This document provides an overview of the credit rating process. It begins by defining a credit rating as a grade that summarizes an entity's willingness and ability to repay obligations. It then discusses the major credit rating agencies and why credit ratings are important for increasing investor acceptance and lowering borrowing costs. The rest of the document outlines the various types of ratings and terminologies used. It then describes the key factors analyzed in the rating process, including industry risk, market position, earnings performance, cash flows, management evaluation, capital structure, and corporate governance. The rating process itself involves initial documents, rating presentations, committee review, and ongoing surveillance.

1. “Credit Rating Process”
Learning Objective
Pricing the Risk!!!
Presented By:
Asif Naqvi

2. What is a Rating:
• Grade summarizing the willingness and ability to
repay.
• Ability to pay-quantitative
• Willingness to pay-qualitative
• Letter Grades
• Sub-categories of grades.
• Major Credit Rating Companies: S & P, Moody’s,
Fitch etc.
• Locally: JCR-VIS & PACRA
• Why Credit Rating???

3. A rating is NOT:
• A judgment or statement regarding any aspect of
public policy.
• A political statement in favor of or against a particular
person or administration.
• A dictate of which should be done or how a matter
should be handled.

4. Why bother a rating/rating agency:
• Increase investor acceptance.
• Current economic environment.
• Current capital market environment.
• BOTTOM LINE: Lower Interest Cost.

5. Types of Credit Ratings:
• Sovereign Ratings: Assess the country Credit risk
and is used as a point of reference for country
borrowings from WB, IMF, ADB, IDB etc
• Entity Ratings: Risk ratings of Corporate entities.
• Instrument Ratings: Ratings of the Bonds issued by
different corporations and municipalities.

6. Rating Terminologies – Long Term:
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AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBB- etc (Please refer to notes)

7. Rating Terminologies – Short Term:
• A1+: Obligations supported by the highest capacity for timely
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repayment.
A1: Obligations supported by a strong capacity for timely
repayment.
A2: Obligations supported by a satisfactory capacity for timely
repayment, although such capacity may be susceptible to
adverse changes in business, economic, or financial conditions.
A3: Obligations supported by an adequate capacity for timely
repayment. Such capacity is more susceptible to adverse
changes in business, economic, or financial conditions than for
obligations in higher categories.
B: Obligations for which the capacity for timely repayment is
susceptible to adverse changes in business, economic, or
financial conditions.
C: Obligations for which there is an inadequate capacity to
ensure timely repayment.
D : Obligations which have a high risk of default or which are
currently in default.

8. Sectors where Credit Rating Plays a Vital Role:
– Commercial Banks:
– Mutual Funds:
– Investment Banks:
– Leasing Companies:
– Insurance Companies:
– Bonds & Securitization etc.

9. The Rating Process:
– Step I: Decision and documents
– Step II: Rating Presentations – meetings, conference
calls, and /or site visits
– Step III: Rating Committee, communication, press
release, report
– Appeal process, if necessary
– Surveillance

10. Rating Methodology
Following major factors are assessed in the Credit Rating
Process:
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Industry Risk
Market Position
Ownership & Support
Earning & Performance
Cash Flows
Management Evaluation
Capital & Debt Structure
Funding & Flexibility
Corporate Governance
Additional Factors for Financial Institutions

11. I - Industry Risk
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Economic importance of the industry to the country.
Potential for support.
Employment significance.
Industrial relations record.
Significance of legislation: protective and harmful, relationship with
government.
Maturity of the industry.
International competition.
Barriers to entry.
Competitive situation domestically: monopoly, oligopoly, fragmentation.
Nature of the industry: capital intensity, product lifespan, marketing
requirements.
Cyclic factors: demand, supply, implications for price volatility.
Industry cost and revenue structure: susceptibility to energy prices,
interest rate levels, government policies.
Important developments and trends in the industry.

12. II - Market Position:
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Competitive position within the industry: size, market share &
trend, price-setting ability.
Major product importance.
Product lives and competition.
Degree of product diversification.
Significance of R&D expenditure and of new product
development.
Geographic diversity of sales and production.
Significance of major customers.
Dependence on major suppliers and access to alternatives.
Marketing needs.
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Distribution network, control and susceptibility to external
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factors.
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What are the growth trends, and sources of growth?

13. III – Ownership & Support
The specific issues include:
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Ownership of the entity.
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Relationship with owners, autonomy, control.
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Financial strength of owner (s).
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Potential for support or for funds withdrawals.
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Structure of ownership.
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Other benefits: access to technology, products.
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Access to capital markets.

14. IV- Earnings & Performance
The specific issues include:
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Consistency and trend of core earnings.
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Earnings mix by activity and geography.
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Exceptional and extraordinary items: non-recurring impacts on
past earnings levels.
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True earnings levels available for cash flow: equity accounting,
restrictions on profit repatriation.
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Internal growth versus acquired earnings.
Contd…

15. IV- Earnings & Performance
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Profitability and protection measures.
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Profit margins.
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Interest & pre-tax coverage measures.
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Dividend cover, payment levels and future policy.
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Taxation situation: effective tax rate, specific relief.
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Sufficiency of retained earnings to finance growth internally.

16. V – Cash Flows
Relationship of cash flow to leverage and ability to internally meet
all cash requirements is evaluated. The volatility of cash flow
over time and the impact of seasonality on cash flow is also
assessed.
The specific issues include :
• Adequacy of cash flow to maintain the operating capacity of the
business: working capital levels, replacement of fixed assets.
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Contribution from cash flow towards expansion: major capital
spending projects, acquisitions.
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Discretionary spending included in cash flow including
advertising, exploration, research & development expenditure.
contd…

17. V – Cash Flows
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Volatility of cash flow over time.
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Relationship between cash flow and total debt.
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Restrictions on cash flow : limits on repatriation, potential
taxation effects, access to dividends from subsidiaries.
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Liquidity levels and fluctuations: seasonality, sensitivities.
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Working capital management and measurements. .

18. VI – Management Evaluation
The specific issues include:
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Record to date in financial terms.
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Corporate goals and outlook: aggressive stance, attitude to risk.
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Experience, background, credibility.
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Depth of management: key individuals, succession.
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Record compared with peers.

19. VII – Capital & Debt Structure
The specific issues include:
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Debt/Equity measures: historic, present and projected.
Leverage (total liabilities/equity) measures: historic, present and
projected
Sensitivity Analysis on projected levels
Seasonal variations
Coverage measures on interest & leasing
Adjustments for off-balance sheet items.
Appropriateness of capital structure for the business: overreliance on short term funding, sensitivity to interest rate
changes.
Debt Structure: Type, maturity, currency, service schedule,
covenants, security, default clause.

20. VIII – Funding & Flexibility
The specific issues include:
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Flexibility of planned financial needs : capital spending, dividend
levels, acquisitions.
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Ability to raise additional financing under stress.
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Back-up and standby lines of credit : periods and covenants of
underwriting facilities and committed lines, bank relationships
generally.
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Ability to attract capital : shareholder make-up, access to equity
markets.
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Capital commitments.
Cont..

21. VIII – Funding & Flexibility
The specific issues include:
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Flexibility of planned financial needs : capital spending, dividend
levels, acquisitions.
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Ability to raise additional financing under stress.
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Back-up and standby lines of credit : periods and covenants of
underwriting facilities and committed lines, bank relationships
generally.
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Ability to attract capital : shareholder make-up, access to equity
markets.
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Capital commitments.
Cont..

22. VIII – Funding & Flexibility
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Margin of safety in present and planned gearing/leverage levels.
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Asset make-up : nature of assets and potential for reductions or
disposals under stress, scalable units.
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Off-balance sheet assets and liabilities : goodwill or other
intangibles written off, undervalued assets, pension under
funding.

23. IX – Corporate Governance
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The independence and effectiveness of the board of directors
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Oversight of related party transactions that may lead to conflicts of
interest.
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Board oversight of the audit function.
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Executive and director remuneration.
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Complex holding company structures.
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Ownership by private individuals and families.
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Also examine other aspects of corporate governance whose impact on
bondholders is less clear cut; these include equity ownership by
executives and directors

24. X – Additional Factors for Financial Institutions
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Quality of the asset portfolio
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Stability of earning
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Sources and cost of funds
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Asset / liability structure
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Capital adequacy and liquidity
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Market environment and strategy
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Prospects

25. The House is Open to Any Number of Questions
Thanks