One of the critical aspects in conducting a financial analysis of a company is identifying the possibility of the business to experience financial distress. The organization should be able to meet its short-term and long-term responsibilities. Some of the integral tools utilized in the assessment of the solvency of the company include determining the firm’s Altman Z-Score, its bond rating using the Kaplan-Urwitz Models, and its actual bond rating. The firm’s capital structure and its expected default frequency may also be used as appropriate tools in the assessment.
The debt rating of a firm will influence the yield that must be provided to the organization’s investors. Netflix Inc offers bonds in the United Kingdom, China, and United States markets. The entertainment company in 2017 announced a $1.6 billion issuance of debt with a 10.5 year maturity in 2028 and 4.875% coupon rate. Netflix Inc achieved a record high-yield rate in its history. The debt is intended to finance the company’s large content spending as it sought to expand its products in 2018. Primarily, the company utilizes licensed products to increase the number of viewers subscribing to its web based entertainment products. The amount is significantly higher than the previous $1.53 billion junk-bond in 10-year euro-denominated bonds in May 2017 with a maturity date of May 2027. In this regard, Netflix has a substantial amount of bonds that are due over the next 11 years. The organization is depicted to be consistent in loading up its amount of debt to finance the continued increase in the costs of content-streaming expansion. Netflix continues to increase its expenditure in expanding its business portfolio while raising the amount of debt incurred. Although this is a worrying trend to many of its investors, the corporation identifies the practice as one that is in line with the business model of the company. As of December 2017, Netflix had a total long-term debt of $6.499 billion and $15.7 billion in corporate bonds, while its equity stands at $75 billion. Although the proportion of debt-to-equity has been on a steady rise from the previous financial years, this is merely a small proportion of the company’s market value. This is a clear indicator of the company’s financial health and its ability to leverage its creativity as critical factor to reduce programming expenditure that has been growing faster than the revenue over the past few years. Netflix maintains a low beta of 1.57 setting it in place to continue competing with the industry giants in the entertainment industry.
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Calculation of Altman’s Z-Score
The Altman Z-score was developed in 1967 by Professor Edward Altman as an effective tool of identifying the possibility of the company going bankrupt. This technique incorporated incorporates the use of five considerable financial data that are readily available in the annual 10K report of the company. The original study conducted by Altman utilizes various manufacturing corporations. However, with significant changes made to the formula, it can be used to identify the performance of other firms in different industries. Over the past ten years, Netflix Inc. has achieved high Z-scores ranging between 2.25 as its lowest and 14.04 as the highest score. In this regard, the corporation is operating within the safe zone with the current Z-score at 5.49. This is comparable to other notable firms in the industry including Walt Disney Co (3.8), Time Warner Inc (0.5), News Corporations [FOXVV and FOXAV] both at (2.4), Twenty-First Century Fox Inc [FOXA and FOX] both at (2.4), and Viacom Inc (2.5). This valuation is a clear indicator that the corporation has a better financial health than most established entertainment network companies in the industry.
Z > 2.99 -“Safe” Zones. The company is considered ‘Safe’ based on the financial figures only.
1.8 < Z > 2.99 -“Grey” Zones. There is a good chance of the company going bankrupt within the next 2 years of operations.
Z < 1.80 -“Distress” Zones. The score indicates a high probability of distress within this period (Stockopedia, 2011).
A = Working Capital / Total Assets. This measures liquid assets as firm in trouble will usually experience shrinking liquidity. Working Capital is: (current assets – cash and marketable securities) – (current liabilities – short-term & current portion of long-term debt). [(7,670-2,823) – (5,466-15,431)/ 19,013= 0.779]
B = Retained Earnings / Total Assets. This indicates the cumulative profitability of the firm, as shrinking profitability is a warning sign. (1,731/19,013= 0.091 )
C = Earnings Before Interest and Taxes / Total Assets. This ratio shows how productive a company in generating earnings, relative to its size. (737/19,013= 0.0387 )
D = Market Value of Equity / Book Value of Total Liabilities. This offers a quick test of how far the company's assets can decline before the firm becomes technically insolvent (i.e. its liabilities exceed its assets). Market Value of Equity is the total dollar value of all outstanding shares. This number changes daily as the stock price and number of shares outstanding changes. Book Value of Total Liabilities is sum of current and long-term liabilities). Market value calculated from a stock price of $264.56 as on 2/7/18. (114,805/15,430= 7.44 )
E = Sales/ Total Assets. Asset turnover is a measure of how effectively the firm uses its assets to generate sales. (11,692/19,013= 0.6149 )
Z-score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
= 1.2(0.779) + 1.4(0.091) + 3.3(0.0387) + 0.6 (7.44) + 1.0 (0.6149) = 6.26881
Estimation of Bond Rating Using Kaplan Urwitz Model
A bond rating is a grade given to a bond that represents the credit worthiness of an investment in corporate or government bonds. This grade should not be confused with a credit score usually given to an individual as it is completely different. Independent credit rating agencies provide these services of identifying the credit quality of a bond and ascertain the likelihood of the debt being paid. Some of these credit rating agencies in the US include Standard and Poor’s (S&P), Moody’s Investors Service, and Fitch Ratings Inc. Various financial ratios affect the debt ratings. The profitability and leverage of the company will also be an important factor in assessing the rating grade provided. Nevertheless, the size of the firm rather than any other quantitative factor plays a major role in determining the rating. The larger firms are more likely to receive better rating grades as opposed to the smaller ones. Netflix Inc.’s financial ratios demonstrate that the company has a bond rating significantly lower than the estimates of its peers. Increased competition in content-streaming by corporations such as Amazo.com, Hulu, CBS, and Dish Network has been a critical factor for the downgraded grade. The action of Netflix offering $1.6 billion in senior unsecured notes shows the negative outlook by S&P and Moody’s ratings which gave a B+ from BB- and B1 from Ba respectively. In this regard, the offering has been classified as junk and of a speculative risk.
One of the models developed by researchers as a speculation of the formula used by these independent agencies is the Kaplan-Urwitz model. There are two separate models for identifying quoted and unquoted companies. For the quoted companies, the formula given is:
Y = 5.67 + 0.011F + 5.13π - 2.36S – 2.85L + 0.007C – 0.87β – 2.90σ
Where
Y= this is the score that the model will produce in rating the credit quality of the company.
F= This is the size of the organization in terms of its total assets.
π= The value of Net income/total assets
S= The debt status where subordinate debt =1, else=0
L=The gearing of the company in terms of long-term debt/total assets
C=The interest cover in terms of PBIT/Interest payment
β= Beta of the firm from CAPM
σ= Variance of the residuals from CAPM equation ( √(σ– β– σ ) ) where σ is the variance of the market.
For the unquoted companies, there is a subtle difference in the constants used in the equation and it remains without beta.
Y = 4.41 + 0.0014F + 6.4π - 2.56S – 2.72L + 0.006C– 0.56σ
The values for the letters remain the same except σ which is Standard deviation of earnings.
| Score (Y) | Rating |
| y>6.76 | AAA |
| Y= 5.20 - 6.75 | AA |
| Y = 3.29 – 5.19 | A |
| Y = 1.58 – 3.28 | BBB |
| Y = 0 – 1.57 | BB |
Actual Bond Rating
As mentioned earlier, some of the independent credit rating agencies in the U.S. include Standard and Poor’s (S&P), Moody’s, and Fitch Ratings. S&P recently downgraded Netflix Inc.’s bond rating to B+ from BB-. The same was evident by Moody’s who reduced the bond rating from Ba to B1. This reduction comes as a result of the significant offering of $1.6 billion in senior unsecured notes. Netflix has clearly stated its intent on expanding its content by creating its own movies, program series, and documentary. Previously the company would seek licenses from regular television networks such as FOX, Twenty-First Century, Disney, and CBS. The costs for seeking these licenses have become extremely expensive for the company resulting in lower revenues in an annual basis. In this regard, the firm identified the need to produce its own content for screening which will result in low expenditures in the long-run. However, the credit rating agencies have identified the bond offering as a speculative risk of a marginal grade. This has been echoed by significant doubts by the investors of the company.
References
Gomez-Uribe, C. A., & Hunt, N. (2016). The netflix recommender system: Algorithms, business value, and innovation. ACM Transactions on Management Information Systems (TMIS), 6 (4), 13.
Hwang, R. C., Chung, H., & Chu, C. K. (2010). Predicting issuer credit ratings using a semiparametric method. Journal of Empirical Finance, 17 (1), 120-137.
Mazzolini, P. (2016). Netflix: financial position analysis and evolution in the market for online streaming services . Retrieved from http://tesi.eprints.luiss.it/18543/1/174501_MAZZOLINI_PIERFRANCESCO.pdf
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