Criteria | Corporates | Request for Comment:
Request for Comment: Corporate
Criteria: Ratios And Adjustments
Primary Credit Analysts:
Leonard A Grimando, New York (1) 212-438-3487; leonard.grimando@standardandpoors.com
Sam C Holland, London (44) 20-7176-3779; sam.holland@standardandpoors.com
Mark W Solak, CPA, New York (1) 212-438-7692; mark.solak@standardandpoors.com
Criteria Officer:
Peter Kernan, EMEA Criteria Officer, Corporates, London (44) 20-7176-3618;
peter.kernan@standardandpoors.com
Table Of Contents
SCOPE OF THE PROPOSAL
SUMMARY OF THE PROPOSAL
SPECIFIC QUESTIONS FOR WHICH WE ARE SEEKING A RESPONSE
IMPACT ON OUTSTANDING RATINGS
RESPONSE DEADLINE
PROPOSED METHODOLOGY
Proposed Changes To Ratio Elements
Proposed Changes To Analytical Adjustments
Partly Superseded Criteria
APPENDIX
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Table Of Contents (cont.)
Standard & Poor's Core And Supplemental Credit Ratios In "Request for
Comment: Corporate Criteria," Published June 26, 2013
Additional Debt Service Ratios In "Request for Comment: Corporate
Criteria," Published June 26, 2013
Related Research And Criteria
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Criteria | Corporates | Request for Comment:
Request for Comment: Corporate Criteria: Ratios
And Adjustments
1. Standard & Poor's Ratings Services is requesting comments on proposed changes to a number of analytical
adjustments and definitions of ratio elements that it uses in its corporate credit analysis. Ratio elements comprise the
numerators and denominators of our credit ratios. This article supplements the proposed corporate criteria, "Request
For Comment: Corporate Criteria," also published on June 26, 2013. The proposed criteria in this article would partly
supersede, "2008 Corporate Criteria: Ratios And Adjustments," published April 15, 2008, which details Standard &
Poor's current analytical adjustments for corporate issuers. For a list of Standard & Poor's corporate credit ratios, see
the Appendix.
2. The intention of the proposed changes is to add clarity to the adjustments that Standard & Poor's may make to the
reported results of issuers and to enhance the consistency and comparability of our adjusted credit ratios. Standard &
Poor's makes analytical adjustments to ratio elements to better align the ratio elements with our view of the underlying
economic reality of a particular arrangement or transaction, and to improve the comparability of the financial results of
issuers. Our analysts may also employ adjustments to portray what we view as a more appropriate depiction of
recurring activity.
3. The proposed criteria constitute specific methodologies and assumptions under "Principles Of Credit Ratings,"
published Feb. 16, 2011.
SCOPE OF THE PROPOSAL
4. The proposed methodology applies to issuer credit ratings on nonfinancial companies globally. This Request for
Comment does not apply to project finance entities and corporate securitizations because of the unique characteristics
of these asset classes, which are subject to a different analytical framework.
SUMMARY OF THE PROPOSAL
5. We are requesting comment on proposed changes to:
• The definition of funds from operations (FFO), which as proposed would be calculated as EBITDA less net interest
expense less current tax expense, subject to our analytical adjustments.
• The definition of EBITDA, which as proposed would be calculated as revenues less operating expenses plus
depreciation and amortization (D&A), subject to our analytical adjustments.
• The operating lease adjustment, which as proposed would: apply two standard discount rates in the calculation of
the lease adjustments to debt, one for companies with long-term issuer ratings of 'BBB-' or higher, and one for
companies with long-term issuer ratings of 'BB+' or lower; add back the full operating lease rental expense in
calculating adjusted EBITDA; and eliminate the lease capital expenditure adjustment from the calculation of our
standard measure of free operating cash flow (FOCF).
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• Our postretirement employee benefits (PRB) adjustment for any financial reporters that calculate pension interest
using an expected return on plan assets, such as companies that use U.S. generally accepted accounting principles
or GAAP. The proposal would accord equal treatment to U.S. GAAP reporters and reporters under IFRS
(International Financial Reporting Standards). That is because IFRS reporters are obliged under new accounting
rules to calculate net interest on their net PRB deficits, abandoning the expected return concept for annual periods
beginning on or after Jan. 1, 2013.
• Our asset retirement obligations (ARO) adjustment, which as proposed excludes new provisions from the
computation of FFO.
• In addition, we propose to clarify our calculation of the surplus cash adjustment, which is the amount of cash and
liquid investments that are subtracted from gross debt to calculate net debt.
SPECIFIC QUESTIONS FOR WHICH WE ARE SEEKING A RESPONSE
6. Standard & Poor's is seeking market feedback on its proposed methodology and to the following questions:
• Do you agree with the proposed change to the surplus cash adjustment?
• Do you agree with the proposed changes to the operating lease adjustment?
• Do you agree with the proposed changes to the PRB criteria?
IMPACT ON OUTSTANDING RATINGS
7. We do not expect these proposed criteria, if implemented, in and of themselves to result in changes in ratings.
RESPONSE DEADLINE
8. We encourage interested market participants to submit their written comments on the proposed criteria by Sept. 16,
2013, to http://www.standardandpoors.com/criteriaRFC/en/us. We will review and take such comments into
consideration before publishing our definitive criteria once the comment period is over. Generally, Standard & Poor's
Ratings Services (Ratings Services) may, in cases when the commenter has not requested confidentiality, publish
comments in their entirety, except when the full text, in Ratings Services' view, would be unsuitable for reasons of tone
or substance.
PROPOSED METHODOLOGY
Proposed Changes To Ratio Elements
Funds from operations
9. We propose defining FFO as "EBITDA less net interest expense less current tax expense," subject to our analytical
adjustments. Our current criteria define FFO as "operating profits from continuing operations, after tax, plus
depreciation and amortization (D&A), plus deferred income tax, plus other major recurring noncash items" (see "2008
Corporate Criteria: Ratios And Adjustments," published April 15, 2008).
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Earnings before interest, taxes, depreciation, and amortization
10. We propose defining EBITDA as revenues less operating expenses plus D&A expenses (including noncurrent asset
impairment and impairment reversals), subject to our analytical adjustments. Cash dividends received from affiliates,
associates, or joint ventures would be included in EBITDA, while the company's share of profits in these affiliates
would be excluded from EBITDA. As a related analytical adjustment, we propose to add back the issuer's full operating
lease rental expense, which we apportion to interest and depreciation, in the calculation of adjusted EBITDA (see
paragraph 13 for further detail). Our current criteria define EBITDA as "operating profits before interest income,
interest expense, income taxes, D&A, and asset impairment" and do not include undistributed equity earnings of
affiliates (see "2008 Corporate Criteria: Ratios And Adjustments," published April 15, 2008).
Proposed Changes To Analytical Adjustments
Operating lease adjustment
11. Lease discount rate: We propose applying two standard discount rates in the calculation of the operating lease
adjustments, one rate of 6% for companies with long-term issuer ratings of 'BBB-' or higher, and one rate of 8% for
companies with long-term issuer ratings of 'BB+' or lower . These rates most closely match the current average rates
that we use for companies rated 'BBB-' and higher and companies rated 'BB+' and lower. This approach in our view is
straightforward and clear to issuers and investors, and broadly incorporates the credit quality of the issuer.
12. The current criteria allow for one of three ways to calculate the discount rate:
• Using the imputed discount rate associated with the lease. In practice, however, this rate is rarely available as it is
typically not publicly disclosed.
• Using the average rate on the company's secured debt. Again, in practice, this rate is often not available as many
issuers, in particular investment-grade companies, do not borrow on a secured basis; and
• Using a rate imputed from the company's total interest expense and average debt. This rate is in practice highly
variable and its use can result in volatility in the operating lease adjustment to debt.
Operating lease rental expense
13. We propose adding back the company's entire noncancellable operating lease rental expense, which we apportion to
interest and depreciation, in the calculation of adjusted EBITDA. This would be a change from our current criteria,
which add back only the interest component in the calculation of adjusted EBITDA and include the lease depreciation
component as an expense in the calculation of EBITDA. The proposed change would be consistent with the definition
of EBITDA, which measures earnings before interest, taxes, and D&A expenses.
Lease capital expenditure adjustment
14. We propose eliminating the lease capital expenditure adjustment from the standard measure of FOCF. Our current
criteria make an adjustment to a company's capital expenditures, which are increased by an amount that is calculated
as the year-over-year change in operating lease debt plus annual operating lease depreciation. Standard & Poor's
proposes to retain the capital expenditure operating lease adjustments but calculate separate FOCF measures that
would include and exclude the adjustment. The standard FOCF measure would exclude the capital expenditure
operating lease adjustment. The measure that includes the capital expenditure operating lease adjustment would be
reserved for comparing companies' decisions to lease instead of purchase assets.
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Postretirement employee benefits
15. We propose changing the PRB adjustment for any financial reporters that calculate pension interest using an expected
return on plan assets, such as companies that use U.S. GAAP. The proposal would accord equal treatment to U.S.
GAAP reporters and reporters under IFRS. IFRS reporters are obliged to calculate net interest on their net PRB
deficits, abandoning the expected return concept for annual periods beginning on or after Jan. 1, 2013.
16. Replacing the concept of expected return on pension plan assets, the revised version of International Accounting
Standard (IAS) 19, effective Jan. 1, 2013, establishes a new standard of "net interest" calculated on any net pensions
deficit. This is significantly different from U.S. GAAP accounting, which continues to use the "expected return on plan
assets" concept. This accounting change will affect our adjusted credit metrics for IFRS reporters. Standard & Poor's
pension adjustment currently adds "pension interest" (if a net expense) to reported interest. The amount of pension
interest also affects the pension adjustment to FFO and operating cash flow.
17. The proposed approach deals with this divergence in accounting standards so that pension interest is calculated in the
same way for U.S. GAAP reporters (and any other reporters who continue to apply an expected return on plan assets)
as for IFRS reporters. This would have the advantage of treating IFRS and U.S. GAAP reporters in the same way and
would make the pension interest (and therefore interest and FFO) of U.S. GAAP and IFRS reporters directly
comparable.
Asset retirement obligations
18. We propose changing our approach to ARO within FFO to exclude new ARO provisions. This would be a change from
our current criteria that reduce FFO by the sum of new ARO provisions and interest costs, less the return on any assets
set aside to meet future ARO. The proposed change in our view is consistent with our treatment of new ARO
provisions within EBITDA, where they are considered as a capital cost and therefore included as a component of
depreciation.
Surplus cash
19. To enhance the transparency of this adjustment, we propose introducing a standard method of calculating surplus
cash, which is the amount of cash and liquid investments that is subtracted from gross debt to calculate debt.
20. Standard & Poor's cash flow and leverage ratios are intended to capture the degree to which a company has leveraged
its risk assets. Highly liquid financial assets are often low risk. Moreover, we consider that surplus cash is available to
repay debt, in addition to cash flow generation. Therefore, it would be appropriate to evaluate debt net of surplus cash.
Accordingly, under this proposal, we deduct surplus cash from adjusted gross debt in the calculation of debt.
21. The current criteria include strategies that support and do not support net debt treatment. However, these strategies
sometimes do not readily match the characteristics of the particular company under analysis. For that reason, we
propose to adapt a standard methodology to calculate surplus cash, which will allow the netting of available cash and
liquid investments if our financial forecasts indicate that they are not earmarked for a specific use (such as funding
forecast negative cash flows). That is, that the cash and liquid investments are truly surplus and therefore could be
used to repay debt.
22. The proposed methodology for calculating surplus cash comprises three steps:
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Step 1: For each company, take cash at period end (A), identified as "cash and liquid investments" in "Liquidity
Descriptors for Global Corporate Issuers," (published Sept. 28, 2011), and subtract cash that is required to fund the
seasonal working capital peaks of the business, calculated as the difference between year-end working capital and the
peak intrayear working capital (PIYWC) needs of the business (B) to derive gross available cash (C). C = A – B. If C is
positive, move to step 2. (See the box below for a definition of working capital and further details about PIYWC.)
Step 2: Then take a fixed 25% haircut (deduction) on gross available cash (C) to derive adjusted available cash.
Therefore, adjusted available cash (D) = C * 0.75. If available information indicates greater or lesser accessibility to
cash and liquid investments, the haircut would be raised or lowered. For example, the haircut would increase if a large
proportion of cash is held abroad in a nonconvertible currency. The haircut adjusts for cash that might be inaccessible
due to, among other reasons:
•
•
•
•
•
Being held abroad in a nonconvertible currency;
Distribution restrictions (for example, covenants and cash held in escrow);
Unknown tax effects on repatriation of cash;
Accounting variances or quarter-end window dressing; or
Being held in a country outside the company's domicile whose country risk we assess as "high" or "very high"
(unless held in the company's country of domicile).
Step 3: Then, for each year in the forecast horizon (generally two years; see Section E.2 of "Request For Comment:
Corporate Criteria"), forecast cash available for debt repayment (E). (If E is positive, use "0"). Forecast cash available
for debt repayment is defined as forecast discretionary cash flow adjusted for our expectations of: share buybacks, net
of any share issuance, and mergers and acquisitions. Discretionary cash flow is defined as cash flow from operating
activities less capital expenditures and total dividends.
23. Surplus cash available for netting against gross debt = (D + E). If E is positive, its value is "0".
24. We propose to generally not net surplus cash from debt if the issuer is either 1) owned by a financial sponsor (defined
in Section I.4 of "Request For Comment: Corporate Criteria"; 2) has a business risk profile assessment of "weak" or
"vulnerable"; or 3) has demonstrated or is projected to demonstrate volatile discretionary cash flow that equals or
exceeds surplus cash available for netting against gross debt. However, we propose to deduct surplus cash from debt
for such a company if it doesn't meet any of the conditions specified above, as long as:
• We believe that the company has surplus cash identified to retire maturing debt or other debt-like obligations; and
• We believe, typically from the company's track record, market conditions, or financial policy that management will
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use the cash to pay off maturing debt, or debt-like obligations.
Partly Superseded Criteria
25. If adopted, for those companies within the scope of this Request for Comment, the proposed methodology would
partly supersede these criteria articles:
• 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
• Methodology And Assumptions: Standard & Poor's Revises Key Ratios Used In Global Corporate Ratings Analysis,
Dec. 28, 2011
APPENDIX
Standard & Poor's Core And Supplemental Credit Ratios In "Request for
Comment: Corporate Criteria," Published June 26, 2013
Core debt payback ratios
26. Funds from operations/debt (FFO/debt)
27. Debt/EBITDA
Supplemental debt payback and debt service ratios
28. Operating cash flow/debt (OCF/debt)
29. Free operating cash flow/debt (FOCF/debt)
30. Discretionary cash flow/debt (DCF/debt)
31. (FFO + interest)/cash interest (FFO cash interest cover)
32. EBITDA/interest
Additional Debt Service Ratios In "Request for Comment: Corporate Criteria,"
Published June 26, 2013
33. Reported OCF before any cash interest/cash interest. For non-U.S. GAAP issuers (such as IFRS issuers) any dividends
received or interest paid or received that is classified in investing or financing cash flows are reclassified to operating
cash flows
34. EBITDA/cash interest
Ratio element definitions for the purposes of calculating Standard & Poor's core, supplemental, and
additional ratios
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EBITDA
35. EBITDA = revenues - operating expenses + D&A expenses (including noncurrent asset impairment and impairment
reversals).
Dividends (cash) received from affiliates, associates, and joint ventures are added, while the company's share of profits
in these affiliates is excluded.
+/- All applicable adjustments as defined in "2008 Corporate Criteria: Ratios And Adjustments," except if superseded
by the criteria proposed in this Request for Comment (referred to subsequently as "all applicable adjustments")
FFO
36. FFO = EBITDA less net interest expense less current tax expense.
+/- All applicable adjustments
Debt
37. Debt is gross financial debt (including items such as bank loans, debt capital market instruments, and finance leases),
net of surplus cash +/- all applicable adjustments.
OCF
38. OCF (Operating cash flow, also referred to as cash flow from operations [CFO]).
This measure reflects cash flows from operating activities (as opposed to investing and financing activities) including
all interest received and paid, dividends received, and taxes paid in the period. For non-U.S. GAAP issuers (such as
IFRS issuers) any dividends received or interest paid or received that is classified in investing or financing cash flows
are reclassified to operating cash flows.
+/- All applicable adjustments
FOCF
39. FOCF = OCF less capital expenditures.
+/- All applicable adjustments
DCF
40. DCF = FOCF less cash common dividends paid and preferred stock cash dividends paid.
+/- All applicable adjustments
Cash interest
41. For the purposes of calculating FFO, OCF, and EBITDA cash interest cover ratios, "cash interest" includes only cash
interest payments on gross financial debt (including items such as bank loans, debt capital market instruments, and
finance leases, and including capitalized interest), and does not include any Standard & Poor's adjusted interest on
debt-like obligations such as postretirement benefit obligations or operating leases.
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Interest
42. "Interest" is interest expense as reported, which includes noncash interest expense on conventional debt instruments
(for example, payment-in-kind (PIK) debt, zero-coupon debt, and inflation-linked debt) minus any interest income
derived from assets structurally linked to a borrowing.
+/- All applicable adjustments
Net interest expense
43. Interest expense as reported, including noncash interest expense on conventional debt instruments (for example, PIK
debt, zero-coupon debt, and inflation-linked debt), minus the sum of interest income and dividend income.
+/- All applicable adjustments
Current tax expense
44. Current tax expense is defined as the amount of income taxes payable in respect of the taxable profit or recoverable in
respect of tax losses for the period.
+/- All applicable adjustments
Related Research And Criteria
•
•
•
•
•
Special Report: Requests For Comment: Corporate Criteria, June 27, 2013
Request For Comment: Corporate Criteria, June 26, 2013
Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
Principles Of Credit Ratings, Feb. 16, 2011
2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
These criteria represent the specific application of fundamental principles that define credit risk and ratings opinions.
Their use is determined by issuer- or issue-specific attributes as well as Standard & Poor's Ratings Services' assessment
of the credit and, if applicable, structural risks for a given issuer or issue rating. Methodology and assumptions may
change from time to time as a result of market and economic conditions, issuer- or issue-specific factors, or new
empirical evidence that would affect our credit judgment.
Additional Contact:
Industrial Ratings Europe; Corporate_Admin_London@standardandpoors.com
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