DEBT RATINGS IN THE CHEMICAL INDUSTRY
Based on the available information, estimate what rating would be assigned to each debt
security described in the case.
ACCOUNTING PREDICTORS OF DEBT RATINGS
Table 9-1 [Palepu, Bernard, and Healy (1997)] suggests that there is a link between S&P debt
ratings and four ratios reflecting profitability, leverage and a combination of profitability and
leverage:

Pre-tax return on long-term capital;

Pre-tax interest coverage;

Working capital from operations to total debt;

Long-term debt to total capital;
DEFINITIONS OF THE FOUR ACCOUNTING RATIOS

Pre-tax return on long-term capital;
EBIT/(LTL+SE)

Pre-tax interest coverage;
EBIT/NIE

Working capital from operations to total debt;
(NI+D&A+NIE*(1-TR))/(STD+LTD)

Long-term debt to total capital;
(LTD/STD+LTD+SE)
FARGO CHEMICAL COMPANY

Fargo has been relatively profitable:
The 1990 pre-tax return on capital suggests it should be rated AA or A1!

Fargo took on a higher level of debt in 1990:
Leverage in 1990 (long-term debt to total capital) suggests it should be rated BBB
only;

Fargo’s ratio of working capital from operations to total debt is consistent with an
intermediate rating: A or BBB;

Pre-tax interest coverage for 1990 is suggestive of a higher rating: AA or A (it may
however be misleading since the denominator does not reflect a full year’s interest on
the new debt).

Based on the ratios for 1990, Fargo’s debt should be rated as A or BBB!

The actual rating assigned was A, even though the debt is subordinated. This may be
due to the historically high level of profitability experienced by the firm and the fact
that many chemical companies suffered some decline in profitability in 1990;
Pre-tax returns on capital are consistent with
higher ratings.
1
TEXAS GULF

Texas Gulf has been extremely profitable in the past. Even if profits did plummet in
1990, the pre-tax return on long-term capital suggests a rating of AAA!

Texas Gulf took an extraordinary degree of leverage in a recapitalization: the ratio of
long-term debt to total capital indicates a rating below CCC;

However, both ratios are distorted by Texas Gulf’s negative equity balance;

Pre-tax interest coverage looks strong in 1990, suggesting a rating of A or BBB (This
ratio however overstates the firm’s financial strength);

The ratio, most likely to be free of distortion, is working capital from operations to
total debt, reflecting both profitability and leverage and pointing to a rating of BB;

Texas Gulf’s actual rating was B, one class lower than predicted. This may be due to
the facts that:
The debt is subordinated;
Texas Gulf is the smallest of the firms considered;
Texas Gulf’s income stream has been relatively volatile (compared with Fargo,
MST, or Borland);
MST COMPANY

Each of the four ratios is pointing to A or AA;

Moreover, there is no major source of distortion for any of the ratios;

Neither are there any major differences between recent and prior values of the ratios,
aside from the impact of the moderate decline in profitability in 1990;

MST’s actual rating was A;
BOLAND

Each of the four ratios points to a rating of BBB or A;

The actual rating was BBB;
QUOTRON CHEMICAL CORPORATION

Quotron has produced some extraordinary profits in the past;

Operating profits however have been more volatile than for any of the other five
firms;

Moreover, the firm is highly leveraged as a result of a leveraged recapitalization that
occurred in 1989;

Based solely on profitability, as measured by pre-tax return on capital, Quotron
appears to be healthy and the associated rating is A or BBB;

At the other extreme, based purely on leverage, as reflected by the ratio of long-term
debt to total capital, Quotron would be assigned a ratio of less than CCC;

The two ratios that combine profitability and leverage, pre-tax interest coverage and
the ratio of working capital flow to total debt, both point to ratings of BB or B;

Quotron’s debt could thus be rated as BB or B;

The actual debt ratings were:
B for subordinated debt;
BB for senior debt;