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Finance
and Credit Rating
Anand P Sharma
Ratings,
usually expressed in alphabetical or alphanumeric symbols , are a simple
and easily understood tool enabling the investor to differentiate between
debt instruments on the basis of their underlying credit quality. The
credit rating is thus a symbolic indicator of the current opinion of the
relative capability of the issuer to service its debt obligation in a
timely fashion , with specific reference to the instrument being rated .
It is focused on communicating to the investors , the relative ranking
of the default loss probability for a given fixed income investment , in
comparison with other rated instruments.
A rating is specific to a debt instrument and is intended as a grade ,
an analysis of the credit risk associated with the particular
instrument. It is based upon the relative capability and willingness of
the issuer of the instrument to service the debt obligations (both
principal and interest) as per the terms of the contract. Thus a rating
is neither a general purpose evaluation of the issuer , nor an overall
assessment of the credit risk likely you be involved in all the debts
contracted or to be contracted by such entity.
The
primary objective of rating is to provide guidance you investors\creditors in determining a credit risk associated with a debt
instrument\credit obligation. It doesn't amount to a recommendation to
buy, hold or sell an instrument as it doesn't take into consideration
factors such as market prices, personal risks preferences and other
considerations which may influence an investment decision. The rating
process is itself based on certain ‘givens’.The agency ,for instance
, does not perform an audit.Instead , it is required to rely on
information provided by the issuer and collected by analysts from
different sources , including interactions in -person with various entities. Consequently
, the agency doesnot guarantee the completeness or
accuracy of the information on which the rating is based. To quote
"In determining a rating , both quantitative and qualitative
analyses are employed. The judgment is qualitative in nature and the
role of the quantitative analysis is to help make the best possible
overall qualitative judgment because, ultimately , a rating is an
opinion." Standard & Poor’s.
Credit
Rating; as elucidated by the leading rating agencies of the world
"
A rating is an opinion on the future ability and legal obligation of the
issuer to make timely payments of principal and interest on a specific
fixed income security. The rating measures the probability that the
issuer will default on the security over its life, which depending on
the instrument , may be a matter of days to 30 years or more. In
addition , long term ratings incorporate an assessment of the expected
monetary loss should a default occur." Moody’s
"Credit
ratings help investors by providing an easily recognizable , simple tool
that couples a possibly unknown issuer with an informative and
meaningful symbol of credit quality." Standard & Poor’s
Rating
Process
Rating
is an interactive process with a prospective approach. It involves
series of steps. The main points are described as below :
(
a ) Rating request : Ratings in India are initiated by a formal request
(or mandate ) from the prospective issuer . This mandate spells out the
terms of the rating assignment . Important issues that are covered
include : binding the credit rating agency to maintain confidentiality ,
the right to the issuer to accept or not to accept the rating and binds
the issuer to provide information required by the credit rating agency
for rating and subsequent surveillance.
(
b ) Rating team : The team usually comprises two members. The
composition of the team is based on the expertise and skills required
for evaluating the business of the issuer.
(
c ) Information requirements : Issuers are provided a list of
information requirements and the broad framework for discussions. These
requirements are derived from the experience of the issuers business and
broadly conforms to all the aspects which have a bearing on the rating.
These factors have been discussed in detail under Rating framework.
(
d ) Secondary information : The credit rating agency also draws on the
secondary sources of information including its own research division.
The credit rating agency also has a panel of industry experts who
provide guidance on specific issues to the rating team. The secondary
sources generally provide data and trends including policies about the
industry.
(
e ) Management meetings and plant visits : Rating involves assessment of
number of qualitative factors with a view to estimate the future
earnings of the issuer. This requires intensive interactions with the
issuer’s management specifically relating to plans , future outlook ,
competitive position and funding policies.
Plan
visits facilitate understanding of the production process , assess the
state of equipment and main facilities , evaluate the quality of
technical personnel and form an opinion on the key variables that
influence level , quality and cost of production. These visits also help
in assessing the progress of projects under implementation.
(
f ) Preview meeting : After completing the analysis , the findings are
discussed at length in the internal committee , comprising senior
analysts of the credit rating agency. All the issues having a bearing on
the rating are identified. At this stage , an opinion on the rating is
also formed.
(
g ) Rating Committee meeting : This is the final authority for assigning
ratings. A brief presentation about the issuers business and the
management is made by the rating team . All the issues identified during
discussions in the internal committee are discussed. The rating
committee also considers the recommendation of the internal committee for
the rating. Finally , a rating is assigned and all the issues which
influence the rating are clearly spelt out.
(
h ) Rating communication : The assigned rating along with the key issues
is communicated to the issuer’s top management for acceptance. The
ratings which are not accepted are either rejected or reviewed. The
rejected ratings are not disclosed and complete confidentiality is
maintained.
(
I ) Rating Reviews : If the rating is not acceptable to the issuer , he
has a right to appeal for a review of the rating . These reviews are
usually taken up only if the issuer provides fresh inputs on the issues
that were considered for assigning the rating . Issuers response is
presented to the Rating Committee. If the inputs are convincing , the
Committee can revise the initial rating decision.
(
j ) Surveillance : It is obligatory on the part of the credit rating
agency to monitor the accepted ratings over the tenure of the rated
instrument. As has been mentioned earlier , the issuer is bound by the
mandate letter to provide information to the credit rating agency. The
ratings are generally reviewed every year , unless the circumstances of
the case warrant an early review . In a surveillance review the initial
rating could be retained or revised (upgrade or downgrade ). The various
factors that are evaluated in assigning the ratings have been explained
under rating framework.
Rating
Framework
The
basic objective of rating is to provide an opinion on the relative
credit risk ( or default risk ) associated with the instrument being
rated. This in a nutshell includes , estimating the cash generation
capacity of the issuer through operations (primary cash flows) vis a vis
its requirements for servicing obligations over the tenure of the
instrument. Additionally , an assessment is also made of the available
marketable securities (secondary cash flows) which can be liquidated if
required , to supplement the primary cash flows. It may be noted that
secondary cash flows have a greater bearing in the short term ratings ,
while the long term ratings are generally entirely based on the adequacy
of primary cash flows.
All
the factors which have a bearing on future cash generation and claims
that require servicing are considered to assign ratings. These factors
can be conceptually classified into business risk and financial risk
drivers.
Business
risk drivers Financial risk
drivers
Industry
characteristics Funding
policies
Market
position Financial
flexibility
Operational
efficiency
New
projects
Management
quality
Industry
characteristics : This is the most important factor in the credit risk
assessment. It is a key determinant of the level and volatility in
earnings of any business. Other factors remaining the same , industry
risk determines the cap for ratings. Some of the factors that are analyzed
include :
Demand
factors State of competition
Drivers
& potential Existing & expected capacities
Nature
of product Intensity of competition
Nature
of demand - seasonal , cyclical Entry barriers for new entrants
Bargaining
position of customers Exit barriers
Threat of substitutes
Environmental
factors Bargaining position of suppliers
Role
of the industry in the economy Availability of raw material
Extent
of government regulation Dependence on a particular supplier
Government
policies -current and. future direction
Threat of forward integration
Switching costs
For
credit risk evaluation, stable businesses (low industry risk) with lower
level of cash generation are viewed more favorably compared to
businesses with higher cash generation potential but relatively higher
degree of volatility (higher industry risk).
It
needs to be mentioned that with the opening up of the Indian economy ,
it is also critical to establish international competitiveness both at
the industry and the unit level.
Market
position: All the factors influencing the relative competitive position
of the issuer are examined in detail. Some of these factors include
positioning of the products, perceived quality of products or brand
equity, proximity to the markets , distribution network and relationship
with the customers. In markets where competitiveness is largely
determined by costs, the market position is determined by the unit’s
operational efficiency. The result of these factors is reflected in the
ability of the issuer to maintain /improve its market share and command
differential in pricing. It may be mentioned that the issuers, whose
market share is declining, generally do not get favourable long-term
ratings.
Operational
efficiency: In a competitive market, it is critical for any business
unit to control its costs at all levels. This assumes greater importance
in commodity or "me too " businesses, where low cost producers
almost always have an edge. Cost of production to a large extent is
influenced by:
Location
of the production unit(s)
Access
to raw materials
Scale
of operations
Quality
of technology
Level
of integration
Experience
and
last but not the least the ability of the unit to efficiently use its
resources.
A
comparison with the peers is done to determine the relative efficiency
of the unit. Some of the indicators for measuring production efficiency
are : resource productivity both assets and manpower), material usage
(or input-output ratios) and energy consumption. Collection efficiency
and inventory levels are important indicators of both the market
position and operational efficiency.
New
project risks: The scale and nature of new projects can significantly
influence the risk profile of any issuer. Unrelated diversification’s
into new products are invariably assessed in greater detail.
The
main risks from the new projects are: Time and cost overruns, even
non-completion in an extreme case, during construction phase; financing
tie-up ; operational risks ; and market risk. Besides clearly
establishing the rationale of new projects, the protective factors that
are assessed include: track record of the management in project
implementation, experience and quality of the project implementation
team, experience and track record of technology supplier, implementation
schedule, status of the project, project cost comparisons, financing
arrangements, tie-up of raw material sources, composition of operations
team and market outlook and plans.
Besides
on the assessment of various project risks , assumptions about
completion and contribution to/from these projects are incorporated in
the issuer’s overall projections.
It
needs to be emphasized that the impact of the project risk on the rating
depends on the scale of projects in relation to the size of assets and
cash flows of the existing operations.
Management
quality: The importance of this factor cannot be overemphasized. When
the business conditions are adverse, it is the strength of management
that provides resilience. A detailed discussion is held with the
management to understand its objectives, plans & strategies ,
competitive position and views about the last performance and future
outlook of the business.
These
discussions provide insights into the quality of the management. It also
helps in establishing management’s priorities. A review of the organization
structure and information system is done to assess whether
it aligns with the management’s plans and priorities. The interactions
with key operating personnel help in determining the quality of the
management. Issues like dependence on a particular individual and
succession planning are also addressed.
Other
important factors are: labor relations , track record of meeting
promises specifically relating to returns and project implementation ,
performance of "group" companies , transactions with the
"group" companies etc.
Funding
policies: This determines the level of financial risk. Management’s
views on its funding policies are discussed in detail. These discussions
are generally focused on the following issues:
Future
funding requirements
Level
of leveraging
Views
on retaining shareholding control
Target
returns for shareholders
Views
on interest rates
Currency
exposures including policies to control the currency risk
Asset-liability
tenure matching.
Financial
flexibility: While the primary source for servicing obligations is the
cash generated from operations, an assessment is also made of the
ability of the issuer to draw on other sources , both internal
(secondary cash flows) and external , during periods of stress.
These
sources include: availability of liquid investments, unutilized lines of
credit , financial strength of group companies , market reputation ,
relationship with financial institutions and banks , investor’s
perceptions and experience of tapping funds from different sources.
Generally
financial flexibility factor facilitates determination of the relative
strength within a rating category (i.e., + or - prefix with the rating)
and has a greater bearing on the short-term ratings.
Past
financial performance: The impact of the various risk drivers is
reflected in the actual performance of the issuer. Thus while the focus
of rating exercise is to be determined the future cash flow adequacy for
servicing debt obligations , a detailed review of the past financial
statements is critical for better understanding of the influence of all
the business and financial risk factors. Evaluation of the existing
financial position is also important for determining the sources of
secondary cash flows and claims that may have to be serviced in future.
Accounting
quality: Consistent and fair accounting policies are a pre-requisite for
financial evaluation and peer group comparisons. It may be mentioned
that accounting quality is also an important indicator of the management
quality. Rating analysts review the accounting policies, notes to the
accounts and auditors comments in detail . Where necessary, rating
analysts adjust the financial statements to reflect the correct position
. Over a period of time the focus of financial analysis at the credit
rating agency has shifted towards evaluation of cash flow statements as
cash flows to a large extent offset the impact of "financial
engineering".
Indicators
of financial performance: Financial indicators over the last few years
(typically five years) are analysed and performance of the issuer is
compared with its peers. Comparison with peers is important for better
understanding of the industry trends and determining the relative
position of the issuer. Some of the important indicators that are
analysed are presented below :
Profitability:
A traditional indicator of success or failure of any business endeavor has been its ability to add value to its wealth or generate profits. A
few important indicators are, trends in:
Return
on capital employed
Return
on net worth
Gross
operating margins
Higher
profitability implies greater cushion to debt holders. Profitability
also determines the market perception, which has a bearing on the
support of share holders and other lenders. This support can be an
important factor during stress.
Gearing
or level of leveraging: This is an important determinant of the
financial risk. Some important indicators are:
Total
debt as a % of net worth
Long
term debt as a % of net worth
Total
outside liabilities as a % of total assets
It
needs to be emphasized that business risk is a prime driver , while
gearing has a secondary role in determining the overall rating
(especially long term). To illustrate , an issuer whose gearing level is
favourable but relative business fundamentals are weak is unlikely to
get a favourable long term rating . This is so because gearing is
considered to be a "controllable" factor while business
factors are relatively difficult to alter significantly.
Coverage
ratios: Considered to be of primary importance to the debt holders. The
important ratios are :
Interest
coverage ratio (OPBDIT/Interest)
Debt
service coverage ratio
Net
cash accruals as a % of total debt
The
level of these ratios reflect the result of business risk drivers and
the funding policies. Generally speaking, higher the level of coverage,
higher is the rating. However as mentioned earlier, business with lower
level of coverage can get higher ratings if the earnings are steady
(i.e., business with low industry risk).
Liquidity
position: The indicators of liquidity position are, the levels of:
Inventory
Receivables
Payables
The
state of competition , issuer’s market position & policies ,
relationship with customers and suppliers are the important factors that
impact the above levels. Comparison with peers on these indicators help
to determine the relative position of the issuer in the industry. The
funding profile with respect to matching of assets -liability tenures
also has an important bearing on the liquidity position.
Cash
flow analysis: Cash is required to service obligations. Thus, any
financial evaluation would be incomplete if cash flow analysis is not
carried out. Cash flows reflect the sources from which cash is generated
and its deployment. As has been mentioned earlier, cash flows also to a
very large extent offset the impact of diverse accounting policies and
hence facilitate peer comparisons.
The
coverage ratios enumerated above can be modified to factor the impact of
actual cash flows only. Issuers which are not able to generate
sufficient cash to service obligations do not normally get favourable
ratings.
Future
cash flow adequacy: The ultimate objective of the rating is to determine
the adequacy of cash generation to service obligations. Number of
assumptions based on the future outlook of the business are made to draw
projections of financial statements. Invariably, the financial
projections are carried out for a number of scenarios incorporating a
range of possibilities in the set of assumptions for the key cash flow
drivers. A few important drivers are expectations of growth, selling
prices, input costs, working capital requirements, value of currencies
etc.
Analysis
of Operations
A
finance company’s fund-based business, if broken down to its bare
essentials, can be described as a chain of the following events:
Sourcing
funds [raw material] at the lowest possible cost,
Packaging
it for customers [in the form of products like lease, hire purchase,
bill discounting, etc. for different types of borrowers] at an
appropriate price [read yield],
Effecting
the collections over the tenure of the contract as envisaged, and
Starting
the cycle all over again.
While
the above analysis over –simplifies the fund-based business of a
finance company, the day to day business of a finance company, in
reality, is a continuous and simultaneous happening of all events
identified above. Since the share of borrowed funds in the total funds
of a company is usually quite significant, the objective of a rating
exercise is to assess the risk of default, i.e., indicate to the
investor a relative measure of probability that the company will be
unable to meet its financial obligations as per schedule. Again, going
back to basics, it can be argued that a finance company will be unable
to meet its obligations when due, under one [or a combination] of the
following circumstances:
it
lends money for longer maturities than it borrows, and is unable to
bridge the gap from other sources.
there
is a deterioration in the quality of its receivables, that is, there is
a significant delay in the collection, so much so, that there is a
shortage of funds with the company to meet maturing liabilities. The
delay in the collections could arise due to one or several reasons,
principal ones being, [a] poor appraisal of borrowers, [b] tax
collection, or [c] general deterioration in receivables due to a
recession / crunch among the borrowers.
the
pricing is improper for a large number of transactions, that is, the
finance company is not covering all costs while charging its borrowers.
In such a case, the company doe not generate adequate surplus after
meeting interest costs, administrative expenses, provisions for losses,
taxes, and dividends for equity. If this situation prolongs, the company
is bound to run out of funds.
In
the real world, most of the finance companies continually face one or
more of the above situations, without running into serious problems most
of the time. This happens because the management is able to access
additional funds by way of fresh equity, fresh borrowings, liquidation
of assets, or extending its creditors. However, when the shortage of
funds are for extended periods, and the company gets to be perpetually
dependent on borrowings, it becomes more vulnerable to default. The
above argument ignores fee-based business, which is a significant source
of revenue and profits for several finance companies. However, it is
unlikely that the conclusions will change, even if fee-based business
were to be included in the analysis.
The
Rating Methodology
The
rating methodology is built around the way finance companies operate,
and is comprehensive in its concept and approach. As in any opinion on
credit quality, the credit rating agency’s ratings factor the entire
gamut of risks that can possibly affect the operations of a finance
company. These risks can be broadly classified under three heads:
Operating
risks
Financial
risks
Management
risks
It
should be noted that the business risks cannot be compartmentalised as
above, as some of the risks are overlapping. The classification is made
here for the purpose of easy comprehension.
Since
there is a wide variety in the nature of operations of financial
companies, the variation in the operating risks are also considerable.
If every investor were to make an informed investment decision, and were
to do the analysis himself or herself, the investment process would be
very inefficient indeed ! while using a rating as an investment tool,
the investor sees only a "combination of letters" that are
used to assigns its ratings. The above risks are packaged into the
credit rating agency’s rating scale in a manner that is consistent
across time and across different issuers of debt instruments. Thus, an
investor is spared the task of a detailed evaluation of the claims made
by the company or an analysis of its financial statements, and can
instead make an informed investment decision on the basis of the credit
ratings.
Major
Determinants of Operating Risks
Volatility
in revenues and expenses: The operating risks for a finance company
manifest in the form of fluctuations in the income and / or expenses,
and consequently, affect the profitability and financial position.
Volatility in the revenue stream of the company can arise out of the
intrinsic nature of the operation [e.g. trading in equity stocks can be
a roller-coaster ride] and / or the fluctuations in the economy [which
affects the paying capacities of the borrowers]. An increase in the cost
of borrowings can temporarily derail the business plan of a finance
company, as its margins would be squeezed. Similarly, the revenues from
fee-based businesses are also dependent on the underlying business
activities [e.g. merchant banking on the mood of the capital market],
and there are attendant fluctuations in the revenues.
Regulatory
risks: Since the financial sector is fairly regulated in India, a
finance company’s operations are governed by the changes in regulation
that occur from time to time, some of which can be sudden and
unpleasant. A case in instance is the introduction of prudential norms
in 1994 by the RBI, which shackled the marginal and weaker companies to
a considerable extent. Also, the recent deregulation of interest rates
for the NBFC sector is likely to have far-reaching effects on several
companies. The effect of these changes in regulation on the industry and
individual companies while assigning its ratings are also evaluated by a
credit rating agency.
Risk
of administrative expenses going out of hand: A finance company needs to
keep a close watch on the administrative expenses that it incurs in the
course of its operations. If the proportion of earning assets is low in
relation to the expenses, that is, there is insufficient volume of
business to spread the fixed costs over, the company runs the risk of
not being able to cover its costs. The share of earning assets can
decline due to other reasons as well, for example – diversion of funds
into other businesses that have a long gestation period [e.g. real
estate projects], buying up large premises that lock up funds,
inefficiency in collection and remittance which increases the idle cash
balances, etc.
Deterioration
in Asset Quality: Quality of loans and receivables is a key factor that
determines the cash flows and consequently, the debt-servicing ability
of a finance company. The loss of income and the need to provide for
loan losses can seriously undermine a company’s financial base. Also,
even if the loans are not lost cases, a continuous delay brings down the
effective yield on loans, and could jeopardise viability. The potential
asset quality by analysing the concentration risks [across regions,
borrower segments, industry segments, relative size of loan, etc.], by
evaluating the appraisal and monitoring systems in place for the kind of
business the company is in, and examining the safeguards taken by the
company is in, and examining the safeguards taken by the company to
ensure that its money comes back, as scheduled, are evaluated.
Major
Determinants of Financial Risk
Capital
adequacy: The capital structure of a finance company confers varying
degree of security to its lenders against the risk of going insolvent.
Capital adequacy refers to the quantum of shareholders’ funds in the
business in relation to the risk-weighted assets that the company has.
While there are regulatory minimum limits for this figure, different
businesses have different risks depending on a variety of factors such
as location of operation, size of clients, competition, etc. which could
mandate a higher level of capital adequacy for some of them. Thus, it is
recognized that there are differences in risks associated with different
types of assets, although they may carry the same risk weight for
computation of capital adequacy as per the regulator.
Asset
liability management: Money management is the core of the operations of
all finance companies, and a critical aspect of this is the proper
control on the assets and liabilities, the company is vulnerable to
shortage of cash, and needs to take corrective action. There is also the
problem of mismatch in the interest rates between the two, and unless
the management consciously attempts to make amends, the margins can be
affected seriously due to changes in the external environment.
Solvency:
For a company to remain viable, it is vital that it is able to
consistently generate a surplus in the long run, after meeting all its
operating expenses and cost of funds (including shareholders’ equity).
In the long run, it is only the plough-back of surplus earnings, that
can support increasing quantum of borrowings that fund the company’s
growth. In the event of continuous losses or inadequate surplus
generation, the company can fall into a debt trap, if it continues to
increase its borrowings to fund its growth. Therefore, a negative view
of finance companies that consistently fail to generate adequate surplus
after meeting all the obligations is taken. Of course, one option for a
finance company is to increase its owned funds by infusion of equity by
way of a public / rights / preferential issue. But in the absence of
effective deployment of such funds to generate surplus after meeting the
servicing costs, the company is likely to fall into a debt trap sooner
or later.
Financial
Flexibility: The financial flexibility is an important determinant of
credit quality of any borrower. Financial flexibility refers to the
ability of the company to raise financial resources from any source
under conditions of financial duress. This ability of a company enables
it to dip into its pockets or borrow from lenders who are willing to
finance it despite its crunch, and help meet its immediate obligations.
Financial flexibility arises out of the ability of a company:
To
borrow from other entities – maybe on the strength of one’s balance
sheet, corporate image or the clout of the top management.
To
borrow from entities, maybe, in the same group or under the same
management.
To
utilize indrawn lines of credit or borrowing power.
To
liquidate some assets that have been kept for such contingencies.
Accounting
Quality: As credit rating is a comment on relative safety, rather than a
measure of absolute safety, emphasis is laid on how a company’s
performance measures up to that of its peers. As different companies
follow different accounting policies to draw up their financial
performances, the financial statements of different companies cannot be
directly compared. The figures need to be re-computed so that they are
drawn up on the same basis, before meaningful comparison can be made.
The difference is accounting policies were numerous a few years back,
but after the application of Prudential accounting norms by the RBI for
NBFCs since 1994-95, there has been a significant convergence in the
policies followed by the different players. Nonetheless, there are
several areas where there is freedom for different companies, and it is
necessary to re-compute some of the figures to make comparisons. For
instance, the law is silent about the mode of income recognition from
hire purchase contracts. Some companies use the "sum of digits
method," while some accrue the interest evenly over the life of the
contract. These can cause significant changes to the bottom line or to
the balance sheet of the company, significant enough to change the views
of a credit analyst.
Management
Risks
Management
Quality: A significant weightage is attached to the quality of the
company’s management in its ultimate opinion on credit quality of the
company’s debt. In evaluating a management, the credibility of the
management’s plans for the company in the backdrop of the economic
scenario and the outlook for the specific company is assessed. To make a
judgment on the quality of management, the historical track record of
the management in several areas is analysed, inter alias, [a] in
overcoming adversity in operating conditions, such as, a funds crunch,
strong competition, sudden deterioration in asset quality, etc. [b]
attitude towards the interests of investors and other stakeholders in
the company, [c] conformance to regulation and adoption of fair business
practices [d] ability to professionalise and delegate decision-making
with reference to the nature and scale of operations. It is unlikely
that the company’s credit quality will be viewed favorably, if the
credit rating agency is uncomfortable with the quality of the management
in any of the above or other parameters, despite the company’s
financial performance and position warranting a high rating. The credit
rating agency has evolved and laid down for itself, a clear methodology
and norms for management evaluation so that there is consistency and
fairness in what is essentially a subjective exercise.
Evaluation
of systems: The systematic and timely flow of correct information, in
the form of plans, budgets, targets, management information for review
and / or control is the lifeblood of a finance company’s operations.
The extent of automation is a reflection of several factors such as the
scale of operations, the attitude of the management, and the economics
of automating the operations. In its assessment process, more emphasis
is laid on the "appropriateness" of the systems with reference
to the operations of the company, rather than to evaluate the status of
the systems and procedures in an absolute sense. For instance, a finance
company that has a large base of fixed deposit holders but poor systems
for keeping track of the due dates of interest payments and maturities
is not likely to make a good impression. An example of
"appropriate" systems can be that of a truck-financing company
that has an efficient system to track the movement of the hirers’
vehicles and adequate checks and balances to handle large amount of cash
collections at remote branches. The "appropriateness" of the
policies and procedures of the company are evaluated with reference to
the projected nature and level of business for the company. Implicit in
this statement is the concept that any plan for the future is only as
good as the control systems that are in place to implement and review
the same. While the credit rating agency does not conduct a systems or a
financial audit during a rating exercise, it relies on several methods
of checking the adequacy of the systems, such as, meeting with the
statutory and internal auditors, sample checks of critical records, scrutinizing
statutory returns filed with different regulatory
authorities, and analysis of internal review reports. The credit rating
agency’s analysts are trained to identify inconsistencies that can
arise if data is falsified or suppressed in any way.
The
Final Rating Judgment
Despite
working under similar circumstances and environment, each finance
company is unique and has distinct characteristics. As there are several
factors that effect the credit quality of a company, it is not possible
to use a simple quantitative formula to arrive at the
"correct" rating. In fact, there are several qualitative
aspects in a rating exercise, where the credit rating agency exercises
its judgment on the basis of logical and acceptable norms that ensure
consistency and fairness. The weightages that are assigned explicitly or
implicitly to a particular parameter in a rating judgment, can vary
from company to company.
For
instance, a finance company that has a diversified income stream is
considered more stable than one which has income from only one source, coteries
paribus. However, while comparing two companies both of which
have a large share of their incomes from the same business, it is
possible that the credit rating agency could be comfortable with one
company that has been in that business for 25 years, while it may have
reservations about giving such a benefit to the other company, which is
a new entrant to the business. Thus, the fact that the company is
dependent on one business for most of its revenues would tend to have a
higher weightage in the case of the second company than in the case of
the first company in the above illustration.
The
analysis of historical performance and inter-firm comparison of
historical financial statements give useful insights into the strengths
and weaknesses of a finance company. However, the analyst has to pick up
leads from this analysis, identify the critical factors that will have a
bearing credit quality in the future, and as far as possible quantify
the effects. This forms the crux of the rating decision.
RATINGS
LAAA
Highest safety. Indicates fundamentally strong position. Risk factors
are negligible. There may be circumstances adversely affecting the
degree of safety but such circumstances, as may be visualized, are not
likely to affect the timely payment of principal and interest as per
terms.
LAA+
LAA
LAA-
High safety. Risk factors are modest and may vary slightly. The
protective factors are strong and the prospect of timely payment of
principal and interest as per terms under adverse circumstances, as may
be visualized, differs from LAAA only marginally.
LA+
LA
LA-
Adequate safety. The risk factors are more variable and greater in
periods of economic stress. The protective factors are average and any
adverse change in circumstances, as may be visualized, may alter the
fundamental strength and affect the timely payment of principal and
interest as per terms.
LBBB+
LBBB
LBBB-
Moderate safety. Considerable variability in risk factors. The
protective factors are below average. Adverse changes in
business/economic circumstances are likely to affect the timely payment
of principal and interest as per terms.
LBB +
LBB
LBB-
Inadequate safety. The timely payment of interest and principal are more
likely to be affected by present or prospective changes in
business/economic circumstances. The protective factors fluctuate in
case of changes in economy/business conditions.
LB + LB
LB-
Risk prone. Risk factors indicate that obligations may not be met when
due. The protective factors are narrow. Adverse changes in
business/economic conditions could result in inability/unwillingness to
service debts on time as per terms.
LC+
LC
LC-
Substantial
risk. There are inherent elements of risk and timely servicing of
debts/obligations could be possible only in case of continued existence
of favourable circumstances.
LD
Default. Extremely speculative. Either already in default in payment of
interest and/or principal as per terms or expected to default. Recovery
is likely only on liquidation or re-organization.
Medium
Term including Certificate of Deposit and Fixed Deposit Programmes
MAAA
Highest safety. The prospect of timely servicing of interest and
principal as per terms is the best.
MAA+
MAA
MAA-
High safety. The prospect of timely servicing of interest and principal
as per terms is high, but not as in MAAA rating.
MA+
MA
MA-
Adequate safety. The prospect of timely servicing of interest and
principal is adequate. However, debt servicing may be affected by
adverse changes in the business/economic conditions.
MB+
MB
MB-
Inadequate safety. The timely payment of interest and principal are more
likely to be affected by future uncertainties.
MC+
MC
MC-
Risk prone. Susceptibility to default high. Adverse changes in
business/economic conditions could result in inability/unwillingness to
service debts on time and as per terms.
MD
Default Either already in default or expected to default.
Short
Term – including Commercial Paper
A1+
A1
Highest safety. The prospect of timely payment of debt/obligation is the
best.
A2+
A2
High safety. The relative safety is marginally lower than in 'A1'
rating.
A3+
A3
Adequate safety. The prospect of timely payment of interest and
instalment is adequate, but any adverse changes in business/economic
conditions may affect the fundamental strength.
A4+
A4
Risk prone. The degree of safety is low. Likely to default in case of
adverse changes in business/economic conditions.
A5
Default. Either already in default or expected to default. Inadequate
capacity.
Special
Symbols
The
assessment symbols group together (but not necessarily identical)
entities in terms of their relative capacity of timely servicing of
debts/obligations, as per terms of contract, i.e. the relative degree of
safety/risk.
+,
- : The suffix of + or - may be used with the assessment symbol to
indicate the comparative position of the borrower within the group
covered by the symbol. Thus LAA+, MAA+, A1+ lies one notch above LAA,
MAA, A1 respectively.
(P):
The letter P in parenthesis after the rating symbol indicates that the
debt instrument is being issued to raise resources by a new Company for
financing a new project and the rating assumes successful completion of
the project. The rating symbols for different instruments of the same
company need not necessarily be the same.
@:
Under Rating Watch with negative implications
&:
Under Rating Watch with developing implications
#:
Under Rating Watch
*:
Rating withdrawn as no outstanding amount/ instrument not issued
~:
Sub-Judice
:
Rating upgraded during the past one year
:
Rating downgraded during the past one year
ICRA
Rating Symbols For Debt Funds
The
ICRA Rating Symbols for Credit Risk Rating of Debt Funds and their
implications are as follows:
MfAAA
Indicates highest quality. The investment quality is of highest grade
and is similar to that of fixed income obligations of highest safety.
mfAA+
mfAA
mfAA-
Indicates high quality. The investment quality is of high grade and is
similar to that of fixed income obligations of high safety.
mfA+
mfA
mfA-
Indicates adequate quality. The investment quality is of upper medium
grade and is similar to that of fixed income obligations of adequate
safety.
mfBBB+
mfBBB
mfBBB-
Indicates moderate quality. The investment quality is of medium grade
and is similar to that of fixed income obligations of moderate safety.
mfBB+
mfBB
mfBB-
Indicates inadequate quality. The investment quality is of low grade and
is similar to that of fixed income obligations of inadequate safety.
mfB+
mfB
mfB-
Indicates poor quality. The investment quality is of lowest grade and is
similar to that of fixed income obligations that are risk prone.
The
ICRA Rating Symbols for Market Risk Rating of Debt Funds and their
implications are as follows:
M1
Indicates very low sensitivity to changing interest rates and other
market conditions.
M2
Indicates low sensitivity to changing interest rates and other market
conditions.
M3
Indicates moderate sensitivity to changing interest rates and other
market conditions.
M4
Indicates high sensitivity to changing interest rates and other market
conditions.
M5
Indicates very high sensitivity to changing interest rates and other
market conditions.
Rating
Scale for Insurance Companies
iAAA
Highest claims paying ability. Indicates fundamentally strong position.
Prospect of meeting policyholder obligations is best.
iAA
High claims paying ability. Risk factors are modest and may vary
slightly. Prospect of meeting policy holder obligations is high and
differs from iAAA only marginally.
iA
Adequate claims paying ability. Prospect of meeting policyholder
obligations is adequate. The risk factors are more variable and greater
in periods of economic stress and adverse changes in business/ economic
circumstances as may be visualized, may alter the fundamental strength.
iBBB
Moderate claims paying ability. The protective factors are below average
and adverse changes in business/ economic circumstances are a likely to
affect the prospect of meeting policyholder obligations.
iBB
Inadequate claims paying ability. The protective factors fluctuate in
case of changes in business/ economic conditions and prospects of
meeting policyholder obligations are more likely to be affected by such
changes.
iB
Weak claims paying ability. Risk factors indicate that policyholders'
obligations may not be met when due. Adverse changes in business/
economic conditions could result in inability / unwillingness to service
policyholder obligations.
iC
Lowest claims paying ability. Indicates fundamentally poor position.
Such companies may often be in default on policyholder obligations and
may be or likely to be placed under supervision of insurance regulators.
Grading
Scale for Collective Investment Schemes
Investment
Grades
CS
1 High Grade :Schemes rated CS 1 are considered to have high probability
of achieving indicated returns. The protective factors are above
average.
CS
2 Adequate Grade : Schemes rated CS 2 are considered to have adequate
probability of achieving indicated returns. The risks associated with
such schemes are higher than schemes rated as CS 1. The protective
factors are average. Returns are susceptible to adverse changes in
circumstances.
CS
3 Moderate Grade : Schemes rated CS 3 are considered to have moderate
probability of achieving indicated returns. The risks associated with
such schemes are higher than schemes rated in the higher categories. The
protective factors are below average. Adverse changes in circumstances
are more likely to affect returns.
Speculative
(Non Investment) Grades
CS
4 Inadequate Grade : Schemes rated CS 4 are considered to have
inadequate probability of achieving indicated returns. The protective
factors are weak. Such schemes are considered to have speculative
characteristics.
CS
5 High Risk :Schemes rated CS 5 are considered to have very high risks.
Such schemes are Extremely Speculative.
Anand P Sharma
ICFAIAN Business School(IBS), New Delhi
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