Operating Leverage and Credit Ratings

• In Event: Research Paper Session—FARS

Abstract

We estimate operating leverage using time series fluctuations in recent operating earnings and revenues, postulating that firms with higher operating leverage have lower credit ratings. We find that high operating leverage results in lower credit ratings and increases to operating leverage result in a lower likelihood of being upgraded. We also observe that a one standard deviation increase in operating leverage decreases the conditional probability of being rated investment grade by approximately 7%. Our results apply to both long- and short-term credit ratings. This effect is exacerbated for growth firms and for firms with more variation in revenues. Alternatively, higher operating leverage benefits financially distressed firms in the form of higher credit ratings. Our main findings are not limited to credit ratings; we also find an economically significant effect upon long term corporate bond spreads. Overall, our results suggest operating leverage is an important factor used by ratings agencies in evaluating corporate risk profiles and should be considered by both lenders and investors.

Authors

• Douglas Ayres, Ball State University

• Douglas Brian Blank