S&P's Positively Charged About AES

On Friday, independent power producer AES (NYSE:AES) received a nice endorsement letter from McGraw-Hill's (NYSE:MHP) Standard & Poor's. S&P reaffirmed its credit ratings and upgraded the outlook from stable to positive. The positively charged credit endorsement excited equity investors to the tune of a 2.7% increase to $10.37.

The Enron debacle was painful. Most merchant energy firms got caught up in the shakedown. Mirant went bankrupt. AES and Calpine (NYSE:CPN) saw their debt downgraded to junk status. Their stock prices lost 90% of their value because of the massive amount of debt used to aggressively build up generating capacity.

But things are changing. A few days ago, Reliant Energy (NYSE:RRI) received an upgrade to positive from Fitch. And for AES, S&P noted "improving credit metrics both at the parent level and on a consolidated basis over the past year."

That's nice, but the article left out the numbers. Don't worry, Fools. I'm up to challenge of digging them up. I'll analyze two credit ratios to see what's happening:

Current ratio = current assets/current liabilities

Coverage ratio = earnings before interest and taxes (EBIT)/interest payments

AES generates and sells electricity. Because inventories are small, the current ratio measures AES' ability to manage cash and receivables relative to payables and current debt. And the closer the ratio is to 1, the better. The upward trend toward 1 is a sign that the debt restructuring is paying off. Why pay creditors now when you can pay them later?

The trend of the coverage ratio is like turning up the dimmer switch for the lights in your dining room. The lights are brighter for AES, as it now creates more EBIT than it pays out in interest. Please do not confuse EBIT with that nasty EBITDA (D is depreciation and A is amortization). I think it is foolish (small "f") to say EBITDA measures how well a company can cover its interest payments.

D and A cannot be tossed out willy-nilly. AES is a capital-intensive business. Its capital assets produce and distribute the electricity it sells. These assets require maintenance, a real cost, as they are used. So throwing D and A out of the equation is like playing the banker in Monopoly and giving yourself an extra $200 each time you pass Go. It's not right.

So why is this good? If the S&P upgrades AES' credit ratings in the future, then a few things could happen. AES could access credit markets at lower interest rates, driving its cost of debt capital lower. Also, AES could refinance its current debt at lower rates. Finally, AES may be able to reduce its debt burden at a faster rate.

As I mentioned in a previous article, lowering the cost of financing is one way to increase value. And, more important, less interest payments to creditors means more money for shareholders like me.

Fool contributor David Meier owns shares of AES. He does not own shares of any other company mentioned.