8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

1/19

Credit RatingCredit RatingWith the increasing market orientation of the Indian economy,

investors value a systematic assessment of two types of risks, namelybusiness risk arising out of the open economy and linkagesbetween money, capital and foreign exchange markets and paymentsrisk. With a view to protect small investors, who are the main targetfor unlisted corporate debt in the form of fixed deposits withcompanies, credit rating has been made mandatory. India was perhaps

the first amongst developing countries to set up a credit rating agencyin 1988. The function of credit rating was institutionalised when RBImade it mandatory for the issue of Commercial Paper (CP) andsubsequently by SEBI. when it made credit rating compulsory for certain categories of debentures and debt instruments. In June 1994,RBI made it mandatory for Non-Banking Financial Companies

(NBFCs) to be rated. Credit rating is optional for Public Sector Undertakings (PSUs) bonds and privately placed non-conve11ibledebentures upto Rs. 50 million. Fixed deposits of manufacturingcompanies also come under the purview of optional credit rating.information. Duff and Phelps has tied up with two Indian NBFCs toset up Duff and Phelps Credit Rating India (P) Ltd. in 1996.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

2/19

Meaning and DefinitionMeaning and Definition

Credit rating is the opinion of the rating agency on the relativeability and willingness of tile issuer of a debt instrument to meetthe debt service obligations as and when they arise. Rating isusually expressed in alphabetical or alphanumeric symbols.Symbols are simple and easily understood tool which help theinvestor to differentiate between debt instruments on the basis of their underlying credit quality. Rating companies also publishexplanations for their symbols used as well as the rationale for the ratings assigned by them, to facilitate deeper understanding.In other words, the rating is an opinion on the future ability andlegal obligation of the issuer to make timely payments of principal and interest on a specific fixed income security. Therating measures the probability that the issuer will default on thesecurity over its life, which depending on the instrument may bea matter of days to thirty years or more.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

3/19

Imp ortance of Credit RatingImp ortance of Credit Rating

i. The growth of information technology.

ii. Globalisation of financial markets.

iii. Increasing role of capital and moneymarkets.

iv. Lack of government safety measures.

v. The trend towards privatisation.

vi. Securitisation of debt.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

4/19

n ca ons o e ss gne a ngsn ca ons o e ss gne a ngs

Rating symbols assigned to a security issue is an indicator of the following:i. the nature and terms of the particular security being

issued;

ii. the ability and the willingness of the issuer of asecurity to make payments in time;iii. the probability that the issuer will make a default in

payments; and ensure that the rating process is free

from any possible clash of interest.iv. the degree of protection available to the investors if the security issuer company is liquidated, re- organizedor declared bankrupt.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

5/19

ac ors ec ng ss gneac ors ec ng ss gneRatingsRatings

The following factors generally influence the ratings to beassigned by a credit rating agency:

1. The security issuers ability to service its debt. In order, theycalculate the past and likely future cash flows and compare

with fixed interest obligations of the issuer.2. The volume and composition of outstanding debt.3. The stability of the future cash flows and earning capacity of

company.4. The interest coverage ratio i.e. how many number of times the

issuer is able to meet its fixed interest obligations.5. Ratio of current assets to current liabilities (i.e. current ratio(CR)) is calculated to assess the liquidity position of the issuing

firm.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

6/19

6. Th e value of assets p ledged as collateral securityand t h e securitys p riority of clai m against t h eissuing fir m s assets .

7. Market p osition of t h e co mp any p roducts is judgedby t h e de m and for t h e p roducts, co mp etitorsm arket s h are,

distribution ch

annels etc.

8. O p erational efficiency is judged by ca p acityutilisation,p ros p ects of ex p ansion, m odernisation and

diversification,

availability of raw m aterial etc .9. T rack record of p ro m oters, directors and ex p ertise

of staff also affect t h e rating of a co mp any .

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

7/19

Rating Met h odologyRating Met h odology

Rating methodology used by the major Indian credit ratingagencies is more or less the same. The rating methodologyinvolves an analysis of all the factors affecting thecreditworthiness of an issuer company e.g. business, financialand industry characteristics, operational efficiency,management quality, competitive position of the issuer andcommitment to new projects etc. A detailed analysis of thepast financial statements is made to assess the performanceand to estimate the future earnings. The companys ability toservice the debt obligations over the tenure of the instrumentbeing rated is also evaluated. In fact, it is the relative comfortlevel of the issuer to service obligations that determine therating. While assessing the instrument, the following are themain factors that are analyzed into detail by the credit ratingagencies.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

8/19

1 . Business Risk Analysis2 . F inancial Analysis3 . Manage m ent Evaluation4 . Geogra p h ical Analysis5 . Regulatory and Co mp etitive Environ m ent6. F unda m ental Analysis

Th ese are ex p lained as under:

I. Business Risk AnalysisBusiness risk analysis ai m s at analysing t h e

industry risk, m arket p osition of t h e co mp any,

op erating efficiency and legal p osition of t h eco mp any . Th is includes an analysis of industry risk,m arket p osition of t h e co mp any, o p erating efficiencyof t h e co mp any and legal p osition of t h e co mp any .

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

9/19

a. Industry risk : The rating agencies evaluates the industry risk bytaking into consideration various factors like strength of the industryprospect, nature and basis of competition, demand and supply

position, structure of industry, pattern of business cycle etc.Industries compete with each other on the basis of price, productquality, distribution capabilities etc. Industries with stable growth indemand and flexibility in the timing of capital outlays are in astronger position and therefore enjoy better credit rating.

b. Market position of the company :

Rating agencies evaluate the market standing of a company taking intoaccount:i. Percentage of market shareii. Marketing infrastructureiii. Competitive advantages

iv. Selling and distribution channelv. Diversity of productsvi. Customers basevii. Research and development projects undertaken to identify obsolete

productsviii. Quality Improvement programs etc.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

10/19

c. Operating efficiency: Favorable locational advantages,management and labor relationships, cost structure, availabilityof raw-material, labor, compliance to pollution controlprograms, level of capital employed and technologicaladvantages etc. affect the operating efficiency of every issuer company and hence the credit rating.

d. Legal position: Legal position of a debt instrument is assessedby letter of offer containing terms of issue, trustees and their

responsibilities, mode of payment of interest and principal intime, provision for protection against fraud etc.e. Size of business : The size of business of a company is a relevant

factor in the rating decision. Smaller companies are more proneto risk due to business cycle changes as compared to larger companies. Smaller companies operations are limited in terms of product, geographical area and number of customers. Whereaslarge companies enjoy the benefits of diversification owing towide range of products, customers spread over larger geographical area. Thus, business analysis covers all theimportant factors related to the business operations over anissuer company under credit assessment.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

11/19

II. Financial AnalysisFinancial analysis aims at determining the financial strength of theissuer company through ratio analysis, cash flow analysis and study

of the existing capital structure. This includes an analysis of four important factors namely:a. Accounting qualityb. Earnings potential/profitabilityc. Cash flows analysis

d. Financial flexibilityFinancial analysis aims at determining the financial strength of the

issuer company through quantitative means such as ratio analysis.Both past and current performance is evaluated to comment thefuture performance of a company. The areas considered areexplained as follows.

a. Accounting quality : As credit rating agencies rely on the auditedfinancial statements, the analysis of statements begins with the studyof accounting quality. For the purpose, qualification of auditors,overstatement/ understatement of profits, methods adopted for recognising income, valuation of stock and charging depreciation onfixed assets are studied.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

12/19

b. E arnings potential/profitability: Profits indicate companys abilityto meet its fixed interest obligation in time. A business with stableearnings can withstand any adverse conditions and also generatecapital resources internally. Profitability ratios like operating profitand net profit ratios to sales are calculated and compared with last 5years figures or compared with the similar other companies carryingon same business. As a rating is a forward-looking exercise, moreemphasis is laid on the future rather than the past earning capacity of the issuer.

c. Cash flow analysis : Cash flow analysis is undertaken in relation todebt and fixed and working capital requirements of the company. Itindicates the usage of cash for different purposes and the extent of cash available for meeting fixed interest obligations. Cash flowsanalysis facilitates credit rating of a company as it better indicates theissuers debt servicing capability compared to reported earnings.

d. Financial flexibility : Existing Capital structure of a company isstudied to find the debt/equity ratio, alternative means of financingused to raise funds, ability to raise funds, asset deployment potentialetc. The future debt claims on the issuers as well as the issuersability to raise capital is determined in order to find issuersfinancial flexibility.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

13/19

III . Management Ev aluationAny companys performance is significantly affected by themanagement goals, plans and strategies, capacity to overcomeunfavorable conditions, staffs own experience and skills,planning and control system etc. Rating of a debt instrument

IV. Geographical AnalysisGeographical analysis is undertaken to determine the location

advantages enjoyed by the issuer company. An issuer

company having its business spread over large geographicalarea enjoys the benefits of diversification and hence gets better credit rating. A company located in backward area may enjoysubsidies from government thus enjoying the benefit of lower cost of operation. Thus geographical analysis is undertaken todetermine the locational advantages enjoyed by the issuer company.

V. Regulatory and Competiti v e E n v ironmentCredit rating agencies evaluate structure and regulatory

framework of the financial system in which it works. Whileassigning the rating symbols, ICRA evaluates the impact of

regulation/ deregulation on the issuer company.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

14/19

VI. Fundamental AnalysisFundamental analysis includes an analysis of liquidity

management, profitability and financial position, interest andtax rates sensitivity of the company. This includes an analysisof liquidity management, profitability and financial position,interest and tax rates sensitivity of the company.

1. Liquidity management involves study of capital structure,availability of liquid assets corresponding to financing

commitments and maturing deposits, matching of assets andliabilities.2. Asset quality covers factors like quality of companys credit

risk management, exposure to individual borrowers andmanagement of problem credits etc.

3. Profitability and financial position covers aspects like pastprofits, funds deployment, revenues on non-fund basedactivities, addition to reserves.

4. Interest and tax sensitivity reflects sensitivity of companyfollowing the changes in interest rates and changes in tax law.

Fundamental analysis is undertaken for rating debt instruments of financial institutions, banks and non-banking financecom anies.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

15/19

Credit Rating of Instru m entsCredit Rating of Instru m entsCredit rating is the process of assigning standard scores whichsummarize the probability of the issuer being able to meet itsrepayment obligations for a particular debt instrument in atimely manner. Credit rating is integral to debt markets as ithelps market participants to arrive at quick estimates and

opinions about various instruments. In this manner it facilitatestrading in debt and money market instruments especially ininstruments other than Government of India Securities.Rating is usually assigned to a specific instrument rather thanthe company as a whole. In the Indian context, the rating isdone at the instance of the issuer, which pays rating fees for this service. If it is unsatisfied with the rating assigned to itsproposed instrument, it is at liberty not to disclose the ratinggiven to it. There are 4 rating agencies in India. These are asfollows

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

16/19

C RISIL - Th e oldest rating agency was

originally p ro m oted by ICICI . S tandard & Poor, t h e global leader in ratings, h asrecently taken a s m all 10% stake inCR I S IL .

I C RA - Pro m oted by I F CI . Moodys, t h eot h er global rating m ajor, h as recentlytaken a s m all 11% stake in ICRA .

C ARE - Pro m oted by IDB I .

Duff and Phelps - Co - p ro m oted by Duff and P h el p s, t h e worlds 4t h largest ratingagency . CRI S IL is believed to h ave about42 % m arket s h are followed by ICRA wit habout 3 6 % , CARE wit h 1 8 % and Duff andPh el p s wit h 4 % .

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

17/19

Each of the rating agencies has different codes for expressingrating for different instruments; however, the number of grades andsub-grades is similar e.g. for long term debentures/ bonds and fixeddeposits, CRISIL has 4 main grades and a host of sub-grades. Indecreasing order of quality, these are AAA, AA+, AA, AA-, A+,A, A-, BBB-, BBB, BBB+, BB+, BB, BB-, B+, B, B-, C and D.ICRA, CARE and Duff and Phelps have similar grading systems.The following table contains a key to the codes used by CRISILand ICRA. Credit rating is a dynamic concept and all the ratingcompanies are constantly reviewing the companies rated by themwith a view to changing (either upgrading or downgrading) therating. They also have a system whereby they keep ratings for particular companies on rating watch in case of major events,which may lead to change in rating in the near future. Ratings aremade public through periodic newsletters issued by ratingcompanies, which also elucidate briefly the rationale for particular ratings. In addition, they issue press releases to all major newspapers and wire services about rating events on a regular basis.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

18/19

RatingsRatings

The following factors generally influence the ratings to beassigned by a credit rating agency:

1. The security issuers ability to service its debt. Inorder, they calculate the past and likely future cashflows and compare with fixed interest obligations of the issuer.

2. The volume and composition of outstanding debt.3. The stability of the future cash flows and earning

capacity of company.4. The interest coverage ratio i.e. how many number of

times the issuer is able to meet its fixed interestobligations.

8/7/2019 4558_1019_99_1004_46_Credit Rating (1)

19/19

5. Ratio of current assets to current liabilities (i.e. current

ratio (CR)) is calculated to assess the liquidity positionof theissuing firm.

6. The value of assets pledged as collateral security andthe securitys priority of claim against the issuingfirms assets.

7. Market position of the company products is judged bythe demand for the products, competitors market share,distribution channels etc.

8. Operational efficiency is judged by capacityutilization, prospects of expansion, modernization anddiversification, availability of raw material etc.

9. Track record of promoters, directors and expertise of staff also affect the rating of a company.