Synthetic Ratings from Interest Coverage

Not every company has a credit rating from an agency like Moody's or S&P — many private companies and smaller public ones don't bother paying for one. To still estimate a plausible cost of debt for these companies, analysts build a synthetic rating: they compute the company's interest coverage ratio (operating income divided by interest expense) and match it against published tables showing what interest coverage range corresponds to each rating tier for actually-rated companies of similar size.

Once the interest coverage ratio is matched to a rating band, that rating is paired with a typical default spread for companies at that rating tier, and the default spread is added to the risk-free rate to estimate the company's pre-tax cost of debt — without ever needing an agency to have rated the company itself.

Worked example. A private manufacturer has operating income of $50 million and interest expense of $8 million, giving interest coverage of $50 / 8 = 6.25$. A reference table shows that coverage ratios between 6.0 and 7.5 are typical of A-rated companies, which currently carry a default spread of about 1.0% over the risk-free rate. If the risk-free rate is 4.5%, the synthetic pre-tax cost of debt is $4.5\% + 1.0\% = 5.5\%$.

Synthetic ratings are an approximation calibrated on public, rated companies, so they work best for companies of a broadly similar size and sector to the sample the coverage bands were built from — applying the same bands to a tiny company or a highly cyclical industry can be misleading.