Credit ratingFunctions, origins, benefits,methodology and regulations
Concept It is essentially a symbolic indicator of the current opinion of the rating agency regarding the relative ability and willingness of the issuer of a financial instrument (debt) to meet the service obligations as and when they arise. It reduces the informational asymmetry between the investor and the issuing company.
Continue. It is only an opinion expressed by an independent professional organization, on the basis of a detailed study of all relevant factors, the rating does not amount to any recommendation to buy, hold, or sell an instruments as it does not take into consideration factors such as market prices and personal risk preference of the investor
Continue.. It is done for specific debt security and not for a company as a whole A debt rating is not an one time evaluation of the credit risk, which can be regarded as valid for the entire life of the security.
Benefits to rated companies Sources of additional certification Increase the investor population Forewarns risks Encourages financial discipline Merchant bankers job made easy Foreign collaboration made easy Benefits the industry as a whole Low cost of borrowing Rating as a marketing tool
MethodologyAny debt obligation and the issuer is evaluated on the basis of :1. Business risk analysis Industry risk Market position of the company Operating efficiency of the company Management evaluation
A .Business risk analysis Industry risk1. Is the industry in a growth, stable or declining phase?2. Is the business cycle independent of economy or it moves with economy in general3. What is the nature of the competition? Is it regional, national, or international?4. What is the nature of govt regulation and policies?5. What is the labour situation? Is it unionised6. Does the industry have good control of key raw material7. To what extent the industry is fixed capital or working capital intensive?8. Ease of entry or exit
Market position of the companyThe rating company would evaluate a company’s sales position in terms of:Market shareMarketingDistributionStrengths and weaknessesDiversity of products and customer base
Operating efficiencyThis is assessed from the operatingmargins of the company and its ability tomaintain or improve them based uponpricing or cost advantages.
Management evaluationManagement is assessed for its role indetermining operational success and also for itsrisk tolerance.A company’s earning performance, financialstructure and business mix are all a function ofmanagement.Evaluation of management emphasises pastperformance, fulfillment of earlier plans and debtusage policies. It has also concern with thephilosophy, experience, maturity, capability anddepth of management
B. Financial risk analysisEarning protection can be viewed from1. Profit potential angle2. Break even analysis the most significant measures of profitability are1. Return on capital (pre-tax)2. Profit margin Finally the aim is to find out the source of future earning growth.
Continue Leverage and asset protection1. Long term debt/total capitalisation2. Total debt/total capitalisationThe concept of asset protection refers to measurement of the relative amount of equity supporting the asset base
Cash flow adequacy: Earnings may be the best long-term determinant of creditworthiness. The principal ratio computed is the debt service coverage ratio.Financial flexibilityIt is an evaluation of a company’s financing needs, plans and alternatives and its flexibility to accomplish its financing program under adverse condition without damaging creditworthiness
Accounting quality The various aspects reviewed in this category would include:1. Auditor’s qualification2. Method of income recognition3. Inventory valuation policies4. Depreciation policies5. Interconnection with subsidiaries6. Undervaluation/overvaluation of assets7. Off-balance sheet liabilities
Indenture Whether the provision of indenture deviate the standard practice? Whether the indenture allow the company to issue other bonds with equal or greater claim on the assets of the company? Whether creation of sinking fund for redemption of principal is stipulated? Are bonds senior or subordinated to other bonds. Is the indenture too restrictive in terms of payments of dividends, further borrowings, etc.
Credit rating for advance accounts with fund based working capital limits of Rs. 1 cr and above from the banking systemPARAMETERS1. financial standing (actual) Current ratio score 1.33 and above 10 1.25 to 1.32 08 1.34 to 1.24 05 1.00 to 1.10 03 below 1.00 00
Continue..D/E ratio 3.0 and below 10above 3.00 and upto 4.00 08Above 4.00 and upto 5.00 05Above 5.00 00
Continue Sales increasing trendAchievement more than 90% 05Achievement between 75% and 90% 03Achievement less than 75% 02 Tangible net worth increasing trend for last 3 yrs 03 stangant 01 decreasing 00
Continue ..PARAMETERS SCOREII Information systema. various statements Timely submission 03 delayed upto 30 days 01 non submission 00b.Renewal data timely submission 06 delayed 03Non submission 00