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CFA Level I · CFA Level I Exam · Credit Analysis for Corporate Issuers

Two issuers in the same industry have identical EBITDA interest coverage of 5.0x. Issuer P has stable free operating cash flow after dividends and capital expenditures. Issuer Q has negative free operating cash flow after dividends and capital expenditures, funded by new borrowing. Which statement best describes the relative capacity to pay?

Issuer P has the stronger capacity to pay because its free operating cash flow after dividends and capital expenditures is positive, so it can service debt without further borrowing. Identical EBITDA coverage hides Q's reliance on new debt, which increases leverage and refinancing risk.

  1. AQ has stronger capacity because new borrowing adds liquidity
  2. BBoth have equal capacity because coverage ratios are identical
  3. CP has stronger capacity because its cash flow can service debt without more borrowingCorrect

Explanation

EBITDA coverage ignores capital spending, dividends and working capital needs. Q depends on additional debt to fund these outflows, which raises leverage over time and makes it vulnerable if markets close. P's internally generated cash after these outflows is stronger evidence of capacity to pay.

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