Financial Health Ratings

Rapid Ratings International has developed a unique proprietary process for measuring the financial health of a company called the FHR™. The FHR is a multi-dimensional measure of the rating levels or steps in a continuum between financial health success and failure of a company with respect to 62 financial ratios with no market inputs.

Each ratio is weighted, representing its significance in predicting success and failure in each global industry. Because we are not just focused on defaults but on all aspects of a company’s lifecycle (from birth to death) our underlying database is very broad, rendering the weightings of the coefficients very robust and stable.

It is the combination of the weights for each ratio in each company multiplied by the rated company’s individual score for each ratio that determines the overall FHR. That overall Financial Health Rating can be described as a weighted mosaic, wherein, depending on the global industry, each ratio plays a larger or smaller role in determining the health of a company. But each piece of the mosaic is important no matter how small.

Financial health failure is defined as bankruptcy or default while financial health success is defined as optimal performance in a combination of sales, cost structure, profitability, leverage, debt service management and working capital efficiency as determined across many decades. That optimality is multi-dimensional because:

1. No single variable determines success or failure, rather large clusters of factors are important
2. The global industry data covers over thirty years of data and hence the distribution for each of the 62 ratios represents both the best to worst life-cycle performance potential for each company across time in each industry, and
3. Independent modeling demonstrates that high FHR scores on our cardinal scale are highly correlated with a low probability of default on a geometric scale, while low FHR scores are highly correlated with a high probability of default.

Thus, companies make non-linear progress on the FHR rating scale because of the differing weights for each ratio in each industry and because of the high correlation of the FHRs with the default probability scale. Companies with high FHR scores are very likely to remain competitive in the future, while those with low scores will struggle to remain competitive (and struggle to service their debts and pay their obligations). The FHR system measures the absolute level of risk in terms of the probability of default and the optimal frontier and the relative risk (in terms of the rating point distance between a company’s current position relative to its previous ratings and relative to those of other companies in the same industry.)

Traditional rating agencies have an ordinal ranking system. In a 100 metre race, that system can tell you reasonably well who is running first, who is running second, who is third etc. But it cannot tell you how far they are from the starting line, what the distance is between each runner and how far they are from the finish line. A cardinal ranking system can tell you how far each runner is from both zero and the finish line, and how far each runner is from the other. Rapid Ratings operates a cardinal rating system which measures both absolute and relative risk.

Dana Corp.: FHR vs. S&P and Moody's Ratings Trends

Dana Corporation represents an example of Rapid Ratings' timely, realistic ratings in contrast to late responses by the major rating agencies. We saw Dana as a high risk credit when S&P saw investment grade and Moody's Ba2, just a little over one year before default. We saw Dana as a deeply distressed three months before default, while the Agencies were at B1/B+. Without question, Rapid Ratings provided critical early warning. Moody's and S&P are the trademarks of their respective companies.