On the Nonlinearity of the Financial Ratios-Credit Ratings Relationship

Abstract

In this paper, we study the specificity of financial ratios in determining credit ratings. Specifically, we examine the nonlinearity of the financial ratios-credit ratings relationship.

Among financial ratios, the interest coverage and debt coverage ratios have the most pronounced effect on credit ratings. To determine the form of the nonlinearity, the interest and debt coverage ratios are divided to four sub-variables with different weights associated to each increment. We find that different coefficients are associated to different increments of the interest coverage and debt coverage ratios. An interest coverage ratio loses all significance when it is less than zero and when it exceeds 20. Similarly, a debt coverage ratio loses all significance when it less than negative one and when it exceeds one. Our results confirm the nonlinearity of the financial ratios-credit rating relationship.