theextentofitsfinancialobligations—includinginterestand
principal payments.
44 Firms that generate high cash flows relative to their
financialobligationsshouldhavelowerdefaultriskthanfirms
that generate low cash flows relative to their financial
obligations. Other things remaining equal, firms with
significant existing investments, which generate relatively
highcashflows,willhavelowerdefaultriskthanfirmsthat
donot.Thesecondisthevolatilityinthesecashflows.The
morestabilitythereisincashflows,theloweristhedefault
riskinthefirm.Firmsthatoperateinpredictableandstable
businesseswillhavelower defaultrisk thanwillotherwise
similarfirms thatoperate incyclical orvolatilebusinesses.
Mostmodelsofdefaultriskusefinancialratiostomeasurethe
cashflowcoverage(i.e.,themagnitudeofcashflowsrelative
toobligations)andcontrolforindustryeffectstoevaluatethe
variability in cash flows.
Measuring Default Risk
Themostwidelyusedmeasureofafirm’sdefaultriskisits
bondrating,whichisgenerallyassignedbyanindependent
ratingsagency.ThetwobestknownareStandard&Poor’s
andMoody’s.Thousandsofcompaniesareratedbythesetwo
agencies,whoseviewscarrysignificantweightwithfinancial
markets.Theprocessofratingabondusuallystartswhenthe
issuing company requests a rating from a bond ratings
agency. Theratingsagency thencollects informationfrom
bothpubliclyavailablesources,suchasfinancialstatements,
andthecompanyitselfandmakesadecisionontherating.If
the company disagrees with the rating, it is given the
opportunity to present additional information.