Cfar: A New Tool For Predicting Credit Quality

Because of the limitations of traditional analytical ratios based on book leverage and coverage ratios, Fitch IBCA established a credit rating methodology that gives primacy to cash flow measurements. Its approach focuses on the “cash flow adequacy ratio,” or CFAR. CFAR is based on the premise that companies generating strong cash flow from operations relative to maturing debt have better credit profiles than those forced to rely on outside sources of capital. CFAR serves as proxy for company's financial flexibility; the higher the CFAR, the more financial stress the company can withstand. To assess the effectiveness of CFAR as a credit tool, Fitch IBCA surveyed 47 U.S. industrial companies with a Bloomberg composite rating of ‘A' from 1990–1995. Based on its cash flow analysis, the rating agency ranked the companies and predicted that many were likely to be upgraded or downgraded. In a three‐year period, 30% of the ratings in the sample group changed. Of the 14 ratings changes, Fitch IBCA forecast 10 correctly, which translates into a predictive score of over 70%.