Credit managers are desperate to find ways to identify -- and protect their companies against -- potential deadbeats. For Jim Ludlow, the chemicals-group credit manager at Air Products and Chemicals, based in Allentown, Pa., the financial ratio to look at when considering extending credit to customers is the interest-coverage ratio. "A financially weak company's survival depends on its ability to generate enough cash to cover its debt payments," he says, "so instead of using a traditional, balance-sheet-oriented approach to analyzing customers -- looking at things like the current ratio of assets to liabilities or the debt-to-equity ratio -- I focus on cash flow." The interest-coverage ratio can be calculated in three relatively simple steps:
1. Figure out operating cash flow -- a company's earnings before interest and taxes, added to depreciation, amortization, and other noncash transactions. All those numbers are listed on a company's "statement of cash flows," which public companies prepare for their annual reports. Private companies are likely to prepare similar information for their bankers.
2. Find out interest expense paid. Forget the interest-expense figure that you see on the balance sheet, which may be easier to find. There can be a large difference between the interest listed for tax purposes and the amount actually paid to banks, which you should request if it's not noted in the annual report.
3. Divide operating cash flow by interest expense paid. "I look for a ratio of higher than three to one, which indicates that management has considerable breathing room to make its debt payments," says Ludlow. "When the ratio drops below three to one, I'll probe further in financial footnotes, directly with the company, with Value Line, Standard & Poor's, or whatever other source of information I can find to gauge what operating pressures management is under and whether or not it will be able to pay our bills. When the ratio drops below one to one, it clearly indicates management is under tremendous pressure to raise cash. The risk of default or bankruptcy is very high.
"By relying on this ratio, we've avoided involvement with two companies that went on to file Chapter 11," he says. "We have also taken steps to reduce our receivables exposure with several other high-risk companies. The interest-coverage ratio is an important credit-evaluation tool." -- Jill Andresky Fraser