Case 090Corporate credit and ratingsHard

A cash-rich technology company announces its first annual dividend and a buyback funded with new debt. Compute net cash and leverage after the first year, and assess what the change in financial policy means for its rating.

S&P GlobalChicago · 2022

The situation

Quillmark Technologies, a software and services company, has never paid a dividend and carries no debt. It expects to finish the year with net cash of Rs 8,000 crore, after this year's free cash flow, and EBITDA of Rs 4,000 crore. Free cash flow before shareholder payouts runs at about Rs 2,500 crore a year.

The board announces a new policy: an annual dividend of Rs 2,000 crore, paid from cash, and a Rs 5,000 crore share buyback funded by issuing bonds at about 8%. Management says it wants a more efficient balance sheet and will consider further buybacks. Tax is 25%. You are the rating analyst.

Your task

What are net cash and gross leverage after the first year, and how should the rating view change?

Quick check

After the dividend and the debt-funded buyback, what is Quillmark's net cash?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Net cash falls from Rs 8,000 crore to Rs 1,000 crore and gross debt rises to 1.25x EBITDA, still a strong balance sheet on the first year's numbers. The rating question is the policy, not the ratio. If the dividend and debt-funded buybacks repeat, net leverage passes 2.2x by year 3. A dividend alone would barely matter; together with borrowing to buy back shares it signals value moving from creditors to shareholders, so the analyst would ask for a stated leverage target and rate to that.

Step 1What happens to the balance sheet in year one?

Take the two moves separately. The dividend is paid from cash: Rs 8,000 crore becomes Rs 6,000 crore. The buyback is paid with new bonds: Rs 5,000 crore is borrowed and handed to selling shareholders, so cash is unchanged and debt rises by Rs 5,000 crore. Net cash is Rs 6,000 crore less Rs 5,000 crore of debt, Rs 1,000 crore, and gross debt is Rs 5,000 crore over Rs 4,000 crore of EBITDA, 1.25x. Interest of about Rs 400 crore is covered ten times by EBITDA.

Net cash after the new payout policy, Rs crore8,000Net cash before-2,000Dividend-5,000Debt-funded buyback1,000Net cash afterAfter: cash 6,000, debt 5,000. Gross debt 1.25x EBITDA of 4,000; still net cash of 1,000.
Quillmark's net cash falls from Rs 8,000 crore to Rs 1,000 crore after a Rs 2,000 crore dividend and a Rs 5,000 crore buyback funded with new debt, leaving Rs 6,000 crore of cash against Rs 5,000 crore of debt.
Step 2If the ratios still look strong, why does the rating analyst care?

Because a rating is a view of the next several years, and the announcement tells you how management will use the balance sheet. A family that has always saved and then starts taking loans to fund holidays may still have savings this year; what changed is the habit. Financial policyManagement and the board stated and demonstrated approach to leverage, payouts and acquisitions, which rating agencies weigh alongside the ratios. is what moved: a company that hoarded cash has chosen to borrow to pay shareholders, and said it may do more.

Step 3Where does the policy lead if it repeats?

Run it forward with the same dividend and a Rs 5,000 crore debt-funded buyback each year, and free cash flow of Rs 2,500 crore less after-tax interest. Net leverage goes from minus 2.0x today to minus 0.25x after year 1, 0.95x after year 2 and 2.23x after year 3, while gross debt reaches Rs 15,000 crore. The first year looks like a net cash company; by the third it is a leveraged one.

YearNet cash (+) or net debt (-), Rs croreGross debt, Rs croreNet debt / EBITDA
0+8,0000-2.00x
1+1,0005,000-0.25x
2-3,80010,000+0.95x
3-8,90015,000+2.23x
If Quillmark repeats the Rs 2,000 crore dividend and a Rs 5,000 crore debt-funded buyback each year, it moves from Rs 8,000 crore of net cash to about Rs 8,900 crore of net debt, 2.23x EBITDA, by year 3.
One year's ratio against the path the policy sets-2x-1x+1x+2x+3x0x2x: a plausible stated target-2.00xYear 0-0.25xYear 1+0.95xYear 2+2.23xYear 3Below zero: net cash. Above: net debt.
Quillmark's net debt to EBITDA moves from minus 2.0x to minus 0.25x in the first year, which still reads as net cash, but repeating the policy takes it to 0.95x in year 2 and 2.23x in year 3, past a 2x line.
Step 4What is the rating view?

Separate the dividend from the borrowing. A Rs 2,000 crore dividend from a company with Rs 8,000 crore of net cash and Rs 2,500 crore of annual free cash flow leaves Rs 6,000 crore of net cash and barely moves the credit; borrowing to buy back shares is what transfers value from bondholders to shareholders. The analyst asks management for an explicit leverage target and whether buybacks are one-off or a programme, then rates to the target rather than to today's cash. Until that is clear, a negative outlook is the honest signal.

Where candidates lose it

The usual slip is to report net cash of Rs 6,000 crore because the buyback did not touch cash. Net cash subtracts debt; the buyback added Rs 5,000 crore of it.

The second is concluding that nothing changes because leverage is only 1.25x. Rating committees weigh policy because ratios lag decisions; a candidate who reads only the first-year ratio misses what the question is testing.

What the interviewer asks next

  • Management commits to net debt no higher than 1.0x EBITDA. How does that change your view?
  • Would you treat a special one-off dividend differently from a recurring one?
  • How do bond covenants protect lenders against debt-funded buybacks, and why do investment-grade bonds usually lack them?

Asked at S&P Global, Debt Capital Markets, Chicago, 2022 (Wall Street Oasis): What do you think if a company like Google began paying dividends?

Company names and figures are illustrative.