What is the relationship between operating cash flow and earnings with risk and credit-worthiness? Justify and give an example.

 

The main relationship of a an operating cash flow with earnings with risk and credit worthiness is that cash flows denotes the mainstream of defining whether a borrower is worthy of the credit or not. Operating Cash-flow is one of the single most critical aspects of among credit worthiness decisions. Operating Cash Flows plays an important role in picturing the financial performance of a company or a firm. It takes on added value of importance for speculative-grade issuers. Creditworthiness is determined by several factors including your repayment history and credit score. Some lending institutions also consider available assets and the number of liabilities you have when they determine the probability of default. While other companies with investment-grade worthiness generally have ready access with regards to external financing in covering temporary cash shortfalls, junk-bond issuers lack this degree of flexibility and have fewer alternatives to internally generated cash for servicing debt

Understanding the Relationship

Your creditworthiness tells a creditor just how suitable you are for that loan or credit card application you filled out. The decision the company makes is based on how you've dealt with credit in the past. In order to do this, they look at several different factors: your overall credit report, credit score, and payment history. This liquidity ratio is considered an accurate measure of short-term liquidity, as it only uses cash generated from core business operations rather than from all income sources. A ratio less than 1 indicates short-term cash flow problems; a ratio greater than 1 indicates good financial health, as it indicates cash flow more than sufficient to meet short-term financial obligations.

Your credit report outlines how much debt you carry, the high balances, the credit limits, and the current balance of each account. It will also flag any important information for the potential lender including whether you've had any past due amounts, any defaults, bankruptcies, and collection items.

Your creditworthiness is also measured by your credit score, which measures you on a numerical scale based on your credit report. A high credit score means your creditworthiness is high. Conversely, low creditworthiness stems from a lower credit score.

Payment history also plays a key role in determining your creditworthiness. Lenders don't generally extend credit to someone whose history demonstrates late payments, missed payments, and overall financial irresponsibility. If you've been up-to-date with all your payments, the payment history on your credit report should reflect that and you should have nothing to worry about. Payment history counts for 35% of your credit score, so it's a good idea to stay in check, even if you have to just make the minimum payment.

Your creditworthiness is important because it will determine whether you get that car loan or that new credit card. But that's not all. The more creditworthy you are, the better it is for you in the long run because it normally means better interest rates, fewer fees, and better terms and conditions on a credit card or loan, which means more money in your pocket. It also affects employment eligibility, insurance premiums, business funding, and professional certifications or licenses.

The Operating Cash Flow Ratio, is a measure of how well a company can pay off its current liabilities with the cash flow generated from its core business operations that is with regard to the risk of credit worthiness. This financial metric shows how much a company earns from its operating activities, per dollar of current liabilities. Since earnings involve accruals and can be manipulated by management, the operating cash flow ratio is considered a very helpful gauge of a company's short-term liquidity.

Operating cash flow (OCF) is one of the most important numbers in a company's accounts. It reflects the amount of cash that a business produces solely from its core business operations. Operating cash flow is intensely scrutinized by investors, as it provides vital information about the health and value of a company. If a company fails to achieve a positive OCF, the company cannot remain solvent in the long term. A negative OCF indicates that a company is not generating sufficient revenues from its core business operations, and therefore needs to generate additional positive cash flow from either financing or investment activities.

Credit Analysis Example

An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest, principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow.

EXAMPLE

For example, a debt service coverage ratio of 0.89 indicates that the company's net operating cash flows is enough to cover only 89% of its annual debt payments. In addition to fundamental factors used in credit analysis, environmental factors such as regulatory climate, competition, taxation, and globalization can also be used in combination with the fundamentals to reflect a borrower's ability to repay its debts relative to other borrowers in its industry.

Credit worthiness analysis is also used to estimate whether the credit rating of a bond issuer is about to change. By identifying companies that are about to experience a change in debt rating, an investor or manager can speculate on that change and possibly make a profit.

Another example is that, assume a manager is considering buying junk bonds in a company. If the manager believes that the company's debt rating is about to improve, which is a signal of relatively lower default risk, then the manager can purchase the bond before the rating change takes place, and then sell the bond after the change in rating at a higher price. On the other side, an equity investor can buy the stock since the bond rating change might have a positive impact on the stock price.