Case 077Corporate credit and ratingsCore
You are lead analyst meeting the CFO of a consumer products company with high fixed costs, a one-time charge and a large debt maturity next year. What do you ask, and what does a 10% revenue fall do to operating profit?
1The situation
Pranvika Home Products makes kitchenware and cleaning products sold through distributors and modern retail. Revenue is Rs 2,000 crore. Variable costs, mostly materials, packaging and freight, run at 70% of revenue. Fixed costs, plants, salaries and brand spend, are Rs 500 crore. This year it booked a one-time restructuring charge of Rs 80 crore to close a plant.
It has Rs 700 crore of debt costing about Rs 50 crore of interest a year, and Rs 600 crore of that debt matures next year. You are the lead analyst on the rating and have an hour with the CFO next week.
2Your task
What questions do you take into the meeting, and what does a 10% fall in revenue do to operating profit and interest cover?
Quick check
Revenue falls 10% and nothing else changes. By how much does operating profit before the one-time charge fall?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
A 10% revenue fall cuts operating profit by 60%, from Rs 100 crore to Rs 40 crore, and interest cover from 2.0x to 0.8x. Fixed costs are five times operating profit, so every point of revenue lost moves profit six points. Take four sets of questions to the CFO: how durable revenue is, how much of the cost base can flex, whether the one-time charge is really one-time, and exactly how the Rs 600 crore maturing next year will be refinanced.
Step 1Where do you start before the meeting?
Rebuild the income statement in two columns, variable and fixed, because that split decides how the company behaves in a bad year. A taxi owner who pays a monthly car loan and a driver's salary still owes both when bookings fall; a driver who rents a car by the day does not. Pranvika earns Rs 600 crore after variable costs and spends Rs 500 crore of it on costs that do not move, leaving Rs 100 crore of operating profit before the Rs 80 crore charge. That ratio, contribution of 600 over profit of 100, is the company's operating leverageHow strongly operating profit reacts to a change in revenue; high fixed costs mean a small revenue change becomes a large profit change.: six.
Step 2What does a 10% revenue fall do?
Revenue drops to Rs 1,800 crore and contribution to Rs 540 crore. Fixed costs are still Rs 500 crore. Operating profit falls to Rs 40 crore, 60% lower, which no longer covers Rs 50 crore of interest. Revenue only has to fall to Rs 1,667 crore, about 16.7% below today, for operating profit to reach zero. A rating analyst reads that distance to break-even as the company's cushion, and here it is thin.
Step 3Which questions do you put to the CFO, and why each one?
Group them by the three things a lender is paid from, revenue, costs and the ability to refinance, and tie each to a number above. Every question should be one whose answer would move the rating, not one that fills the hour.
| Area | Question to the CFO | Why it matters here |
|---|---|---|
| Revenue quality | What share of sales comes from the top five distributors, and how many renewed last year? | At operating leverage of six, losing one large account is a profit event |
| Revenue quality | How much of this year's growth came from price rather than volume? | Price gains can reverse faster than volume |
| Costs | How much of the Rs 500 crore of fixed cost could be cut within a year if sales fell? | Flexible fixed cost is the real cushion |
| One-time costs | Is the Rs 80 crore charge the last closure, and what cash does it still need? | Charges that recur every year are operating costs |
| Debt | Who refinances the Rs 600 crore next year, on what committed terms, and by when? | Refinancing is the nearest date that can cause default |
| Debt | What cash and undrawn committed lines exist if refinancing slips six months? | Liquidity decides survival while the market is shut |
Close with the view you would carry into committee. The rating turns less on this year's Rs 100 crore of profit than on the refinancing plan for the Rs 600 crore, because a company with 2.0x interest cover and a 60% profit swing cannot rely on the next year's cash to repay it. A signed refinancing, or undrawn committed lines above Rs 600 crore, would support the current rating; an open plan six months before the date would put it under pressure.
Where candidates lose it
The frequent miss is taking the reported Rs 20 crore of profit after the charge as the base, or ignoring the charge completely. The charge is real cash this year; the question is whether it recurs. Analysts separate the Rs 100 crore of underlying profit from the Rs 80 crore charge and then ask how often such charges have appeared.
The second is a question list that could apply to any company. Interviewers want each question tied to a number in front of you, here operating leverage of six and a Rs 600 crore maturity, and a sentence on what answer would change the rating.
What the interviewer asks next
- The CFO says 30% of fixed costs can be cut in six months. Redo the 10% revenue fall.
- What covenant would you want if you were the bank refinancing the Rs 600 crore?
- How would the answer change if variable costs were 40% of revenue and fixed costs Rs 1,100 crore?
Asked at Moody's, Corporate Finance, New York, 2018 (Wall Street Oasis): If you were in a meeting with the CFO of a company and were the lead analyst, what questions would you ask?
Company names and figures are illustrative.