. Debt Payback Period = Total Debt / Discretionary Cash Flow

- The lower the ratio, the stronger the issuer's capacity to pay

5. Funds from Operations / Capital spending requirements

- The higher the ratio, the stronger the issuer's capacity to pay.

It is noticeable that companies with lower credit ratings and Speculative-grade issuers must be analysed using

- Free Operating Cash Flows
- Debt service coverage ratios

High credit rating firms should be analysed using Funds from Operations measure.

Based on above methodologies one can see that cash flow analysis is not only interesting but capable of giving a direction which can be used to judge the capacity of a company to meet its debt obligations. Merely relying on traditional ratio analysis, which itself is an important tool but must not be considered the sole one, can give a view which could be misleading.

thanks for this outline, was really helpful!

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