corporate ratings criteria

Corporate RatingsCriteria

2006

For the most complete and up-to-date ratings criteria, please visit Standard & Poor’s Web site at www.corporatecriteria.standardandpoors.com.

Standard & Poor’s � Corporate Ratings Criteria 2006 3

Standard & Poor’s Ratings Services’ criteria publications represent ourendeavor to convey the thought processes and methodologies employed

in determining Standard & Poor’s ratings. They describe both the quantita-tive and qualitative aspects of the analysis. We believe our rating producthas the most value if users appreciate all that has gone into producing theletter symbols.

Bear in mind, however, that a rating is, in the end, an opinion. The ratingassignment is as much an art as it is a science.

Solomon B. SamsonChief Rating Officer, Corporate Ratings

To Our Clients

Published by Standard & Poor’s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, NewYork, NY 10020. Editorial offices: 55 Water Street, New York, NY 10041. Subscriber services: (1) 212-438-7280. Copyright 2005 by TheMcGraw-Hill Companies, Inc. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information hasbeen obtained by Standard & Poor’s from sources believed to be reliable. However, because of the possibility of human or mechanicalerror by our sources, Standard & Poor’s or others, Standard & Poor’s does not guarantee the accuracy, adequacy, or completeness ofany information and is not responsible for any errors or omissions or the result obtained from the use of such information. Ratings arestatements of opinion, not statements of fact or recommendations to buy, hold, or sell any securities.

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Analytic services provided by Standard & Poor’s Ratings Services (“Ratings Services”) are the result of separate activities designed topreserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solelystatements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any otherinvestment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinioncontained herein in making any investment decision. Ratings are based on information received by Ratings Services. Other divisions ofStandard & Poor’s may have information that is not available to Ratings Services. Standard & Poor’s has established policies andprocedures to maintain the confidentiality of non-public information received during the ratings process.

Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities orthird parties participating in marketing the securities. While Standard & Poor’s reserves the right to disseminate the rating, it receivesno payment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available atwww.standardandpoors.com/usratingsfees.

Permissions: To reprint, translate, or quote Standard & Poor’s publications, contact: Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-9823; or by e-mail to: [email protected].

Analytical ContactsSolomon B. Samson

New York (1) 212-438-7653

Scott Sprinzen

New York (1) 212-438-7812

Emmanuel Dubois-Pelerin

Paris (33) 1-4420-6673

Kenneth C. Pfeil

New York (1) 212-438-7889

Contents

Standard & Poor’s Role in the Financial Markets 7

Ratings Definitions 11

The Rating Process 15

Rating Methodology: Industrials & Utilities 19

Factoring Cyclicality Into Corporate Ratings 33

Loan Covenants 35

Country Risk 37

Ratings and Ratios 42

Rating Each Issue: Distinguishing Issuers and Issues 45

Junior Debt: Notching Down 46

Well-Secured Debt: Notching Up 54

Commercial Paper 55

Preferred Stock 59

Secured Debt/Recovery Ratings, Overview 61

Bank Loan Rating Methodology 63

Collateral Value Analysis 65

Debtor-in-Possession (DIP) Financing 72

Equity Credit: What It Is and How You Get It 74

Factoring Future Equity Into Ratings 77

Tax-Deductible Preferred and Other Hybrids 80

Streamlining Hierarchy of Hybrid Securities 83

Modified Hybrid Hierarchy 83

Parent/Subsidiary Links 85

General Principles 85

Subsidiaries/Joint Ventures/Nonrecourse Projects 86

Finance Subsidiaries’ Rating Link to Parent 89

Operating Lease Analytics 92

Using The Methodology 92

Limitations of the Model 94

Postretirement Obligations 96

Corporate Asset-Retirement Obligations 112

The Role of Corporate Governance in Credit Rating Analysis 115

Securitization’s Effect on Corporate Credit Quality 118

Short-Term Speculative-Grade Rating Criteria 123



Standard & Poor’s now rates more than $13trillion in bonds and other financial obliga-tions of obligors in more than 50 countries.Standard & Poor’s rates and monitorsdevelopments pertaining to these issues andissuers from an office network based in 21world financial centers.

Despite its tremendous growth over theyears, Standard & Poor’s core values remainthe same: to provide high-quality, objective,

value-added analytical information to theworld’s financial markets.

What is Standard & Poor’s?Standard & Poor’s is an organization ofprofessionals that provides analytical services and operates under the basic principles of:� Independence;� Objectivity;

Standard & Poor’s Role in the Financial Markets

Standard & Poor’s Ratings Services traces its history back to

1860. It currently is the leading credit rating organization and

a major publisher of financial information and research services

on U.S. and foreign corporate and municipal debt obligations.

Standard & Poor’s was an independent, publicly owned corpora-

tion until 1966, when all of its common stock was acquired by

McGraw-Hill Inc., a major publishing company. Standard & Poor’s

is now a business unit of McGraw-Hill. In matters of credit analy-

sis and ratings, Standard & Poor’s Credit Market Services oper-

ates entirely independently of McGraw-Hill. Investment Services

and Corporate Value Consulting are the other units of Standard &

Poor’s. They provide investment, financial, and trading informa-

tion, data, and analyses—including on equity securities—but

operate separately from the ratings group.

www.corporatecriteria.standardandpoors.com8

� Credibility; and� Disclosure.

Standard & Poor’s operates with no gov-ernment mandate and is independent of anyinvestment banking company, bank, or simi-lar organization.

Standard & Poor’s recognition as a ratingagency ultimately depends on investors’willingness to accept its judgment. Webelieve it is important that all users of ourratings understand how we arrive at thoseratings, and regularly publish ratingsresearch and detailed reports on ratings cri-teria and methodology.

Credit RatingsStandard & Poor’s began rating the debt ofcorporate and government issuers decadesago. Our credit rating criteria and method-ology have grown in sophistication andhave kept pace with the introduction of new financial products. For example,Standard & Poor’s was the first major rat-ing agency to assess the credit quality of,and assign credit ratings to, the claims-pay-ing ability of insurance companies (1971);financial guarantees (1971); mortgage-backed bonds (1975); mutual funds (1983);asset-backed securities (1985); and securedloan recovery (2003).

A credit rating is Standard & Poor’s opin-ion of the general creditworthiness of anobligor, or the creditworthiness of an oblig-or with respect to a particular debt securityor other financial obligation, based on rele-vant risk factors. Over the years, these cred-it ratings have achieved wide investoracceptance as easily usable tools for differentiating credit quality, because aStandard & Poor’s credit rating is judged bythe market to be reliable and credible. Arating does not constitute a recommenda-tion to purchase, sell, or hold a particularsecurity. In addition, a rating does not com-ment on the suitability of an investment fora particular investor.

Standard & Poor’s credit ratings and sym-bols originally applied to debt securities. Asdescribed below, we have developed creditratings that may apply to an issuer’s generalcreditworthiness or to a specific financialobligation. Standard & Poor’s historically

has maintained separate and well-estab-lished rating scales for long-term and short-term instruments. (A separate scale forpreferred stock was integrated with the debtscale in February 1999. There is an addi-tional scale exclusively for medium-termmunicipal notes.)

Credit ratings are based on informationfurnished by the obligors or obtained by usfrom other sources we consider reliable.Standard & Poor’s does not perform anaudit in connection with any credit ratingand may, on occasion, rely on unauditedfinancial information. Credit ratings may bechanged, suspended, or withdrawn as aresult of changes in, or unavailability of,such information.

Long-term credit ratings are divided intoseveral categories, ranging from ‘AAA’—reflecting the strongest credit quality—to ‘D’,reflecting the lowest. Long-term ratings from‘AA’ to ‘CCC’ may be modified by the addi-tion of a plus or minus sign to show relativestanding within the major rating categories.

A short-term credit rating is an assessmentof an issuer’s credit quality with respect to aninstrument considered short term in the rele-vant market. Short-term ratings range from‘A-1’, for the highest-quality obligations, to‘D’, for the lowest. The ‘A-1’ rating may alsobe modified by a plus sign to distinguish thestrongest credits in that category.

Issue-Specific Credit RatingsA Standard & Poor’s issue credit rating is acurrent opinion of the creditworthiness of anobligor with respect to a specific financial obli-gation, a specific class of financial obligations,or a specific financial program. This opinionmay reflect the creditworthiness of guarantors,insurers, or other forms of credit enhancementon the obligation, and takes into account statu-tory and regulatory preferences.

On a global basis, Standard & Poor’s issuecredit-rating criteria have long identified theadded country-risk factors that give externaldebt a higher default probability than domes-tic obligations. In 1992, we revised our crite-ria to define external rather than domesticobligations by currency instead of by marketof issuance. This led to the adoption of thelocal currency/foreign currency nomencla-



tures for issue credit ratings. Because ratingcoverage now has expanded to a growingrange of emerging-market countries, theanalysis of political, economic, and monetaryrisk factors are even more important.

Long-term Credit RatingsNotes, note programs, certificate of depositprograms, syndicated bank loans, bonds anddebentures (‘AA’, ‘AA’...‘D’); shelf registra-tions (preliminary).Debt Types:� Equipment trust certificates;� Secured;� Senior unsecured;� Subordinated;� Junior subordinated; and� Preferred stock and deferrable

payment debt.Recovery Ratings (1-5)Municipal Note Ratings (tenor: less thanthree years) (‘SP-1+’, ‘SP-1’...’SP-3’)Short-Term Ratings (‘A-1+’, ‘A-1’...‘D’):� Commercial paper programs;� Put bonds/demand bonds; and� Certificate of deposit programs.

Issuer Credit RatingsLong-Term Ratings and Short-Term Ratings� Corporate credit ratings;� Counterparty ratings; and� Certificate of deposit programs.

Other Rating Products� Mutual Bond Fund Credit Quality Ratings

(‘AAAf’...‘CCCf’);� Money Market Fund Safety Ratings

(‘AAAm’...‘BBBm’);� Mutual Bond and Managed Fund Risk

Ratings (‘aaa’, ‘aa’,...‘ccc’);� Financial strength ratings for insurance

companies (also, pi ratings based on quan-titative model);

� Ratings estimates; and� National-scale credit ratings.

Issuer Credit RatingsIn response to a need for rating evaluationson a company when no public debt is out-standing, Standard & Poor’s provides anissuer credit rating—an opinion of theobligor’s overall capacity to meet its finan-

cial obligations. This opinion focuses on theobligor’s capacity and willingness to meetits financial commitments as they come due.The opinion is not specific to any particularfinancial obligation, because it does nottake into account the specific nature or pro-visions of any particular obligation. Issuercredit ratings do not take into accountstatutory or regulatory preferences, nor dothey take into account the creditworthinessof guarantors, insurers, or other forms ofcredit enhancement that may pertain to aspecific obligation.

Counterparty ratings, corporate creditratings, and sovereign credit ratings are allforms of issuer credit ratings.

Because a corporate credit rating providesan overall assessment of a company’s credit-worthiness, it is used for a variety of finan-cial and commercial purposes, such asnegotiating long-term leases or minimizingthe need for a letter of credit for vendors.

If the credit rating is not assigned in con-junction with a rated public financing, thecompany can choose to make its rating pub-lic or to keep it confidential.

Rating ProcessStandard & Poor’s provides a rating onlywhen there is adequate information availableto form a credible opinion, and only afterapplicable quantitative, qualitative, and legalanalyses are performed.

The analytical framework is divided intoseveral categories to ensure that salient qualita-tive and quantitative issues are considered. Forexample, with industrial companies, the quali-tative categories are oriented to business analy-sis, such as the company’s competitivenesswithin its industry and the caliber of manage-ment; the quantitative categories relate tofinancial analysis.

The rating process is not limited to anexamination of various financial measures.Proper assessment of credit quality for anindustrial company includes a thoroughreview of business fundamentals, includingindustry prospects for growth and vulnera-bility to technological change, labor unrest,or regulatory actions. In the public financesector, this involves an evaluation of thebasic underlying economic strength of the


public entity, as well as the effectiveness ofthe governing process to address problems.In financial institutions, the reputation ofthe bank or company may have an impacton the future financial performance and theinstitution’s ability to repay its obligations.

Standard & Poor’s assembles a team ofanalysts with appropriate expertise toreview information pertinent to the rating.A lead analyst is responsible for conductingthe rating process. Members of the analyti-cal team meet with the organization’s man-agement to review, in detail, key factors thathave an impact on the rating, includingoperating and financial plans and manage-ment policies. The meeting also helps ana-lysts develop the qualitative assessment ofmanagement itself, an important factor inmany rating decisions.

Following this review and discussion, arating committee meeting is convened. Atthe meeting, the committee discusses thelead analyst’s recommendation and the pertinent facts supporting the rating.Finally, the committee votes on the recommendation.

The issuer subsequently is notified of therating and the major considerations sup-porting it. A rating can be appealed prior toits publication—if meaningful new or addi-tional information is to be presented by theissuer. Obviously, there is no guarantee thatany new information will alter the ratingcommittee’s decision.

Once a final rating is assigned, it is dissemi-nated to the public through the news media. Inthe U.S., Standard & Poor’s assigns and pub-lishes its ratings irrespective of issuer request, ifthe financing is a public deal. In the case of pri-vate transactions, the company has publicationrights. (Most 144A transactions are viewed aspublic deals.) In most markets outside the U.S.,ratings are assigned only on request, so thecompany can choose to make its rating publicor to keep it confidential. (Confidential ratingsare disclosed by Standard & Poor’s only toparties designated by the rated entity.) After apublic rating is released to the media by Standard & Poor’s, it is published in CreditWeek or another Standard & Poor’s publication, with the rationale and other commentary.

Surveillance and ReviewAll ratings are monitored, including continualreview of new financial or economic informa-tion. Our surveillance is ongoing, whichmeans staying abreast of all current develop-ments. Moreover, it is routine to scheduleannual review meetings with management,even in the absence of the issuance of newobligations. These meetings enable analysts todiscuss potential problem areas and beapprised of any changes in the issuer’s plans.

As a result of the surveillance process, it issometimes necessary to reassess a rating.When this occurs, the analyst undertakes areview, which may lead to a CreditWatch list-ing, if the likelihood of change is sufficientlyhigh. This is followed by a comprehensiveanalysis—including, if warranted, a meetingwith management—and a presentation to arating committee. The rating committee eval-uates the circumstances, arrives at a ratingdecision, notifies the issuer, and entertains anappeal, if one is made. After this process, therating change or affirmation is announced.

Issuers’ Use of RatingsIt is common for companies to structurefinancing transactions to reflect rating criteriaso they qualify for higher ratings. However,the actual structuring of a given issue is thefunction and responsibility of an issuer andits advisors. We will react to a proposedfinancing, publish and interpret its criteria fora type of issue, and outline the rating implica-tions for an issuer, underwriter, bond counsel,or financial advisor, but do not function asan investment banker or financial advisor.Adoption of such a role ultimately wouldimpair the objectivity and credibility that arevital to our continued performance as anindependent rating agency.

Standard & Poor’s guidance also is soughton credit quality issues that might affect therating opinion. For example, companies solic-it our view on hybrid preferred stock, themonetization of assets, or other innovativefinancing techniques before putting these intopractice. Nor is it uncommon for debt issuersto undertake specific and sometimes signifi-cant actions for the sake of maintaining theirratings. For example, one large companyfaced a downgrade of its ‘A-1’ commercial



paper rating because of a growing componentof short-term, floating-rate debt. To keep itsrating, the company chose to restructure itsdebt maturity schedule in a way consistentwith our view of what was prudent.

Many companies go one step further andincorporate specific rating objectives as cor-porate goals. Indeed, possessing an ‘A’ rat-ing, or at least an investment-grade rating,affords companies a measure of flexibilityand may be worthwhile as part of an over-all financial strategy. Beyond that, we donot encourage companies to manage them-selves with an eye toward a specific rating.The more appropriate approach is to oper-ate for the good of the business as manage-ment sees it and to let the rating follow.Ironically, managing for a very high ratingcan sometimes be inconsistent with thecompany’s ultimate best interests, if itmeans being overly conservative and forgo-ing opportunities.

Ratings DefinitionsCredit ratings can be either long term orshort term. Short-term ratings are assigned tothose obligations considered short term in therelevant market. In the U.S., for example,that means obligations with an original matu-rity of no more than 365 days—includingcommercial paper.

Commercial paper ratings pertain to theprogram established to sell these notes. Thereis no review of individual notes. Nonetheless,such program ratings characterize the notesas “rated paper.”

Short-term ratings also are used to indicatethe creditworthiness of an obligor withrespect to put features on long-term obliga-tions. The result is a dual rating, in which theshort-term rating addresses the put feature inaddition to the usual long-term rating.

Medium-term notes (MTNs) are assignedlong-term ratings. A rating is assigned to theMTN program and, subsequently, to indi-vidual notes, as they are identified.

Issue and issuer credit ratings use the iden-tical symbols (shown below), and the defini-tions closely correspond to each other. Issuerratings and short-term issue ratings focusentirely on the default risk of the entity.

Long-term issue ratings also take intoaccount risks pertaining to loss-given-default.However, both the issuer and issue rating def-initions are expressed in terms of default risk,which refers to the capacity and willingnessof the obligor to meet its financial commit-ments on time, in accordance with the termsof the obligation. As noted, issue credit rat-ings also take into account the protectionafforded by, and relative position of, the obli-gation in the event of bankruptcy, reorganiza-tion, or other arrangement under the laws ofbankruptcy and other laws affecting credi-tors’ rights.

Therefore, in the cases of junior debt andsecured debt, the rating may not conformexactly with the category definition. Juniorobligations typically are rated lower than theissuer credit rating (i.e., default risk) to reflectthe lower priority in bankruptcy, as notedabove. (Such differentiation applies when anentity has both senior and subordinated obli-gations, secured and unsecured obligations,operating company and holding companyobligations, or preferred stock.) Debt thatprovides good prospects for ultimate recovery(such as secured debt) often is rated higherthan the issuer credit rating.

Long-term credit ratings‘AAA’: An obligation rated ‘AAA’ has thehighest rating assigned by Standard &Poor’s. The obligor’s capacity to meet itsfinancial commitment on the obligation isextremely strong.

‘AA’: An obligation rated ‘AA’ differs fromthe highest-rated obligations only to a smalldegree. The obligor’s capacity to meet itsfinancial commitment on the obligation isvery strong.

‘A’: An obligation rated ‘A’ is somewhatmore susceptible to the adverse effects ofchanges in circumstances and economic con-ditions than obligations in higher rated cate-gories. However, the obligor’s capacity tomeet its financial commitment on the obliga-tion is still strong.

‘BBB’: An obligation rated ‘BBB’ exhibitsadequate protection parameters. However,adverse economic conditions or changing cir-cumstances are more likely to lead to a weak-


ened capacity of the obligor to meet its finan-cial commitment on the obligation.

Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’,and ‘C’ are regarded as having significantspeculative characteristics. ‘BB’ indicates theleast degree of speculation, and ‘C’ the high-est. While such obligations likely will havesome quality and protective characteristics,these may be outweighed by large uncertain-ties or major exposure to adverse conditions.

‘BB’: An obligation rated ‘BB’ is less vul-nerable to nonpayment than other specula-tive issues. However, it faces major ongoinguncertainties or exposure to adverse busi-ness, financial, or economic conditions thatcould lead to the obligor’s inadequatecapacity to meet its financial commitmenton the obligation.

‘B’: An obligation rated ‘B’ is more vulner-able to nonpayment than obligations rated‘BB’, but the obligor currently has the capaci-ty to meet its financial commitment on theobligation. Adverse business, financial, oreconomic conditions likely will impair theobligor’s capacity or willingness to meet itsfinancial commitment on the obligation.

‘CCC’: An obligation rated ‘CCC’ current-ly is vulnerable to nonpayment and isdependent on favorable business, financial,and economic conditions for the obligor tomeet its financial commitment on the obliga-tion. In the event of adverse business, finan-cial, or economic conditions, the obligor isnot likely to have the capacity to meet itsfinancial commitment on the obligation.

‘CC’: An obligation rated ‘CC’ currently ishighly vulnerable to nonpayment.

‘C’: The ‘C’ rating may be used when abankruptcy petition has been filed or similaraction has been taken but payments on thisobligation are being continued. ‘C’ is alsoused for a preferred stock that is in arrears(as well as for junior debt of issuers rated‘CCC-’ and ‘CC’).

‘D’: The ‘D’ rating, unlike other ratings, isnot prospective; rather, it is used only when adefault actually has occurred—not when adefault is only expected. Standard & Poor’schanges ratings to ‘D’:� On the day an interest and/or principal

payment is due and is not paid. An excep-tion is made if there is a grace period and

we believe a payment will be made, inwhich case the rating can be maintained;

� Upon voluntary bankruptcy filing or simi-lar action. An exception is made if weexpect debt-service payments will continueto be made on a specific issue. In theabsence of a payment default or bankrupt-cy filing, a technical default (i.e., covenantviolation) is not sufficient for assigning a‘D’ rating;

� Upon the completion of a distressedexchange offer, whereby some or all of anissue is either repurchased for an amountof cash or replaced by other securities hav-ing a total value that clearly is less thanpar; or

� In the case of ratings on preferred stock ordeferrable payment securities, upon non-payment of the dividend, or deferral of theinterest payment.With respect to issuer credit ratings (i.e.,

corporate credit ratings, counterparty ratings,and sovereign ratings), failure to pay a finan-cial obligation—rated or unrated—leads to arating of either ‘D’ or ‘SD’. Ordinarily, anissuer’s distress leads to general default, andthe rating is ‘D’. ‘SD’ (selective default) isassigned when an issuer can be expected todefault selectively, i.e., continue to pay cer-tain issues or classes of obligations while notpaying others. In the corporate context, selec-tive default might apply when a companyconducts a distressed or coercive exchangewith respect to one or some issues, whileintending to honor its obligations regardingother issues. (In fact, it is not unusual for acompany to launch such an offer preciselywith such a strategy—to restructure part ofits debt to keep the company solvent.)

Nonpayment of a financial obligation sub-ject to a bona fide commercial dispute or amissed preferred stock dividend does notcause the issuer credit rating to be changed.

Plus (+) or minus (-): The ratings from‘AA’ to ‘CCC’ may be modified by the addi-tion of a plus or minus sign to show relativestanding within the major rating categories.

r: In 1994, Standard & Poor’s initiated asymbol to be added to an issue credit ratingwhen the instrument could have significantnon-credit risk. The symbol “r” was addedto such instruments as mortgage interest-



only strips, inverse floaters, and instrumentsthat pay principal at maturity based on anon-fixed source, such as a currency orstock index. The symbol was intended toalert investors to non-credit risks andemphasizes that an issue credit ratingaddressed only the credit quality of the obli-gation. Use of the r was discontinued in July 2000.

Short-Term Credit Ratings‘A-1’: A short-term obligation rated ‘A-1’ israted in the highest category by Standard &Poor’s. The obligor’s capacity to meet itsfinancial commitment on the obligation isstrong. Within this category, certain obliga-tions are designated with a plus sign (+). Thisindicates that the obligor’s capacity to meetits financial commitment on these obligationsis extremely strong.

‘A-2’: A short-term obligation rated ‘A-2’ issomewhat more susceptible to the adverseeffects of changes in circumstances and eco-nomic conditions than obligations in higherrating categories. However, the obligor’scapacity to meet its financial commitment onthe obligation is satisfactory.

‘A-3’: A short-term obligation rated ‘A-3’exhibits adequate protection parameters.However, adverse economic conditions orchanging circumstances are more likely to leadto a weakened capacity of the obligor to meetits financial commitment on the obligation.

‘B’: A short-term obligation rated ‘B’ isregarded as having significant speculativecharacteristics. The obligor currently has thecapacity to meet its financial commitment onthe obligation; however, it faces major ongo-ing uncertainties that could lead to the oblig-or’s inadequate capacity to meet its financialcommitment on the obligation.

Standard & Poor’s is currently experiment-ing with an expanded short-term rating scalefor the speculative-grade part of the ratingspectrum. The ‘B’ short-term rating categoryhas been divided into ‘B-1’, ‘B-2’, and ‘B-3’.A full explanation of this rating productextension can be found in the last chapter ofthis book: Short-Term Speculative GradeRating Criteria.

‘C’: A short-term obligation rated ‘C’currently is vulnerable to nonpayment and

is dependent on favorable business, finan-cial, and economic conditions for the oblig-or to meet its financial commitment on theobligation.

‘D’: The same as the definition of ‘D’ under“Long-term credit ratings.”

Investment and Speculative GradesThe term “investment grade” originally wasused by various regulatory bodies to connoteobligations eligible for investment by institu-tions such as banks, insurance companies,and savings and loan associations. Over time,this term gained widespread use throughoutthe investment community. Issues rated in thefour highest categories—‘AAA’, ‘AA’, ‘A’, and‘BBB’—generally are recognized as beinginvestment grade. Debt rated ‘BB’ or belowgenerally is referred to as “speculativegrade.” The term “junk bond” is merely anirreverent expression for this category ofmore risky debt. Neither term indicates whichsecurities we deem worthy of investment,because an investor with a particular riskpreference may appropriately invest in securi-ties that are not investment grade.

Ratings continue as a factor in many regu-lations, both in the U.S. and abroad, notablyin Japan. For example, the Securities &Exchange Commission (SEC) requires invest-ment-grade status in order to register debt onForm-3, which, in turn, is one way to offerdebt via a Rule 415 shelf registration. TheFederal Reserve Board allows members ofthe Federal Reserve System to invest in secu-rities rated in the four highest categories, justas the Federal Home Loan Bank System per-mits federally chartered savings and loanassociations to invest in corporate debt withthose ratings, and the Department of Laborallows pension funds to invest in commercialpaper rated in one of the three highest cate-gories. In similar fashion, California regu-lates investments of municipalities andcounty treasurers; Illinois limits collateralacceptable for public deposits; and Vermontrestricts investments of insurers and banks.The New York and Philadelphia stockexchanges fix margin requirements for mort-gage securities depending on their ratings,and the securities haircut for commercialpaper, debt securities, and preferred stock


that determines net capital requirements isalso a function of the ratings assigned.

CurrencyStandard & Poor’s devised two types or rat-ings in order to comment on the risks associ-ated with payment in currencies other thanthe entity’s home country. These ratings typesare defined as follows:

Local Currency Credit Rating: A currentopinion of an obligor’s overall capacity togenerate sufficient local currency resources tomeet its financial obligations (both foreignand local currency), absent the risk of directsovereign intervention that may constrainpayment of foreign currency debt. Local currency credit ratings are provided onStandard & Poor’s global scale or on separatenational scales, and they may take the formof either issuer or specific issue credit ratings.Country or economic risk considerations per-tain to the impact of government policies onthe obligor’s business and financial environ-ment, including factors such as the exchangerate, interest rates, inflation, labor marketconditions, taxation, regulation, and infra-structure. However, the opinion does notaddress transfer and other risks related todirect sovereign intervention to prevent thetimely servicing of cross-border obligations.

Foreign Currency Credit Rating: A currentopinion of an obligor’s overall capacity tomeet its foreign-currency-denominatedfinancial obligations. It may take the formof either an issuer or an issue credit rating.As in the case of local currency credit rat-ings, a foreign currency credit opinion onStandard & Poor’s global scale is based onthe obligor’s individual credit characteristics,including the influence of country or eco-nomic risk factors. However, unlike localcurrency ratings, a foreign currency creditrating includes transfer and other risks relat-ed to sovereign actions that may directlyaffect access to the foreign exchange neededfor timely servicing of the rated obligation.Transfer and other direct sovereign risksaddressed in such ratings include the likeli-hood of foreign-exchange controls and theimposition of other restrictions on therepayment of foreign debt.

National Scale RatingsStandard & Poor’s produces national scaleratings in several countries, includingMexico, Brazil, and Argentina. These ratingsare expressed with the traditional letter sym-bols, but the rating definitions do not con-form to those employed for the global scale.The rating definitions of each national scaleand its correlation to global scale ratings areunique, so there is no basis for comparabilityacross national scales.

CreditWatch Listings and Rating OutlooksA Standard & Poor’s rating evaluates defaultrisk over the life of a debt issue, incorporat-ing an assessment of all future events to theextent they are known or can be anticipated.But we also recognize the potential forfuture performance to differ from initialexpectations. Rating outlooks andCreditWatch listings address this possibilityby focusing on the scenarios that couldresult in a rating change.

Ratings appear on CreditWatch when anevent or deviation from an expected trend hasoccurred or is expected, and additional infor-mation is necessary to take a rating action. Forexample, an issue is placed under such specialsurveillance as the result of mergers, recapital-izations, regulatory actions, or unanticipatedoperating developments. Such rating reviewsnormally are completed within 90 days, unlessthe outcome of a specific event is pending.

A listing does not mean a rating change isinevitable. However, in some cases, it is cer-tain that a rating change will occur, and onlythe magnitude of the change is unclear. Inthose instances—and generally, wheneverpossible—the range of alternative ratings thatcould result is shown.

An issuer cannot automatically appeal aCreditWatch listing, but analysts are sensi-tive to issuer concerns and the fairness ofthe process.

Rating changes also can occur without theissue appearing on CreditWatch beforehand.In fact, if all necessary information is avail-able, ratings should immediately be changedto reflect the changed circumstances; thereshould be no delay merely to signal via aCreditWatch placement that a ratings changeis to occur.



A rating outlook is assigned to all long-termdebt issuers and assesses the potential for a rat-ing change. Outlooks have a longer time framethan CreditWatch listings—typically, twoyears—and incorporate trends or risks withless certain implications for credit quality. Anoutlook is not necessarily a precursor of a rat-ing change or a CreditWatch listing.

CreditWatch designations and outlooksmay be “positive,” which indicates a ratingmay be raised, or “negative,” which indicatesa rating may be lowered. “Developing” isused for those unusual situations in whichfuture events are so unclear that the ratingpotentially may be raised or lowered.

“Stable” is the outlook assigned when rat-ings likely will not be changed, but it shouldnot be confused with expected stability of thecompany’s financial performance.

The Rating ProcessMost corporations approach Standard &Poor’s to request a rating prior to sale orregistration of a debt issue. That way, first-time issuers can receive an indication ofwhat rating to expect. Issuers with rateddebt outstanding also want to know inadvance the impact on their ratings of thecompany’s issuing additional debt. (In anyevent, as a matter of policy, in the U.S., weassign and publish ratings for all public cor-porate debt issues over $100 million—withor without a request from the issuer. Publictransactions are defined as those registeredwith the SEC, those with future registrationrights, and other 144A deals that havebroad distribution.)

In all instances, Standard & Poor’s staff willcontact the issuer to elicit its cooperation. Theanalysts with the greatest relevant industryexpertise are assigned to evaluate the creditand commence surveillance of the company.Our analysts generally concentrate on one ortwo industries, covering the entire spectrum ofcredits within those industries. (Such specializa-tion allows accumulation of expertise and com-petitive information better than if junk-bondissuers were followed separately from high-grade issuers.) While one industry analyst takesthe lead in following a given issuer and typical-ly handles day-to-day contact, a team of expe-

rienced analysts is always assigned to the ratingrelationship with each issuer.

Meeting with ManagementA meeting with corporate management is anintegral part of Standard & Poor’s ratingprocess. The purpose of such a meeting is toreview in detail the company’s key operatingand financial plans, management policies, andother credit factors that have an impact on therating. Management meetings are critical inhelping to reach a balanced assessment of acompany’s circumstances and prospects.

ParticipationThe company typically is represented by itschief financial officer. The chief executive offi-cer usually participates when strategic issuesare reviewed (usually the case at the initial rat-ing assignment). Operating executives oftenpresent detailed information regarding businesssegments. Outside advisors may be helpful inpreparing an effective presentation. We neitherencourage nor discourage their use: it is entire-ly up to management whether advisors assist inthe preparation for meetings, and whether theyattend the meetings.

SchedulingManagement meetings usually are scheduledat least several weeks in advance, to assuremutual availability of the appropriate partici-pants and to allow adequate preparation timefor our credit analysts. In addition, if a ratingis being sought for a pending issuance, it is tothe issuer’s advantage to allow about threeweeks following a meeting for Standard &Poor’s to complete its review process. Moretime may be needed in certain cases, forexample, if extensive review of documenta-tion is necessary. However, where special cir-cumstances exist and a quick turnaround isneeded, we will endeavor to meet the require-ments of the marketplace.

Facility ToursTouring major facilities can be very helpfulfor Standard & Poor’s in gaining an under-standing of a company’s business. However,this is generally not critical. Given the timeconstraints that typically arise in the initialrating exercise, arranging facility tours may


not be feasible. As discussed below, suchtours may well be a useful part of the subse-quent surveillance process.

Preparing for MeetingsCorporate management should feel free tocontact its designated Standard & Poor’scredit analyst for guidance in advance of themeeting regarding the particular areas thatwill be emphasized in the analytic process.Published ratings criteria, as well as industrycommentary and articles on peer companiesfrom CreditWeek, may also be helpful tomanagement in appreciating the analyticperspective. However, Standard & Poor’sprefers not to provide detailed, written listsof questions, because these tend to constrainspontaneity and artificially limit the scope ofthe meeting.

Well in advance of the meeting, the compa-ny should submit background materials (ide-ally, several sets), including:� five years of audited annual financial

statements;� the last several interim financial statements;

narrative descriptions of operations andproducts; and

� if available, a draft registration statementor offering memorandum, or equivalent.Apart from company-specific material, rele-

vant industry information also may be useful.While not mandatory, written presentationsby management often provide a valuableframework for the discussion. Such presenta-tions typically mirror the format of the meet-ing discussion, as outlined below. Where awritten presentation is prepared, it is particu-larly useful for Standard & Poor’s analyticalteam to be afforded the opportunity to reviewit in advance of the meeting. There is no needto try to anticipate all questions that mightarise. If additional information is necessary toclarify specific points, it can be provided sub-sequent to the meeting. In any case, our creditanalysts generally will have follow-up ques-tions that arise as the information covered atthe management meeting is further analyzed.

ConfidentialityA substantial portion of the information setforth in company presentations is highlysensitive and is provided by the issuer to

Standard & Poor’s solely for the purpose ofarriving at ratings. Such information is keptstrictly confidential by the ratings group.Even if the assigned rating is subsequentlymade public, any rationales or other infor-mation Standard & Poor’s publishes aboutthe company will refer only to publiclyavailable corporate information. It is not tobe used for any other purpose, nor by anythird party, including other Standard &Poor’s units. Standard & Poor’s maintains a“Chinese Wall” between its rating activitiesand its equity information services.

Conduct of MeetingThe following is an outline of the topics wetypically expect issuers to address in a man-agement meeting:� the industry environment and prospects;� an overview of major business segments,

including operating statistics and compar-isons with competitors and industry norms;

� management’s financial polices and finan-cial performance goals;

� distinctive accounting practices; � management’s projections, including

income and cash flow statements and bal-ance sheets, together with the underlyingmarket and operating assumptions;

� capital spending plans; and� financing alternatives and contingency

plans.It should be understood that Standard &

Poor’s ratings are not based on the issuer’sfinancial projections or management’s viewof what the future may hold. Rather, ratingsare based on our assessment of the compa-ny’s prospects. However, management’sfinancial projections are a valuable tool inthe rating process, because they indicatemanagement’s plans, how managementassesses the company’s challenges, and howit intends to deal with problems. Projectionsalso depict the company’s financial strategyin terms of anticipated reliance on internalcash flow or outside funds, and they helparticulate management’s financial objectivesand policies.

Management meetings with companies newto the rating process typically last two to fourhours—or longer if the company’s operationsare particularly complex. If the issuer is



domiciled in a country new to ratings or par-ticipates in a new industry, more time is usu-ally required. When, in addition, there aremajor accounting issues to be covered, meet-ings can last a full day or two. Short, formalpresentations by management may be usefulto introduce areas for discussion. Our prefer-ence is for meetings to be largely informal,with ample time allowed for questions andresponses. (At management meetings, as wellas at all other times, we welcome the compa-ny’s questions regarding our procedures,methodology, and analytical criteria.)

Rating CommitteeShortly after the issuer meeting, a rating com-mittee, normally consisting of five to sevenvoting members, is convened. A presentationis made by the industry analyst to the ratingcommittee, which has been provided withappropriate financial statistics and compara-tive analysis. The presentation follows themethodology outlined in the methodologysection of Corporate Ratings Criteria. Thus,it includes analysis of the nature of the com-pany’s business and its operating environ-ment; evaluation of the company’s strategicand financial management; financial analysis;and a rating recommendation. When a specif-ic issue is to be rated, there is an additionaldiscussion of the proposed issue and terms ofthe indenture.

Once the rating is determined, the compa-ny is notified of the rating and the major con-siderations supporting it. It is our policy toallow the issuer to respond to the rating deci-sion prior to its publication by presentingnew or additional data. Standard & Poor’sentertains appeals in the interest of havingavailable the most information possible and,thereby, the most accurate ratings. In the caseof a decision to change an extant rating, anyappeal must be conducted as expeditiously aspossible, i.e., within a day or two. The com-mittee reconvenes to consider the new infor-mation. After notifying the company, therating is disseminated via the media, orreleased to the company for dissemination inthe case of private placements or corporatecredit ratings.

In order to maintain the integrity andobjectivity of the rating process, Standard &

Poor’s internal deliberations and the identi-ties of those who sat on a rating committeeare kept confidential, and not disclosed tothe issuer.

SurveillanceCorporate ratings on publicly distributedissues are monitored for at least one year. Thecompany can then elect to pay Standard &Poor’s to continue surveillance. Ratingsassigned at the company’s request have theoption of surveillance, or being on a “point-in-time” basis. Surveillance is performed bythe same industry analysts who work on theassignment of the ratings. To facilitate sur-veillance, companies are requested to put theprimary analyst on mailing lists to receiveinterim and annual financial statements, pressreleases, and bank documents, including com-pliance certificates.

The primary analyst is in periodic tele-phone contact with the company to discussongoing performance and developments.Where these vary significantly from expecta-tions, or where a major, new financingtransaction is planned, an update manage-ment meeting is appropriate. We alsoencourage companies to discuss hypotheti-cally—again, in strict confidence—transac-tions that perhaps are only beingcontemplated (e.g., acquisitions, new financ-ings), and we endeavor to provide frankfeedback about the potential ratings impli-cations of such transactions.

In any event, management meetings rou-tinely are scheduled at least annually. Thesemeetings enable analysts to keep abreast ofmanagement’s view of current develop-ments, discuss business units that have per-formed differently from originalexpectations, and be apprised of changes inplans. As with initial management meetings,Standard & Poor’s willingly provides guid-ance in advance regarding areas it believeswarrant emphasis at the meeting. Typically,there is no need to dwell on basic informa-tion covered at the initial meeting.

Apart from discussing revised projections,it is often helpful to revisit the prior projec-tions and to discuss how actual performancevaried, and why.


A significant and increasing proportion ofmeetings with company officials takes placeon the company’s premises. There are severalreasons: to facilitate increased exposure tomanagement personnel—particularly at theoperating level; obtain a first-hand view ofcritical facilities; and achieve a better under-standing of the company by spending moretime reviewing the business units in depth.While we actively encourage meetings oncompany premises, time and scheduling con-straints on both sides dictate that arrange-ments for these meetings be made some timein advance.

Because the staff is organized by specialty,credit analysts typically meet each year withmost major companies in their assigned areato discuss the industry outlook, businessstrategy, and financial forecasts and poli-cies. This way, competitors’ forecasts ofmarket demand can be compared with oneanother, and we can assess implications ofcompetitors’ strategies for the entire indus-try. The credit analyst can judge manage-ment’s relative optimism regarding marketgrowth and relative aggressiveness inapproaching the marketplace.

Importantly, the analyst compares businessstrategies and financial plans over time andseeks to understand how and why theychanged. This exercise provides insights regard-ing management’s abilities with respect to fore-casting and implementing plans. By meetingwith different managements over the course ofa year and the same management year afteryear, analysts learn to distinguish between

those with thoughtful, realistic agendas andthose with wishful approaches.

Management credibility is achieved whenthe record demonstrates that a company’sactions are consistent with its plans andobjectives. Once earned, credibility can helpto support continuity of a particular ratinglevel, because Standard & Poor’s can relyon management to do what it says torestore creditworthiness when faced withfinancial stress or an important restructur-ing. The rating process benefits from theunique perspective on credibility gained byextensive evaluation of management plansand financial forecasts over many years.

Rating ChangesAs a result of the surveillance process, itsometimes becomes apparent that changingconditions require reconsideration of theoutstanding debt rating. When this occurs,the credit analyst undertakes a preliminaryreview, which may lead to a CreditWatchlisting. This is followed by a comprehensiveanalysis, communication with management,and a presentation to the rating committee.The rating committee evaluates the matter, arrives at a rating decision, andnotifies the company—after which Standard & Poor’s publishes the rating. The process is exactly the same as the rating of a new issue.

Reflecting this surveillance, the timing ofrating changes depends neither on the saleof new debt issues nor on our internalschedule for reviews. ■



Credit ratings often are identified with finan-cial analysis, and especially ratios. But it iscritical to realize that ratings analysis startswith the assessment of the business and com-petitive profile of the company. Two compa-nies with identical financial metrics are ratedvery differently, to the extent that their busi-ness challenges and prospects differ.

Standard & Poor’s developed the matricesshown below to make explicit the rating out-comes that are typical for various businessrisk/financial risk combinations.

Business Risk/Financial Risk Matrix Table 1 illustrates the relationship of businessand financial risk profiles to the issuer creditrating. Table 2 shows the financial risk ratiosfor industrial companies.

How can one use the matrices to betterunderstand rating conclusions? Here is one illustration:

Company ABC is deemed to have a ‘satisfac-tory’ business risk profile. (It is typical, in thatrespect, of investment-grade industrial corpo-rates—what we previously labeled ‘average’.)

If ABC’s financial risk were ‘intermediate’,the expected rating assignment should be‘BBB’. The table of indicative ratios can beused as a simple starting point. ABC’s ratios

of cash flow to debt of 35% and debt lever-age of 40% are characteristic of ‘intermedi-ate’ financial risk. In reality, of course, theassessment of financial risk is not so simplis-tic! It encompasses financial policies and risktolerance; several perspectives on cash flowadequacy, including free cash flow and thedegree of flexibility regarding capital expen-ditures; and various measures of liquidity,including coverage of short-term maturities.

Company ABC can aspire to beingupgraded to the ‘A’ category, by reducing itsdebt burden to the point that cash flow todebt is over 60% and debt leverage is only25%. Conversely, ABC may choose tobecome more financially aggressive—say, toreward shareholders by borrowing to repur-chase shares. It can expect to be rated in the‘BB’ category if its cash flow to debt ratio is20% and debt leverage remains below 55%,and there is a commitment to keepingfinances at these levels.

The rating outcomes indicated are notmeant to be precise. There can always besmall positives and negatives that wouldlead to a notch higher or lower than thetypical outcomes. Moreover, there willalways be exceptions—cases that do not fitneatly into this analytical framework: Forexample, liquidity concerns or litigationcould pose overarching risks.

Rating Methodology: Industrials & Utilities

Standard & Poor’s uses a format that divides the analytical

task, so that all salient issues are considered. The framework

we use looks first at fundamental business analysis; then comes

financial analysis.


The matrix does not address the lowestrungs of the credit spectrum, i.e., the ‘CCC’category and below. Those ratings alwaysreflect some impending crisis or extraordi-nary vulnerability. The balanced approachthat underlies the matrix framework just doesnot work well for such situations.

Standard & Poor’s strives for transparencyaround the rating process. It should be appar-ent, however, that the ratings process cannotbe entirely reduced to a cookbook approach:Ratings incorporate many subjective judg-ments, and remain as much an art as a science.

Corporate credit analysis factors.There are several categories underlying boththe business and financial risk assessments.These can vary by industry, in order to focuson the most relevant factors.

Business risk � Country risk� Industry characteristics� Company position� Product portfolio/Marketing� Technology� Cost efficiency� Strategic and operational management

competence� Profitability/Peer group comparisons

Financial risk� Accounting� Corporate governance/Risk

tolerance/Financial policies� Cash-flow adequacy� Capital Structure/Asset Protection� Liquidity/Short-term factors

Industry riskEach rating analysis begins with an assess-ment of the company’s environment. Thedegree of operating risk facing a participantin a given business depends on the dynamicsof that business. This analysis focuses on thestrength of industry prospects, as well as thecompetitive factors affecting that industry.

The many factors assessed include industryprospects for growth, stability, or decline,and the pattern of business cycles (see“Cyclicality”). It is critical, for example, todetermine vulnerability to technologicalchange, labor unrest, or regulatory interfer-ence. Industries that have long lead times orthat require fixed plant of a specializednature face heightened risk. The implicationsof increasing competition obviously are cru-cial. Standard & Poor’s knowledge of invest-ment plans of the major players in anyindustry offers a unique vantage point fromwhich to assess competitive prospects.

While any particular profile category canbe the overriding rating consideration, theindustry risk assessment can be a key factorin determining the rating to which any par-ticipant in the industry can aspire. It wouldbe hard to imagine assigning ‘AA’ and ‘AAA’debt ratings to companies with extensiveparticipation in industries of above-averagerisk, regardless of how conservative theirfinancial posture. Examples of these indus-tries are integrated steel makers, tire andrubber companies, home-builders, and mostof the mining sector.

Conversely, some industries are regardedfavorably. They are distinguished by suchtraits as steady demand growth, ability tomaintain margins without impairing future

Rating Methodology

Table 1—Business Risk/Financial Risk

Financial Risk Profile

Business Risk Profile Minimal Modest Intermediate Aggressive Highly Leveraged

Excellent AAA AA A BBB BB

Strong AA A A- BBB- BB-

Satisfactory A BBB+ BBB BB+ B+

Weak BBB BBB- BB+ BB- B

Vulnerable BB B+ B+ B B-


prospects, flexibility in the timing of capitaloutlays, and moderate capital intensity.Industries possessing one or more of theseattributes include manufacturers of brandedconsumer products, drug companies, andpublishing and broadcasting. High marks inthis category do not translate into high rat-ings for all industry participants, but thecushion of strong industry fundamentals pro-vides helpful support.

Again, the industry risk assessment sets thestage for analyzing specific company risk fac-tors and establishing the priority of these fac-tors in the overall evaluation. For example, iftechnology is a critical competitive factor,R&D prowess is stressed. If the industry pro-duces a commodity, cost of productionassumes major importance.

Keys to successAs part of the industry analysis, key ratingfactors are identified: the keys to successand areas of vulnerability. A company’s rat-ing is, of course, crucially affected by itsability to achieve success and avoid pitfallsin its business.

The nature of competition is, obviously,different for different industries. Competitioncan be based on price, quality of product,distribution capabilities, image, product dif-ferentiation, service, or some other factor.Competition may be on a national basis, as isthe case with major appliances. In otherindustries, such as chemicals, competition isglobal, and in still others, such as cement,competition is strictly regional. The basis forcompetition determines which factors areanalyzed for a given company.

For any particular company, one or morefactors can hold special significance, even ifthat factor is not common to the industry.For example, the fact that a company hasonly one major production facility normallyis regarded as an area of vulnerability.Similarly, reliance on one product createsrisk, even if the product is highly successful.For example, a pharmaceutical company hasreaped a financial bonanza from just twomedications. The company’s debt is reason-ably highly rated, given its exceptional profitsand cash flow, but it would be viewed stillmore favorably were it not for the depend-ence on only two drugs (which are, after all,subject to competition and patent expiration).

Diversification factorsWhen a company participates in more thanone business, each segment is separately ana-lyzed. A composite is formed from thesebuilding blocks, weighting each elementaccording to its importance to the overallorganization. The potential benefits of diver-sification, which may not be apparent fromthe additive approach, are then considered.

A truly diversified company will not havea single business segment that is dominant.One major automobile company receivedmuch attention for “diversifying” into aero-space and computer processing. But it neverbecame a diversified company, because itssuccess was still determined substantially byone line of business.

Limited credit is given if the various linesof business react similarly to economic cycles.For example, diversification from nickel intocopper cannot be expected to stabilize per-

Table 2—Financial Risk Indicative Ratios*

Cash flow (Funds from operations/Debt) (%) Debt leverage (Total debt/Capital) (%)

Minimal Over 60 Below 25

Modest 45-60 25-35

Intermediate 30-45 35-45

Aggressive 15-30 45-55

Highly leveraged Below 15 Over 55

* Fully adjusted, historically demonstrated, and expected to consistently continue

Rating Methodology


formance; similar risk factors are associatedwith both metals.

Most critical is a company’s ability to man-age diverse operations. The skills and prac-tices needed to run a business differ greatlyamong industries, not to mention the chal-lenge posed by participation in several differ-ent industries. For example, a number ofold-line industrial companies rushed to diver-sify into financial services, only to find them-selves saddled with unfamiliar businesses theyhad difficulty managing.

Some companies have adopted a portfolioapproach to their diverse holdings. The busi-ness of buying and selling businesses is differ-ent from running operations and is analyzeddifferently. The ever-changing character of thecompany’s assets typically is viewed as a neg-ative. On the other hand, there is often anoffsetting advantage: greater flexibility inraising funds if each line of business is a dis-crete unit that can be sold off.

Size considerationsStandard & Poor’s has no minimum size cri-terion for any given rating level. However,size turns out to be significantly correlated toratings. The reason: size often provides ameasure of diversification, and/or affectscompetitive position.

Small companies also can possess the com-petitive benefits of a dominant market posi-tion, although that is not common. Obviously,the need to have a broad product line or anational marketing structure is a factor inmany businesses and would be a rating con-sideration. In this sense, sheer mass is notimportant; demonstrable market advantage is.

Market-share analysis often providesimportant insights. However, large sharesare not always synonymous with competitiveadvantage or industry dominance. Forinstance, if an industry has a number oflarge but comparably sized participants,none may have a particular advantage ordisadvantage. Conversely, if an industry ishighly fragmented, even the large companiesmay lack pricing leadership potential. Thetextile industry is an example.

Small companies are, almost by definition,more concentrated in terms of product, num-ber of customers, or geography. In effect, they

lack some elements of diversification that canbenefit larger companies. To the extent thatmarkets and regional economies change, abroader scope of business affords protection.This consideration is balanced against the per-formance and prospects of a given business.

In addition, lack of financial flexibility isusually an important negative factor in the caseof very small companies. Adverse develop-ments that would simply be a setback for com-panies with greater resources could spell theend for companies with limited access to funds.

There is a controversial notion that small,growth-oriented companies represent a bettercredit risk than older, declining companies.While this is intuitively appealing to some, itignores some important considerations. Largecompanies have substantial staying power,even if their businesses are troubled. Theirconstituencies—including large numbers ofemployees—can influence their fates. Banks’exposure to these companies may be quiteextensive, creating a reluctance to abandonthem. Moreover, such companies often haveaccumulated a lot of peripheral assets thatcan be sold. In contrast, the promise of smallcompanies can fade very quickly and theirminuscule equity bases will offer scant pro-tection, especially given the high debt burdensome companies deliberately assume.

Fast growth often is subject to poor execu-tion, even if the idea is well conceived. Therealso is the risk of overambition. Moreover,some companies tend to continue high-riskfinancial policies as they aggressively pursueever-greater objectives, limiting any credit-quality improvement. There is little evidenceto suggest growth companies initially receiv-ing speculative-grade ratings have particularupgrade potential. Many more defaulted overtime than achieved investment grade. Oilexploration, retail, and high technology com-panies especially have been vulnerable, eventhough their great potential was touted at thetime they first came to market.

Management evaluationManagement is assessed for its role in deter-mining operational success and also for itsrisk tolerance. The first aspect is incorporatedin the business-risk analysis; the second isweighed as a financial policy factor.


Subjective judgments help determine eachaspect of management evaluation. Opinionsformed during the meetings with senior man-agement are as important as management’strack record. While a track record may seemto offer a more objective basis for evalua-tion, it often is difficult to determine howresults should be attributed to management’sskills. The analyst must decide to whatextent they are the result of good manage-ment; devoid of management influence; orachieved despite management.

Plans and policies are judged for their real-ism. How they are implemented determinesthe view of management consistency andcredibility. Stated policies often are not fol-lowed, and the ratings may reflect skepticismuntil management has established credibility.Credibility can become a critical issue whena company is faced with stress or restructur-ing, and the analyst must decide whether torely on management to carry out plans forrestoring creditworthiness.

Other organizational/corporate culture considerationsStandard & Poor’s evaluation is sensitive topotential organizational problems. Theseinclude situations where:� The company has a highly aggressive

business model, e.g., growing throughlarge acquisitions or expansion intounproven markets;

� The company has made frequent and sig-nificant changes to its strategy;

� The company has a history of retrenchmentand restructuring;

� There is significant organizational relianceon an individual, especially one who maybe nearing retirement;

� The transition from entrepreneurial or fam-ily-bound to professional management hasyet to be accomplished;

� Management compensation is excessive or poorly aligned with the interests ofstakeholders;

� There is excessive management turnover;� The company is involved in legal, regulato-

ry, or tax disputes to a significantly greaterextent than its peers;

� The company has an excessively complexlegal structure, perhaps employing intricateoff-balance-sheet structures;

� The relationship between organizationalstructure and management strategy is unclear;

� Shareholders impose constraints on man-agement prerogatives;

� The finance function and finance consider-ations do not receive high organizationalrecognition;

� The company is particularly aggressive inthe application of accounting standards, ordemonstrates a lack of opaqueness in itsfinancial reporting (see also “AccountingCharacteristics,” below), and;

� Management’s financial policy is exception-ally aggressive, as evidenced by heavy debtusage or a history of aggressive actions todirectly reward shareholders (see also“Financial Policy,” below).(See also “The Evolving Role of Corporate

Governance in Credit Rating Analysis.”)

Measuring performance and riskHaving evaluated the issuer’s competitiveposition and operating environment, theanalysis proceeds to several financial cate-gories. To reiterate: the company’s business-risk profile determines the level of financialrisk appropriate for any rating category.

Financial risk is portrayed largely throughquantitative means, particularly by usingfinancial ratios. Profitability benchmarksvary greatly by industry, but broad meas-ures of financial risk are correlated to thecompany’s level of business risk (whichincorporates both the industry and positionwithin the industry).

Several analytical adjustments typicallyare required to calculate ratios for an individual company. Cross-border compar-isons require additional care, given the dif-ferences in accounting conventions andlocal financial systems.

Accounting characteristics and information riskFinancial statements (and related disclosures)serve as our primary source of informationregarding the financial condition and finan-cial performance of industrial or utility com-

Rating Methodology


panies. The analysis of financial statementsbegins with a review of accounting character-istics. The purpose is to determine whetherratios and statistics derived from the state-ments can be used appropriately to measure acompany’s performance and position relativeto both its direct peer group and the largeruniverse of corporates. The rating process is,in part, one of comparisons, so it is impor-tant to have a common frame of reference.

The starting point of accounting qualityanalysis is an understanding of differentnational and international accounting frame-works, as these vary widely. Recent moves toadopt International Financial ReportingStandards (IFRS) in many countries—includ-ing Australia, Canada, and across theEuropean Union—as well as an ongoingeffort to effect convergence between U.S.GAAP and IFRS, ultimately could enhancecomparability among companies. However,this ought not be seen as a panacea. WithinIFRS, just as within the separate nationalaccounting systems, companies are calledupon to chose among numerous alternativemethods—for example, cost as opposed tofair-value methods—and the resulting differ-ences can have a significant effect on compa-rability among peers. In addition, even inapplying the same methods within the sameaccounting frameworks, companies showvarying degrees of aggressiveness in theunderlying estimates and judgments theyemploy. Moreover, the carrying value ofassets can be greatly influenced by the histori-cal development of a company—for example,whether it has grown primarily through inter-nal development or through acquisitions, orwhether it previously underwent a leveragedbuyout or bankruptcy reorganization—andthis also affects many of the quantitativemeasures employed in financial analysis.

Some of the accounting issues to bereviewed include:� Consolidation basis. The accounting

approach to consolidation may differ fromhow we define the economic entity for ana-lytical purposes.

� Revenue and expense recognition. Forexample, percentage of completion com-pared with completed contract in the con-struction industry;

� Cash and investments. For example, areinvestments valued at cost or market?

� Receivables—trade and finance. For exam-ple, how conservative are loss provisions?

� Inventory valuation methods. For example,FIFO or LIFO;

� Fixed assets—including depreciation meth-ods and asset lives;

� Intangible assets, including treatment ofgoodwill;

� Postretirement benefits obligations (see dis-cussion in the “Criteria Topics” section);

� Other liabilities and contingent obligations,recognized on the balance sheet and other-wise, such as operating leases, environmen-tal liabilities, asset retirement obligations,guarantees, litigation;

� Derivatives and hedges;� Foreign currency;� Inflation accounting;� Cash-flow matters. For example, to what

extent are R&D and interest costsexpensed rather than capitalized? To whatextent is operating cash flow affected bynonrecurring items?

� Segment reporting. How are segmentsdefined, and how are transfer prices fortransactions between segments determined?To the extent possible, analytical adjust-

ments are made to better portray reality andto level the differences among companies.Although it is rarely possible to completelyrecast a company’s financial statements, it isimportant to at least have some notion of theextent to which different financial measuresare overstated or understated. Apart from itsimportance to the quantitative aspects of theanalysis, conclusions regarding accountingcharacteristics and financial transparency canalso influence qualitative aspects of theanalysis, such as the assessment of manage-ment, including financial policy and internalinformation systems.

As part of its surveillance process,Standard & Poor’s closely monitors thepotential impact of pending changes inaccounting standards. Such changes do nothave any direct impact on credit quality;however, accounting changes may reveal newinformation about a company—informationthat then needs to be factored into ourunderstanding of the company. For example,


the ratings for a few U.S. companies werelowered following the implementation ofnew accounting for retiree medical liabilitiesin the early 1990s, because little informationpreviously was available about these obliga-tions. It also is possible accounting changescould trigger financial covenant violations orregulatory or tax consequences, and couldeven influence changes in business behavior,such as a change in hedging policy.

Standard & Poor’s typically relies on audit-ed financial statements, and does not view itsrole as “auditing the auditors.” However, arating can sometimes be assigned even in theabsence of audited statements. This especiallyis the case when a new company is formedfrom a division of another company that didproduce audited financials. In other cases,there may be unaudited physical data—suchas oil-production data—that corroboratescompany results. In any event, to the extent“information risk” exists, it can influence thelevel of the rating assigned. In cases wherethe information uncertainty is so significantthat it precludes a meaningful analysis, wewould decline to assign a rating.

An increasing number of companies arefaced with the finding of accounting andfinancial reporting irregularities of varioustypes. Their auditors may identify “materialweakness” in the accounting systems. Actualmistakes—or even fraud—may have beenuncovered. The SEC or other regulatoryagencies may order “formal” or “informal”investigations of the accuracy and/or adequa-cy of financial reporting. In many instances,there is no way for us to immediately knowhow serious any of these troubling events willturn out to be. The underlying reality canrange from an almost trivial problem to com-plete audit and financial failure. (And, occa-sionally, a small problem can turn into alarge one, as “headline risk” takes a toll onthe company’s access to financing.)

Standards & Poor’s seeks to assess thepotential ramifications, possibly through fur-ther discussions with management, in-houseor external legal counsel, auditors, independ-ent members of the board and the audit com-mittee. However, in some such cases, detailedinformation may not be available for sometime, and we will react, if necessary, based on

the best available information, throughCreditWatch actions, intermediate ratingchanges or in extreme cases with the suspen-sion or withdrawal of the ratings.

Financial policyStandard & Poor’s attaches great importanceto management’s philosophies and policiesinvolving financial risk. A surprising numberof companies have not given this questionserious thought, much less reached strongconclusions. For many others, debt leverage(calculated without any adjustment to report-ed figures) is the only focal point of such pol-icy considerations. More sophisticatedbusiness managers have thoughtful policiesthat recognize cash-flow parameters and theinterplay between business and financial risk.

Even companies that have set goals may nothave the wherewithal, discipline, or manage-ment commitment to achieve these objectives.A company’s leverage goals, for example,need to be viewed in the context of its pastrecord and the financial dynamics affectingthe business. If management states, as manydo, that its goal is to operate with a 35%debt-to-capital ratio, we factor that into ouranalysis only to the extent it appears plausi-ble. For example, if a company has aggressivespending plans, that 35% goal would carrylittle weight, unless management has commit-ted to a specific program of asset sales, equitysales, or other actions that in a given timeperiod would produce the desired results.

Standard & Poor’s does not encouragecompanies to manage themselves with an eyetoward a specific rating. The more appropri-ate approach is to operate for the good of thebusiness as management sees it, and let therating follow. Certainly, prudence and creditquality should be among the most importantconsiderations, but financial policy should beconsistent with the needs of the businessrather than an arbitrary constraint.

If opportunities are foregone merely toavoid financial risk, the company is makingpoor strategic decisions. In fact, it may besacrificing long-term credit quality for thefacade of low risk in the near term. Onefinancial article described a company thatcurtailed spending expressly “to become an‘A’-rated company.” As a result, “...the

Rating Methodology


company’s business responded poorly to anincrease in market demand. Needless to say,the sought-after ‘A’ rating continued toelude the company.”

In any event, pursuit of the highest ratingattainable is not necessarily in the company’sbest interests. ‘AAA’ may be the highest rat-ing, but that does not suggest that it is the“best” rating. Typically, a company with vir-tually no financial risk is not optimal as faras meeting the needs of its various constituen-cies. An underleveraged company is not mini-mizing its cost of capital, thereby deprivingits owners of potentially greater value fortheir investment. In this light, a corporateobjective of having its debt rated ‘AAA’ or‘AA’ is at times suspect. Whatever a compa-ny’s financial track record, an analyst mustbe skeptical if corporate goals are implicitlyirrational. A company’s “conservative finan-cial philosophy” must be consistent with itsoverall goals and needs.

Profitability and coverageProfit potential is a critical determinant ofcredit protection. A company that generateshigher operating margins and returns oncapital has a greater ability to generate equi-ty capital internally, attract capital external-ly, and withstand business adversity.Earnings power ultimately attests to thevalue of the company’s assets, as well. Infact, a company’s profit performance offersa litmus test of its fundamental health andcompetitive position. Accordingly, the con-clusions about profitability should confirmthe assessment of business risk.

The more significant measures of prof-itability are:� Pretax, pre-interest return on capital;� Operating income as a percentage of

sales; and� Earnings on business segment assets.

While the absolute levels of ratios areimportant, it is equally important to focus ontrends and compare these ratios with those ofcompetitors. Various industries follow differ-ent cycles and have different earnings charac-teristics. Therefore, what may be consideredfavorable for one business may be relativelypoor for another. For example, the drugindustry usually generates high operating

margins and high returns on capital. Defensecontractors generate low operating margins,but high returns on capital. The pipelineindustry has high operating margins and lowreturns on capital. Comparisons with a com-pany’s peers influence our perception of itscompetitive strengths and pricing flexibility.

The analysis proceeds from historical per-formance to projected profitability. Because arating is an assessment of the likelihood oftimely payments in the future, the evaluationemphasizes future performance. However,the rating analysis does not attempt to fore-cast performance precisely or to pinpointeconomic cycles. Rather, the forecast analysisconsiders variability of expected future per-formance based on a range of economic andcompetitive scenarios.

Particularly important are management’splans for achieving earnings growth. Canexisting businesses provide satisfactorygrowth, especially in a low-inflation envi-ronment, and to what extent are acquisitionsor divestitures necessary to achieve corpo-rate goals? At first glance, a mature, cash-generating company offers a great deal ofbondholder protection, but Standard &Poor’s assumes a corporation’s central focusis to augment shareholder value over thelong run. In this context, a lack of indicatedearnings growth potential is considered aweakness. By itself this may hinder a compa-ny’s ability to attract financial and humanresources. Moreover, limited internal earn-ings growth opportunities may lead manage-ment to pursue growth externally, implyinggreater business and financial risks.

Earnings also are viewed in relation to acompany’s burden of fixed charges. Suchratios link profit performance with purefinancing considerations, such as aggressive-ness of debt usage. The two primary fixed-charge coverage ratios are:� Earnings before interest and taxes (EBIT)

coverage of interest; and� Earnings before interest and taxes and rent

(EBITR) coverage of interest plus total rents.If preferred stock is outstanding and mate-

rial, coverage ratios are calculated bothincluding and excluding preferred dividends,to reflect the company’s discretion over pay-ing the dividend when under stress. Similarly,


if interest payments can be deferred, adjust-ments to the calculation help capture thecompany’s flexibility in making payments.

To reflect more accurately the ongoingearnings power of the company, reportedprofit figures are adjusted. These adjustmentsremove the effect of foreign-exchange gainsand losses; litigation reserves; writedownsand other nonrecurring or extra-ordinarygains and losses; and unremitted equity earn-ings of a subsidiary.

In some countries it is not uncommon forindustrial companies to establish their treas-ury operations as a profit center. In Japan, forexample, the term “zaiteku financing” refersto the practice of generating profits througharbitrage and other financial-market transac-tions. If financial position-taking is a materialpart of a company’s aggregate earnings,Standard & Poor’s segregates those earningsto assess the profitability of the core business.We also may view with skepticism the abilityto realize such profits on a sustained basisand may treat them like nonrecurring gains.

Similarly, there are numerous analyticaladjustments to the interest amounts. Interestthat has been capitalized is added back. Aninterest component is computed for debtequivalents such as operating leases andreceivable sales. Amounts may be subtractedto recognize the impact of borrowings inhyperinflationary environments or borrowingsto support cash investments as part of a taxarbitrage strategy. And interest associatedwith finance operations is segregated in accor-dance with the methodology spelled out in“Finance Subsidiaries’ Rating Link to Parent”.

Earnings differencesShareholder pressures and accounting stan-dards in certain countries—such as the U.S.—can result in companies seeking to maximizeprofits on a quarter-to-quarter or short-termbasis. In other regions—aided by local taxregulation—it is normal practice to take pro-visions against earnings in good times to pro-vide a cushion against downturns, resultingin a long-run “smoothing” of reported prof-its. Given local accounting standards, it is notrare to see a Swiss or German companyvaguely report “other income” or “otherexpenses”—largely provisions or provision

reversals—as the largest line items in a profitand loss account. In meetings with manage-ment, Standard & Poor’s discusses provision-ing and depreciation practices to see to whatextent a company employs noncash chargesto reduce or bolster earnings.

Capital structure/leverage and asset protectionRatios employed by Standard & Poor’s tocapture the degree of leverage used by a com-pany include:� Total debt/total debt + equity;� Total debt + off-balance-sheet

liabilities/total debt + off-balance-sheet lia-bilities + equity; and

� Total debt/total debt + market value of equity.Traditional measures focusing on long-

term debt have lost much of their signifi-cance, because companies rely increasinglyon short-term borrowings. It is now com-monplace to find permanent layers of short-term debt, which finance not only seasonalworking capital but also an ongoing portionof the asset base.

In many countries, notably in Japan andEurope, local practice is to maintain a highlevel of debt while holding a large portfolioof cash and marketable securities. Manycompanies manage their finances on a “net-debt” basis. In these situations, we focus onnet debt to capital—and, similarly, net inter-est coverage, and cash flow to net debt.When a company consistently demonstratessuch excess liquidity, debt leverage is calcu-lated by netting out excess liquidity fromshort-term borrowings. Each situation is ana-lyzed on a case-by-case basis, subject to addi-tional information regarding a company’sliquidity position, normal working cashneeds, nature of short-term borrowings, andfunding philosophy. Funds earmarked forfuture use, such as an acquisition or a capitalproject, are not netted out. This approachalso is used, for example, in the case of cash-rich U.S. pharmaceutical companies thatenjoy tax arbitrage opportunities withrespect to these cash holdings.

What is considered “debt” and “equity”for the purpose of ratio calculation is notalways so simple (See “Equity Credit: What

Rating Methodology


It Is, And How To Get It”). In the case ofhybrid securities, the analysis is based ontheir features—not the accounting or thenomenclature. Pension and retiree healthobligations are similar to debt in manyrespects. Their treatment is explained in“Postretirement Obligations.”

Indeed, not all subtleties and complexitieslend themselves to ratio analysis. Original-issue discount debt, such as zero coupondebt, is included at the accreted value.However, since there is no sinking fund pro-vision, the debt increases with time, creatinga moving target. (The need, eventually, torefinance this growing amount representsanother risk.) In the case of convertible debt,it is somewhat presumptuous to predictwhether and when conversion will occur,making it difficult to reflect the real risk pro-file in ratio form.

A company’s asset mix is a critical determi-nant of the appropriate leverage for a givenlevel of risk. Assets with stable cash flow ormarket values justify greater use of debtfinancing than those with clouded mar-ketability. For example, grain or tobaccoinventory would be viewed positively, com-pared with apparel or electronics inventory;transportation equipment is viewed morefavorably than other equipment, given itssuitability for use by other companies.

Accordingly, we believe it is critical to ana-lyze each type of business and asset class in itsown right. While FASB and IAS now requireconsolidation of nonhomogenous businessunits, we analyze each separately. This is thebasis for our methodology for analyzing cap-tive finance companies (See “FinanceSubsidiaries’ Rating Link to the Parent”).

Asset valuationKnowing the true values to assign a compa-ny’s assets is key to the analysis. Leverage asreported in the financial statements is mean-ingless if the assets’ book values are material-ly undervalued or overvalued relative toeconomic value. Standard & Poor’s considersthe profitability of an asset as an appropriatebasis for determining its economic value.Market values of a company’s assets or inde-pendent asset appraisals can offer additionalinsights. However, there are shortcomings in

these methods of valuation (just as there arewith historical cost accounting) that preventreliance on any single measure. Similarly,ratios using the market value of a company’sequity in calculations of leverage are givenlimited weight as analytical tools. The stockmarket emphasizes growth prospects and hasa short time horizon; it is influenced bychanges in alternative investment opportuni-ties and can be very volatile. A company’sability to service its debt is not affecteddirectly by such factors.

The analytical challenge of which values touse is especially evident in the case of mergedand acquired companies. Accounting stan-dards allow the acquired company’s assetsand equity to be written up to reflect theacquisition price, but the revalued assets havethe same earning power as before; they can-not support more debt just because a differ-ent number is used to record their value.Right after the transaction, the analysis cantake these factors into account, but down theroad the picture becomes muddied. Weattempt to normalize for purchase account-ing, but the ability to relate to pre-acquisitionfinancial statements and to make compar-isons with peer companies is limited.

Presence of a material goodwill accountindicates the impact of acquisitions and pur-chase accounting on a company’s equitybase. Intangible assets are no less “valu-able” than tangible ones. But comparisonsare still distorted, because other companiescannot record their own valuable businessintangibles, i.e., those that have been devel-oped, rather than acquired. This alonerequires some analytical adjustment whenmeasuring leverage. In addition, analysts areentitled to be more skeptical about earningprospects that rely on turnaround strategiesor “synergistic” mergers.

Off-balance-sheet financingAnalysis of liabilities is not limited to thoseshown on the company’s balance sheet. Off-balance-sheet items factored into the leverageanalysis include:� Operating leases;� Guarantees, debt of joint ventures, and

unconsolidated subsidiaries;


� Take-or-pay contracts and obligations underthroughput and deficiency agreements;

� Receivables that have been factored, trans-ferred, or securitized; and

� Contingent liabilities, such as potentiallegal judgments or lawsuit settlements.Various methodologies are used to deter-

mine the proper adjustment value for eachoff-balance-sheet item. In some cases, theadjustment is straightforward. For example,the amount of guaranteed debt can simplybe added to the guarantor’s liabilities toreflect the potential burden of this contin-gent liability. Other adjustments are morecomplex or less precise.

Nonrecourse debt of a joint venture maybe attributed to the parent companies, espe-cially if they have a strategic tie to the opera-tion. The analysis may burden one parentwith a disproportionate amount of the debt ifthat parent has the greater strategic interestor operating control or its ability to servicethe joint-venture debt is greater. Other con-siderations that affect a company’s willing-ness to walk away from such debt—andother nonrecourse debt—include sharedbanking relationships and common countrylocation. In some instances, the debt may beso large in relation to the owner’s investmentthat the incentives to support the debt areminimized. In virtually all cases, however, theparent likely would invest additional amountsbefore deciding to abandon the venture.Accordingly, adjustments would be made toreflect the owner’s current and projectedinvestment, even if the venture’s debt werenot added to the parent’s balance sheet.

In the case of contingencies, estimates aredeveloped. Insurance coverage is estimated,and a present value is calculated if the pay-ments will stretch over many years. Theresulting amount is viewed as a corporate lia-bility from an analytical perspective. The saleor securitization of accounts receivable repre-sents a form of off-balance-sheet financing(i.e, whenever such assets continue to be gen-erated on an onging basis for the company).If proceeds are used to reduce other debt, theimpact on credit quality is neutral. (There canbe some incremental benefit to the extent thatthe company has expanded access to capital,and this financing may be lower in cost.

However, there may also be an offset in thehigher cost of unsecured financing.) For ratiocalculations, Standard & Poor’s adds backthe amount of receivables and a like amountof debt. This eliminates the distorting, cos-metic effect of using an off-balance-sheettechnique and allows better comparison withother companies that have chosen otheravenues of financing. Similarly, if a companyuses proceeds from receivables sales to investin riskier assets—and not to reduce otherdebt—the adjustment will reveal this increasein financial risk.

The debt-equivalent value of operatingleases is determined by calculating the presentvalue of minimum operating lease obligationsas reported in the annual report’s footnotes.The lease amount beyond five years isassumed to mature at a rate approximatingthe minimum payment due in year five.

The variety of lease types may require theanalyst to obtain additional information oruse estimates to evaluate lease obligations.This is needed whenever lease terms areshorter than the assets’ expected economiclives. For example, retailers report only thefirst period of a lease written with an initialperiod and several renewal options over along term. Another limitation develops whena portion of the lease payment is contingent,e.g., a percentage of sales, as is often the casein the retailing industry.

(Traditionally, operating leases were rec-ognized by the “factor method”: annuallease expense is multiplied by a factor thatreflects the average life of the company’sleased assets. This method is an attempt tocapitalize the asset, rather than just the useof the asset for the lease period. However,the method can overstate the asset to becapitalized by failing to recognize asset useover the course of the lease. It also is tooarbitrary to be realistic.)

Preferred stockPreferred stocks can qualify for treatment asequity or be viewed as debt—or somethingbetween debt and equity—depending on theirfeatures and the circumstances. The degree ofequity credit for various preferreds is dis-cussed in “Equity Credit.” Preferred stockswith a maturity receive diminishing equity

Rating Methodology


credit as they progress toward maturity. Inthe same vein, sinking-fund preferreds are lessequity-like. The sinking fund requirementsthemselves are of a fixed, debt-like nature.Moreover, they usually are met through debtissuance, which results in the sinking-fundpreferred being just the precursor of debt. Itwould be misleading to view sinking-fundpreferreds—particularly that portion comingdue in the near to intermediate term—asequity, only to have each payment convert todebt on the sinking fund’s payment date.

A preferred that may eventually be refi-nanced with debt is viewed as a debt equiva-lent, not equity, all along. Auctionpreferreds, for example, are “perpetual” onthe surface. However, they often representmerely a temporary debt alternative for com-panies that are not current taxpayers—untilthey once again can benefit from taxdeductibility of interest expense. Moreover,the holders of these preferreds would pres-sure for a redemption in the event of a failedauction or even a rating downgrade.

Redeemable preferred stock issues mayalso be refinanced with debt once an issuerbecomes a taxpayer. Preferreds that can beexchanged for debt at the company’s optionalso may be viewed as debt in anticipationof the exchange. However, the analysis alsowould take into account offsetting positivesassociated with the change in tax status.Often the trigger prompting an exchange orredemption would be improved profitability.Then, the added debt in the capital struc-ture would not necessarily imply lowercredit quality. The implications are differentfor many issuers that do not pay taxes forvarious other reasons, including availabilityof tax-loss carry-forwards or foreign taxcredits. For them, a change in taxpayingstatus is not associated with better prof-itability, while the incentive to turn the pre-ferred into debt is identical.

Cash-flow adequacyInterest or principal payments cannot be serv-iced out of earnings, which is just an account-ing concept; payment has to be made withcash. Although there usually is a strong rela-tionship between cash flow and profitability,many transactions and accounting entries

affect one and not the other. Analysis of cash-flow patterns can reveal a level of debt-servic-ing capability that is either stronger or weakerthan might be apparent from earnings.

Cash-flow analysis is the single most criticalaspect of all credit rating decisions. It takes onadded importance for speculative-gradeissuers. While companies with investment-grade ratings generally have ready access toexternal financing to cover temporary cashshortfalls, junk-bond issuers lack this degreeof flexibility and have fewer alternatives tointernally generated cash for servicing debt.

Cash-flow ratiosRatios show the relationship of cash flow todebt and debt service, and also to the com-pany’s needs. Because there are calls on cashother than repaying debt, it is important toknow the extent to which those require-ments will allow cash to be used for debtservice or, alternatively, lead to greater needfor borrowing.

Some of the specific ratios considered are:� Funds from operations/total debt (adjusted

for off-balance-sheet liabilities);� Debt/EBITDA;� EBITDA/interest;� Free operating cash flow + interest/interest;� Free operating cash flow + interest/interest

+ annual principal repayment obligation(debt-service coverage);

� Total debt/discretionary cash flow (debtpayback period);

� Funds from operations/capital spendingrequirements, and

� Capital expenditures/capital maintenance.Where long-term viability is more assured

(i.e., higher in the rating spectrum) there canbe greater emphasis on the level of fundsfrom operations and its relation to total debtburden. These measures clearly differentiatebetween levels of protection over time.Focusing on debt service coverage and freecash flow becomes more critical in theanalysis of a weaker company. Speculative-grade issuers typically face near-term vulner-abilities, which are better measured by freecash flow ratios.

Interpretation of these ratios is not alwaysstraightforward; higher values can sometimesindicate problems rather than strength. A


company serving a low-growth or decliningmarket may exhibit relatively strong free cashflow, because of minimal fixed and workingcapital needs. Growth companies, in compar-ison, often exhibit thin or even negative freecash flow because investment is needed tosupport growth. For the low-growth compa-ny, credit analysis weighs the positives ofstrong current cash flow against the dangerthat this high level of protection might not besustainable. For the high-growth company,the problem is just the opposite: weighing thenegatives of a current cash deficit againstprospects of enhanced protection once cur-rent investment begins yielding cash benefits.There is no simple correlation between credit-worthiness and the level of current cash flow.

Measuring cash flowDiscussions about cash flow often sufferfrom lack of uniform definition of terms.Table 1 illustrates Standard & Poor’s termi-nology with respect to specific cash flowconcepts. At the top is the item from thefunds flow statement usually labeled “funds

from operations” (FFO) or “working capitalfrom operations.” This quantity is netincome adjusted for depreciation and othernoncash debits and credits factored into it.Back out the changes in working capitalinvestment to arrive at “operating cashflow.” Next, capital expenditures and cashdividends are subtracted out to arrive at“free operating cash flow” and “discre-tionary cash flow,” respectively. Finally, costof acquisitions is subtracted from the run-ning total, proceeds from asset disposalsadded, and other miscellaneous sources anduses of cash netted together. “Prefinancingcash flow” is the end result of these compu-tations, which represents the extent to whichcompany cash flow from all internal sourceshas been sufficient to cover all internalneeds. The bottom part of the table recon-ciles prefinancing cash flow to various cate-gories of external financing and changes inthe company’s own cash balance. In theexample, XYZ Inc. experienced a $35.7 mil-lion cash shortfall in year one, which had to

Table 3—Measuring Cash Flow

Cash flow summary: XYZ Corp.

Year One Year Two

(Mil. $)

Funds from operations (FFO) 18.6 22.3

Dec. (inc.) in noncash current assets (33.1) 1.1

Inc. (dec.) in nondebt current liabilities 15.1 (12.6)

Operating cash flow 0.5 10.8

(Capital expenditures) (11.1) (9.7)

Free operating cash flow (10.5) 1.0

(Cash dividends) (4.5) (5.1)

Discretionary cash flow (15.0) (4.1)

(Acquisitions) (21.0) 0.0

Asset disposals 0.7 0.2

Net other sources (uses) of cash (0.4) (0.1)

Prefinancing cash flow (35.7) (4.0)

Inc. (dec.) in short-term debt 23.0 0.0

Inc. (dec.) in long-term debt 6.1 13.0

Net sale (repurchase) of equity 0.3 (7.1)

Dec. (inc.) in cash and securities 6.3 (2.0)

35.7 4.0

Rating Methodology


be met with a combination of additional bor-rowings and a drawdown of its own cash.

The need for capitalStandard & Poor’s analysis of cash flow inrelation to capital requirements begins withan examination of a company’s capital needs,including both working and fixed capital.While this analysis is performed for all debtissuers, it is critically important for fixedcapital-intensive companies and growth com-panies. Most companies seeking workingcapital are able to finance a significant por-tion of current assets through trade credit.However, rapidly growing companies typical-ly experience a buildup in receivables andinventories that cannot be financed internallyor through trade credit.

Improved working-capital managementtechniques have, over the recent past, greatlyreduced the investment that might otherwisehave been required. This makes it difficult tobase expectations on extrapolating recenttrends. In any event, improved turnover expe-rience would not be a reason to project con-tinuation of such a trend to yet better levels.

Because we evaluate companies as ongoingenterprises, our analysis assumes companiescontinually will provide funds to maintaincapital investments as modern, efficientassets. Cash flow adequacy is viewed fromthe standpoint of a company’s ability tofinance capital-maintenance requirementsinternally, as well as its ability to finance cap-ital additions. To quantify the requirementsfor capital maintenance, data typically areprovided by the company.

An important dimension of cash flow ade-quacy is the extent of a company’s flexibilityto alter the timing of its capital requirements.Expansions are typically discretionary.However, large plants with long lead timesusually involve, somewhere along the way, acommitment to complete the project.

There are companies with cash flow ade-quate to the needs of their existing business-es, but that are known to beacquisition-minded. Their choice of acquisi-tion as an avenue for growth means thisactivity must also be anticipated in the creditanalysis. Management’s stated acquisitiongoals and past takeover bids—including those

not consummated—provide a basis for judg-ing prospects for future acquisitions.

Liquidity analysis: Key factors for considerationDebt characteristics:� Maturity structure;� Dependence on commercial paper and

other confidence-sensitive forms of debt;� Exposure to interest rate fluctuations—i.e.,

fixed/floating mix;� Credit triggers;� Rating triggers;� Financial covenants;� Material adverse change (MAC) clauses; and� Defined events of default.

Other potential calls on cash:� Postretirement benefits obligations;� Environmental liabilities;� Asset retirement obligations;� Take or pay obligations;� Obligations arising from guarantees and

support agreements;� Obligations arising from derivatives;� Litigation; and� Other contingent liabilities.

Operating sources of liquidity:� Expected near-term free cash flow;� Ability to liquidate working capital; and� Flexibility to curtail spending.

Bank credit facilities:� Total amount of facilities;� Nature of bank commitments;� Availability under facilities;� Facility maturities;� Bank group quality;� Evidence of support/lack of support of

bank group; and� Credit triggers (see above).

Other alternative sources of liquidity:� Cash and other liquid assets;� Ability to tap debt and equity markets;� Ability to sell nonstrategic assets;� Flexibility to curtail common and preferred

stock dividends; and� Parental support.

Financial flexibility and liquidityThe previously discussed financial factors(profitability, capital structure, cash flow) andliquidity considerations are combined toarrive at an overall view of financial health.


In addition, sundry considerations that donot fit in other categories are examined,including serious legal problems, lack ofinsurance coverage, or restrictive covenants inloan agreements that place the company atthe mercy of its bankers. The potentialimpact of such contingencies is considered,along with the company’s contingency plans.Access to various capital markets, affiliationswith other entities, and ability to sell assetsare important factors in determining a com-pany’s options under stress.

Flexibility can be jeopardized when a com-pany is overly reliant on bank borrowings orcommercial paper. Reliance on commercialpaper without adequate backup facilities is abig negative. An unusually short maturityschedule for long-term debt and limited-lifepreferred stock also is a negative. In general,a company’s experience with different finan-cial instruments gives management betteraccess to capital markets. A company’s sizeand its financing needs can play a role inwhether it can raise sufficient funds in thepublic debt markets. Similarly, a company’srole in the national economy—and this isparticularly true outside the U.S.—canenhance its access to bank and public funds.

Access to the common stock market mayprimarily be a question of management’swillingness to accept dilution of earnings pershare, rather than a question of whetherfunds are available. (However, in some

countries, including Japan and Germany,equity markets may not be so accessible.)When a new common stock offering is pro-jected as part of a company’s financing plan,Standard & Poor’s tries to measure manage-ment’s commitment to this plan, and its sen-sitivity to changes in share price.

As going concerns, companies should notbe expected to repay debt by liquidatingoperations. Clearly, there is little benefit inselling natural resource properties or manu-facturing facilities if these must be replaced ina few years. Nonetheless, a company’s abilityto generate cash through asset disposalsenhances its financial flexibility.

Pension obligations, environmental liabili-ties, and serious legal problems restrict flexi-bility, apart from the obligations’ directfinancial implications. For example, a largepension burden can hinder a company’s abili-ty to sell assets, because potential buyers willbe reluctant to assume the liability, or toclose excess, inefficient, and costly manufac-turing facilities, which might require theimmediate recognition of future pension obli-gations and result in a charge to equity.

When there is a major lawsuit against acompany, suppliers or customers may bereluctant to continue doing business, and thecompany’s access to capital may also beimpaired, at least temporarily.

Factoring Cyclicality intoCorporate RatingsStandard & Poor’s credit ratings are meant tobe forward-looking, and their time horizonextends as far as is analytically foreseeable.Accordingly, the anticipated ups and downsof business cycles—whether industry-specificor related to the general economy—should befactored into the credit rating all along.Ratings should never be a mere snapshot ofthe present situation. Accordingly, ratings areheld constant throughout the cycle, or, alter-natively, the rating does vary—but within arelatively narrow band.

Cyclicality and business riskCyclicality is, of course, a negative incorpo-rated in the assessment of a company’s busi-ness risk. The degree of business risk, in turn,

Rating in an Ideal World...

Time

Corporateperformance

AA

A

BBB

Standard & Poor’s rating

Rating Methodology


becomes the basis for establishing ratio stan-dards for a given company for a given ratingcategory. The analysis then focuses on a com-pany’s ability to meet these levels, on average,over a full business cycle and the extent towhich it may deviate and for how long.

The ideal is to rate “through the cycle.”There is no point in assigning high ratings

to a company enjoying peak prosperity if thatperformance level is expected to be only tem-porary. Similarly, there is no need to lowerratings to reflect poor performance as long asone can reliably anticipate that better timesare just around the corner.

However, rating through the cyclerequires an ability to predict the cyclicalpattern—usually, difficult to do. The phasesof a cycle probably will be longer or short-er, steeper or less severe, than just repeti-tions of earlier cycles. Interaction of cyclesfrom different parts of the globe and theconvergence of secular and cyclical forcesare further complications.

Moreover, even predictable cycles can affectindividual companies in ways that have a last-ing impact on credit quality. For example, acompany may accumulate enough cash in theupturn to mitigate the risks of the next down-turn. (Auto manufacturers have been able—during cyclical upswings—to accumulate hugecash hoards that should exceed cash outflowsanticipated in future recessions.) Conversely, acompany’s business can be so impaired during

a downturn that its competitive position maybe permanently altered. In the extreme, acompany will not survive a cyclical downturnto participate in the upturn!

Accordingly, ratings may well be adjustedwith the phases of a cycle. Normally, howev-er, the range of the ratings would not fullymirror the amplitude of the company’s cycli-cal highs or lows, given the expectation that acyclical pattern will persist. The expectationof change from the current performancelevel—for better or worse—would temperany rating action. In most cases, then, thetypical relationship of ratings and cyclesmight look more like that below.

Sensitivity to cyclical factors—and ratingsstability—also varies considerably along therating spectrum. As the credit quality of acompany becomes increasingly marginal, thenature and timing of near-term changes inmarket conditions could mean the differencebetween survival and failure. A cyclicaldownturn may involve the threat of defaultbefore the opportunity to participate in theupturn that may follow. In such situations,cyclical fluctuations usually will lead directlyto rating changes—possibly, even several rat-ing changes in a relatively short period.Conversely, a cyclical upturn may give com-panies a breather that may warrant a modestupgrade or two from those very low levels.

In contrast, companies viewed as havingstrong fundamentals—i.e., those enjoyinginvestment-grade ratings—are unlikely to seetheir ratings changed significantly because offactors deemed to be purely cyclical, unlessthe cycle is either substantially different fromwhat was anticipated or the company’s per-formance is somehow exceptional relative towhat had been expected.

Analytical challengesCyclicality encompasses several different phe-nomena that can affect a company’s perform-ance. General business cycles, marked byfluctuations in overall economic activity anddemand, are only one type. Demand-drivencycles may be specific to a particular industry,e.g., product-replacement cycles lead tovolatile swings in demand for semiconduc-tors. Other types of cycles arise from varia-tions in supply, as seen in the pattern of

...And in the Real World

Corporateperformance

Standard & Poor’s rating

Time

AA

A

BBB


capacity expansion and retrenchment that ischaracteristic of the chemicals, forest prod-ucts, and metals sectors. In some cases, natu-ral phenomena are the driving forces behindswings in supply. For example, variations inweather conditions result in periods of short-age or surplus in agricultural commodities.

The confluence of different types of cyclesis not unusual: a general cyclical upturncould coincide with an industry’s construc-tion cycle that has been spurred by newtechnology. The interrelationship of differ-ent national economies is an additionalcomplicating factor.

All these cycles can vary considerably intheir duration, magnitude, and dynamics. Forexample, the unprecedented eight years ofuninterrupted, robust economic expansion inthe U.S. that followed the 1982 trough wastotally unforeseen. On the other hand, therewas no basis to assume in advance that thedownturn that followed would be so severe,albeit relatively brief. Indeed, at any givenpoint, it is difficult to know the stage in thecycle of the general economy, or a givenindustrial sector. A “plateau” following aperiod of demand growth might indicate thepeak has been reached—or represent a pausebefore the resumption of growth.

Even general downturns vary in theirdynamics, affecting industry sectors differ-ently. For example, the soaring interest ratesthat accompanied the recession of 1980-1981 had a particularly adverse effect onsales of consumer durables such as autos.Sometimes, sluggish demand for large-ticketitems can spur demand for other, less costlyconsumer products.

In any case, purely cyclical factors are diffi-cult to differentiate from coincident secularchanges in industry fundamentals, such as theemergence of new competitors, changes intechnology, or shifts in customer preferences.Similarly, it may be tempting to view cyclicalbenefits—such as good capacity utilization—as a secular improvement in an industry’scompetitive dynamics.

A high degree of rating stability for a com-pany throughout the cycle also should entailconsistency in business strategy and financialpolicy. In reality, management psychology isoften strongly influenced by the course of a

cycle. For example, in the midst of a pro-longed, highly favorable cyclical rebound, agiven management’s resolve to pursue a con-servative growth strategy and financial policymay be weakened. Shifts in management psy-chology may affect not just individual compa-nies, but entire industries. Favorable marketconditions may spur industrywide acquisitionactivity or capacity expansion.

Standard & Poor’s understands that publicsentiment about cyclical credits may fluctuatebetween extremes over the course of thecycle, with important ramifications for finan-cial flexibility. Whatever our own viewsabout the long-term staying power of a givencompany, the degree of public confidence inthe company’s financial viability is critical forit to have access to capital markets, bankcredit, and even trade credit. Accordingly, thepsychology and the perceptions of capitalproviders must be taken into account.

Loan CovenantsPublic-market participants long ago stoppeddemanding significant covenant protection,perhaps because poorly written covenantpackages with weak tests and significantloopholes enabled managements to circum-vent them. Furthermore, in a widely heldtransaction, a covenant violation that nor-mally would be waived could deteriorate intoa payment default, because of the difficulty ofhaving all the investors act in unison.Moreover, investors in publicly traded debtinstruments have little interest in workingwith borrowers and probably have fewerresources to do so. Their primary protectionis their ability to sell their investments ifthings should turn sour.

Traditional private-placement investors andbank lenders do have the resources and theexpertise to work out problem credits. Suchinvestors negotiate covenant packages care-fully, to give themselves the most advanta-geous position from which to exercisecontrol, and they expect to be compensatedadequately for accepting covenants that areweak, i.e., those that might allow manage-ment more leeway to cause a deterioration incredit quality. In general, however, covenantpackages are more relaxed than in the past,

Rating Methodology


because liquidity has increased, and financialmarkets broadened.

Covenants’ intended functions include:� Preservation of repayment capacity. Some

covenants limit new borrowings or assurelenders that cash generated both fromongoing operations and from asset saleswill not be diverted from servicing debt.Credit quality is preserved by share-repur-chase and dividend restrictions, which seekto maintain funds available for debt service.

� Protection against financial restructur-ings. All lenders are concerned with therisk of a sudden deterioration in creditquality that can result from a takeover, arecapitalization, or a similar restructur-ing. Properly crafted covenants may pre-vent some of these credit-damaging eventsfrom occurring without the debt’s firsthaving been repaid or the pricing’s firsthaving been adjusted.

� Protection in the event of bankruptcy ordefault. These covenants preserve the valueof assets for all creditors and—what is par-ticularly important—safeguard the prioritypositions of particular lenders. Protection isprovided through negative-pledge clauses,cross-acceleration (or cross-default) provi-sions, and limits on obligations that eitherare more senior or rank equally.

� Signals and triggers. Signals and triggersassure the steady flow of information, pro-vide early warning signals of credit deterio-ration, and place the lender in a position ofinfluence should deterioration occur. Sincetriggers can bring the parties to the table, toenable the lender to decide whether it mightbe appropriate to modify or waive restric-tions, they must therefore be set at appro-priate levels, to signal deterioration beforethe credit drops to unacceptable levels. Enforcement is dubious. A company deter-

mined to do so can often, with the assistanceof its lawyers, find ways to evade the letter ofthe agreement embodied in covenants. Theycould even choose to ignore them altogether.A court usually will not force a company tocomply with covenants. Rather, the court willaward damages—if the breach of covenants isconsidered the cause of the damages. As longas the company continues to pay principaland interest, the court is unlikely to recognize

any damages as having occurred. In the eventof a breach of the covenant, the usual remedyis the ability to declare an event of defaultand accelerate the loan. However, this remedyis so severe that, more often than not, lenderschoose not to precipitate a default bydemanding immediate repayment—despite astipulated right to do so. Instead, the lendermay prefer to take a security position or toget additional collateral, to raise rates, toobtain a waiver fee, or to provide more inputinto the company’s decisions. In reality, theseare the benefits of covenant protection.

Covenants and ratingsCovenants play a limited enhancing role indetermining the corporate credit rating:� Covenants do not address fundamental

credit strength. Covenants do not andcannot affect the potential for facing busi-ness adversity, competitive reverses, andother risks that are outside the control ofthe company.

� The level of a covenant is often inconsistentwith the rating level desired. For example, acovenant that allows a company to leverageitself no more than 60% has little bearingon the company’s achieving a ‘BBB’ rating,if 40% is the maximum leverage toleratedfor that specific company as a ‘BBB’.

� In practice, lenders waive covenants for avariety of reasons. Waivers might resultfrom company/bank relationship issues, alack of understanding of the magnitude ofproblems, or a realization that the originallevels were unnecessarily tight. The bankersnormally waive the covenant for a fee, orextract higher interest rates. This benefitsthe banker, without enhancing the creditquality for the benefit of all creditors.

� Finally, if the covenants appear only in cer-tain issues, those issues could be refinanced.For all these reasons, in most cases,

Standard & Poor’s does not believe particularcovenant or group of covenants can improvea particular borrower’s ability to meet itsobligations in a timely fashion.

The main reason to be aware of a ratedentity’s covenants is quite the opposite: Tightcovenants could imperil credit quality bycausing a default that might otherwise havebeen avoided. When bankers have the discre-


tion to accelerate debt because of a covenantbreach, they might do so to preserve theadvantage held (e.g., based on being secured).

Covenants can, however play a valuablerole in a more limited fashion. First, they mayprotect the specific debt issue that includesthe covenants—particularly with respect toultimate recovery. Second, they may preventcertain deliberate actions that could hurtcredit quality, and that would be meaningfulin cases where the credit-rating assessment isspecifically concerned about the potential forthose actions.

Covenants may be more effective at pro-tecting the credit quality of a subsidiary fromits parent company or group. Nonetheless,the parent could always choose to file thesubsidiary into bankruptcy, unless it werelegally structured to be “bankruptcy remote.”The benefit would then be in terms of betterrecovery for the creditors of the subsidiary.We usually would not rate a subsidiary basedon its strong “stand-alone” profile, even ifthere were significant covenant restrictions,because of the concerns noted above.

Moreover, a covenant package can be help-ful as an expression of management’s intent.Since most companies (especially public com-panies) would be expected to honor—notevade—commitments they make, covenantscan provide an insight into management’splans. An analyst would consider how com-plying with covenants were consistent withother articulated strategic goals.Management’s willingness to agree to certainrestrictive covenants, in essence, “puts theirmoney where their mouth is.” For example, ifa company had traditionally been highlyleveraged but planned to deleverage in thefuture, the analyst would expect to see a debttest that ratcheted down over time.

Country RiskIt has long been Standard & Poor’s view thatcountry risk plays a critical role in determin-ing all ratings within a given domicile.Sovereign-related stress can have an over-whelming impact upon company creditwor-thiness, both direct and indirect. This wasdemonstrated vividly most recently in theRepublic of Argentina (2001-2002), as well

as in the Russian Federation (1998-1999) andin the Republics of Indonesia (1997-1998)and Ecuador (1998-1999).

Sovereign credit ratings are suggestive ofgeneral risk faced by local entities, but theymay not fully capture risk applicable to theprivate sector. As a result, when rating cor-porate or infrastructure companies or proj-ects, we look beyond the sovereign ratings toevaluate the specific economic or countryrisk that may impact the entity’s creditwor-thiness. Such economic or country risk per-tains to the impact of government policiesupon the obligor’s business and financialenvironment, and a company’s ability toinsulate itself from these risks.

Economic riskThe macroeconomic factors most relevant tocorporate credit analysis when determiningeconomic risk include: � Country growth prospects; � Volatility of the economy;� Inflation and real interest rate trends; � Devaluation/overvaluation risk; � Political stability;� Banking-system and payment-system risk; � Local capital-market depth; and � The extent of integration into global

trade and capital markets, and relativesensitivity of foreign direct investmentand portfolio flows.

Industry riskCountry risk analysis also covers industryrisk specific to corporates, including: � Labor issues; � Infrastructure challenges; � Accounting and transparency; and� Institutional risk (i.e., legal and regulatory

risk and credit culture issues, tax risk, andcorruption levels). Depending on the country, there can be

strong, creditworthy companies that demon-strate they are significantly sheltered fromsovereign and country risk, and would beunlikely to default on their local currencyobligations during a sovereign local- and for-eign-currency default scenario. On the otherhand, we also would expect there to be caseswhere default levels will be much higher thanthe sovereign rating benchmark would indi-

Rating Methodology


cate. Therefore, depending upon the country,the degree of country risk, and relativestrength of the corporate sector in a givenjurisdiction, there can be cases where a com-pany’s local currency ratings can exceed theforeign currency, or even the local currency,sovereign credit rating. Otherwise, wherecountry risk is very high, most corporate rat-ings will be below that of the sovereign. In allcases, local currency ratings are determined inreference to our country risk framework.

It should be noted that in recent cases ofsovereign stress, corporate default levels havebeen very high. The most notable example isArgentina, where a rather extreme sovereigndefault scenario has ensued. Nearly every enti-ty rated by Standard & Poor’s has defaultedon bond, bank, or supplier debt. The keycountry risk factors in that case were: � Maxi-devaluation of the currency; � Price controls in the form of frozen

utility tariffs; � Frozen bank deposits, and a banking sys-

tem in crisis; � Currency controls that restricted the ability

of companies to make payments abroadand interrupted supply chains; and

� A recession more than four years old. Regulated utilities were perhaps the most

affected, although exporters also sufferedboth a severe contraction in credit and multi-ple levels of taxes imposed by a governmentin desperate need of revenue sources.

Foreign exchange-rate risk/Foreign-exchange controlsThere are many risk factors in this category,related to both the rate and availability offoreign exchange. Exposure to exchange-rate risk includes: � Operating margin. Where costs have a sig-

nificant dollar/hard currency componentwhile revenue is denominated in the localcurrency, the company will suffer margincompression in a currency devaluation.Examples would be manufacturing compa-nies that must import raw materials, mediacompanies that import content, or wirelesscompanies that import handsets. Assumingthe devaluation occurs during a time of eco-nomic recession—as often is the case—thecompany typically will not be able to pass

on increased costs directly, at least notimmediately. The flip side of this is wherecosts are in the local currency while revenueis in or linked to a hard currency; thesecompanies will be affected when the curren-cy is overvalued. Commodity exportersbased in countries with overvalued localcurrencies have been harshly affected by thisrisk, particularly when it coincided withperiods of weak commodity prices. Analystsshould carefully evaluate any currency mis-match between revenue and expenses.

� Capital expenditures. A related risk iswhere companies generate local currencycash flows, but have hard currency capitalexpenditures, e.g., must rely on importedcapital equipment.

� Mismatch between local currency revenueand foreign debt. Companies with largelylocal currency cash flows, but depend ondollar or dollar-linked debt (or anotherhard currency) are most vulnerable. Most recent cases of sovereign distress have

included sharp currency devaluations, includ-ing Argentina (where the currency lost nearly75% of its value against the U.S. dollar, withthe exchange rate falling from a fixed 1:1 atDec. 31, 2001, to near 3.6 Argentine pesosper U.S. dollar by October 2002); Russia(where the currency lost 65% of its value inU.S. dollar terms between July 1998 andNovember 1998); and Indonesia (where thecurrency lost 58% of its value over a three-month period in early 1998).

Exposure to foreign-exchange availabilityrisk pertains when a company is heavilydependent on imported supplies or importedcapital equipment. The company’s operationscould be interrupted if foreign-exchange con-trols are imposed by the sovereign (which isplausible in the case in event of a sovereignforeign-currency default). For example, theimposition of exchange controls in Argentina,together with a prolonged period of uncertain-ty over the implementation of controls and rel-evant exchange rate, caused widespreaddisruption in distribution chains because ofsharply curtailed imports (and exports).

Hedging/Financial policyDoes the company hedge foreign-exchangerisk, to the extent it is within its control to do


so? In many emerging markets, it is not prac-ticable to hedge foreign-exchange exposureover the long term because of the unavailabil-ity or cost of long-term hedging instruments.Does the company show a propensity to spec-ulate with financial arbitrage opportunities?(For example, does the company borrow inU.S. dollars to invest in high interest ratelocal currency instruments, exposing itself todevaluation risk?)

Political riskIs there a history or likelihood of civilunrest in the region or country where thecompany operates that could disrupt opera-tions? Does the company operate in a politi-cally sensitive industry that could be subjectto expropriation?

Macroeconomic volatility riskAre the company’s prospects tied to localeconomic conditions? Volatile growth ratesor extended periods of economicrecession/depression could reduce pre-dictability of cash flows or severely hampersales volumes, pricing power, etc.

Institutional risk: Legal system risk/Credit culture/CorruptionHow dependable is the rule of law? Is therean independent judicial system? Are creditors’rights respected? Is the bankruptcy codetransparent? Are there credit-culture issueswhereby companies have a cultural incentiveto default on debt? Are corruption levels gen-erally high in the country?

Accounting and reporting transparencyIs there a strong regulatory enforcementagency for publicly reporting companies inthe country? Are accounts generally auditedby top international accounting companies?Are quarterly and annual financial statementstypically available within a reasonable timeafter a period closes? Are disclosure levelsgenerally adequate, or is significant supple-mental information required? In jurisdictionswhere majority family ownership is common,disclosure often lags. In addition, particularlywhere there is majority family ownership, theentire family group of companies should be

analyzed, and intercompany operations andrelationships should be scrutinized.

Taxes/Royalties/DutiesDoes the company or its key investmentsenjoy tax subsidies or royalty arrangementsthat have renegotiation risk at the federal orregional level? Does the government have ahistory of micromanaging the current accountbalance through changing taxes or duties onimports/exports/foreign borrowings?

Government regulationIs there a particular risk to the company thatthe government may change the rules throughimport/export restrictions; direct interventionin service quality or levels; redefining bound-aries of competition (such as service areas);altering existing barriers to entry; changingsubsidies; changing antitrust legislation;changing the maximum percentage level offoreign ownership participation; or changingterms to concession contracts for utilities?For extractive industries, is there a risk ofgovernment contract renegotiation?

Infrastructure and labor problemsTo what extent might the company be vulner-able to the reduced public services and laborstrife that could accompany the sovereigndefault scenario? Are there potential bottle-necks, poor transport, high-cost/inefficientport services? Is there a need to supply elec-tricity or other basic services/infrastructure?

Inflation riskWhere existing or potential high/acceleratinginflation is an issue, does the company havethe pricing flexibility, systems, and know-howto keep revenue increasing in line with orahead of costs? How much price elasticity istypical for the product of the company, par-ticularly during times of economic weakness?

Price controls particularly are a threat forregulated industries, such as telephone/electricservices, and possibly for some basic com-modities such as gasoline sales. At times ofrising inflation, governments often try toappease consumers by failing to allow full-cost passthroughs on prices in regulatedindustries, and under severe stress may freezeall prices in an effort to control inflation. For

Rating Methodology


example, Argentina froze utility tariffs forgas, electric, and local telephone services inJanuary 2002, which effectively cut the earn-ings power of those companies by 60%-75%relative to their dollar debt, because of theconcurrent currency devaluation. In othercases, sovereigns have more indirectly con-strained price increases on politically sensitivegoods or services, or have moved to imposeeven broader price controls (such asVenezuela did in mid-1994).

Interest-rate riskDoes the country have a history of high realinterest rates, which can make local borrow-ing expensive? If local borrowings areindexed to local reference (such as bankdeposit rates or inflation) or foreign exchangerates, the company can be subject to suddenand large rate hikes at times of sovereignstress. Such borrowings may originally haveappeared cheaper, only in that the risk wasnot fully recognized.

Restricted access to capitalDoes the company have a large concentra-tion of assets in a particular emerging marketcountry? The risk that access to cash flowsof foreign subsidiaries could be constrainedby potential transfer/convertibility riskshould be reviewed.

Access to capitalIs the company a top-tier name in the localmarket, that would benefit from a “flight toquality” from local bank lending duringcrises? Does the company have committedlines of credit from international banks thatare not subject to sovereign-related “materialadverse change” clauses? Does the companyhave ample access to trade credit? Can thecompany withstand the cuts in trade linesand increase in costs that typically occur dur-ing periods of sovereign stress? (An examplewas the sharp reduction in trade-line avail-ability from foreign banks for Brazilian cor-porates during 2002). Where short-term debtcan be rolled over, it should be assumed thatsubstantially higher interest rates would beincurred in a stress scenario. Limited accessto capital often is a key constraint for emerg-

ing-market issuers: it broadly penalizes theircredit quality relative to those of companiesin developed markets. Even the strongestLatin American private-sector issuers had dif-ficulties accessing local or international capi-tal markets during periods of stress.Companies are affected by volatile interna-tional investor confidence in emerging mar-kets. While economic problems may originatein a particular country or region, we haveseen many cases of regional or emerging mar-ket contagion. Thin domestic capital marketsalso prevent companies from accessing localmarkets at reasonable rates; in times of stress,the local banking system would be sufferingilliquidity because of high capital flight. Aweak or poorly regulated local banking sys-tem can introduce additional volatility.Moreover, many emerging-market-basedcompanies typically do not have access tocommitted credit lines.

Debt maturity structureFor emerging-market issuers, concentration inshort-term debt, whether dollar- or local-cur-rency denominated, exposes the company tocritical rollover risk. This risk is highest forcompanies with large upcoming bullet matu-rities on capital market debt, although thequality and likelihood of continued bank sup-port also is analyzed. Emerging-market com-panies partially can mitigate this risk byprefunding the refinancing of large bulletmaturities well in advance. It cannot beassumed availability under uncommittedlines—or programs such as euro-denominatedcommercial paper or medium-term notes—where pricing and availability always are sub-ject to market sentiment.

LiquidityIs the company’s near-term financial flexibili-ty supported by substantial liquidity? If so, isthe company’s liquid asset position held inlocal government bonds, local banks, or localequities, and will the issuer have access tothese assets in times of stress on the sover-eign? Local banks broadly are affected bysovereign stress scenarios, with the extremecase demonstrated by Argentina’s bank-deposit freeze. Similarly, Ecuador froze


deposits in 1998 in an effort to halt a run onits banks. Ideally, the company should haveliquidity positions that are well diversifiedamong top local and foreign financial institu-tions. Having liquidity outside the country ofdomicile is also a significant enhancement(although the risk that companies may berequired by the sovereign to repatriatefunds/export proceeds is also be considered).

Foreign-currency ratingsThe local-currency credit rating, by defini-tion, excludes the risk of direct sovereignintervention that may constrain payment offoreign currency debt. The foreign-currencycredit rating is a current opinion of an oblig-or’s overall capacity to meet its obligations inforeign currency. In many cases, sovereigndefault and sovereign intervention risk areassumed to be roughly equivalent, and mostforeign-currency credit ratings in these juris-dictions are limited by that of the sovereign.However, in some countries, we may deter-mine that sovereign intervention risk is differ-ent than sovereign default risk. In these cases,foreign-currency credit ratings for private-sec-tor entities may be higher than that of thesovereign. Examples include currency unions

such as the European Monetary Union(EMU), where the ‘AAA’ rating of theEuropean Central Bank indicates an ‘AAA’ability to convert euros to foreign currencyand transfer foreign currency. Thus, no rat-ings of entities within the EMU are con-strained by transfer and convertibility risk.There are other company- or issue-specificreasons why the entity’s foreign-currency rat-ing may be higher than that of the sovereign.For example, companies domiciled in a givencountry but with substantial offshore opera-tions, or companies that are subsidiaries ofoffshore parents, could have a rating higherthan the country of domicile. In addition,transactions can be structured to reducetransfer and convertibility (T&C) risk by cap-turing transaction flows off shore, throughinsurance for T&C risk, or using other struc-tural techniques, and therefore receive a rat-ing higher than the foreign-currencysovereign credit rating. (For additional com-ments, see “Sovereign Risk and RatingsAbove the Sovereign,” July 23, 2001, and“Rating Above The Sovereign: CriteriaUpdate,” Nov. 3, 2005, both published onRatingsDirect, Standard & Poor’s Web-basedresearch and credit analysis system.) ■


Company data are adjusted for the following: Nonrecurring gains or losses are eliminatedfrom earnings. This includes gains on assetsales, significant transitory income items,unusual losses, losses on asset sales, andcharges because of asset writedowns, plantshutdowns, and retirement programs. These

adjustments chiefly affect interest coverage,return, and operating margin ratios.

Unusual cash-flow items similar in originto the nonrecurring gains or losses also are reversed.

The operating lease adjustment is per-formed for all companies. Companies thatbuy all plant and equipment are put on amore comparable basis with those that lease

Ratings And Ratios: Ratio Medians

The key ratio medians for U.S. corporates by rating category

and their definitions are displayed below. The ratio medians

are purely statistical, and are not intended as a guide to achieving

a given rating level. They are not hurdles or prerequisites that

should be achieved to attain a specific debt rating.

Caution should be exercised when using the ratio medians for

comparisons with specific company or industry data because of

differences in method of ratio computation, importance of indus-

try or business risk, and the impact of mergers and acquisitions.

Because ratings are designed to be valid over the entire business

cycle, ratios of a particular company at any point in the cycle may

not appear to be in line with its assigned debt ratings. Particular

caution should be used when making cross-border comparisons,

because of differences in accounting principles, financial prac-

tices, and business environments.


Table 1—Key Industrial Financial Ratios, Long-Term Debt

Three-year (2002 to 2004) medians

AAA AA A BBB BB B CCC

EBIT interest coverage (x) 23.8 19.5 8.0 4.7 2.5 1.2 0.4

EBITDA interest coverage (x) 25.5 24.6 10.2 6.5 3.5 1.9 0.9

FFO/total debt (%) 203.3 79.9 48.0 35.9 22.4 11.5 5.0

Free operating cash flow/total debt (%) 127.6 44.5 25.0 17.3 8.3 2.8 (2.1)

Total debt/EBITDA (x) 0.4 0.9 1.6 2.2 3.5 5.3 7.9

Return on capital (%) 27.6 27.0 17.5 13.4 11.3 8.7 3.2

Total debt/total debt + equity (%) 12.4 28.3 37.5 42.5 53.7 75.9 113.5

Table 2—Key Utility Financial Ratios, Long-Term Debt

Three-year (2002 to 2004) medians

AA A BBB BB B

EBIT interest coverage (x) 4.4 3.1 2.5 1.5 1.3

FFO interest coverage (x) 5.4 4.0 3.8 2.6 1.6

Net cash flow/capital expenditures (%) 86.9 76.2 100.2 80.3 32.5

FFO/average total debt (%) 30.6 18.2 18.1 11.5 21.6

Total debt/Total debt + equity (%) 47.4 53.8 58.1 70.6 47.2

Common dividend payout (%) 78.2 72.3 64.2 68.7 (4.8)

Return on common equity (%) 11.3 10.8 9.8 4.4 6.0

Table 3—Key Ratios

Formulas

1. EBIT interest coverage Earnings from continuing operations* before interest and taxes/Gross interestincurred before subtracting capitalized interest and interest income

2. EBITDA interest coverage Adjusted earnings from continuing operations** before interest, taxes, deprecia-tion, and amortization/Gross interest incurred before subtracting capitalized inter-est and interest income

3. Funds from operations (FFO)/total debt Net income from continuing operations, depreciation and amortization, deferredincome taxes, and other non-cash items/Long-term debt§ + current maturities +commercial paper, and other short-term borrowings

4. Free operating cash flow/total debt FFO – capital expenditures – (+) increase (decrease) in working capital (excludingchanges in cash, marketable securities, and short-term debt)/Long-term debt§ +current maturities, commercial paper, and other short-term borrowings

5. Total debt/Total debt + equity Long-term debt§ + current maturities, commercial paper, and other short-termborrowings/Long-term debt§ + current maturities, commercial paper, and othershort-term borrowings + shareholders' equity (including preferred stock) + minority interest

6. Return on capital EBIT/Average of beginning of year and end of year capital, including short-termdebt, current maturities, long-term debt§, non-current deferred taxes, minorityinterest, and equity (common and preferred stock)

7. Total debt/EBITDA Long-term debt§ + current maturities, commercial paper, and other short-termborrowings/Adjusted earnings from continuing operations before interest, taxes,and D&A

*Including interest income and equity earnings; excluding nonrecurring items. **Excludes interest income, equity earnings, and nonrecurring items; alsoexcludes rental expense that exceeds the interest component of capitalized operating leases. §Including amounts for operating lease debt equivalent, and debtassociated with accounts receivable sales/securitization programs.


part or all of their operating assets. The leaseadjustment affects all ratios.

The net debt adjustment affects medianratios largely for the ‘AAA’ rating category,composed almost entirely of cash-rich phar-maceutical companies.

The captive-finance adjustment has a greateffect, mainly on automobile, departmentstore, and some capital goods companies.

The adjusted ratio median universe forindustrials includes about 1,000 companies.The data exclude transportation companiesthat exhibit different financial-ratio profiles.

The medians themselves are affected byeconomic and environmental factors, as wellas mergers and acquisitions. The universe ofrated companies constantly is changing, andin certain rating categories, adding or deletinga few companies also can affect the financial-ratio medians.

Strengths and weaknesses in differentareas have to be balanced and qualitativefactors evaluated. There are many nonnu-meric distinguishing characteristics thatdetermine a company’s creditworthiness (seeTables 1, 2, and 3). ■

Ratings and Ratios


Standard & Poor’s Ratings Services assigns two types of credit

ratings—one to corporate issuers and the other to individual

corporate debt issues (or other financial obligations). The first

type is called a Standard & Poor’s corporate credit rating. It is a

current opinion on an issuer’s overall capacity to pay its financial

obligations—i.e., its fundamental creditworthiness. This opinion

focuses on the issuer’s ability and willingness to meet its financial

commitments on a timely basis. It generally indicates the likeli-

hood of default regarding all financial obligations of the company,

because, in most countries, companies that default on one debt

type or file under the Bankruptcy Code virtually always stop pay-

ment on all debt types. It does not reflect any priority or prefer-

ence among obligations. In the past, we published the ”implied

senior-most rating“ of corporate obligors—a different term for

precisely the same concept. “Default risk rating” and “natural

rating” are additional ways of referring to this issuer rating.

Generally, a corporate credit rating is pub-lished for all companies that have issue rat-ings—in addition to those companies thathave no ratable issues, but request just anissuer rating. Where it is germane, both alocal currency and foreign currency issuer rat-ing are assigned.

Standard & Poor’s also assigns credit rat-ings to specific issues. In fact, the vast majori-ty of credit ratings pertain to specific debtissues. Issue ratings are a blend of default risk(sometimes referred to as “timeliness”) andthe recovery prospects associated with thespecific debt being rated. Accordingly, junior

Rating Each Issue:Distinguishing Issuers and Issues


debt is rated below the corporate credit rat-ing. Preferred stock is rated still lower (see“Preferred Stock”). Well-secured debt can berated above the corporate credit rating.

Recovery ratings were added in 2003.These ratings address only recoveryprospects, using a scale of 1+ to 6, ratherthan the letter ratings.

Notching Down; Notching UpThe practice of differentiating issues in rela-tion to the issuer’s fundamental creditworthi-ness is known as “notching.” Issues arenotched up or down from the corporate cred-it rating level.

Payment on time as promised obviously iscritical with respect to all debt issues. Thepotential for recovery in the event of adefault—i.e., ultimate recovery, albeitdelayed—also is important, but timeliness isthe primary consideration. That explains whyissue ratings are still anchored to the corpo-rate credit rating. They are notched—up ordown—from the corporate credit rating inaccordance with established guidelinesexplained here.

As default risk increases, the concern overwhat can be recovered takes on greater rele-vance and, therefore, greater rating signifi-cance. Accordingly, the loss-given-defaultaspect of ratings is given more weight as onemoves down the rating spectrum. For exam-ple, subordinated debt can be rated up to twonotches below a noninvestment grade corpo-rate credit rating, but one notch at most ifthe corporate credit rating is investmentgrade. In the same vein, the ‘AAA’ rating cat-egory need not be notched at all, while at the‘CCC’ level the gaps may widen.

There is also an important distinctionbetween notching up and notching down.Whenever a financial obligation is judged tohave a materially worse recovery prospectthan other debt of that issuer—by being unse-cured, subordinated, or because of a holding-company structure—the issue rating isnotched down. Thus, priority in bankruptcyis considered in broad, relative terms; there isno full-blown attempt to quantify the poten-

tial severity of loss. And, because the focus isrelative to the various obligations of theissuer, no comparison between unsecuredissues of different companies is warranted.For example, the fact that a senior issue ofcompany A is not notched at all does notimply anything about its recovery prospectsrelative to the junior debt of company B—with the same corporate credit rating—whichis notched down.

When a rigorous recovery analysis is per-formed, the notching of issue ratings focuseson a central recovery tendency of approxi-mately 50%. Therefore, issues with recoveryrates significantly above 50% are rated abovethe corporate credit rating, those recoveringsignificantly below 50% are rated below thecorporate credit rating.

The entire notion of junior obligations—and the related difference it makes withrespect to recovery prospects—is specific tothe applicable legal system. Notching guide-lines are, therefore, a function of the bank-ruptcy law and practice in the legaljurisdiction that governs a specific instru-ment. For example, distinguishing betweensenior and subordinated debt can be mean-ingless in India, where companies may beallowed to continue paying even commondividends at the same time they are indefault on debt obligations; accordingly,notching is not applied in India. The majori-ty of legal systems broadly follow the prac-tices underlying Standard & Poor’s criteriafor notching—but it always is important tobe aware of nuances of the law as they per-tain to a specific issue.

Junior Debt: Notching DownWhen a debt issue is judged to be junior toother debt issues of the company, and,therefore, to have relatively worse recoveryprospects, that issue is assigned a lower rat-ing than—i.e., it is “notched down” from—the corporate credit rating. As a matter ofrating policy, the differential is limited toone rating designation in the investment-grade categories. For example, when the

Rating Each Issue: Distinguishing Issuers and Issues


corporate credit rating is ‘A’, junior debtmay be rated ‘A-’. In the speculative-gradecategories, where the possibility of a defaultis greater, the differential is up to two rating designations.

Notching relationships are based on broadguidelines that combine consideration ofasset protection and ranking. The guidelinesare designed to identify material disadvan-tage for a given issue by virtue of the exis-tence of better-positioned obligations. Theanalyst does not seek to predict specificrecovery levels, which would involve know-ing the exact asset mix and values at a pointwell into the future.

Notching relationships are subject toreview and change when actual developmentsvary from expectations. Changes in notchingdo not necessarily have to be accompanied bychanges in default risk.

Guidelines for NotchingTo the extent that certain obligations have apriority claim on the company’s assets, lower-ranking obligations are at a disadvantagebecause a smaller pool of assets will be avail-able to satisfy the remaining claims. One caseis when the issue is contractually subordinat-ed—that is, the terms of the issue specificallyprovide that debt holders will receive recov-ery in a reorganization or liquidation onlyafter the claims of other creditors have beensatisfied. Another case is when the issue isunsecured, while assets representing a signifi-cant portion of the company’s value collater-alize secured borrowings.

A third form of disadvantage can arise if acompany conducts its operations through anoperating subsidiary/holding-company struc-ture. In this case, if the whole group declares

bankruptcy, creditors of the subsidiaries—including holders of even contractually sub-ordinated debt—would have the first claimto the subsidiaries’ assets, while creditors ofthe parent would have only a junior claim,limited to the residual value of the sub-sidiaries’ assets remaining after the sub-sidiaries’ direct liabilities have been satisfied.The disadvantage of parent-company credi-tors owing to the parent/subsidiary legalstructure is known as “structural subordina-tion.” Even if the group’s operations aresplintered among many small subsidiaries,the individual debt obligations of whichhave only dubious recovery prospects, theparent-company creditors may still be disad-vantaged compared with a situation inwhich all creditors would have an equalclaim on the assets (see table 1).

As a rough generic measure of asset avail-ability, we look at the cumulative percentageof priority debt and other liabilities relativeto all available assets. When this ratio reachescertain threshold levels, the next, more junior,debt is considered disadvantaged debt, and israted one or two notches below the corporatecredit rating. These threshold levels take intoaccount that it normally takes more than $1of book assets—as valued today—to satisfy$1 of priority debt. (In the case of secureddebt—which limits the priority to the collat-eral pledged—the remaining assets are stillless likely to be sufficient to repay the unse-cured debt, inasmuch as the collateral ordi-narily consists of the company’s better assetsand often substantially exceeds the amount ofthe debt.)

For investment-grade companies with atypical asset mix, the threshold is 20%. Thatis, if priority debt and liabilities equal 20%

Table 1—Investment-Grade Example

Corporate credit rating: ‘A’

Issue ratings

Assets $100 Priority debt $30 A

Lower-priority debt $10 A-

Equity $60

The lower-priority debt is rated one notch below the corporate credit rating of 'A', because the ratio of priority debt to assets (30 to 100) is greater than 20%.


or more of the company’s assets, the lower-priority debt (unsecured, subordinated, orholding company) is rated one notch belowthe corporate credit rating (see table 2).

If the corporate credit rating is speculativegrade, there are two threshold levels. If prior-ity obligations equal even 15% of the assets,the lower-priority debt is penalized onenotch. When priority debt and other liabili-ties amount to 30% of the assets, lower-pri-ority debt is substantially disadvantaged andis, therefore, differentiated by two notches.

The concept behind these thresholds is tomeasure material disadvantage with respectto the various layers of debt. At each level, aslong as the next layer of debt still enjoysplenty of asset coverage, we do not considerthe priority of the top layers as constituting areal disadvantage for the more junior issuers.Accordingly, the nature of the individualcompany’s asset is important: If a companyhas an atypical mix of assets, the thresholdscould be higher or lower to reflect the relativeamounts of better or worse assets.

The relative size of the next layer of debtalso is important. If the next layer is especial-ly large—in relation to the assets assumed toremain after satisfying the more senior lay-ers—then coverage is impaired. There arenumerous LBOs financed with outsized issuesjust below the senior layers. Although the pri-ority debt issues may be small (below thethreshold levels), they pose a real disadvan-tage for the junior issues, given the paucity ofcoverage remaining—so the junior debtshould be notched down.

Multiple LayersA business entity can have many levels ofobligations, each ranking differently with

respect to priority of claim in a bankruptcy.For analytical purposes, debt levels areranked as follows, from highest priority to lowest:� Debt secured with higher-quality operating

asset collateral;� Debt secured with lesser-quality operating

asset collateral;� Lease obligations/securitizations;� Senior debt of the operating company;� Senior liabilities (ranked pari passu with

senior debt);� Subordinated debt;� Junior subordinated debt;� All other operating company liabilities;� Senior debt of the holding company; and� Subordinated debt of the holding company.

Once a notching threshold level iscrossed—aggregating successive layers of pri-ority claims—notching applies to the remain-ing, lower-ranking issues (see chart 1).

The reason notching is constrained to onenotch for investment-grade companies andtwo notches for speculative-grade companiesis to maintain the important weighting oftimeliness in all ratings. Remember, notchingpertains only to differentiating recoveryprospects: it is presumed a default will inter-rupt payment on all of a company’s debtissues. Issues with the highest recoveryprospect receive the corporate credit rating,or sometimes a higher rating; those issueswith weaker recovery prospects are ratedlower than the corporate credit rating, butwill never be rated lower than one notchunder the investment-grade corporate creditrating, or two notches in the case of nonin-vestment-grade corporate credit ratings.

This rating convention often results in debtissues of significantly different standing being


Table 2—Speculative-Grade Example

Corporate credit rating: ‘BB+’

Issue ratings

Assets $100 Priority debt $35 BB+

Lower-priority debt $20 BB-

Equity $45

The lower-priority debt is rated two notches below the corporate credit rating of ‘BB+’, because the ratio of priority debt to assets (35 to 100) is greater than 30%.


rated the same. If, for example, a two-notchdistinction is indicated for a senior subordi-nated issue, that issue and the worse-posi-tioned issues at the holding company are allrated at the same two-notch gap relative tothe corporate rating. No distinction is madeto highlight the differences between juniorissues (see table 3).

Senior Secured DebtNot all senior secured debt of an issuer isnecessarily equally secured. Second-mortgagedebt, for example, has only a junior claim toan asset also securing first-mortgage debt,making it inferior to a first-mortgage issuesecured by the same asset. The second-mort-gage debt issue would receive the corporatecredit rating only if the amount of first-mort-gage debt outstanding was sufficiently smallrelative to the assets.

In general, secured debt is notched accord-ing to the expected recovery associated withits specific collateral (see “Bank LoanMethodology” and “Recovery Ratings”). Ifthe collateral that secures a particular debtissue is of dubious value, while the morevaluable collateral is pledged to another loan,even secured debt may be notched downfrom the corporate credit rating.

Application of Guidelines� Perspective. Notching takes into account

expected future developments. For exam-ple, a company may be in the process of

refinancing secured debt so that it wouldhave little or no secured debt within a year.If there is confidence that the plan will becarried out, a notching differential shouldnot be needed, even currently. Conversely,if companies have open first-mortgageindentures or the leeway to increasesecured borrowings under negative pledgecovenants (or if no negative pledgecovenants are in place), Standard & Poor’sattempts to determine the likelihood thatthe company will incur additional securedborrowings. But the analyst would notautomatically base notching on the harsh-est assumptions.If an issuer has a secured bank credit facili-

ty, such borrowings would be reflected innotching to the extent that the issuer wasexpected to draw on the facility. Typically, asa company approaches a financial crisis, itwill need to tap its sources of financing. Inthe absence of expectations to the contrary,Standard & Poor’s takes a conservativeapproach, assuming available bank borrow-ing capacity is fully utilized. Likewise, if acompany typically uses bank borrowings tofund seasonal working capital requirements,we focus on expected peak borrowing levels,rather than the expected average amount.� Adjustments. Book values are used as a

starting point; analytic adjustments aremade if assets are considered significantlyovervalued or undervalued for financialaccounting purposes. This analysis focuseson the varying potential of different typesof assets to retain value over time and inthe default context based on their liquiditycharacteristics, special-purpose nature, anddependence on the health of the company’sbusiness. Goodwill especially is suspect,considering its likely value in a default sce-nario. In applying the notching guidelines,Standard & Poor’s generally eliminatesfrom total assets goodwill in excess of a“normal” amount—10% of total assets.The particular characteristics of specificintangibles, as distinct from goodwill, areconsidered. (For example, some credit typi-cally is given for the enduring value ofwell-established brands in the consumerproducts sector.) We do not, however, per-form detailed asset appraisals or attempt to

Chart 1—XYZ Corp. and XYZ Holdings Inc.

Corporate credit ratings ‘BB’

Secured debt $15

Senior debt $15

Subordinated debt $15

Other liabilities $15

Holding company debt $20

Issueratings

‘BB’ (or higher)

‘BB-’

‘B+’

Not rated

‘B+’

<15% No notches

15% to 30% one notch

>30% two notches

Assets$100

Liabilities$80

Equity$20


postulate specifically about how marketvalues might fluctuate in a hypotheticalstress scenario (except in the case ofsecured debt).In applying the guidelines above, lease obli-

gations—whether capitalized in the compa-ny’s financial reporting or kept off balancesheet as operating leases as priority debt—and the related assets are included on theasset side. Similarly, sold trade receivablesand securitized assets are added back, alongwith an equal amount of priority debt. Othercreditors are just as disadvantaged by suchfinancing arrangements as by secured debt. Inconsidering the surplus cash and marketablesecurities of companies that presently arefinancially healthy, Standard & Poor’sassumes neither that the cash will remainavailable in the default scenario, nor that itwill be totally dissipated, but rather that,over time, this cash will be reinvested in oper-ating assets that mirror the company’s currentasset base, subject to erosion in value of thesame magnitude.� Local- and foreign-currency issue ratings.

In determining local-currency issue ratings,the point of reference is the local-currencycorporate credit rating: local-currency issueratings may be notched down one notchfrom the local-currency corporate creditrating in the case of investment-gradeissuers, or one or two notches in the case

of speculative-grade issuers. A company’sforeign-currency corporate credit rating isoften lower than its local-currency corpo-rate credit rating, reflecting the risk that asovereign government could take actionsthat would impinge on the company’s abili-ty to meet foreign-currency obligations. Butjunior foreign-currency issues are notnotched down from the foreign-currencycorporate credit rating, because the govern-ment action would apply regardless of thesenior/junior character of the debt. Ofcourse, the issue would never be ratedhigher than if it had been denominated inlocal currency. For example, if a company’slocal-currency corporate credit rating were‘BB+’ and its foreign-currency corporatecredit rating were ‘BB-’, subordinated for-eign currency-denominated issues could berated ‘BB-’. But, if a company’s local-cur-rency corporate credit rating were ‘BB+’and its foreign currency corporate creditrating were ‘BB’, subordinated foreign-cur-rency denominated issues would be rated‘BB-’, as would subordinated local-currencydenominated issues. (See chart 1).

� Short-term ratings. All short-term ratings,including commercial paper ratings, arelinked to the issuer’s corporate credit rat-ing. Although commercial paper generallyis unsecured, commercial paper ratingsfocus exclusively on default risk. For exam-


Table 3—Speculative-Grade Example

Corporate credit rating: ‘BB+’

Issue ratings


Lower-priority debt $15 BB

Equity $60

“Here, assuming the issuer was speculative grade, the lower-priority debt might be rated one notch below the corporate credit rating,rather than two notches, although the ratio of priority debt to assets (25 to 100) is close enough to the guideline threshold of 30% to makethis a borderline case.”

Issue ratings


Lower-priority debt $30 BB-

Equity $45

In this case, the lower-priority debt should be rated two notches below the corporate credit rating. Although the ratio of priority debt toassets is still 25 to 100, the substantial amount of lower-priority debt would dilute recoveries for all lower-priority debtholders.


ple, if an issuer has an ‘A’ corporate creditrating and secured debt issue rating, and an‘A-’ unsecured rating, its commercial paperrating would still be ‘A-1’—the commercialpaper rating associated with the ‘A’ issuerdefault rating—not ‘A-2’, the commercialpaper rating ordinarily appropriate at the‘A-’ default risk rating level.

Parents and Subsidiaries: Structural SubordinationAt times, a parent and its affiliate grouphave distinct default risks. The difference inrisk may arise from covenant restrictions,regulatory oversight, or other considera-tions. This is the norm for holding compa-nies of insurance operating companies andbanks. In such situations, there are no fixedlimits governing the gaps between corporatecredit ratings of the parent and its sub-sidiaries. The holding company has higherdefault risk, apart from post-default recov-ery distinctions. If such a holding companyissued both senior and junior debt, its jun-ior obligations would be notched relative tothe holding company’s corporate credit rat-ing by one or two notches.

Often, however, a parent holding compa-ny with one or more operating companies isviewed as a single economic entity. Whenthe default risk is considered the same forthe parent and its principal subsidiaries,they are assigned the same corporate creditrating. Yet, in a liquidation, holding-compa-ny creditors are entitled only to the residualnet worth of the operating companiesremaining after all operating company obli-gations have been satisfied.

Parent-level debt issues are notched downto reflect structural subordination when thepriority liabilities create a material disad-vantage for the parent’s creditors, after tak-ing into account all mitigating factors. Inconsidering the appropriate rating for aspecific issue of parent-level debt, priorityliabilities encompass all third-party liabili-ties (not just debt) of the subsidiaries—including trade payables, pension andretiree medical liabilities, and environmen-tal liabilities—and any relatively better-positioned parent-level liabilities. (Forexample, parent-level borrowings collateral-

ized by the stock of the subsidiaries wouldbe disadvantaged relative to subsidiary lia-bilities, but would rank ahead of unsecuredparent-level debt.)

Potential mitigating factors include:� Guarantees. Guarantees by the subsidiaries

of parent-level debt (i.e., upstream guaran-tees) may overcome structural subordina-tion by putting the claims of parentcompany creditors on a pari passu basiswith those of operating company creditors.Such guarantees have to be enforceableunder the relevant national legal system(s),and there most be no undue concernregarding potential allegations of fraudu-lent conveyance (see “UpstreamGuarantees”). Although joint and severalguarantees from all subsidiaries provide themost significant protection, several guaran-tees by subsidiaries accounting for a majorportion of total assets would be sufficientto avoid notching of parent debt issues inmost cases.

� Operating assets at the parent. If the par-ent is not a pure holding company, butrather also directly owns certain operatingassets, this gives the parent’s creditors apriority claim to the parent-level assets.This offsets, at least partially, the disadvan-tage that pertains to being structurally sub-ordinated with respect to the assets ownedby the subsidiaries.

� Diversity. When the parent owns multipleoperating companies, more liberal notch-ing guidelines may be applied to reflect thebenefit the diversity of assets might pro-vide. The threshold guidelines are relaxed(but not eliminated) to correspond withthe extent of business and/or geographicdiversification of the subsidiaries. Forbankrupt companies that own multiple,separate business units, the prospects forresidual value remaining for holding com-pany creditors improve as individual unitswind up with shortfalls and surplusesAlso, holding companies with diverse busi-nesses—in terms of product or geogra-phy—have greater opportunities fordispositions, asset transfers, or recapital-ization of subsidiaries. If, however, thesubsidiaries are operationally integrated,economically correlated, or regulated, the


company’s flexibility to reconfigure ismore limited.

� Concentration of debt. If a parent has anumber of subsidiaries, but the preponder-ance of subsidiary liabilities are concentrat-ed in one or two of these, e.g., industrialgroups having finance or trading units, thisconcentration of liabilities can limit the dis-advantage for parent-company creditors.Although the net worth of the leveragedunits could well be eliminated in the bank-ruptcy scenario, the parent might stillobtain recoveries from its relativelyunleveraged subsidiaries. In applying thenotching guideline in such cases, it may beappropriate to eliminate the assets of theleveraged subsidiary from total assets, andits liabilities from priority liabilities. (Theanalysis then focuses on the assets and lia-

bilities that remain, but the standard notch-ing guideline must be substituted by otherjudgments regarding recovery prospects.)However, to the extent the company isviewed as one consolidated entity, the pre-sumption that the healthier subsidiarieswould remain healthy is questionable. Thisalso would dilute the value of guaranteesfrom individual subsidiaries.

� Downstream loans. If the parent’s invest-ment in a subsidiary is not just an equityinterest, but also takes the form of down-stream senior loans, this may enhance thestanding of parent-level creditors becausethey would have not only a residual claimon the subsidiary’s net worth, but also adebt claim that would generally be paripassu with other debt claims. Standard &Poor’s gives weight to formal, documented


Table 4—Single Economic Entity Example

Parent—corporate credit rating: ‘BB+’

Debt type* Issue rating

Senior secured BB-

Senior unsecured BB-

Subordinated BB-

Subsidiary—corporate credit rating: ‘BB+’


Senior secured BB+

Senior unsecured BB

Subordinated BB-

Different Default Risk Example

Parent—corporate credit rating: ‘BB+’


Senior secured BB+

Senior unsecured BB

Subordinated BB-

Subsidiary—corporate credit rating: ‘B+’


Senior secured B+

Senior unsecured B

Subordinated B-

*Debt types are used here merely as illustrative of typical results for different priority debt; notching actually depends on the guidelines explained above. Inthe first example, because the parent and subsidiary are viewed as having the same default risk, the lowest rating at either is two notches below the singlecorporate credit rating. If the parent is a holding company without assets other than its ownership interest in the subsidiary, the parent’s debt is viewed asjunior and notched down. In contrast, in the second example, the parent and subsidiary are viewed as having different default risks, so each has a differentcorporate credit rating (assumed to be ‘BB+’ at the parent and ‘B+’ at the subsidiary), and the two-notch limit is relative to the corporate credit ratings at eachentity: there is no limit on the span of ratings that applies across the two legal entities.


loans—not to informal advances, whichare highly changeable. (On the otherhand, if the parent has borrowed fundsfrom its subsidiaries, the resulting inter-company parent-level liability could fur-ther dilute the recoveries of externalparent-level creditors.) As with guaran-tees, the assessment of downstreamadvances must take into account theapplicable legal framework.

� Adjustments. Additional adjustments arenecessary in assessing structural subordi-nation. We eliminate from the notchingcalculations subsidiaries’ deferred taxassets and liabilities and other accountingaccruals and provisions that are not likelyto have clear economic meaning in adefault (see table 4).

Upstream GuaranteesWhen a subsidiary guarantees the debt of itsparent, it commonly is referred to as anupstream guarantee. The object of the exer-cise is to address the structural subordina-tion that would otherwise apply toparent-company debt if the debt, liabilities,and preferred stock of the operating compa-ny are material. Upstream guarantees, ifvalid, eliminate the rating distinction, sincethe operating company becomes directlyresponsible for the guaranteed parent debt.However, the validity of the guarantee issubject to legal risk. An upstream guaranteemay be voided in court, if it is deemed toconstitute a fraudulent conveyance. Theoutcome depends on the specific fact pat-tern, not legal documentation—so one can-not standardize the determination. But, ifeither the guarantor company received valueor was solvent for a sufficiently long periodsubsequent to issuing the guarantee, theupstream guarantee should be valid.Accordingly, we consider upstream guaran-tees valid if any of these conditions are met:� The proceeds of the guaranteed obligation

are provided to (downstreamed to) theguarantor. It does not matter whether theissuer downstreams the money as an equityinfusion or as a loan. Either way, thefinancing benefits the operations of thesubsidiary, which justifies the guarantee;

� The legal risk period—ordinarily, one ortwo years from entering into the guaran-tee—has passed;

� There is a specific analytical conclusionthat there is little default risk during theperiod that the guarantee validity is atrisk; or

� The rating of the guarantor is at least ‘BB-’in jurisdictions that involve a two-year risk,or at least ‘B+’ in jurisdictions with one-year risk.Accordingly, there will be cases where we

decline to recognize the upstream guaranteeat the time of issuance—because of legalrisk—but would upgrade the issue a year(or two) later. Standard & Poor’s accepts an upstream guarantee whenever the guar-antor obtained value. As long as the guar-antor is the recipient of the funds, it meetsthis test.

Well-Secured Debt: Notching UpIn 1996, Standard & Poor’s first published itsframework for weighting both timeliness andrecovery prospects in a default or bankruptcyscenario when assigning ratings to well-secured debt. The extent of any ratingenhancement depends on the following three considerations:

EconomicsWill the “second way out” provide 100%recovery? Of principal only, or interest, aswell? When the collateral value exceeds theamount of the claim, the creditor couldreceive postpetition interest. Managing thelegal nuances of bankruptcy would be animportant aspect of achieving postpetitioninterest. Although accurately predicting thisoutcome is extremely difficult, the criteriarecognize the potential for such payment. (Ifall accrued interest, from before and after thedefault, can be recovered, the length of anydelay in recovery is less consequential.)

There can be different degrees of confi-dence with respect to recovery. For example,excess collateral translates into a greater like-lihood that there will be enough value torecover the entire obligation—although obvi-ously, the creditor will never get more than


the obligation amount. Subjective judgmentsare critical in deciding how to stress collateralvalues in hypothetical postdefault scenarios.

How long will the delay be?The time it takes to realize ultimate recoveryof the loan obligation can be critical. At best,the recovery would be highly valued becauseof its nearly timely character—almost like agrace period. At worst, we would not giveany credit for a very delayed payment. In esti-mating the length of any delay in recovery,the analysis would focus on: � How the legal system resolves bankruptcies

or provides access to collateral. This variesby legal jurisdiction. In the U.S., 18 to 24months typically is needed to resolve aChapter 11 filing. (The analysis wouldidentify and differentiate cases that might

take longer than usual because of perceivedcomplexities, such as litigation.) In jurisdic-tions that are more creditor-oriented, theaccess to collateral may be expedited.

� The structure of an obligation. The analysiscould distinguish between a bond, a leaseobligation, and certificates governed bySection 1110 of the U.S. Bankruptcy Code,which provides specific legal rights toobtain certain transportation assets duringa bankruptcy proceeding.

� The terms of an obligation. For example,in the case of a guarantee that provided forultimate—but not necessarily timely—pay-ment, it would be important to know with-in what period payment must be made.

Guidelines for notchingTo get even one notch above the corporate rat-ing, a debt issue must have significantly betterthan average recovery prospects. As theprospects improve, based on the nature and/oramount of the collateral, another notch may beadded. If the analysis indicates great confidencein full recovery, three or four notches are possi-ble. This reflects the highest expectations forfull recovery, following more rigorous stressingof collateral values in various scenarios.

These guidelines pertain to the speculative-grade portion of the rating spectrum. At theupper end, notching generally is less gener-ous. For example, in the case of first mort-gage bonds of investment-grade companies, ittakes greater enhancement to achieve thesame notch or two.

With respect to short-term ratings, timeli-ness of payment is paramount. Accordingly,there is no enhancement of short-term ratingsbased on ultimate recovery.

Commercial PaperCommercial paper (CP) consists of unsecuredpromissory notes issued to raise short-termfunds. CP ratings pertain to the programestablished to sell such notes. There is noreview of individual notes. Typically, onlycompanies of strong credit standing can selltheir paper in the money market, althoughthere periodically is some issuance of lesser-quality, unrated paper (notably, prior to thejunk bond market collapse late in 1989).


*Dotted lines indicate combinations that are highly unusual.

AAA

A-1+

A-1

A-2

A-3

B

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

Chart 2—Correlation of CP Ratings

with Long-Term Corporate

Credit Ratings*


Alternatively, companies sell commercialpaper backed by letters of credit (LOC) frombanks. Credit quality of such LOC-backedpaper rests entirely on the transaction’s legalstructure and the bank’s creditworthiness. Aslong as the LOC is structured correctly, creditquality of the direct obligor can be ignored.

Rating criteriaEvaluation of an issuer’s commercial paperreflects Standard & Poor’s opinion of theissuer’s fundamental credit quality. The ana-lytical approach is virtually identical to theone followed in assigning a long-term cor-porate credit rating, and there is a stronglink between the short-term and long-termrating systems (see chart 2).

Indeed, the time horizon for CP ratings isnot a function of the typical 30-day life of acommercial-paper note, the 270-day maxi-mum maturity for the most common type ofcommercial paper in the U.S., or even theone-year tenor typically used to determinewhich instrument gets a short-term rating inthe first place.

To achieve an ‘A-1+’ CP rating, the com-pany’s credit quality must be at least theequivalent of an ‘A+’ long-term corporatecredit rating. Similarly, for commercial paperto be rated ‘A-1’, the long-term corporatecredit rating would need to be at least ‘A-’.(In fact, the ‘A+’/‘A-1+’ and ‘A-’/‘A-1’ com-binations are rare. Ordinarily, ‘A-1’ CP rat-ings are associated with ‘A+’ and ‘A’long-term ratings.)

Conversely, knowing the long-term ratingwill not fully determine a CP rating, consid-ering the overlap in rating categories.However, the range of possibilities is alwaysnarrow. To the extent that one of two CPratings might be assigned at a given level oflong-term credit quality (e.g., if the long-term rating is ‘A’), overall strength of thecredit within the rating category is the mainconsideration. For example, a marginal ‘A’credit likely would have its commercialpaper rated ‘A-2’, whereas a solid ‘A’ wouldalmost automatically receive an ‘A-1’.

Exceptional short-term credit qualitywould be another factor that determineswhich of two possible CP ratings areassigned. For example, a company may pos-

sess substantial liquidity—providing protec-tion in the near or intermediate term—butsuffer from less-than-stellar profitability, alonger-term factor. Or, there could be a con-cern that, over time, the large cash holdingsmay be used to fund acquisitions. (Havingdifferent time horizons as the basis for long-and short-term ratings implies either one orthe other rating is expected to change.)

Backup policiesEver since the Penn Central bankruptcyroiled the commercial-paper market andsome companies found themselves excludedfrom issuing new commercial paper,Standard & Poor’s has deemed it prudentfor companies that issue commercial paperto make arrangements in advance for alter-native sources of liquidity. This alternative,backup liquidity protects companies fromdefaulting if they are unable to roll overtheir maturing paper with new notes,because of a shrinkage in the overall com-mercial-paper market or some cloud overthe company that might make commercial-paper investors nervous. Many develop-ments affecting a single company or groupof companies—including bad business condi-tions, a lawsuit, management changes, a rat-ing change—could make commercial-paperinvestors flee the credit.

Given the size of the commercial-papermarket, backup facilities could not be reliedon with a high degree of confidence in theevent of widespread disruption. A generaldisruption of commercial-paper marketscould be a highly volatile scenario, underwhich most bank lines would representunreliable claims on whatever cash wouldbe made available through the banking sys-tem to support the market. Standard &Poor’s neither anticipates that such a sce-nario is likely to develop, nor assumes thatit never will.

Having inadequate backup liquidityaffects both the short- and long-term ratingsof the issuer because it could lead todefault, which would ultimately pertain toall of the company’s debt. Moreover, theneed for backup applies to all confidence-sensitive obligations, not just rated commer-cial paper. Backup for 100% of rated


commercial paper is meaningless if otherdebt maturities—for which there is no back-up—coincide with those of the commercialpaper. Thus, the scope of backup mustextend to euro-denominated commercialpaper, master notes, and short-term bank notes.

The standard for industrial and utilityissuers has long been 100% coverage ofconfidence-sensitive paper for all but thestrongest credits. Backup is provided byexcess liquid assets or bank facilities in an amount that equals all such paper outstanding.

While the backup requirement relatesonly to outstanding paper—rather than theentire program authorization—a companyshould anticipate prospective needs. Forexample, it may have upcoming maturitiesof long-term debt that it may want to refi-nance with commercial paper, which wouldthen call for backup of greater amounts.

Available cash or marketable securitiesare ideal to provide backup. (Of course, itmay be necessary to “haircut” their appar-ent value to account for potential fluctua-tion in value or tollgate taxes surrounding asale. And it is critical that they be immedi-ately saleable.) Yet the vast majority ofcommercial paper issuers rely on bank facil-ities for alternative liquidity.

This high standard for back-up liquidityhas provided a sense of security to the com-mercial-paper market—even though backupfacilities are far from a guarantee that liq-uidity will, in the end, be available. Forexample, a company could be denied fundsif its banks invoked “material adversechange” clauses. Alternatively, a companyin trouble might draw down its credit lineto fund other cash needs, leaving less-than-full coverage of paper outstanding, or issue paper beyond the expiration date of its lines.

Companies rated ‘A-1+’ can provide 50%-75% coverage. The exact amount is deter-mined by the issuer’s overall credit strengthand its access to capital markets. Currentcredit quality is an important consideration intwo respects. It indicates:

� The different likelihood of the issuer’s everlosing access to funding in the commercial-paper market; and

� The timeframe presumed necessary toarrange funding should the company loseaccess. A higher-rated entity is less likely toencounter business reverses of significanceand—in the event of a general contractionof the commercial-paper market—the high-er-rated credit would be less likely to loseinvestors. In fact, higher-rated companiescould actually be net beneficiaries of aflight to quality.In 1999, Standard & Poor’s introduced a

new approach that offers companies greaterflexibility regarding the amount of backupthey maintain, if they are prepared to matchtheir maturities carefully with available liq-uidity. The new approach differentiatedbetween companies that are rolling over alltheir commercial paper in just a few daysand those that have a cushion by virtue ofhaving placed longer-dated paper. The basicidea was that companies—if and when theylose access to commercial paper—shouldhave sufficient liquidity to cover any papercoming due during the time they wouldrequire to arrange additional funding.

However, companies encountered practi-cal difficulties in implementing the newapproach. Moreover, changes in the bankingenvironment have since made us more leeryabout a company arranging new facilitieswhen under stress. Still, notes that comedue only 11-12 months from now do notrequire backup so far in advance.Companies should begin to actively arrangeliquidity backup approximately six monthsprior to maturity. Similarly, 12-month notesthat automatically extend their maturitymonth by month do not require back-uparrangements from day one. They will beable to arrange backup when and if theextensions stop, leaving a full 12 months todo so (see table 5).

Extendible commercial notes (ECN) pro-vide built-in backup by allowing the issuerto extend for several months if there is diffi-culty in rolling over the notes; accordingly,there is no need to provide backup forthem—i.e., until the extension is effected.



However, there is no way to prevent theissuer from tapping backup facilities intend-ed for other debt and use the funds to repaymaturing ECNs, instead of extending. Thisrisk is known as leakage. Accordingly, forissuers that provide 100% backup,unbacked ECNs must not exceed 20% ofextant backup for outstanding conventionalcommercial paper.

All issuers—even if they provide 100%backup—must always ensure that the firstfew days of upcoming maturities are backedwith excess cash or funding facilities thatprovide for immediate availability.

For example, a bank backup facility thatrequires two-day notification to draw downwill be of no use in repaying paper matur-ing in the interim. The same would holdtrue if foreign exchange is needed, and thefacility requires a few days to provide it.Moreover, if a company issuing commercialpaper in the U.S. were relying on a bankfacility in Europe, differences in time zonesor bank holidays could prevent availabilitywhen needed. Obviously, a bank facility inthe U.S. would be equally lacking withrespect to maturing euro-denominated com-mercial paper. So-called “swing lines” typi-cally equal 15%-20% of the program sizeto deal with the maximum amount that willmature in any three- to four-day period.

Quality of backup facilitiesBanks offer various types of credit facilitiesthat differ widely regarding the degree of thebank’s commitment to advance cash under allcircumstances. Weaker forms of commitment,while less costly to issuers, provide banksgreat flexibility to redirect credit at their owndiscretion. Some lines are little more than aninvitation to do business at some future date.

Standard & Poor’s expects all backup linesto be in place and confirmed in writing.

Preapproved lines or orally committedlines are viewed as insufficient. Specific des-ignation for commercial-paper backup is oflittle significance.

Contractually committed facilities aredesirable. In the U.S., fully documentedrevolving credits represent such contractualcommitments. The weaker the credit, thegreater the need for more reliable forms ofliquidity. As a general guideline, if contractu-ally committed facilities cover 10-15 days’upcoming maturities of outstanding paper,that should suffice.

Even contractual commitments ofteninclude “material adverse change” clauses,allowing the bank to withdraw under certaincircumstances. While inclusion of such anescape clause weakens the commitment,Standard & Poor’s does not consider it criti-cal—or realistic—for most borrowers tonegotiate removal of “material adversechange” clauses.

In the absence of a contractual commitment,payment for the facility—whether by fee orbalances—is important because it generally cre-ates some degree of moral commitment on thepart of the bank. In fact, a solid business rela-tionship is key to whether a bank will stand byits client. Standardized criteria cannot captureor assess the strength of such relationships. Wetherefore are interested in any evidence—sub-jective as it may be—that might demonstratethe strength of an issuer’s banking relation-ships. In this respect, the analyst is also mind-ful of the business cultures in different parts ofthe world and their impact on banking rela-tionships and commitments.

Dependence on just one or a few banksalso is viewed as an unwarranted risk.

Table 5—Guidelines for U.S. Industrials and Utilities

% of total outstanding

A-1+/AAA 50

A-1+/AA 75

A-1 100

A-2 100

A-3 100


Apart from the potential that the bank willnot have adequate capacity to lend, there isthe chance it will not be willing to lend tothis issuer. Having several banking relation-ships diversifies the risk that any bank willlose confidence in this borrower and hesi-tate to provide funds.

Concentration of banking facilities alsotends to increase the dollar amount of anindividual bank’s participation. As the dol-lar amount of the exposure becomes large,the bank may be more reluctant to step upto its commitment. In addition, the poten-tial requirement of higher-level authoriza-tions at the bank could create logisticalproblems with respect to expeditious accessto funds for the issuer. On the other hand, acompany will not benefit if it spreads itsbanking business so thinly that it lacks a substantial relationship with any of its banks.

There is no analytical distinction to be madebetween a 364-day and a 365-day facility.

Even multiyear facilities will provide com-mitment for only a short time as theyapproach the end of their terms. It obviouslyis critical that the company arrange for thecontinuation of its banking facilities well inadvance of their lapsing.

It is important to reiterate that even thestrongest form of backup—a revolver withno “material adverse change” clause—doesnot enhance the underlying credit and doesnot lead to a higher rating than indicated bythe company’s own creditworthiness. Creditenhancement can be accomplished onlythrough an LOC or another instrument thatunconditionally transfers the debt obligationto a higher-rated entity.

Banks providing issuers with facilities forbackup liquidity should themselves besound. Possession of an investment-graderating indicates sufficient financial strengthfor the purpose of providing a commercial-paper issuer with a reliable source of fund-ing. There is no requirement that the bank’scredit rating equal the CP issuer’s rating.Nonetheless, Standard & Poor’s would lookaskance at situations where most of a com-pany’s banks were only marginally invest-ment grade. That would indicate animprudent reliance on banks that

might deteriorate to weaker, non-invest-ment-grade status.

Documentation for Commercial-Paper Program ratings� Company letter requesting rating;� Copy of board authorization for program;� Indication of authorized amount;� Indication of program type (e.g., 3(A)3,

4(2), ECN, euro);� Description of use of proceeds;� Listing of dealers (unless company is a

direct issuer); and� Description of backup liquidity (including

list of bank lines, giving the terms of thefacilities, the name of each bank participat-ing, the commitment amount, and the formof the commitment).Accordingly, we believe the tenor of any

backup facility with a hard maturity needs tobe at least 180 days. The rating level of thecompany while it is still issuing commercialpaper is not a consideration.

Preferred StockPreferred stock carries greater credit risk thandebt in two important ways: The dividend isat the discretion of the issuer, and the pre-ferred represents a deeply subordinated claimin the event of bankruptcy. Prior to 1999,Standard & Poor’s used a separate preferredstock scale. In February 1999, the debt andpreferred stock scales were integrated.Accordingly, now, preferred stock generally israted below subordinated debt. When a com-pany’s corporate credit rating is investmentgrade, its preferred stock is rated two notchesbelow the corporate credit rating. For exam-ple, if the corporate credit rating is ‘A+’, thepreferred stock would be rated ‘A-’. (In caseof a ‘AAA’ corporate credit rating, the pre-ferred stock would be rated ‘AA+’.) When thecorporate credit rating is non-investmentgrade, the preferred stock is rated at leastthree notches (one rating category) below thecorporate credit rating. Deferrable paymentdebt is treated identically to preferred stock,given subordination and the right to deferpayments of interest.

Financial instruments that have one ofthese characteristics, but not both (for exam-



ple, deferrable debt with a senior claim), gen-erally are rated one notch below the corpo-rate credit rating for investment grade credits,and two notches below for speculative gradecredits.

There are situations in which the dividendis especially jeopardized, so notching wouldexceed the guidelines above. For example,state charters restrict payment when there is adeficit in the equity account. This can occurfollowing a write-off, even while the compa-ny is healthy and possesses ample cash tocontinue paying. Similarly, covenants in debtinstruments can endanger payment of divi-dends, even while there is a capacity to pay.Also when there is an unusually large divi-dend burden, there is greater risk to that divi-dend. If preferred issues total over 20% ofthe company’s capitalization, it normallywould call for greater differentiation of the preferred rating from the corporate credit rating.

On the other hand, the right to defer can insome instances be constrained by virtue offinancial covenants. In others, the discretionto defer is limited by the remedy that pre-ferred holders possess to take over the issuingentity and liquidate its assets. Note, however,that such situations are exceptional and nor-mally pertain to negotiated, privately placedtransactions. Yet there do exist a handful ofpreferred issues that are rated pari passu withthe company’s debt (in some cases, seniordebt). In all cases, the risk of deferral of pay-ments is analyzed from a pragmatic, ratherthan a legal, perspective.

If a company defers a payment or passes ona preferred dividend, it is tantamount todefault on the preferred issues. The rating ischanged to ‘D’ once the payment date haspassed. The rating usually would be lowered to‘C’ in the interim, if nonpayment were pre-dictable—e.g., if the company were toannounce that its directors failed to declare thepreferred dividend. Whenever a companyresumes paying preferred dividends butremains in arrears with respect to payments itskipped, the rating is, by definition, ‘C’.

Convertible preferredSecurities such as PERCS and DECS/PRIDESprovide for mandatory conversion into com-

mon stock of a company. Such securities varywith respect to the formula for sharing poten-tial appreciation in share value. In the interim,these securities represent a preferred stockclaim. Other offerings package a short-life pre-ferred stock with a deferred common stockpurchase contract to achieve similar economics.

These issues are viewed very positively interms of equity credit—assuming conversionwill take place in a relatively short time frameand the imbedded floor price of the sharesmakes it unlikely the company will regret andreverse its decision to sell new common stock.

Ratings on the issue address only the like-lihood of interim payments and the solvencyof the company at the time of conversion toenable it to honor its obligation to deliverthe shares. These ratings do not address theamount or value of the common stockinvestors ultimately will receive. (We oncehighlighted this risk by appending an “r” tothe ratings of these hybrid securities, butnow rely on the market’s familiarity withsuch instruments and their terms.)

Trust-Preferred stockWhen using a trust preferred stock, a companyestablishes a trust that is the legal issuing enti-ty of the preferred stock. The sale proceeds ofthe preferred stock are lent to the parent com-pany, and the payments on this intercompanyloan are the source for servicing the preferredobligation. In some cases, this financing struc-ture can provide favorable equity treatmentfor the company, even while the paymentsenjoy tax-deductibility.

Standard & Poor’s rating of trust-preferredsecurities is based on the creditworthiness ofthe parent company and the terms of the inter-company loan. Any equity credit that might beassociated with these issues also is a functionof the terms of the intercompany loan, espe-cially with respect to payment flexibility.

This variety of preferred was introduced in1995 as trust originated preferred securities(TOPrS). TOPrS represented a structural alter-native for deferrable payment hybrids that hadbeen sold since late 1993 under the appellationMIPS—Monthly Income Preferred Securities.

The use of a trust neither enhances nordetracts from the structure compared to thealternative issuing entities. The legal form



of the issuing entity can be a business trust,limited partnership, off-shore subsidiary ina tax haven, or on-shore limited liabilitycorporation. What these structures have incommon is an intercompany loan withdeferral features (typically five years), nocross-default provision, a long maturity, and

deep subordination. The preferred dividendis similarly deferrable, as long as commondividends are not being paid. After thedeferral period, the trust preferred holdershave legally enforceable creditors rights—incontrast to conventional preferreds, whichprovide only very limited rights. ■


We apply the new framework to all secureddebt—not just bank loans. This includes firstmortgage debt issued by utilities. But, becausethese issuers primarily are investment-gradecompanies with more remote likelihood ofdefault, recovery is less relevant as an invest-ment focus, so the weighting of recoveryprospects plays a lesser role in the rating. Thetable below shows how notching standards

change as they pertain to first mortgagebonds of companies in the various invest-ment-grade categories (see table 2).

In December 2003, Standard & Poor’slaunched its recovery ratings for secured debt.Recovery ratings use a new scale—1+through 6. These ratings do not blend defaultrisk and recovery given default, as the con-ventional issue ratings do. Rather, they express

Secured Debt/Recovery Ratings, Overview

In 1996, Standard & Poor’s Ratings Services introduced criteria

that allowed for “notching up” certain debt obligations. If a par-

ticular obligation had reasonable prospects for full recovery, given

a default, it could be rated above the corporate credit rating.

This innovation coincided with the expansion of rating bank

loans—an asset class rarely rated previously. The secured position

of many of these loans helped make it possible to analyze ulti-

mate recovery prospects on an absolute basis. In some cases, the

collateral’s value is independent of the company’s business for-

tunes. In many others, the priority of the secured debt allows one

to conclude that there will be sufficient value—even making harsh

assumptions about the bankruptcy scenario—to allow for full

recovery. Furthermore, the legal protection of the secured debt

removes much of the uncertainty associated with the bankruptcy

process itself (see table 1).


only our assessment of an issue’s recoveryprospects. Each rating category correspondsto a specific range of recovery values (seetable 1 again).

Notice the current correlation between thebank loan rating and recovery rating scales.They incorporate a “crosswalk” from theexpected recovery percentage to both thedegree of notching and the recovery ratinglevel. Also, there are cases where the notch-ing is less generous—such as secured invest-ment grade debt. It is possible for thesecured debt of a highly rated company (i.e.,investment grade) to receive a recovery rat-ing of ‘1’ and still not be notched above thecorporate rating. Finally, there is a maxi-mum of two notches that are subtracted toreflect the weak recovery prospects of agiven debt issue. Therefore, debt issues withrecovery ratings of four and five both getthe same two notches when it comes to theconventional rating.

Absolute trumps relativeOur more recent recovery analysis focuses onthe absolute values that may be expected in apotential default scenario. This contrasts withthe long-standing convention in the assign-ment of issue ratings, which differentiatedsenior and junior debt of a company merelyin relative terms. Junior issues were rated anumber of notches below the corporate ratingbased on the relative position of the debtissues of that particular company.

Bank Loan Rating MethodologyBoth syndicated bank loans and privatelyplaced debt frequently provide collateraldesigned to protect the lender against loss ifthe borrower defaults. In assigning ratings tobank loans and private placements—both theconventional debt ratings and the more recentrecovery ratings—Standard & Poor’s takesloss-given-default into account when analyz-ing the recovery prospects of a specific loan.To the extent a loan is well-secured or con-tains other loan-specific features that enhancethe likelihood of full recovery, the debt ratingon that loan can be higher than the borrow-er’s corporate credit rating—and it willreceive a high recovery rating.

Globally, creditor rights vary greatly,depending on legal jurisdiction. Well-secureddebt of borrowers subject to the U.S.Bankruptcy Code generally receives a ratingone or two notches higher than the corporatecredit rating. Even greater weight could begiven to collateral elsewhere in the worldwhere legal jurisdictions may be more favor-able for secured creditors, allowing anenhancement of three notches. On the otherhand, no consideration is given for security inmany countries such as China, where thebankruptcy process is virtually unpredictable.

Highly rated issuers generally are not expect-ed to provide much collateral or other post-default protection when raising funds in publicor private debt markets. Because the probabilityof their defaulting is low, post-default recovery


Table 1—Revised Recovery Ratings, And Issue Ratings

Speculative-grade issuers

Recovery Recovery Issuerating Description of recovery range (%) rating notches*

1+ Highest expectation, full recovery 100 +3

1 Very high recovery 90-100 +2

2 Substantial recovery 70-90 +1

3 Meaningful recovery 50-70 0

4 Average recovery 30-50 0

5 Modest recovery 10-30 (1)

6 Negligible recovery 0-10 (2)

*Indicates issue rating “notches” relative to Standard & Poor’s issue credit rating.


is of little relevance. For these reasons, it wouldbe unusual to find bank loans of investment-grade companies that deserved a rating higherthan the entity’s corporate credit rating.

Determining ratingsThe starting point for assigning a bank loanrating is determining the borrower’s defaultrisk, based on an analysis of the company’sbusiness strength and financial risk. Theresult is the corporate credit rating. Theanalysis then proceeds to the recovery aspectsof a specific debt issue. Regarding recoveryratings, which purely address the recoveryprospects, the likelihood of default is irrele-vant. Still, the circumstances surrounding apotential default are highly germane to therecovery outcome. So comprehending thedefault scenario is part of every analysis.

We analyze the issue’s legal structure andthe collateral that supports each issue. Therecovery risk profile is established by assess-ing the characteristics of various asset typesused as collateral and subjecting the collateralvalues to stress analysis under different post-default scenarios. High collateral coveragelevels can increase confidence that asset val-ues will cover the secured debt, even underadverse conditions, although greater levels ofcollateral obviously do not entitle a creditorto any more than the amount of the claim.

When the collateral value exceeds theamount of the claim, the creditor could alsoreceive post-petition interest. This excess col-lateral value is referred to as an “equity cush-ion.” The creditor must carefully manage hislegal posture to take advantage of this cush-ion and receive interest—while still asserting

entitlement to the court’s “adequate protec-tion” of the collateral.

Default scenariosThe analysis of recovery prospects for secureddebt—which underpins the assignment ofboth conventional issue ratings and recoveryratings—focuses exclusively on the value ofcollateral in the post-default scenario. Thecurrent value of the collateral—even ifstressed for various economic contingencies—is not relevant. The only meaningful stressscenario is the one consistent with thedefault. This is true whatever method is usedto appraise the collateral’s value, be it dis-counted cash flow of the enterprise, transac-tion prices of discrete assets, market-multipleconventions, capitalization rates, or someother approach.

Comprehending the default scenario is per-haps the most challenging aspect of loss-given-default analysis. In a limited number ofsituations, the default may be imminent, sothe context is already set. But in most cases,it is necessary to make certain assumptions.The analyst must be creative, but avoidengaging in excessive conjecture or specula-tion. The higher the company’s corporate rat-ing, the more remote its risk of default—andthe more obscure the default scenario.

In the absence of a more specific view, weuse a generic model for default scenarios: thecompany’s projected cash flow (EBITDA) willhave fallen below its financial burden of pro-jected interest and debt amortization. Themodel sets a base level for post-default cashflow, while the risk of a still-lower level mustbe taken into account, as well. The validity of

Table 2—Notching Criteria

First mortgage bonds of investment-grade utilities

Corporate rating Asset value/secured debt (x) Notches above corporate rating

A and above 2.0 1

BBB 2.0 2

1.5 1

B and BB 2.0 3

1.5 2

1.0 1


this tool is intuitive, and is also supported bysome empirical evidence.

However, the potential cause of suchdecline in a company’s current EBITDA—tothe level of EBITDA associated withdefault—needs to be understood. The impli-cations for the collateral values will vary,depending on the underlying reasons for thecompany’s decline. Figuring all this out—especially well in advance of a companyexperiencing problems—can be analyticallychallenging. Moreover, there often are severalfactors, rather than a single factor, thattogether cause a default. Accordingly, cash-flow multiple valuations works best for com-panies that are presently highly leveraged.Their default can be expected to result fromthe high level of financial burden, even whilethe company’s business fundamentals are notdrastically impaired.

The model is less accurate where defaultrisk is associated with potential declines inthe business fundamentals. And the modeldoes not apply wherever the risk of default isassociated with vulnerabilities such as litiga-tion, acquisition activity, or liquidity crisis. Inall such situations, the analysis must substi-tute other approaches to model a default sce-nario that is consistent with the thinkingbehind the current rating. For example, manycompanies have low ratings because of a per-ceived propensity to use debt for acquisitionsof other businesses—or to buy the company’scommon stock. In these instances, the compa-ny’s ability to service its current debt isgreater than its rating would indicate. Thereal concern is that the company will take onmore debt, and subsequently lack the cashflow to service that increased corpus of debt.Accordingly, the default scenario to be usedin loss-given-default analysis—and the relatedEBITDA/interest ratio—must focus on theprojected increased debt level, rather than thecurrent amounts.

Similarly, in the current low-interest-rateenvironment, many companies’ risk ofdefault—and, in turn, their credit ratings—isbased on the assumption that interest rateswill rise (unless they have locked in low rateswith fixed rate, long-tenor debt). Indeed, cur-rent coverage ratios for many companieswould otherwise seem out of line with their

low ratings. Default scenarios for loss-given-default analysis relating to these companieswill, therefore, reflect an inability to servicethe potentially higher interest amounts.

In these two examples, the enterprise valuein the default scenario would be appreciablyhigher than if current debt or interestamounts are used in the calculation.

In the same vein, a default could occur ifcreditors accelerate their loans or force arestructuring upon breach of covenants—wellbefore the company ‘runs out of money’, soto speak. The creditors’ motivation would beto preserve recovery values by precipitatingan ‘early’ default, i.e., prior to potential fur-ther declines in the business’ cash-generatingcapacity. Default would then be linked tocovenant levels—ordinarily a multiple ofinterest expense—rather than actual interestexpense levels.

However, the reality is that bankers nor-mally waive covenant breaches (althoughthey could well extract a payment or obtainsecurity for doing so). It is exceptionally diffi-cult to predict in advance the minority ofcompanies that will find their bankers takingthe more radical position of pulling the plug.

Similarly, companies might default if theycannot refinance a large maturity—and,indeed, such a risk does occasionally drivethe rating outcome. Yet, most companiesthat generate enough EBITDA to servicetheir debt do mange to refinance. Especiallyin the current flush financial markets, it israre to see companies that cannot attractnew debt financing.

Note, too, that if the default scenario werebased on presumed intervention upon breachof covenants, the corporate rating would alsohave to reflect this expectation. As pointedout before, there must be consistency regard-ing the default scenario underlying the corpo-rate rating and the recovery analysis. Theeffect of this would be greater default riskand lower corporate ratings. (Any ‘notchingup’ would then be from a lower base.)

Collateral Value AnalysisCollateral can consist of discrete assets (suchas accounts receivable, real estate, or vehi-cles) that have value independent of the



business, discrete assets that are linked—directly or indirectly—to the business’ for-tunes (inventory, production equipment), orthe business enterprise itself. Bank loans tobelow-investment-grade issuers tend to havea first-priority lien on substantially all of acompany’s operating assets: receivables,inventory, trademarks, patents, plants, prop-erty, equipment, and pledges of subsidiarystock. In effect, they have the entire enter-prise as collateral. Indeed, the whole is usu-ally worth more than the sum of its parts, aslong as the business enterprise continues as agoing concern. (Private-placement debtissues are more likely to be secured by oneor more discrete asset types.)

All types of collateral can enhance a credi-tor’s rights and help ensure loan recovery,even though it is rare that a creditor will beable to simply foreclose and seize the collater-al to liquidate it. In the U.S. at least, a bank-ruptcy filing imposes a stay on a creditor’sright to the collateral during what is often along and tortuous reorganization process.Moreover, the bankruptcy judge often haswide discretion (although seldom exercised)to substitute collateral. Indeed, most largecompany bankruptcies never result in liquida-tion: the company is usually reorganized.(The decision of whether to reorganize isinfluenced by a myriad of factors, includingthe legal system, industry trends, perceivedlong-term viability of the business, and regu-latory or political considerations.) The formthe reorganization takes, including the resolu-tion of creditors’ claims, is the result of anegotiated process worked out before or afteran actual bankruptcy filing.

Nonetheless, the outcome for creditors ulti-mately is a function of the collateral’s valuegoing into the reorganization process. Forexample, bankruptcy judges can substitutecollateral, but they must adhere to the princi-ple of “adequate protection” by providingcollateral of comparable value to that of theoriginal. So, knowing the value of the collat-eral—relative to the amount owed—providesan approximation of just how well a creditoris secured.

Consequently, the bank-loan analysisfocuses on determining the value of the vari-ous asset types. The valuation analysis that

produces the higher asset value should beused in determining the bank loan rating.Generally, if the business operating assets areall part of the security package, thinking ofthe collateral as a going-concern businesswould yield the highest values. That explainswhy the enterprise-value analysis is per-formed regularly. However, given the natureof the enterprise-value methodology, thisappropriately is used only when the defaultscenario can be reasonably visualized, e.g.,for highly leveraged companies. In theseinstances, the business presumably continueswithout drastic changes, while the financialoverextension leads to default when the com-pany can no longer service its entire fixed-charge burden. The enterprise value analysiscannot usually be used for investment-gradecompanies or for speculative-grade companieswith conservatively leveraged balance sheets(and whose default risk is based on some seri-ous business vulnerability). Instead, a liquida-tion analysis is conducted to determine theprojected value of the specific assets that con-stitute such companies’ collateral.

Enterprise-Value analysisEnterprise value is established by using a dis-counted cash flow calculation, or, as a short-cut, a general market-multiple approach. Thecompany’s EBITDA (or, where applicable,EBITDAR) at the hypothetical point ofdefault is multiplied by a representative valu-ation multiple. (The value establishedassumes investors would finance the unit witha combination of debt, leasing, and equity).Appropriate discounts are applied to stressboth cash flow and capitalization rates usedto determine the value of the business.

EBITDA is projected to reflect the declinein cash flow at the time the company defaults.For this analytical exercise, the analyst simu-lates default scenarios. First, a base case isconstructed that represents the minimumdecline in EBITDA associated with a potentialdefault. In this scenario, EBITDA falls shortof the company’s periodic interest and debtamortization payments. This scenario resultsin maximum cash flow consistent with adefault and, therefore, equals the highestpotential value for the defaulted company.Second, an alternative scenario is proposed,


under which normalized EBITDA is reducedto a greater extent—usually 50% or more—toreflect other possible, more stressful defaultscenarios. Additional scenarios, with differentreductions, can reflect company-specificdefault factors, such as sector risk, political,regulatory, or other factors. The more nega-tive scenario is not automatically used in therating determination; analysts must judgewhich scenario is appropriate based on thecompany’s individual circumstances.

As explained earlier, a borrower with arespectable business position but a riskyfinancial profile would be more likely todefault (if a default occurs at all) because ofits leverage than because of a decline in itsbusiness strength. Such an entity would beviable over the long term if it were moreappropriately capitalized. The base-case sce-nario would be weighed more heavily. Bycontrast, a borrower with a weak business ismore likely to default because of a decline inits business (failure to keep up with competi-tion, changes in technology, etc.). The impair-ment of its business associated with thedefault scenario could more seriously affectits cash flow and market value. Accordingly,the weighting would lean toward the down-side risks—or we would decide to abandonthe enterprise-value approach altogether.

The cash-flow multiple used in the enter-prise valuation model takes into account themarket multiple of the borrower’s peer group.(This market multiple would always have tobe adjusted to incorporate the negative effecta bankruptcy filing.) Cash-flow multiples, ofcourse, change. If for no other reason, theyshould fluctuate with prevailing interest rates.For rating purposes, 5x has some empiricalvalidity over the long term—and we cannotpredict interest rates at the unspecified timeof the simulated default. Actual experiencewith sales of distressed companies shows the5x multiple to be widely applicable.

A higher multiple might in some instancesbe warranted—for example, if an industryhas unusual growth potential. However, onemust be cautious about arguing for a highermultiple for a company in a very troubled sit-uation—i.e., following a bankruptcy filing. Itis hard to be confident that the industrywould still have such positive characteristics

in that context. When the insolvency risk canbe attributed to a cyclical problem, theremight be some predictability of a post-defaultrebound. That should warrant using a highermultiple of the cash flow at a cyclical lowpoint, which presumably would coincide withthe point of default.

To be conservative, any priority claims—such as product or environmental liabilities—that are material would be deducted from theenterprise value. Similarly, the value of otherexisting secured debt, such as industrial rev-enue bonds or mortgage debt, is subtractedfrom the enterprise value. In some instances,trade creditors could have a perfected first-priority interest in merchandise, and the bankcreditors would have a lower-priority claimon inventory. Importantly, to the extent thecompany relies on operating leases to gener-ate its cash flow, an amount must be sub-tracted from the capitalization to representthe ongoing lease obligation.

The enterprise value analysis also assumesany revolving portion of a bank credit facilityis fully drawn at the time of default.(However, this harsh assumption is not auto-matically made regarding notching down anyunsecured issues.) In some cases, assumedborrowings under the rated facilities are ear-marked for acquisitions. In these instances,the default EBITDA levels would be adjustedfor the additional cash flow from these acqui-sitions. The effect is adequately dealt with inthe base-case scenario, but adjustment iscalled for in the downside case. Given thelikelihood that most acquisitions will not betotally productive, the full amount of cashflow normally attributable to the borrowingsis not added to EBITDA. The conservativeposition is to add 50% of the new cash flowto the EBITDA figure.

Standard & Poor’s default scenario is mod-eled on EBITDA being insufficient to coverinterest and amortization payments. Asnoted, other scenarios may affect the timingof a default. For example, a company maynot be able to meet its amortization scheduleor a bullet maturity, precipitating a default.Other large required outlays—includingnondiscretionary capital expenditure—couldhave a similar effect on a wobbly company.In such cases, the cash flow associated with



the default scenario should be higher than theusual base-case default assumptions.However, (re)financing risk ultimately isrelated to a company’s prospects. As long asprospects for a company suggest an ongoingability to service its debt, lenders shouldmake financing available. The distressed-EBITDA default scenario generally reflectsconditions that preclude refinancing.

Discrete-Asset value analysisStandard & Poor’s has rated loans backed bya broad range of assets, from real estate anddrilling rigs to timberlands and oil and gasreserves. Important considerations include thetype and amount of collateral, whether itsvalue can be objectively verified, and howlikely will it hold up under various post-default scenarios, along with any legal issuesrelated to perfection and enforcement.

The analytical starting point is the assets’current value. Market value is key, and there-fore appraisals often are required. Severalmethods are used to determine the marketvalue, including recent sales of comparableassets and the assets’ replacement cost, adjust-ed to reflect their age and technology. Othervaluation techniques include discounting cashflow, industry norms and multiples of earningsand cash flow, and replacement value and fixedprices per unit of production (for naturalresources). Although all valuation methodolo-gies rely on some subjective aspects, the moreobjective the valuation, the better. (As noted,however, the relevant value is the value of theasset in a distressed scenario. To one degree oranother, the company’s asset values normallywill be affected by the default scenario, when itis not business as usual.)

Book values typically are irrelevant, butmay sometimes suffice to establish the start-ing point—if historical price and deprecia-tion policies are standardized, anddepreciation schedules are adequate to keepbook value in line with market value. Twoexamples of assets for which this approachhas been used are shipping containers andautos. Appraisals usually are necessary whenthe collateral is specialized, such as realestate, plants, or equipment.

The assets’ potential to retain value overtime is critical. Even if not directly linked to

the company’s fortunes, asset values fluctuateand need to be stressed. Therefore, collateralis judged according to volatility, liquidity,special-purpose nature, and any correlationof its value with the health of the issuer’sindustry. Even assets that have value inde-pendent of the specific owner may still becorrelated to industry or market factors.Because the relevant context is the default ofthe assets’ owner, the analyst must be mindfulthat the circumstances leading to a defaultmight also affect the assets’ values. For exam-ple, if the borrower were a supermarket chainand the collateral were its fleet of trucks, theassets’ value would not be reduced by thecompany’s default. But, if the borrower werean offshore contract driller and the collateralwere its fleet of vessels, there might well be astrong correlation between the events leadingto the company’s default and the marketvalue of its drilling ships.

Also, if proper upkeep is critical to theassets’ value, there might be some doubtabout how much maintenance a failing com-pany would provide. Any costs that wouldhave to be expended to realize asset valuesalso must be taken into account. Theseinclude dismantling installation, transporta-tion, foreclosure, and remarketing costs,among others. On the other hand, the analy-sis would be based on an orderly liquidationscenario, rather than a fire sale.

Springing liens.“Springing liens,” as the name implies, areliens that become effective once a company’scredit quality deteriorates to a predeterminedlevel. This level normally reflects the point atwhich creditors would become concernedabout the possibility of default and bankruptcy.Often, the trigger for springing the lien is tiedto a reduction in Standard & Poor’s rating.

As far as rating criteria for corporate rat-ings, these liens ordinarily are consideredidentical to liens that already have been per-fected, because they likely will be in effectby the time that security is relevant—i.e., inbankruptcy. (In the case of structured enti-ties and hybrids, the approach we take isradically different because such entitiesmight well preemptively file for bankruptcyprotection to avoid an elevation in the sta-


tus of claims against their assets by becom-ing secured.)

The corporate approach applies to bothnotching up and notching down. Bank loanscontaining springing liens can be notchedup immediately; unsecured issues are to benotched down immediately to reflect theirultimately disadvantaged position in bank-ruptcy to loans that contain springing liens.

However, one can never completely takefor granted the ability to perfect a lien. Thislegal risk would force some distinctionbetween security that already has been per-fected and security that still requires perfec-tion. In practice, this factor could serve as adamper against assigning a rating two ormore notches above the corporate creditrating in cases that would otherwise deservesuch substantial enhancement.

A lien also cannot be perfected when acompany is in bankruptcy, and problemsregarding preference may apply if the liensprings close to a filing. That makes itimportant to have the trigger level corre-spond to a point in time that presumablywill come well before a default. If a ratingtrigger for springing the lien is ‘BB-’ orhigher, we would expect the lien to be legal-ly enforceable, expecting such a rating toapply well ahead of any bankruptcy filing.

Conversely, some liens are designed to fallaway. The effect of this potential removal ofthe security feature should be reflectedimmediately. A typical example would be afive-year loan secured only for the first yearor two. In that instance, the rating shouldignore the security, given its temporarynature (unless the corporate credit rating isvery low, in anticipation of imminentdefault). Another arrangement allows thelien to fall away when the corporate creditrating is raised. In that case, the loan ratingcan be enhanced at the outset—to the extentthat it would remain at that level even afterthe security lapses, consistent with the high-er corporate credit rating at that point.

Second liensThe bank loan rating for second-lien debtcan range from being notched above thecorporate credit rating, to the same as the

corporate credit rating, to below the corpo-rate credit rating by one or two notches.

The key is to analyze the expected recov-ery following any potential default inabsolute terms.

The best case would be one where the first-lien debt is relatively small in comparison to theassets of the company, so that the disadvantageit poses to the second-lien debt is belowStandard & Poor’s typical threshold levels.

Borrowing basesA borrowing base sets a limit on borrowingbased on a percentage of the assets outstand-ing at a given time. The borrowing-base defi-nitions of eligible assets are used to excludeimpaired assets such as overdue receivables orobsolete inventory. If the analyst is comfort-able with the borrowing base formula at theoutset, its applicability can be relied on overtime. The amount of any new borrowingswould depend on the quality and value ofthen-current assets, although risk remains forwhat has already been borrowed. For exam-ple, the borrowing base may require anamount of oil and gas reserves as collateral.But once the advance is extended, the oil isproduced, and there can be no guarantee thatnew oil will be found to replace it.

Ideally, as oil is produced or inventories aresold and receivables are collected, the proceedsmust be used to repay bank borrowings, andrenewal of borrowing means once again meet-ing the tests. But often, this is not the case.Nonetheless, the proximity of the valuation tothe time of the ultimate default, as well aspotential limitation of exposure to furtherdeterioration are advantages. Periodic moni-toring allows the banker to exercise some con-trol. It is therefore important to know howfrequently compliance with the borrowingbase is calculated and what remedies are avail-able if the base is exceeded. The definition ofeligible assets obviously is critical.

The path to bankruptcy could involve amajor drop in asset values, even if the defaultscenario incorporates an inventory buildupresulting from a decline in sales. Unit valuemay slip as inventory piles up. Accumulationof aging, uncollectible receivables also is possi-ble, but less common. Credit agreements often



have sublimits on inventory borrowings in rela-tion to total borrowings, to guard against justsuch unfavorable shifts in the collateral mix.

Stock as collateralBeing secured by a pledge of a business unit’sstock is not the same as being secured by theassets of that unit. The stock represents onlythe residual value after all claims directlyagainst the unit have been satisfied—and mayin the end be worthless.

The criteria, however, do not precludeassigning value when shares are the collateral.Shares of the borrower—which would bebankrupt in the relevant scenario—presum-ably would have little value. The same wouldapply to the shares of major subsidiaries of abankrupt borrower, especially if the compa-nies are in the same general line of business.However, shares of a subsidiary in a differentline of business, or of a subsidiary abroadthat has independent business prospects, mayretain value, even if that subsidiary is drawninto the bankruptcy.

(Standard & Poor’s Ratings Services’ legalteam has researched the risk of substantiveconsolidation, and concluded that it is remotein nearly all cases.)

The key analytical issue would be the riskthe subsidiary is weakened financially byactions of its parent as the parent struggles tostave off its own default. Even if that unit hasfew liabilities now, there must be legal or reg-ulatory restrictions that prevent incurringadditional debt—or the residual value of theshares could be diminished.

Subsidiary stock has been an effectiveway of providing valuable security in caseswhen assets could not be pledged directly—e.g., certain licenses and contracts. Thelicenses are set aside in dedicated sub-sidiaries, typically as their sole assets—whileliabilities are strictly limited.

Tenor/amortizationLong-term concerns that could constrain acorporate credit rating may extend beyondthe time horizon of an issue or bank loanfacility. Therefore, a short final maturity maybe favorable. (Unsecured debt issues do notbenefit similarly from shorter maturities,because they normally are repaid by refinanc-

ing. The issue’s long-term risk profile wouldaffect the refinancing risk.)

In addition, because confidence in assetvaluations diminishes over a longer timespan, the ratings benefit that could be givenfor asset-based recovery potential is greatestfor short-term loans. For example, at a giventime, the outlook for energy markets maycause little concern for the value of oil rigsfor the next two or three years, but greatconcern about potential loss of value over a12-year period. Also, the risk of obsolescenceor regulatory restrictions increases over timefor certain types of assets such as aircraft.Similarly, when assessing a potential bank-ruptcy scenario, doubts about how operatingassets might be affected would be greater ifbankruptcy proceedings are anticipated to belengthier than normal.

Amortization reduces the amount of debtthat must be covered by the value of the assets,and thereby improves loan-to-value coverage(unless the security is reduced in tandem via aborrowing-base formula). Accordingly, if onetranche of a loan facility amortizes more quick-ly or is significantly shorter than another, thetwo tranches could be rated differently.

Legal considerationsFor collateral to be given weight in the ratingprocess, lenders should have a perfected secu-rity interest in the collateral. Perfection canbe accomplished in a number of ways, includ-ing Uniform Commercial Code filings in theU.S., possession, title, and regulatory filings.

Not all collateral types (e.g., patents andtrademarks) readily lend themselves to perfec-tion. And some assets, such as cargo contain-ers, may be easy to perfect but hard to locateand recover if they are in foreign countries atthe time of a bankruptcy filing. Uncertaintyabout gaining possession of part of the collat-eral can sometimes be offset by providinggreater overcollateralization.

“Tight” covenantsCovenants alone—in the absence of collater-al—seldom result in a higher debt rating,although there could be a boost for therecovery rating.

As far as default risk, if the covenantbreach were to arise from deterioration in the


business, the bank’s enforcement will onlycompound the problem. If the bank refuses toprovide more funds—and especially if itrequires immediate repayment—the compa-ny’s liquidity will suffer and the risk of defaultincreases. The best-case scenario would beone in which the bank waives or renegotiatesthe covenant without penalizing the companyby way of compensation or tougher terms.

If the potential covenant breach is linked toa proposed credit-harming transaction that isdiscretionary, the bank could force the com-pany to abandon the transaction. But, if thebank waives the covenant, or if the companymanages to refinance the bank loan as part ofits deal, the covenant will not have benefitedthe company’s default-risk profile.

Accordingly, tight covenants theoreticallycould benefit the corporate credit rating, butmore often do not. Rating enhancementwould apply only when:� Concern over a deliberate credit-harming

event is the specific rating factor that pre-vents a higher rating (situations in which therating explicitly takes into account such anexpectation or event risk are uncommon—except in the context of a parent tapping thefinancial potential of a subsidiary); and

� The covenants would have to be tightenough to prevent any transaction inconsis-tent with the higher rating level; and

� We could be confident in advance that thebank would not waive the covenant, andcould not (easily) be replaced. In reality,the bank’s waiver or alternative financingshould be available for reasonable credits—i.e., wherever the rating outcome followingthe transaction is ‘BB-’ or better.Enforcement of the covenants and precipi-

tating a bankruptcy might indeed benefit thebank in terms of ultimate recovery of princi-pal from a deteriorating situation. The bankwould be seeking repayment early on, whilethe business retained greater value. However,the rating outcome for the bank loan wouldnot necessarily be higher than it would bewithout the tight covenants—and might evenbe lower: Increased notching would presum-ably be from a lower corporate credit rating,given the increased risk of default.

If the covenant breach arises from a discre-tionary transaction, the bank could avoid

risk—if not by preventing that transaction—byinsisting that it be taken out by other financ-ing. The rating benefit to the bank loan itselfwould still depend on the extent to which sucha potential credit-harming transaction plays arole as a rating factor in the first place. Themore prominent the transaction’s role in therating—i.e., to the exclusion of concern forordinary, fundamental risks—the more thepotential that tight covenants could mitigaterisk and enhance the assigned rating.

Debtor-In-Possession (DIP) FinancingBecause adequate funding is key to a compa-ny’s potential for reorganization and emer-gence from bankruptcy as a viable entity, theU.S. Bankruptcy Code provides incentives forlenders to finance companies operating underthe protection of Chapter 11. Such post peti-tion financing is known as debtor-in-posses-sion (DIP) financing.

Our criteria for rating DIP loans extendedto companies in bankruptcy employs the con-ceptual framework developed for bank loanratings. The analysis for these DIP loans con-sists of two parts:� The first focuses on timely repayment; and� The second focuses on the particulars of

the specific loan and the potential forrecovery on that loan in the event liquidation (a shift to Chapter 7) becomes necessary.

Timely paymentIn the case of DIP loans, timely payment ofprincipal occurs through the debtor-in-posses-sion’s reorganization, its emergence fromChapter 11, and repayment of the DIP loan.Such payment is considered “timely” and inaccordance with the terms of the agreement—not withstanding the possibility of a statedearlier maturity—in keeping with the normalexpectations. DIP lenders generally are tied infor the duration of the reorganization process.

This part of the analysis considers the like-lihood of reorganization. A favorable assess-ment is likely for viable companies,particularly for large, established entities. Ifthe operation is fundamentally healthy, butthe company is saddled with debt because of



a leveraged buyout (LBO), a recapitalization,or an overpriced acquisition, its ability toservice a more appropriate debt load via reor-ganization might be quite strong.

However, if there were any significantdoubt about the company’s viability, theresult probably would be a speculative-gradeoutcome. A failed company in an industrywith poor fundamentals or with a seriouslyflawed business model would be a lesser can-didate for rehabilitation and refinancing.

Accordingly, much of the analysis is identi-cal to the fundamental corporate credit analy-sis relating to a company in the context of itsparticular industry. This analysis focuses onthe supply-and-demand forecasts for the com-pany’s products, its market position, operat-ing history, current cash flow, and ability tooperate profitably once it has a manageablecapital structure. These factors are much thesame as would be considered in assigning acredit rating to a non-bankrupt company. Ofcourse, the impact of the bankruptcy itself—on the company’s business relationships withits customers, its vendors, and its employ-ees—is critical in the case of a DIP loan.

One important difference from other ratedinstruments is the relatively short time hori-zon for a DIP loan (often six months to twoyears), which obviates some of the longer-term considerations factored into traditionalratings. In rating a DIP loan, we focus onlonger-range factors only to the extent theyaffect the company’s ability to reorganize.

Once the company has filed for Chapter 11protection, pre-petition debt service usually issuspended. Obviously, there will be debt serv-ice on the rated loan and there may be otherobligations the court has approved for contin-uing payment. If there is secured debt, thecompany generally will accrue post-petitioninterest—even if no cash payments are beingmade—to the extent the value of the securityexceeds the amount of the debt. It is impera-tive to be aware of any motions that may befiled on behalf of pre-petition creditors toreceive payment of their claims, adequate pro-tection for their position, or otherwise contestthe DIP loan. The company may be planningasset sales, store closings, or lease cancella-tions, all of which could have a bearing on thelevel of cash flow the company can generate

and its attractiveness as a viable candidate forfresh financing to take out the DIP lenders.

Collateral and ultimate recoveryThe second part of the rating analysis looks atthe particulars of the specific loan and itsrecovery potential in the event of liquidation.As with collateralized loans to non-bankruptcompanies, the rating may be enhanced byone or several notches, if there is a reliable,second way out.

Strong legal protection is a hallmark ofDIP lending, and so it would be normal toexpect some enhancement of the DIP loanrating: Thus, the rating is anchored by theperceived likelihood of reorganization, andsupplemented by the potential for recoverythrough asset liquidation.

We analyze collateral with a focus on itsability to retain value through a liquidationprocess. A conservative valuation of the collat-eral should cover the loan by a safe margin (see“Bank Loan and Private Placement RatingCriteria”). This would be the case if a compa-ny entered Chapter 7. Receivables and invento-ry often are the collateral supporting typicalindustrial DIP loans. This collateral is amongthe most liquid types, and typically governedby conservative borrowing bases.

Legal statusSection 364 of the U.S. Bankruptcy Code pro-vides for “superpriority” status to be given to aclaim for payments on the DIP loan if that isthe only way to induce lenders to provide cred-it. Superpriority status—i.e., the right to berepaid from the unencumbered assets of thecompany—gives the DIP lender substantiallythe same recovery rights as a direct securityinterest in the otherwise unencumbered assetsof the company would have. In addition, thebankruptcy court may authorize security forthe loan through a lien on the company’s unen-cumbered property. While a debtor-in-posses-sion may obtain unsecured financing in itsordinary course of business without a courtorder, the bankruptcy court must approve anyloan agreement that puts payments ahead ofother administrative expenses.

By providing clarity on the status of thelender’s claim to be repaid, court ordersauthorizing application of these provisions of


the bankruptcy code give substantial comfort.Analysis of the loan agreement and courtorders can determine the priority of thelender’s claim on the company’s payments. Itis important to review any other claims, eitheron par with or prior to the loan. In addition,there may be liens that can affect the lender’sclaim: Taxes and ERISA claims may be ofsuch a priority. Pension Benefit GuarantyCorp. (PBGC) claims normally are treated asjunior in priority to any DIP claim. To under-stand the nature of any significant liensagainst a company, Standard & Poor’s views aUniform Commercial Code (UCC) search asimportant. We will discuss the results of anysignificant findings with the company, as wellas whether new liens have been filed.

A DIP loan with superpriority claim status,and a tight loan agreement and court order,can get the full measure of rating enhance-ment. A strong court order would state thatno other claim having priority over or being

on par with the DIP loan should be grantedwhile the DIP loan is outstanding. This isimportant because the lender may have asecurity interest in unencumbered collateral.In addition, the court order should explicitlyestablished the superpriority status of the DIPlender’s claim and assure that the automaticstay provisions will not be lifted of modifiedto the detriment of the DIP loan.

Key DIP documentsThe following are the key documents neededfor rating a DIP loan:� Loan agreement, with all modifications

and amendments;� Updated financial information;� Interim orders and final order;� Evidence of a UCC search, with e-mail

confirmation of new prior claims, and� Opinion that the order has become final

and is unappealable. ■



What is equity?What constitutes equity in the first place?Traditional common stock—the paradigmequity—sets the standard. But equity is not amonolithic concept; rather, it has severaldimensions. We look for the following posi-tive characteristics in equity: � It requires no ongoing payments that could

lead to default; � It has no maturity or repayment require-

ment; � It provides a cushion for creditors in the

case of a bankruptcy; and � It is expected to remain as a permanent

feature of the enterprise’s capital structure. If equity has these distinct defining attrib-

utes, it should be apparent that a specificsecurity can have a mixed impact. Hybridsecurities, by their very nature, will be equity-like in some respects and debt-like in others.We analyze the specific features of anyfinancing to determine the extent of financialrisks and benefits that apply to an issuer.

In any event, the security’s economicimpact is relevant: its nomenclature is not. A

transaction labeled debt for accounting, tax,or regulatory purposes may still be viewed asequity for rating purposes, and vice versa.

Attributes of equityEquity provides value for the enterprise.When a company sells equity, it receivesmoney to invest in its business. It is able todo research, buy equipment, or supportinventory and receivables growth—all to gen-erate cash flow and keep the enterprisehealthy. If issuing a security allows the com-pany to avoid a cash outflow that wouldhave been incurred in the course of business,the beneficial impact is identical. Whenshares are issued in lieu of employee benefitsthat otherwise would be paid in cash—forexample, as part of an ESOP—this aspect ofequity is fulfilled. However, if shares areissued as a new—perhaps unnecessary—formof compensation, the benefit is dubious: thequestion is whether the enterprise hasreceived anything of value. Soft capital—acommitment from a nonaffiliated provider ofcapital to inject equity capital at a later

Equity Credit: What It Is AndHow You Get It

Standard & Poor’s Ratings Services often is asked, “Will the

issuer of this hybrid security receive equity credit?” In other

words, has the issuer’s credit quality improved and has its debt

capacity expanded, as is ordinarily the case when equity is added

to the balance sheet?

The question of equity credit is not a yes-or-no proposition. The

notion of partial credit is very appropriate.

(Editor’s note: This articleupdates a Corporate Criteriaarticle originally published onOct. 28, 2004.)


date—offers another example of a transactionthat falls short in terms of this basic attributeof equity. However valuable it may be tohave a call on funds in the future, the busi-ness does not have the funds now. And, bymaking the funds available at the company’sdiscretion, there is the risk that a delay inexercising that option may lead to a situationof “too little, too late.” � Equity requires no ongoing payments that

could lead to default. Equity pays divi-dends, but has no fixed requirements thatcould lead to default and bankruptcy ifthese dividends are not paid. Moreover,there are no fixed charges that might, overtime, drain the company of funds that maybe needed to bolster operations. A compa-ny is under pressure to pay both preferredand common dividends, but ultimatelyretains the discretion to eliminate or deferpayment when it faces a shortage of funds.Of course, a company’s reluctance to passon a preferred dividend is not identical toits reticence to altering its common payout.Accordingly, there is a difference in “equitycredit” afforded to common equity relativeto preferred equity. Similarly, commonequity issued in conjunction with so-calledincome depository securities (IDSs) isviewed as possessing less discretion overdividends: They are marketed with anexpected yield, and investors are promiseda payout of virtually all cash flow. The longer a company can defer dividends,

the better. An open-ended ability to deferuntil financial health is restored is best. As apractical matter, the ability to defer dividendpayments for five or six years is most criticalin helping to prevent default. If the companycannot restore financial health in five years, itprobably never will. The ability to defer pay-ments for shorter periods also is valuable, butequity content diminishes quickly as con-straints on the company’s discretion increase.

Debt instruments can be devised to provideflexibility with regard to debt service.Deferrable payment debt issued directly toinvestors—i.e., without a trust structure—legally affords the company flexibility regard-ing the timing of payments that is analogousto trust preferreds. Yet, by being identified asa debt security, the company’s practical dis-

cretion to defer payments may be con-strained, which diminishes the equity creditattributed to such hybrids compared withdeferrable payment preferred stock.

By removing the discretionary element, cer-tain trigger mechanisms can increase comfortthat deferral actually will occur when the cir-cumstances of the issuer make this desirablefrom the creditors’ perspective. Incomebonds—i.e., where the payment of interest iscontingent on achieving a certain level ofearnings—were designed with this in mind.However, to the extent that cash flowdiverges from earnings measures, incomebonds tend to be imperfect instruments. Arecent variation on the theme pegs the levelof interest payments to the company’s cashflow. The equity content of such instrumentsis a function of the threshold levels used todetermine when payments are diminished. Ifthe level of cash flow that triggers paymentcurtailment is relatively low, that instrumentis not supportive of high ratings. Anotherstraightforward concept entails linking inter-est payments to the company’s common divi-dend, creating an equity-mimicking bond. Anumber of international financial institutionsissued such bonds in the late 1980s. Ofcourse, if a company had an inordinateamount of dividend-linked issues outstand-ing, this ultimately could increase its reluc-tance to curtail its common dividend. � Equity has no maturity or repayment

requirement. Obviously, the ability toretain the funds in perpetuity offers thecompany the greatest flexibility. Extremelylong maturities are next best. Accordingly,100-year bonds possess an equity featurein this respect (and only in this respect)until they get much nearer their maturity.To illustrate the point, consider howmuch, or how little, the company wouldhave to set aside today to defease or han-dle the eventual maturity. However, cross-default provisions would lead to thesebonds being accelerated. Preferred equity often comes with a maturi-

ty—as a limited-life or sinking-fund pre-ferred—which would constitute a clearshortcoming in terms of this aspect of equity.Limited credit would be given for this type ofpreferred, even if the security had a 10-year


life or more. Even if it could be assumed theissue successfully is refinanced at maturity,the potential for using debt in the refinancingwould be a concern (see the following discus-sion on the permanence of equity). � Equity provides a cushion for creditors in

the event of default. What happens inbankruptcy also pertains to the risk ofdefault, albeit indirectly. Companies cancontinue to raise debt capital only as longas the providers feel secure about the ulti-mate recovery of their loans in the event ofa default. Debtholders’ claims have priorityin bankruptcy, while equity holders are rel-egated to a residual claim on the assets.The protective cushion created by suchequity subordination allows the companyaccess to capital, enabling it to stave off adefault in the first place. Subordination typically is a secondary con-

sideration compared with other beneficialaspects of equity. Thus, if an instrument issenior, but ongoing payments are deferrableand it has a long-dated maturity, we couldwell view it as having substantial equity con-tent. On the other hand, if an instrument issubordinated, but lacks the other equity-liketraits, it would be viewed as predominantlydebt-like. The distinction between subordina-tion and deep subordination generally is notsignificant in our analysis, although deep sub-ordination incrementally is more supportive. � Equity is expected to remain a permanent

feature of the enterprise’s capital structure.At any time, a company can choose eitherto repurchase equity or to issue additionalshares. However, some securities are moreprone to being temporary than others. Ouranalysis tries to be pragmatic, looking forinsights as to what may ultimately occur.The ability to call always should give rea-son for pause; however, we have not placedmuch emphasis on this feature if the instru-ment is truly low-cost—such as tax-deductible preferred—and, therefore,should not pressure the company to refi-nance. Calls exercisable after five years arevery common to long-dated hybrids. (Wewould question the rationale for a call dateonly two to three years after issuance.)Sometimes the issuer has the right to callthe instrument not just on the initial call

date, but on each subsequent coupon date:this weakens equity credit, because itincreases the likelihood the issuer ultimate-ly will find conditions attractive for refi-nancing the instrument with debt. Preferredstock, in particular, likely will have provi-sions for redemption or exchange, if not anoutright stated maturity. Coupon step-upsare designed to motivate calling the issue.Auction or remarketed preferred stock isdesigned for easy redemption. Even thoughthe terms of this type of preferred providefor its being perpetual, failed auctions orlowered ratings typically prompt the issuerto repurchase the shares. Our discussions with management regard-

ing a company’s financial policies provideinsights into its plans for the securities:whether a company will call or repurchasean issue and what is likely to replace it.“Replacement language” in the issue thatrestricts refinancing to issues of similar equi-ty content can provide additional comfortregarding management intent, even thoughcompanies’ financial policies can vary overtime, future capital market conditions couldlimit the ability to issue specific types ofsecurities, and legal enforcement is dubious.Another important consideration is theissuer’s tax-paying posture. It is difficult fora nontaxpaying issuer to make the case thatthe company will continue to finance withnontaxdeductible preferred stock once itbecomes a taxpayer and can lower its cost ofcapital by replacing the preferred with debt.Other clues can come from the nature ofinvestors in the issue (e.g., money market, asopposed to long-term fixed-income investors)and the mode of financing that is typical ofthe company’s peer group. For example, util-ities traditionally finance with preferredstock, and industry regulators are comfort-able with it. Therefore, the usual concernthat limited-life preferred stock will be refi-nanced with debt does not generally apply inthe case of utilities.

In the case of so-called tax-deductibleequity, risk exists that their favorable taxstatus is overturned, and—especially withnew hybrids—that risk may be substantial.This concern can be mitigated by provisionsin the transaction to convert into another

Equity Credit: What It Is, and How You Get It


equity-like security in the event of loss oftax-deductibility.

Rating methodologyWhile many focus on the leverage ratio inthinking about equity credit, a company’sleverage is just one of many components of arating assessment. (In fact, cash flow adequa-cy and financial flexibility have long sur-passed balance-sheet considerations asimportant rating factors.)

Standard & Poor’s methodology of break-ing all the analyses into categories allows eachof the several attributes of hybrid securities tobe considered separately and in the appropri-ate analytical category. The aspect of ongoingpayments is considered in fixed-charge cover-age and cash-flow adequacy; equity cushionin leverage and asset protection; need to refi-nance upon maturity in financial flexibility;and potential for conversion in financial poli-cy. The before- and after-tax cost of payingfor the funds also is a component of bothearnings and cash flow analysis.

In practice, the analyst often takes a short-cut approach to reflecting hybrids in creditratios. In general, the analyst calculates alter-native sets of ratios, reflecting that the truthlies in a gray area between two perspectives.(Please see the “Hierarchy” section at the endof this piece.)

But we do not simply “haircut” hybridsecurities or assign fractional equity creditwhen calculating financial ratios.

In any event, the relative importance ofeach equity attribute can vary. The criticalissues for companies can differ. Moreover, thefactors that delineate ‘A’ ratings from ‘AA’ratings tend to differ from those that deter-mine whether a rating will be ‘B’ or ‘BB’. So,the impact of a hybrid may depend on thespecific needs of a given issuer or its place inthe rating spectrum. Aspects affecting near-term flexibility usually are of prime impor-tance for low-rated, troubled credits, whilelong-term considerations are more germanewhen an already highly rated credit is beingreviewed for an upgrade. To illustrate thepoint: Replacing 20-year debt with 100-yeardebt is a nonevent for a company facinginsolvency in the next several quarters.

There are no specific limitations withrespect to the amount of hybrid preferredthat receives equity treatment. However, atsome point, one would question a compa-ny’s creating a capital structure with anunusually large proportion of newfangledsecurities. The analytical comfort rangedepends on the seasoning of the type ofinstrument, peer group comparisons, andany potential negatives (in terms of reputa-tion) for the company that might prompt itto reevaluate and restructure.

Factoring Future Equity IntoRatingsThere are many ways to arrange for the cre-ation of equity in the future. These methodsrange from issuing traditional convertiblesecurities to entering forward purchase con-tracts to establishing grantor trusts for futureissuance. The key considerations for receivingcredit today for the promise of a positivedevelopment in the future are: � How predictable the outcome is, and � How soon it will occur.

If the analyst is reasonably assured that anequity infusion will occur over the next twoto three years, then that event can be incor-porated into the financial analysis on a proforma basis. On the other hand, analyzing anequity infusion in the distant future, even ifone could be certain about this eventuality,requires a different approach. It is not mean-ingful to overlay such an event on currentfinancial measures. To do so would be to iso-late just one transaction from the full pictureof the company’s future, in effect, taking itout of context. Yet a program of equityissuance can be a powerful statement aboutthe issuer’s financial policy—an importantrating consideration.

Predicting the outcomeThe first dimension of the analysis is assess-ing the potential for issuance of, or conver-sion to, equity, and the likelihood of thecompany’s retaining that equity as perma-nent capital. The risks vary by the type ofinstrument and any unique characteristics.The following discussion is arranged in


ascending order, based on the likelihood ofa positive outcome.

Convertible debt usually turns into equityat the option of the investor. The issuer canforce conversion, but only if the security is“in the money.”

The odds of any specific issue convertingis a function of the conversion premium andthe likelihood of the company’s stock priceachieving that level. Standard & Poor’s hasbeen extremely conservative about relyingon anticipated stock price movements. Evenwhen the stock is trading very near thestrike price and the company’s future seemsbright, the risk exists that the stock will fallout of favor or that the market as a wholemay turn bearish. There are mechanismsthat can increase the odds of conversion. Forexample, periodic adjustment of the conver-sion premium is one means. However, thedifficulties in statistically assessing the out-comes still would limit any equity creditgiven for these issues. Conversely, discountbonds, such as LYONs, have a built-inmechanism for always raising the bar as thedebt value accretes, thereby making the oddsof conversion ever more remote.

In some securities, the issuer holds theoption to convert into equity. For example,there may be a provision to pay with cash orstock. This provides a modicum of flexibili-ty; however, no equity credit is given. Theanalyst is still concerned the issuer might notexercise its prerogative except under dire cir-cumstances. After all, any company canissue equity—if it so chooses—at the prevail-ing market price. The reality is that compa-nies rarely are satisfied with the marketprice and are reluctant to add such anexpensive form of capital. Even if the sharesettlement is mandatory, a company disin-clined to issue at the market price wouldmerely repurchase those shares.

There is an analogous problem with softcapital from a ratings perspective. The com-pany has a contractual right to demand atany time an equity infusion from some out-side provider of capital: The question is atwhat point the company makes this demand.Moreover, in the interim, the company doesnot enjoy the use of these funds to invest inmaintaining the health of its business.

Covenants offer another way to influencethe outcome. One popular method is torequire that the repayment of principal uponmaturity must be made with funds raisedthrough the issuance of equity. From our per-spective, this method of providing equity isflawed. For one thing, enforceability is dubi-ous. Second, as discussed earlier, if the com-pany is not inclined to add equity at themarket price, it still can meet the legalrequirement of issuing equity while simulta-neously repurchasing its shares. (Banks haveused this structure to raise Tier 1 regulatorycapital. Indeed, considering the regulatoryimpetus behind the issuance, it is unlikely abank would cavalierly reverse such an equityissuance. But it would be wrong to generalizefor all corporate issuers.)

A different covenant calls for automaticconversion when a trigger event occurs—typically, a rating downgrade or a definedfinancial setback. The debt would be elimi-nated at a time when the company mightfind it difficult to service it. This representsan equity feature and helps to place a floorunder the company’s rating if the thresholdfor conversion is set high enough (e.g., atthe investment-grade level).

The most favorable rating consideration isgiven to issues that are mandatorily convert-ible in the near term and at a fixed price.Conversion is a certainty. At the end of a veryshort period, the investor receives one shareof common stock, or a fractional share, if theprice of the common stock has appreciatedbeyond a certain point. The company’s deci-sion to issue the equity is based on thelocked-in floor price for the common stock.Regardless of the movement in the stockprice, there is little reason for the company toreconsider its decision.

Synthetic mandatory equity securities canbe created by using forward purchase con-tracts and related options contracts; theimpact would be equally positive from a rat-ings viewpoint. (However, if there is a sub-stantial mismatch between the issuance of theequity and the maturity of the debt, there isno assumption the debt will be cancelled bythe equity proceeds. The burden of proof ison the company regarding the use of theequity sums for debt reduction.)



Grantor trusts, ESOPsApart from convertibles, grantor trusts andESOPs offer avenues for future equityissuance. Many companies have establishedprograms that commit them to issuingshares periodically as a means of dealingwith large, unfunded, employee benefit lia-bilities. The company places shares in agrantor trust or ESOP to be used over aperiod of time for employee benefits thatotherwise would be paid in cash.

The vehicles for these programs differ withrespect to the range of benefits that can becovered, the scheduling of issuance andreleases of shares, the degree of exposure tochanges in share price, and tax treatment.The creation of new equity via such programsis highly predictable. However, the majordrawback is the extended period over whichthis will occur—seven years to 10 years formany ESOPs, and 10 years to 15 years in thecase of “rabbi trusts,” such as Flexitrusts.This limits the positive impact on currentcredit quality, as explained below.

Timing the issuanceAs important as knowing what will occur isknowing its context. Events anticipated inthe short term are handled differently in theanalytical process than those further out.Anything expected to occur in the next twoto three years is factored into the projectedfinancial statements and credit ratios thatform a basis for rating assessments. Theanalyst’s projections cover this period, tak-ing into account all known aspects of anissuer’s business environment, strategy, andfinancial plans. (Historical financials arerelevant only as a guide to what may occurin the future, because ratings address therisks of the future.) Therefore, if equity isexpected within two to three years, thetransaction can be fully analyzed and incor-porated in the current ratings.

The rating review of a company making alarge, debt-financed acquisition offers a com-mon example. The analysis would not focuson a snapshot view of the issuer’s financialcondition; rather, the rating would take intoaccount the company’s plan to restore finan-cial health, if such a plan exists. New equityusually is part of such plans. The company

might issue convertible securities or it mightcommit to issuing specific amounts of com-mon equity over the short term.

When a positive or negative developmentis expected farther out in the future, its rat-ings impact is diminished. As a dynamicentity, the issuer will be affected in manyoffsetting ways in the interim. To single outone expected event is to take it out of con-text. To reflect its impact in pro formafinancial ratios would be a distortion.

Still, the willingness to issue equity overtime to maintain credit quality can be animportant element of financial policy.Establishing a program to do so representstangible evidence that adds credence to a stat-ed commitment. From a ratings perspective,the beneficial impact still can be significant,even if the equity program is not reflected infinancial ratios. Indeed, when focusing on thelonger term, rating analysis emphasizes acompany’s fundamentals—its competitiveposition and financial policies.

In this light, consider the case of a promi-nent utility that decided to establish a “rabbitrust” to fund a very substantial amount ofemployee benefits over a 15-year period.Historically, the company had issued a com-bination of debt and equity to maintain itsleverage at 50% and its debt rating at ‘A’.Standard & Poor’s, relying on the company’sfinancial policies, was confident the futureheld more of the same. Based on the legalcommitment to add more than $1 billion ofequity via the trust, the company lobbied fora rating upgrade.

However, we concluded that the futureequity added little in this instance. The com-pany still plans to issue debt alongside thenew equity issued by the trust. The dividendreinvestment plan that was used to issue equi-ty in the past would now be discontinued. Infact, leverage at all times will continue to be50%. In short, nothing has changed. In thiscase, the equity program enhances confidencein the ‘A’ rating, rather than suggesting thatthe rating be upgraded.

Often, companies combine share issuanceprograms with share repurchase transactions.A company may incur debt to purchaseshares already outstanding that will be reis-sued through a trust or an ESOP. Another


option is for the ESOP to borrow to buyshares in the market, with the corporatesponsor guaranteeing the debt. This is knownas a leveraged ESOP. Or, a company mayrepurchase shares and issue convertible debtto limit the credit impact.

The analyst separates the dual aspects ofthese actions. The negative impact is identicalto any debt-financed share repurchase.Separately, the promise of future equity istaken into account, along the lines previouslydiscussed. The positive impact of future equi-ty issuance usually is sufficient to partiallyoffset the credit-harming effects of the sharerepurchase. The net result can be an affirma-tion or a smaller downgrade than otherwisewould have occurred.

Tax-Deductible Preferred AndOther HybridsTexaco Capital LLC issued the first of the so-called “tax-deductible” preferred stocks in1993. This hybrid equity security was amajor innovation in corporate finance, creat-ing a modern-day version of the long-existingpreferred stock.

Tax-deductible preferred has since enjoyedtremendous issuance volume. The total is wellover $300 billion. The product has been espe-cially popular with utilities and banks, buthas attracted issuers of all stripes.

Equity creditThe essence of the new financing vehicle’s suc-cess is achieving simultaneous treatment asequity for credit-rating purposes, and treat-ment as debt for the issuer’s tax purposes.

While the new type of preferred sacrificessome of the equity features of conventionalpreferred stocks, it retains sufficient equitycontent to warrant partial equity credit interms of our rating criteria. Importantly, it iseffectively tax deductible, which benefits thecompany’s after-tax profitability and cashflow. This low cost, in turn, enhances theequity content by increasing the expectationsfor longevity of the instrument.

The financing structure calls for issuance ofthe preferred by a subsidiary entity that paysno taxes. The funds are then lent to the par-ent, with the loan terms closely mirroring the

terms of the preferred. The interest paymentson the intercompany loan are tax deductible.

The Texaco deal used a subsidiary locatedin the Caribbean tax haven of Turks andCaicos to issue the preferred. Subsequently,Delaware LLCs, partnerships, and trustswere used to accomplish the same tax treat-ment. Since 1995, the trust structure hasemerged as the vehicle of choice, hence theterm “trust preferred” coming into use todescribe the genre.

The essential equity features that havebecome standard are: � Deferral of payments for up to 60

months—as long as no common dividendsare being paid. (Conventional preferredshave unlimited potential for nondeclarationof dividends, subject only to board repre-sentation by preferred holders after sixquarters of nonpayment.)

� Deep subordination. � 30-year life. (Conventional preferreds are

perpetual, although many have call provi-sions. The new-genre preferreds also arenominally perpetual, but terminate whenthe intercompany loan matures, normallyin 30 years.) We view preferreds that meet these stan-

dards as having intermediate equity content.As the remaining life of the specific issuedwindles over time, the equity attribution isreduced. Conventional preferreds, by way ofcomparison, typically possess equity contentthat does not diminish over time, given theirperpetual tenor.

Some historyAs this financing instrument became verypopular, the U.S. Treasury moved to deny itstax-deductible status. In particular, there wereattempts to define long-tenor instruments as“equity,” limiting the life of “debt” to 15years. This would have discouraged issuanceof precisely that type of preferred that war-rants credit in the rating process, while theshort-life versions would get no rating bene-fit, eliminating the key motivation for compa-nies to issue such hybrids.

It also put at risk the treatment of manyextant issues that provided for unwinding inthe event of a change in tax treatment. Thecontinuation of equity treatment then



depended on expectations the tax treatmentof outstanding issues would be grandfa-thered. (Other deals would result in a parentpreferred were a change in tax treatment tooccur, and were not a problem.)

In the end, however, Congress did notadopt the proposals, and the tax treatmentis now viewed as safe. The tax rules are left with extremely broad and very vaguedefinitions of debt/equity—including how an instrument is viewed by credit rat-ing agencies.

Another issue confronting the new pre-ferreds has been accounting treatment.Initially, these preferreds were displayed onthe balance sheet as “minority interest.” Asof 2003, however, they must appear as a lia-bility, and the dividend payments show up inthe same category as interest expense.

This change probably dampens the enthusi-asm of companies for issuing these securities.However, the change in accounting does notdrastically affect the equity treatment weafford the preferreds.

Nomenclature and accounting can influ-ence the general perception of the instrument,thereby subtly affecting the company’s discre-tion regarding payment deferral. Still, thesefactors are secondary to the terms of theinstrument and the company’s economicincentives, so the equity content is onlyslightly reduced because of debt accounting.

(Banks and financial institutions face addi-tional issues regarding the acceptance of thesepreferreds as regulatory capital. Regulatorswere first reluctant in this respect, but dideventually allow them, with some modifica-tions, to be treated as Tier 1 capital. In lightof changes in accounting, changes to thestructure may now be needed to continue toget such capital credit in the future.)

Adding featuresSome trust preferreds add convertibility fea-tures to make them more equity-like.Investors can convert to common equity, sub-ject to the stock price appreciating by a cer-tain percentage. Indeed, under Standard &Poor’s criteria, convertible preferreds are typi-cally viewed as having 60% equity content.

To broaden investor appeal, preferredswith variable rates were introduced. This

does not, in our view, alter the equity con-tent, although the exposure to floating rates,if material, can pose a risk that is consideredin other aspects of the analysis.

A further “innovation” called for reset-ting rates after an initial 5- or 10-year peri-od. The idea was to create an incentive forthe company to call the issue at that point,to avoid a penalty rate. We regard issueswith step-up rates as having an effectivematurity at that point, thereby largelyundermining their equity content.

A reset that merely captures any change inthe issuer’s credit spreads is less trouble-some, because the company presumablywould have little incentive to refinance theissue. That still could be problematic, if, forexample, the issuer dropped to non-invest-ment grade: its cost for long-term fundsmight be expected to widen to the point thatonly shorter-term alternatives would bepalatable. Alternatively, the reset could be afixed spread over a floating rate that is high-er than the current credit spread. Arguably,the extra spread could be justified as com-pensation for potential credit deteriorationover a long term. Moreover, it cannot bepresumed to be higher than the company’scredit spread will be at the reset date.

A miniscule rate reset—say, 25 basispoints—is not problematic, nor is movingfrom a fixed to a floating rate, by itself, aproblem. However, adding 50 or more basispoints to the fixed rate or the reference rateproduces a penalty rate. Similarly, if the rateis the higher of two or more reference rates,there is an effective penalty to the issuer.(There can be exceptions, however, depend-ing on the specific rates involved. For exam-ple, there is no concern if one is a 30-dayrate and the other a 30-year rate, since onecan expect the longer-term rate will applyalmost all of the time.)

To mitigate the impact of stepped-up rateson the equity credit afforded to that financ-ing, some issues proffer “replacement lan-guage,” promising that any refinancing ofthe instrument will come from proceeds ofan equity issuance or a new instrument ofequivalent equity content. The legal enforce-ability of such terms is highly dubious.Nonetheless, Standard & Poor’s does put


stock in such provisions, as long as the com-pany involved has a decent record of credi-bility, and the language is highly specificregarding the definition of instruments thatwould qualify as replacements.

Global variationsThe new genre of preferreds has local varia-tions, reflecting differing capital market pref-erences and tax considerations.

In the U.K., for example, Inland Revenueallows a tax deduction even if the debt isperpetual and dividends can be deferredwithout limitation. A handful of deals(notably, from Grand Met PLC and CadburyPLC) did incorporate those equity enhance-ments—and the equity content, from ourperspective, was boosted.

On the other hand, European investors areless inclined to make very long-term invest-ments. European deals, therefore, are morelikely to incorporate reset provisions—mak-ing replacement language critical.

Some European deals introduced greaterrestrictions on the ability to defer dividends.The issuer can defer only after curtailing itscommon dividend for some period of time.This translated into seriously lower equitycredit afforded to those issues. In the caseof companies that do not pay a quarterlycommon dividend—not unusual inEurope—the problem is compounded,because there might be an even longer peri-od between when the company experiencesfinancial distress and when it can defer pre-ferred dividend payments. Similarly, thevalue of deferability is diminished if thedeferral can only occur following a periodwhen the company has reported a net loss,but where the company reports results on asemiannual, rather than quarterly, basis.

In some European instruments, paymentsare noncumulative. This is incrementallymore beneficial than when payments arecumulative, because the need to make uppayments previously deferred can otherwisehinder a company’s turnaround. We arewary of cases where foregone cash distribu-tions must be replaced by the issuance ofcommon stock, given the potential that thecompany would be loathe to accept theensuing dilution.

The Japanese put a toe in the water in2001 with a version of trust preferred securi-ties. NEC Corp. sold a deal that was perpetu-al, but, after the first five years, had a ratereset that would reflect changes in creditspreads. Standard & Poor’s expressed itsreservations about the value of such instru-ments in the Japanese context. Local businessculture involves great reticence with respectto altering dividend payments. Indeed, thewhole notion of preferred stock of any type isa novelty in Japan. Accordingly, the equitycontent of Japanese preferreds will evolveover time as local practices may come toresemble those of Western markets.

Recent innovationsThe quest for enhancing preferreds’ equitycontent continues. One idea is making pay-ment deferral automatic upon reaching cer-tain triggers or occurrence of certain events.Indeed, replacing issuer discretion with a for-mulaic approach to deferral adds significantlyto the equity content—if the threshold forstopping payments is set high. Each issuer’ssituation would require a unique analysis,making standardization impossible.

Triggers could be based on financial dataor ratios or rating levels. Alternatively, thepayments could be linked to the company’scommon dividend. Additionally, it is possi-ble to offer non-cumulative versions thatwould not require the company to make upfor payments skipped because of financialdistress. Beyond that, forgiveness of part ofthe principal in cases of company stresscould theoretically be offered.

The rub is that investors would be leeryabout accepting the risks associated withnonpayment associated with high thresholds.The key is to find the right balance thatwould be meaningful for the issuer and stillacceptable to investors at a reasonable rate.

Some other hybrids� Mandatory exchangeable debt or pre-

ferred (e.g., DECs): If the issue must besettled with the stock of another entity(currently owned by the issuer), the ana-lytical treatment is that of a deferred assetsale. All assets may be positive or nega-tive to credit quality; there is no stan-



dardized impact. The factors that deter-mine the credit impact include priceachieved and use of after-tax proceeds.Will the proceeds be distributed to share-holders? Or used to pay down debt on apermanent basis? Or be reinvested? Ifreinvested, is the new asset more or lessrisky that that which was sold?

� Mismatched mandatory conversion debt(e.g., FELINE PRIDES): Given the mis-match, the equity issuance is not ordinarilynetted against the debt obligation. It isequivalent to a company simultaneouslyissuing deferred equity plus a like amountof debt. The net impact of these two issueswould depend on whether leverage isincreased or decreased, which, in turn,depends on the company’s financial lever-age prior to these two issuances.

� Step-up preferred: If an instrument pro-vides for adjustment of terms, the analystmay consider the adjustment date as theexpected maturity, with the relateddiminution of equity credit. If the adjust-ment is to above-market rates, it is pre-sumed the instrument will berefinanced—and not necessarily withanother equity-like security.

� Remarketed convertible trust preferred (e.g.,HIGH TIDES): On balance, this hybrid isviewed negatively, despite the potential forconversion to common stock and the ratesavings created by the remarketing feature.The need to remarket at a level above parcould lead to terms that are unpalatable tothe issuer, prompting a refinancing.

� Auction preferred: These frequently remar-keted preferreds virtually are treated asdebt. They are sold as commercial paperequivalents, which leads to failed auctionsif credit quality ever falls to ‘A-3’—or even‘A-2’—levels. While the company has nolegal obligation to repurchase the paper—i.e., the last holder could be left with this“perpetual” security—the issuer invariablybows to market pressures, and chooses torepurchase the preferred.

Streamlining Hierarchy Of Hybrid SecuritiesStandard & Poor’s Ratings Services intro-duced the equity hybrid hierarchy in 1999,pioneering a quantitative approach to the‘partial credit’ associated with equity hybridsissued by corporates. (Given different analyticconsiderations, another framework appliesfor financial institutions.) The hierarchy wasexpressed using a scale of 0% to 100%.Ordinary common equity represented theparadigmatic 100%.

This scale was created to provide greatertransparency, as companies and their advis-ers probed the relative benefits associatedwith alternative financial products. At thesame time, we cautioned users to avoidexaggeration of the differences suggested bythe various gradations.

In 2005, we modified the scale by collaps-ing the hierarchy into three categories, andchanging the terminology. This rebalancing ofspecificity with simplicity was to communi-cate our views more effectively—not tochange the underlying analytical methodology.

Three categoriesThe different levels of equity content aregrouped into three categories. Hybrids thathad been 10/20/30 on the previous scale areclassified as possessing “minimal equity con-tent”. Those that were 40/50/60 are classifiedas possessing “intermediate equity content”;those that were 70/80/90 are classified ashaving “high equity content”.

Modified Hybrid Hierarchy� Minimal Equity Content: This group

includes instruments with little or ques-tionable permanence; terms or nomencla-ture that restrict or discourage discretionover payments; after-tax costs or conver-sion terms that may become unattractiveto the issuer.

� Intermediate Equity Content: This groupencompasses most of preferred stockgenre, from 30-year trust preferred withfive-year cumulative deferral rights to per-petual, tax-deductible preferred (as in theU.K.), with unlimited and/or noncumula-tive deferral rights.



� High Equity Content: This group includesinstruments with a mandatory component,either regarding deferral of ongoing pay-ments (at appropriately high trigger levels),or near-term conversion into a fixed num-ber of common equity shares (on a basisthat would not be deemed unpalatable tothe issuer at the time of conversion). (See: “Hybrids’ ‘High Equity Content’

Category Held to High Standards”; publishedSept. 7, 2005, and “CreditFAQ: SundryEquity Hybrid Features”, published Dec. 9,2005, on RatingsDirect, Standard & Poor’sWeb-based research and credit analysis sys-tem, for additional criteria.)

Rating methodologyThe numerical gradations never implied frac-tional treatment for the purpose of ratio cal-culation (a point repeatedly stressed). Thiscontinues to be the case. (We have never splitthe amounts of an issue for ratio calculationsbecause the results can be distortive.) Rather,hybrids with minimal equity content aretreated as debt for ratio purposes; hybrids

with high equity content are treated as equityfor calculating ratios.

For hybrids with intermediate equity con-tent, financial ratios are computed bothways—viewed alternatively as debt and asequity. That is, two sets of coverage ratios arecalculated—to display deferrable ongoingpayments (whether technically dividends orinterest) entirely as ordinary interest andalternatively as an equity dividend. Similarly,two sets of balance-sheet ratios are calculatedfor the principal amount of the hybrid instru-ments, displaying those amounts entirely asdebt and entirely as equity.

For these hybrids in the middle category,analytical ‘truth’ lies somewhere betweenthese two perspectives. Analysts must inter-polate between the two sets of ratios to arriveat the most meaningful depiction of anissuer’s financial profile—normally, by split-ting the difference.

Analysts can still note and give effect toeach more-equity-like/less-equity-like featureof various hybrids in the same category; how-ever, such nuances play, at most, a very subtlerole in the overall rating analysis. ■


General PrinciplesIn general, economic incentive is the mostimportant factor on which to base judgmentsabout the degree of linkage that existsbetween a parent and subsidiary. This mattersmore than covenants, support agreements,management assertions, or legal opinions.Business managers have a primary obligationto serve the interest of their shareholders, andit should generally be assumed they will actto satisfy this responsibility. If this meansinfusing cash into a unit previously termed astand-alone subsidiary, or finding a wayaround covenants to get cash out of a pro-tected subsidiary, then management can beexpected to follow these courses of action tothe extent possible. It is important to thinkahead to various stress scenarios and considerhow management would likely act underthose circumstances. If a parent supports asubsidiary only as long as the subsidiary doesnot need it, such support is meaningless.

A weak entity owned by a strong parentusually—although not always—will enjoy astronger rating than it would on a stand-alone basis. Assuming the parent has the abil-ity to support its subsidiary during a periodof financial stress, the spectrum of possibili-ties still ranges from ratings equalization atone extreme to very little or no help from theparent’s credit strength at the other. The

greater the gap to be bridged, the more evi-dence of support is necessary.

The parent’s rating is, of course, assignedwhen it guarantees or assumes subsidiarydebt. Guarantees and assumption of debt aredifferent legal mechanisms that are equivalentfrom a rating perspective. Cross-default andcross-acceleration provisions in bond inden-tures also can be important rating considera-tions. They can provide a powerful incentivefor a stronger entity to support debt of aweaker affiliate, because they trigger defaultof the stronger unit in the event of a defaultby the weaker affiliate. Bear in mind, howev-er, that cross-default provisions can disappearif the debt that contains the provisions isretired or renegotiated.

A strong subsidiary owned by a weak par-ent generally is rated no higher than the par-ent. The key reasons:� The ability of and incentive for a weak par-

ent to take assets from the subsidiary orburden it with liabilities during financialstress; and

� The likelihood that a parent’s bankruptcywould cause the subsidiary’s bankruptcy,regardless of its stand-alone strength.Both factors argue that, in most cases, a

“strong” subsidiary is no further frombankruptcy than its parent, and thus cannothave a higher rating. Experience has shown

Parent/Subsidiary Links

Affiliation between a stronger and a weaker entity will almost

always affect the credit quality of both, unless the relative

size of one is insignificant. The question rather is how close

together the two ratings should be pulled on the basis of affiliation.


that bankrupt industrial companies file withtheir subsidiaries more often than not.

For rating purposes, the risk of “substan-tive consolidation” is a side issue.Consolidation in bankruptcy, sometimesreferred to as substantive consolidation,occurs when assets of a parent and its sub-sidiaries are thrown together by the bank-ruptcy court into a single pool and theirvalue allocated to all creditors withoutregard for any distinction between the twolegal entities. In such cases, creditors of asubsidiary may lose all claim to the valueassociated with that particular subsidiary.Much more often, a parent and its sub-sidiaries will all file, but each legal entitywill be kept separate in the bankruptcy pro-ceeding. Creditors keep their claim to theassets of the specific legal entity to whichthey extended credit. Because corporate rat-ings address default risk, the key issue is notconsolidation, but rather whether a bank-ruptcy filing will occur. Nonconsolidationopinions are, therefore, of more value withrespect to recovery ratings and issue ratingsof subsidiary debt, because those opinionsaddress the likelihood of substantive consol-idation, rather than the likelihood of simul-taneous bankruptcies for parent andsubsidiary. Perhaps the willingness to obtainsuch an opinion might also serve as someevidence of management intent regarding asubsidiary’s independence.

Protective covenants apparently protect asubsidiary from its parent by restricting div-idends or asset transfers. In general, thistype of covenant is given very limitedweight in a rating determination. Reasonsfor limited value of protective covenants:

� They do not affect the parent’s ability tofile the subsidiary into bankruptcy;

� It is very difficult to structure provisionsthat cannot be evaded; and

� Ultimately, courts usually cannot force acompany to obey the covenant. Duringsevere financial stress, especially prior to abankruptcy, a weak parent may have apowerful incentive to strip a stronger sub-sidiary. The court can, at best, only awardmonetary damages after the fact to a credi-tor who has incurred a loss (when the issuedefaults) and chooses to sue.

Subsidiaries/Joint Ventures/Nonrecourse ProjectsWith respect to the parent’s credit rating,affiliated businesses’ operations and theirdebt may be treated analytically in severaldifferent ways, depending on the perceivedrelationship between the parent and theoperating unit. These alternatives are illus-trated by the spectrum below.

The same alternatives may apply whencompanies invest in joint ventures that issuedebt in their own name, and when compa-nies choose to finance various projects withnonrecourse debt. These analytical issuesalso may apply when companies take painsto finance some of their wholly owned sub-sidiaries on a stand-alone, nonrecoursebasis, especially in the case of noncore orforeign operations.

Sometimes, the relationship may be char-acterized as an investment. In that case, theoperational results are carved out; the par-ent gets credit for dividends received; the parent is not burdened with the operation’s debt obligations; and the value, volatility, and liquidity of the investment are analyzed on a case-specificbasis. The quality of the investment dictateshow much leverage at the parent companyit can support.

At the other end of the spectrum, opera-tions may be characterized as an integratedbusiness. Then, the analysis would fullyconsolidate the operation’s income sheetand balance sheet; and the risk profile ofthe operations is integrated with the overallbusiness risk analysis. Or, the business may


The Parent/Operating Unit Relationship

Investment Integrated Business

No consolidation.Anticipate additionalinvestment.

Pro rataconsolidation.Anticipate additionalinvestment.

Full consolidation.Anticipate additionalinvestment.

No analyticalconsolidation.Dividend income.Analyze riskinessand liquidity ofinvestment’s value.


not fall neatly into either category; it maylie somewhere in the middle of the spec-trum. In such cases, the analytical techniquecalls for partial or pro rata consolidationand usually the presumption of additionalinvestment, that is, the money the companylikely would spend to bail out the unit inwhich it has invested.

This characterization of the relationshipalso governs the approach to rating the debtof the subsidiary or the project. The size ofthe gap between the stand-alone credit qual-ity of the project or unit and that of thegroup, sponsor, or parent is a function ofthe perceived relationship: the greater theintegration, the greater the potential forparent or sponsor support. The reciprocalof burdening the parent with the nonre-course debt is the attribution of support tothat debt. The notion of support extendsbeyond formal or legal aspects—and cannarrow, and sometimes even close, the gapbetween the rating level of the parent andthat of the issuing unit.

If the credit quality of a subsidiary ishigher than that of the parent, the ability ofthe parent to control the unit typically capsthe rating at the parent level. Exceptions aremade in the case of bankruptcy-remote spe-cial purpose vehicles for securitization, reg-ulated entities, independent financesubsidiaries, and the rare instances thathave extremely tight covenant protection.The measure of control the parent can exer-cise is very much a function of ownership,so the percent of ownership of a joint ven-ture or project and the nature of the otherowner are critical rating criteria in such sit-uations. Where two owners can preventeach other from harming the credit qualityof a joint venture, the debt of the venturecan be rated higher than either’s rating, ifjustified on a stand-alone basis.

Formal support—such as a guarantee (notmerely a comfort letter)—by one parent orsponsor ensures that the debt will be ratedat the level of the support provider. Supportfrom more than one party, such as a jointand several guarantee, can lead to a ratinghigher than that of either support provider.(See Public Finance Criteria—JointlySupported Debt.)

Determining FactorsNo single factor determines the analyticalview of the relationship with the businessventure in question. Rather, these are sever-al factors that, taken together, will lead toone characterization or another. These factors include:� Strategic importance—integrated lines of

business or critical supplier;� Percentage ownership (current and

prospective);� Management control;� Shared name;� Domicile in same country;� Common sources of capital;� Financial capacity for providing support;� Significance of amount of investment;� Investment relative to amount of debt at

the venture or project;� Nature of other owners (strategic or finan-

cial; financial capacity);� Management’s stated posture;� Track record of parent company in similar

circumstances; and� The nature of potential risks.

Some factors indicate an economic ration-ale for a close relationship or debt support.Others, such as management control orshared name, pertain also to a moral obliga-tion, with respect to the venture and its lia-bilities. Accordingly, it can be crucial todistinguish between cases where the risk ofdefault is related to commercial or econom-ic factors, and where it arises from litigationor political factors. (No parent company orsponsor can be expected to feel a moralobligation if its unit is expropriated.)

Percentage ownership is an importantindication of control, but it is not viewed inthe same absolute fashion that dictates theaccounting treatment of the relationship.Standard & Poor’s also tries to be pragmat-ic in its analysis. For example, awareness ofa handshake agreement to support an osten-sibly nonrecourse loan would overshadowother indicative factors.

Clearly, there is an element of subjectivityin assessing most of these factors, as well asthe overall conclusion regarding the rela-tionship. There is no magic formula for thecombination of these factors that wouldlead to one analytical approach or another.


Regulated CompaniesNormal criteria against rating a subsidiaryhigher than a parent do not necessarilyapply to a regulated subsidiary. A regulatedsubsidiary is indeed rated higher than theparent if its stand-alone strength so war-rants and regulatory protection is sufficient-ly strong. However, the nature of regulationhas been changing—and creditors can relyon regulators to a much smaller extent thatin the past. For one thing, deregulation isspreading. As competition enters markets,the providers are no longer monopolies—and the basis of regulation is completely different. Most of all, regulators are more concerned with service quality thancredit quality.

For example, some regulated utilities arestrong credits on a stand-alone basis, butoften are owned by companies that financetheir holding in the utility with debt at theparent company (known as double leverag-ing), or that own other, weaker businessunits. To achieve a rating differential fromthat of the consolidated group requires evi-dence—based on the specific regulatory cir-cumstances—that regulators will act toprotect the utility’s credit profile.

The analyst makes this determination ona case-by-case basis, because regulatoryjurisdictions vary. Implications of regulationare different for companies in Wisconsinand those in Florida or those subject to thescrutiny of the Securities and ExchangeCommission under the 1935 Public UtilitiesAct. Also, regulators might react differentlydepending on whether funds that would bewithdrawn from the utility were destined tosupport an out-of-state affiliate or anotherin-state entity. Finally, while regulators maybe inclined to support investment-gradecredit quality, there is little basis to believeregulators would insist that a utility main-tain an ‘A’ profile. Their mandate is to pro-tect provision of services—which is not adirect function of the provider’s financialhealth. In fact, if a utility has little debt, theoverall cost of capital, and therefore thecost of service, can be higher.

There is a corollary that negatively affectsthe parent and weaker units whenever autility subsidiary is rated on its stand-alone

strength. If the regulated utility is indeedinsulated from the other units in its group,its cash flow is less available to supportthem. To the extent, then, that a utility israted higher than the consolidated group’scredit quality, the parent and weaker unitsare correspondingly rated lower than thegroup rating level.

Foreign OwnershipParent/subsidiary considerations are some-what different when a company is owned bya foreign parent or group. The foreign par-ent is not subject to the same bankruptcycode, so a bankruptcy of the parent wouldnot, in and of itself, prompt a bankruptcyof the subsidiary. In most jurisdictions,insolvency is treated differently from theway it is treated in the U.S., and variouslegal and regulatory constraints and incen-tives need to be considered. Still, in all cir-cumstances, it is important to evaluate theparent’s credit quality. The foreign parent’screditworthiness is a crucial factor in thesubsidiary’s rating to the extent the parentmight be willing and able either to infusethe subsidiary with cash or draw cash fromit. A separate parent or group rating will beassigned (on a confidential basis) to facili-tate this analysis.

Even when subsidiaries are rated higherthan foreign parents, the gap usually doesnot exceed one full rating category. It is diffi-cult to justify a larger gap, because it wouldentail a clear-cut demonstration that, evenunder a stress scenario, the parent’s interestwould be best served by keeping the sub-sidiary financially strong, rather than using itas a source of cash.

In the opposite case of weak subsidiariesand strong foreign parents, the ratings gaptends to be larger than if both were domes-tic entities. Sovereign boundaries impedeintegration and make it easier for a foreignparent to distance itself in the event ofproblems at the subsidiary.

“Smoke-and-Mirrors” SubsidiariesSome multibusiness enterprises controlled by a single investor or family are characterized by:� Unusually complex organizational

structures;



� Opportunistic buying and selling of operations, with little or no strategic justification;

� Cash or assets moved between units toachieve some advantage for the controllingparty; and

� Aggressive use of financial leverage.By their nature, these types of companies

tend to be highly speculative credits, and it isinadvisable to base credit judgments on theprofile of any specific unit at any particularpoint in time.

The approach to rating a unit of such anorganization still begins with some assess-ment of the entire group. Some of the affiliat-ed units may be private companies;nonetheless, at least some rough assessmentmust be developed. In general, no unit in thegroup is rated higher than the consolidatedgroup would be rated. Neither indenturecovenants nor nonconsolidation opinions canbe relied on to support a higher rating for aparticular subsidiary.

At the same time, there is no reason for allentities in a “smoke-and-mirrors” family toreceive the identical rating. Any individualunit can be notched down as far as neededfrom the consolidated rating to reflect stand-alone weakness. This reflects the probabilitythat a weak unit will be allowed to fail if thecontrolling party determines no value can besalvaged from it. Complex structures aredeveloped in order to maximize such flexibili-ty for the controlling party.

Finance Subsidiaries’ Rating Link to ParentFinance units are unlike other subsidiariesfrom a criteria perspective. In turn, there aretwo types of finance subsidiaries—independ-ent and captive—that are very distinct interms of the analytical approach employed byStandard & Poor’s Ratings Services.

Independent Finance SubsidiariesIndependent finance subsidiaries can receiveratings higher than those of the parent,because of the high degree of separationbetween these subsidiaries and the parent. Afinance company’s continuous need for capi-tal at a competitive cost creates a powerful

incentive to maintain its creditworthiness.Therefore, it can be argued that the parentwould be better served, in a stress scenario,by divesting the still-healthy subsidiary thanby weakening it or risking drawing it intobankruptcy. In addition, there must be evi-dence of the parent company’s willingness toleave the subsidiary alone, including a historyof reasonable dividend and management feepayouts to the parent.

Nonetheless, a finance company subsidiaryrating still is linked to the credit quality ofthe company to which it belongs. If thefinance company’s credit fundamentals arestronger than those of the consolidated entity,one cannot rule out the risk that this strengthcould be siphoned off to support weakeraffiliates or service the debt burden of theparent. Whatever the rating would be on astand-alone assessment, it is unlikely an inde-pendent finance subsidiary would ever berated more than one full rating categoryabove the parent rating level. To the extentthat part of the receivables portfolio wererelated to parent company sales, there wouldbe an additional tie to the parent risk profile.

Conversely, if the consolidated entity’s rat-ing is higher than the subsidiary’s, because ofthe stronger creditworthiness of the otheraffiliates, the analysis would attribute someof that strength to the finance company, mak-ing possible a higher rating than it couldreceive on its own. Assessing the degree ofcredit support includes the usual subjectivefactors, such as management intentions andshared names of the parent and subsidiary. Inthe case of a subsidiary that has been formedor acquired only recently, a demonstrablerecord of support is lacking and questionsmight remain concerning the long-term strat-egy for the subsidiary. Some formal supportlikely will be required. The most frequentlyused support agreement commits the parentto maintain some minimum level of networth at its subsidiary. Frequently, the parentalso will agree to assume problem assets andto maintain minimum fixed-charge coverage.

Captive Finance CompaniesA captive finance company—i.e., a financesubsidiary with over 70% of its portfolioconsisting of receivables generated by sales of


the parent’s or group’s goods or services—isalways assigned the same rating as the par-ent. Captive finance companies and theiroperating company parents are viewed as asingle business enterprise. The finance com-pany is a marketing tool of the parent, facili-tating the sale of goods or services byproviding financing to the dealer organization(wholesale financing) and/or the final cus-tomer (retail financing).

The business link between an operating-company parent and captive is the key con-sideration supporting the subsidiary’s ratingat the parent company level, apart from anysupport arrangements between the two. Theparent’s investment in the captive (in theform of equity and advances) may also pro-vide economic incentive to maintain the cap-tive’s financial health.

Conversely, a captive that appears strongon a stand-alone basis is not rated higherthan its operating company. Because of theoperational tie-in, the parent does not havethe same options for divesting a healthy cap-tive as in the case of an independent financesubsidiary. Eventually, then, the captive’sbankruptcy risk is closely linked to that of itsparent. This viewpoint is based in part oncase history. A parent-company bankruptcyfiling usually will result in a filing by its cap-tive, either simultaneously or soon thereafter.Captive finance company debtholders may bebetter off than the parent debtholders withrespect to ultimate recovery in a liquidationor reorganization, but bankruptcy wouldimpair the timeliness of payments.

MethodologyWhile the captive and parent ratings areequalized, the two are not analyzed on a con-solidated basis. Rather, the analysis segregatesfinancing activities from manufacturing activ-ities and analyzes each separately, reflectingthe different type of assets they possess. Nomatter how a company accounts for itsfinancing activity in its financial statements,the analysis creates a pro forma captive unitto apply finance-company analytical tech-niques to the captive-finance activity, andcorrespondingly appropriate analytical tech-niques to the operating company. Financeassets and related debt liabilities are included

in the pro forma finance company; all otherassets and liabilities are included with theparent company. Similarly, only finance-relat-ed revenues and expenses are included in thepro forma finance company.

The debt and equity of parents and cap-tives are apportioned and reapportioned sothat both entities will reflect similar creditquality. A tentative rating for the two compa-nies is assumed as a starting point. Next, aleverage factor is determined that is appropri-ate for the captive at the tentative ratinglevel, based on the quality of the captive’swholesale and retail receivables. With theappropriate leverage determined, the analystcalculates the amount of equity required tosupport credit quality at the assumed level,and the proper amounts of debt or equity canbe transferred either to the parent from thecaptive or to the captive from the parent. Nonew debt or equity is created.

Next, the analyst determines levels of rev-enues and expenses reflective of the cap-tive’s receivables and debt. The higher thetentative rating, the greater the level ofimputed fixed-charge coverage and returnon assets. For purposes of this analysis, anyearnings support payments are transferredback to the parent.

The analyst eliminates the parent’s invest-ment in the captive to avoid double leverag-ing. The captive is an integral part of theenterprise, not an investment to be sold.While its assets can be more highly leveragedthan those of the parent, the methodologytakes that into account when determining anamount of equity that is apportioned to sup-port its debt.

Following the segregation of the financeactivity, the operating company profile maynot be consistent with the tentative rating.The methodology is repeated, using parame-ters of a higher or lower rating level.Several iterations may be needed to deter-mine a rating level that reflects the creditquality of both operating and financingaspects of the company.

Leverage GuidelinesThe receivables portfolio of the pro formacaptive entity is analyzed, as for any financecompany. Both quantitative and qualitative



assessments are made. Portfolios deemed tobe of average quality include consumer creditcard, commercial working capital, and agri-cultural wholesale. Auto retail paper is ofhigher quality, all other things being equal,while portfolios of commercial real estate andoil credit-card assets are generally less lever-ageable. Adjustments are made to reflect theperformance of a given subportfolio. In addi-tion, factors such as underwriting, charge-offpolicy, and portfolio concentration or diversi-ty are considered.

Securitization of Finance ReceivablesAn increasingly common funding mecha-nism for finance companies is the sale orsecuritization of finance receivables throughstructured transactions. Where companiessell finance receivables that are regenerativein nature (such as the operating assetsfinanced by a captive for its parent), Ouranalytical approach in assessing leverage isto uniformly add back the sold receivablesoutstanding and a like amount of debt (thesame treatment as the sale of regeneratingtrade receivables of operating companies, asexplained in Rating Methodology:Industrials and Utilities).

When the level of assets being financed istruly at the discretion of the finance compa-ny, there may be no need to add backreceivables sold. The question then is one of

permanence of the level of financial activity.No adjustment is made to add back the soldreceivables, if the analyst has concluded theunit will continue to operate at a lowerasset level. In those cases, the analysisfocuses on the actual economic risksremaining with the company relative to thesold receivables.

Depending on the type of transaction, theresidual risks take the form of capitalizedexcess servicing, spread accounts, depositsdue from trusts, and retained subordinatedinterests. If a company retains the subordinat-ed piece of a securitization, or retains a levelof recourse close to the expected level of loss,essentially all of the economic risk remainswith the seller. There is no rating benefitdeserved because there is no significant trans-fer of risk—and there is no point in analyzingsuch a company differently from the way itwould be analyzed had it kept the receivableson its balance sheet.

Another serious concern is moral recourse,i.e., the reality that companies believe theymust bail out a troubled securitization,although there is no legal requirement forthem to do so. Companies that depend onsecuritization as a funding source may beespecially prone to taking such actions. Inmany situations, this expectation under-mines the notion of securitization as a risk-transfer mechanism. ■


The operating lease model is intended tomake companies’ financial ratios more accu-rate and comparable by taking into consider-ation all assets and liabilities, whether on oroff the balance sheet. In other words, allrated companies are put on a more level play-ing field, no matter how many assets areleased and how the leases are classified forfinancial reporting purposes. (We view thedistinction between operating leases and capi-tal leases as artificial. In both cases, the lesseecontracts for the use of an asset, entering intoa debt-like obligation to make periodic rentalpayments.) The model also helps improveanalysis of how profitably a companyemploys both its leased and owned assets. Byadjusting the capital base for the presentvalue of lease commitments, the return oncapital better reflects actual asset profitability.

Also, leased assets are not available to cor-porate creditors in the event of a bankruptcy.

The resulting ‘junior’ position of creditors rel-ative to lessors may affect our ratings on spe-cific debt issues. (Note, however, thatrecovery of lessors’ claims beyond the valueof the leased assets themselves also is limit-ed.) If warranted, the debt may be lowered anotch or two from the corporate rating toreflect differences in loss-given-defaultprospects. Our lease methodology helps high-light the extent of a company’s leasing activi-ty and, therefore, its materiality with respectto such recovery analysis.

Using The MethodologyLease commitment data for a company aregathered from the notes to its financial state-ments. Annual data for the coming five yearsis required for accounts prepared under USGAAP—plus the aggregate amount for subse-quent years. Under IFRS, all years need not

Operating Lease Analytics

To improve financial ratio analysis, Standard & Poor’s Ratings

Services uses a financial model that capitalizes off-balance-

sheet operating lease commitments and allocates minimum lease

payments to interest and depreciation expenses. Not only are

debt-to-capital ratios affected: so are interest coverage, funds

from operations to debt, total debt to EBITDA, operating margins,

and return on capital. This technique is, on balance, superior to

the alternative “factor method”, which multiplies annual lease

expense by a factor reflecting the average life of leased assets.


be individually displayed; the analyst mustdecide how to best allocate the lump sum toindividual years. For the remaining leaseyears, our model assumes the annual leasepayments approximate the minimum pay-ment due in year five. The number of yearsremaining under the lease is simply theamount “thereafter” divided by the minimumfifth-year payment.

The required lease payments generally aretaken gross, rather than netting out subleaseincome; but, when the head-lease and subleaseare matched and the counterparty is sufficient-ly creditworthy, we would use net payments.

For the present value calculation, we gener-ally use as the discount rate the issuer’s aver-age interest rate (that is, interestexpense/average debt outstanding) from themost recent annual statements, which isreflective of the issuer’s cost of borrowedfunds. (For example, to derive the discountrate for adjusting 2004 financials, we will use2004 interest expense divided by the averageof year-end 2003 and year-end 2004 totaldebt.) Interest cost is adjusted to eliminateany distorting effects of capitalized interest,interest income, or derivatives-relatedgains/losses. (Also, if a company’s borrowingcost has soared because of financial distress,we avoid the perverse result of a seeminglyshrinking lease obligation. In such a case, wewill use the average of several years’ borrow-ing rates or a market ‘B’ rate, instead of thecompany’s average borrowing rate from theprevious year.)

Ideally, we could use an even better alter-native for the discount factor: the interestrates, or “money factors,” imputed in the

company’s actual leases, upon inception.Another alternative might be the company’saverage cost of secured debt. Where sufficientinformation is available and operating leaseobligations are material, it is appropriate touse one of these bases instead. However, it isimportant for the sake of consistency that allcompanies in an industry peer group beadjusted in a consistent manner.

The resulting present-value figure is addedto reported debt to calculate the total-debt-to-capital ratio. The figure also is added toassets to account for the right to use leasedproperty over the lease term. Although lessthan the cost of the property, this adjustmentrecognizes that control of the property createsan economic asset.

The implicit interest is calculated by multi-plying the average net present value at theend of the current and previous years by therate used as the discount rate. This figure isthen added to the company’s total interestexpense. The SG&A adjustment is calculatedby taking the average of the first-year mini-mum lease payments in the current and previ-ous years. SG&A is then reduced by thisamount. Depreciation expense is calculatedby subtracting the implicit interest from theSG&A adjustment. The lease depreciation isthen added to reported depreciation expense.The interest and depreciation adjustmentsattempt to allocate the annual rental cost ofthe operating leases. There is ultimately nochange to reported net income as a result ofapplying the lease analytical methodology.

Financial ratio effect� EBIT: The implicit lease depreciation

adjustment is added to D&A expense; theadjustment to SG&A expense reducesSG&A expense. The result is to increaseEBIT by the difference between theimplicit lease depreciation and SG&Aadjustments, or $17.9 million as shown inTable 2, which also is the amount of theimplicit interest.

� EBITDA: In this case, only the implicitinterest is added to EBITDA. The result isthat EBITDA is increased $17.9 million.The rationale for not including implicitdepreciation is that EBITDA is often usedas a proxy for cash flow. However, rental

Table 1—Lease Model Calculation*

—Reporting year—

Payment period 2004 2003

Year 1 61.0 65.8

Year 2 54.0 53.3

Year 3 46.1 46.5

Year 4 42.6 41.9

Year 5 38.7 39.6

Thereafter 177.9 177.9

Total payments 420.3 425.0

* Reported figures: Future minimum lease commitments (mil. $)


expense is a cash expense, and it seemsinappropriate to consider the entire rentalexpense as being available to pay interest.Moreover, EBITDA interest coverage, a keycredit ratio, can be quite distorted byadding both implicit interest and deprecia-tion to the numerator while adding onlyimplicit interest to the denominator.

� Interest expense: The implicit interest figure, $17.9 million, is added to totalinterest expense.

� Total debt: The net present value of leasepayments, $336.5 million, is added tototal debt.

� Operating income before D&A: Standard &Poor’s typical calculation for the operatingmargin adds D&A back to operatingincome. When the operating lease adjust-ment is made, operating income is increasedby the adjustment to SG&A expense, $63.4 million.

� Funds from operations: Funds from opera-tions is increased by the implicit leasedepreciation expense, $45.5 million—which is recharacterized as an increase incapital expenditures.

� Capital expenditures: The portion of thelease payment that represents the actual useof the asset—$45.5 million in our exam-

ple—is added to capital expenditures,which reduces free cashflow by a likeamount. Also, the increase in the net pres-ent value of lease payments from year toyear is shown as an increase in capitalspending—albeit without any effect on netcash. This adjustment highlights situationswhere a company is increasing its level ofasset leasing—presumably in lieu of con-ventional spending. Without such anadjustment, we might mistakenly conclude,for example, that the company was under-spending for its capital equipment needs.(Since factors other than new lease take-upcan lead to that increase—such as changesin foreign exchange rates or the implicitrate used in calculating the net presentvalue—we would try to be mindful of whatwas actually occurring.)

Limitations Of The ModelAnalysts and investors need to be aware ofthe limitations of our model. In many cases,our computed lease-related debt is signifi-cantly understated. We base our capitaliza-tion of the lease obligation on the disclosedstream of minimum future rental payments,even when we expect contingent payments

Table 2—Calculation Of Operating Lease Adjustments For 2004

2004 2003 2002

Total debt (reported) 659.4 664.9 766.8

Total interest (incl. capitalized interest) 36.2 40.2

Implied interest rate 5.5 5.6

Future minimum lease commitments (mil. $)

2005 61 65.8

2006 54 53.3

2007 46.1 46.5

2008 42.6 41.9

2009 38.7 39.6

2010 - 2014 38.7

2009 - 2012 39.6

Net present value (NPV) 336.5 318.7

2004 implicit interest Avg. NPV ($327.6) x interest rate (5.5%) = $17.9

Lease depreciation expense Adjustment to SG&A* - implicit interest = $63.4 - $17.9 = $45.5

Adjustment to SG&A—rent Avg. first-year min. payments ($61.0 + $65.8)/2 = $63.4

*SG&A—Selling, general, and administrative expenses.

Operating Lease Analytics


to increase actual rental expense significant-ly above the minimums. Also, by basing ourcalculation of the liability on the minimumfuture lease payments, we effectively carveout any consideration of indirect residualrisk because, under FAS 13, if the presentvalue of the minimum lease payments is90% or more of the fair value of the asset,the lease is not classified as an operatinglease—but as a capital lease. So at least 10%of the asset value gets overlooked. (If, how-ever, a company extends a residual guaran-tee for assets under operating leases, thisshould be reflected in our analysis as a debtequivalent.) IFRS accounting poses similarissues of understatement.� More broadly, our adjustment model does

NOT seek to replicate a scenario in whicha company acquired an asset and financedit with debt; rather, our adjustment is nar-rower in scope: it attempts to capture onlythe debt-equivalent of a company’s lease

contracts in place. Whenever a companyleases for five years an asset with a 20-yearproductive life, the adjustment picks uponly the lease period, ignoring the cost ofthe entire asset that would have been pur-chased—and depreciated—by a companythat chose to buy instead of lease. Alternate methodologies (known as factor

methods) attempt to replicate a debt-financedpurchase of the operating asset. The concep-tual advantages of these methodologies—especially in terms of comparingcompanies—are limited by other analyticalshortcomings and considerations. The factormethods use multiples of annual expense toestimate the asset value—typically in a crudeor arbitrary fashion. Also, while incorporat-ing the equivalent of owning the entire asset,these methodologies lack the ability to differ-entiate between the first year of the asset’slife, the last year, and all points in between.(An asset actually purchased would be depre-ciated over its life.) And, by putting leasingand ownership on a supposed ‘apples-to-apples’ basis, they gloss over the potentialflexibility associated with leasing only part ofan asset’s economic life.

Given the alternatives, we prefer our cur-rent, present-value methodology. However,there could be merit in using more than onemethod to capture leasing activity—especiallyif some of the problems with the ‘factor meth-ods’ can be addressed. We intend to explorethe possibility of introducing a methodologythat is more comprehensive (i.e., which wouldreplicate a full asset purchase) to supplementthe current methodology. ■

Table 3—Sample Calculation Results

Without Withcapitalization capitalization

Oper. income/sales (%) 18.6 21.2

EBIT interest coverage (x) 8.7 6.2

EBITDA interest coverage (x) 12.3 8.6

Return on capital (%) 18.9 15.6

Funds from oper./total debt (%) 54.1 40.4

Total debt/EBITDA (x) 1.5 2.1

Total debt/capital (%) 37.6 41.0


Standard & Poor’s Ratings Services views unfunded liabilities

relating to defined benefit pension plans and retiree medical

plans as debt-like in nature. This also is the case with deferred

lump-sum payment schemes, such as termination programs for

employees in Italy. By accepting a portion of their compensation

on a deferred basis, the employees essentially become creditors

of the company. As with conventional debt, these liabilities pose

risks to their corporate sponsors from the call on future cash flow

they represent. (Defined contribution plans generally are not

problematic because they must be funded on a current basis, and

the corporate sponsor does not bear ongoing investment

performance risk.)

A company’s postretirement obligationsaffect its financial position, and also may begermane to its competitive position. Mostproblematic is when peers face differentretiree costs. Companies that have been rela-tively generous, have an older workforce, orhave a comparatively large number ofretirees, cannot raise their own selling pricesmore than those of their competitors’.Likewise, competitors in different countriesoften are not saddled with similar costsbecause of differences in pension and healthcare systems in their respective countries.Any company more burdened with suchretiree costs than its competitors will be

penalized in the assessment of its overallcost position. The implications for its com-petitiveness are no less than if it had older,less efficient manufacturing facilities. Such acompetitive advantage—or disadvantage—isan important rating consideration.

Distinguishing characteristicsVarious characteristics distinguish unfundedpostretirement liabilities from debt obliga-tions. One is the difficulty of measuring theirvalue. Because of the prospective and variablenature of postretirement obligations, theirquantification relies on numerous assump-tions, including:

Postretirement Obligations


� Employee turnover rates and length ofservice, whereby the length of time theworker is employed by the company deter-mines eligibility for and the size of theretiree benefit;

� Mortality rates, given that the employee’slifespan determines how long he or shereceives the benefit;

� Dependency status, if the plan covers sur-viving dependents;

� Compensation levels, if the employee’s wagesor salary prior to retirement is a factor indetermining the amount of the benefit;

� Discount rate, which is required to calcu-late a present value of the future requiredcash outflows; and

� Return on benefit plan investments. To theextent that the benefit is prefunded withinvestment assets, if positive, the returnsrealized on those assets will help defray thecost of the benefit.Because retiree medical benefits are not

monetary in nature, but rather are in-kindbenefits—i.e., the employee is promisedfuture health care services—there is addition-al uncertainty. Assumptions must be madeabout future changes in health care inflationand in health care use and delivery patterns.Not simple matters.

Because of these difficulties, the analyticalexercise does not try to quantify a preciseamount to represent the postretirement obli-gation. As discussed below, sensitivity analy-sis is a better way to capture a company’sexposure than by focusing on a single figure.

Further, management’s actions to modifyplan benefits or regulatory changes couldalter the value of the liability over time.Standard & Poor’s pays close attention tomanagement’s strategies for reducing thecost of the burden and assesses these strate-gies in the context of the company’s laborrelations; however, we naturally are reluc-tant to prejudge the success of any suchstrategies, particularly if the workforce istightly unionized, and determined to resistsuch cost-cutting efforts. Similarly, in theo-ry, there always is the potential that somesignificant change in the regulatory frame-work could enable a corporation to shiftsome portion of its postretirement benefits,burden to the government, but it hardly is

prudent to assume such a solution wouldemerge. Indeed, there also is the risk gov-ernments could tighten funding require-ments, as recently did Spain and the Netherlands.

National/regulatory differencesAnalysis of postretirement benefit obliga-tions must take into account the differencesamong countries’ regulatory systems. Insome countries (e.g., France, Italy, andSpain), corporations do not bear such obli-gations directly to any material extent; pen-sion and other postretirement benefits areprovided largely under governmental, ratherthan corporate, schemes. Corporations gen-erally must support these schemes indirectlythrough taxes. Obviously, a company’s over-all tax burden must be considered in theanalysis of its cash flow.

In other cases, the benefit is provideddirectly by corporations. Furthermore, strictregulations require the company to prefundthe benefit by making contributions to dedi-cated trusts well in advance of the ultimatedisbursal of funds to retirees or third-partyinsurers. This insulates retirees from the riskthat the company might become unable tohonor its commitments. Under such regula-tions, however, the company typicallyretains some discretion to decide how muchto contribute in a given year. This is thecase with defined-benefit plans in the U.S.,governed by the Employee Retirement andIncome Security Act (ERISA) of 1974 andby the tax code, and with such plans in theU.K. and the Netherlands.

In still other cases (e.g., defined-benefitpensions in Germany and retiree medicalbenefits in the U.S.), the benefit is provideddirectly by companies, but there is no regu-latory requirement to prefund and, typically,no tax incentive for doing so. In such pay-as-you-go systems, the cash burden on thecompany may be light for many years if thecompany has a young workforce and fewretirees. On the other hand, if the companyhas a high ratio of retirees to active employ-ees, the ongoing cash outlays may be oner-ous. Moreover, under this system, there isvirtually no flexibility in the timing of pay-ments: the retirees are owed their benefits.


If a company does business in more thanone country, Standard & Poor’s pays closeattention to the geographic profile of itspostretirement benefits obligations and therelevant regulatory requirements.

Assessing the liabilityAs a practical matter, the company’s financialreporting is the best starting point because ofthe accessible, timely, and comprehensivenature of financial reporting informationcompared with other sources. Analysts mustbe wary, however, of the relatively uncertainnature of accounting for postretirement obli-gations, given all the assumptions necessaryfor their measurement, discussed above.

Moreover, in virtually all national account-ing systems, as well as under InternationalAccounting Standards (IAS), those setting theaccounting standards have sought to avoidvolatile swings in earnings and liability val-ues; hence, the extensive use of varioussmoothing techniques, in which underlyingnet liability changes and variations in actualperformance—rather than assumptions—arerecognized on a deferred basis over anextended period. (See “Pitfalls of U.S.Pension Accounting and Disclosure.”)

The first step in analyzing postretirementobligations is to examine key assumptionsused to quantify the obligations and deter-mine expense accrual for financial reportingpurposes. The discount rate, wage apprecia-tion, expected investment return, and medicalinflation rate are all disclosed under U.S.GAAP. The use of actuarial assumptionsregarding mortality, dependency status, andturnover can lead to more or less conserva-tive estimations, but these assumptions arenot disclosed directly in financial reporting;however, unrecognized losses or gains relatingto changes in actuarial assumptions indicatefurther investigation is warranted.

When assessing assumptions, we focus ondifferences among companies. Assumptionsare considered in light of an issuer’s individ-ual characteristics, but also are comparedwith those of industry peers and generalindustrial norms. In addition, assumptionsare assessed in terms of their internal consis-tency. For example, both the discount rateand rate of future compensation increases

should be closely linked to the rate of infla-tion. If the discount rate assumption signifi-cantly exceeds the assumed rate ofcompensation increases, this may reflectoveroptimism by management about its abili-ty to contain wage and salary increases.

Quantitative adjustments may be made tonormalize assumptions. For example, onerough rule of thumb is that for each per-centage point increase or decrease in thediscount rate, the liability decreases orincreases by 10% to 15%. At the very least,any liberal or conservative bias is taken intoaccount when looking at the reported planobligations and assets.

The next step is to compare the currentvalue of a company’s plan assets to the pro-jected benefit obligation (PBO) for pensions,or to the accumulated postretirement benefitobligations (APBO) for retiree medical benefitobligations. In the case of flat-benefit pensionplans (i.e., the pension benefit is a fixedamount per year of service, rather than pay-related plans, in which the benefit for eachretiree is derived from a formula tied to com-pensation over a specified period), the PBOlikely understates the true economic liability.This is because the PBO does not takeaccount of future benefit improvements forthese plans, even if probable, unless providedfor in the current labor agreement. In suchcases, the analyst estimates the additionaleconomic liability based on the company’spattern of granting benefit improvements andmanagement’s current strategies with respectto compensation.

A company’s plan assets as a percentage ofthe PBO or APBO is a simple, basic measureof plan solvency, referred to here as the fund-ing ratio. Companies with the same fundingratios in their benefit plans do not, however,necessarily bear the same risks related to theirplans. The size of the gross liability is alsoimportant because, where the gross liability islarge relative to the company’s assets, anygiven percentage change in the liability orrelated plan assets will have a much more sig-nificant effect than if the gross liability hadbeen less substantial.

To bring the depiction of postretirement-related items in the financial statementsmore in line with its own analytical perspec-



tive, Standard & Poor’s has devised certainratio adjustments (see “Adjusting Financialsfor Postretirement Liabilities”). Theseadjustments are intended to undo thesmoothing of the accounting treatment andreallocate certain accounting effects in thestatements while integrating the analysis ofpostretirement obligations with other aspectsof the financial analysis. This last point isparticularly important because of the differ-ent funding approaches and regulations thatpertain to different plans. For example, asnoted earlier, pension plans in Germanylargely are unfunded; however, majorGerman industrial companies commonlyhold large cash balances and long-termfinancial assets on the balance sheet to pro-vide for future pension-related cash require-ments. Analytically, as long as Standard &Poor’s is comfortable that these assets willbe retained over the long term to satisfy thepension-related obligations, the arrangementmight well be viewed as if the pension planhad been funded. If, however, such a compa-ny’s capitalization were analyzed withoutfactoring in the pension liability, one couldmake the mistake of netting the surplus cashagainst debt, thereby double-counting thecash position and underestimating the com-pany’s financial leverage.

Beyond determining the plan’s current levelof funding, the analyst must also consider thelikelihood of significant changes made in theliability or assets in the future. As an exam-ple, workforce downsizing through earlyretirement programs is a major issue in thecurrent economic environment. The potentialfor changes in benefits largely is a function ofthe labor climate and the level of benefits rel-ative to those of direct competitors and otherregional employers. Similarly, to take aprospective view of plan assets requires thesponsor’s input regarding its funding strate-gies and asset allocation guidelines.Regarding the latter, we do not have a pre-ferred strategy: heavy weighting toward equi-ties heightens near-term volatility, but—ifexperience holds true—should enhance long-range returns. Conversely, heavy weightingtoward fixed-income holdings should mini-mize near-term volatility, but may well limitlong-range returns.

Although Standard & Poor’s views unfundedpostretirement obligations as debt-like, thesurplus relating to overfunded plans generallycannot be viewed as a cash equivalent. Havinga significantly overfunded postretirement bene-fit plan is, of course, a positive from a creditperspective. If nothing else, it generally meansthe company can curtail future contributionsto the plan, barring changes in asset or liabili-ty levels. Companies can use the surplus toenrich the retiree benefits (possibly in lieu ofraising wages) or sometimes to fund specialworkforce reduction programs. In the U.S., aportion of the surplus can also be used to fundretiree medical benefits in some circumstances.But in the U.S.—as in most other countries—companies with overfunded pension plans mayhave little practical ability to revert the sur-plus: In the U.S., there are harsh tax conse-quences for doing so. (Amounts recaptured aresubject to ordinary income tax, plus a punitiveexcise tax.)

Cash-Flow implicationsThe level of necessary future cash outlays hasthe most immediate effect on a company’sfinancial health. Standard & Poor’s focuses onprospective outlays. Information about the reg-ulatory funding status of the plan, a company’sworkforce, the makeup of its retiree popula-tion, its benefit plan characteristics, and man-agement’s cost-cutting and funding strategieshelps the analyst understand the likely direc-tion of future cash outlays.

For plans in which prefunding is mandat-ed by regulations, the degree of discretionover payments is critical. The cash require-ments for U.S. corporate sponsors are sig-nificantly shorter term than the underlyingdisbursals to retirees, but ERISA usuallygrants considerable flexibility in the year-to-year timing of contributions, except whenthe plan is severely underfunded. Near-termminimum funding requirements often arelow enough that companies can sharply cur-tail contributions temporarily if needed tomaintain liquidity. (In Japan, pension regu-lations grant companies significantly greaterflexibility to defer contributions over anextended period than the U.S.) When fund-ing is required in the near term to complywith ERISA guidelines, the amounts


involved are viewed in a different, moresevere, light.

The calculation of minimum pension plancontributions under ERISA is a highly complexmatter. Although the ERISA framework hassome similarities to the financial reportingframework, ERISA uses its own distinctmethodologies and assumptions for valuing theassets and liabilities of the plan. Fundingrequirements are not just a function of the cur-rent funded status of the plan, but also takeinto account the past funded status, the level ofpast contributions relative to requirements, andthe nature of the events that gave rise to anyunderfunding, among other factors.

In theory, it is possible to arrive at a roughestimate of the company’s minimum futurecontribution levels by using the publiclyavailable Annual Return/Report of EmployeeBenefit Plan on Form 5500, filed by the cor-porate plan sponsor; however, one such formis filed for each qualified U.S. plan of a com-pany, and large companies may have dozensof separate plans. Moreover, the timeliness ofForm 5500 is problematic: it must be filed210 days after the end of the plan year orafter the sponsor has filed its federal incometax form, whichever is later. As a practicalmatter, then, Standard & Poor’s relies onmanagement for information regarding thecompany’s future minimum pension contribu-tions to meet regulatory requirements.

Other factors besides funding regulationscan influence funding decisions. For example,in the U.S., benefits provided under qualified,defined-benefit pension plans are guaranteedby a quasi-governmental entity, the PensionBenefit Guaranty Corp. (PBGC), which, inturn, charges plan sponsors an annual premi-um, currently $19 per plan participant. If aplan’s assets are less than the vested portionof the liability (as measured under the veryconservative methodology stipulated by thePBGC, which is different from the ERISAapproach), an additional, variable annualpremium is assessed of $9 for each $1,000 ofunfunded liability. Moreover, the plan spon-sor must notify plan participants of the plan’sunderfunded status. Companies often makesufficient contributions to their pension plansto avoid these consequences, even if they arenot required to do so under ERISA.

Perversely, perhaps, financial reporting canalso drive funding decisions. For example,under U.S. GAAP, if the value of plan assetsfalls below that of the APBO, a large chargeto equity can result (“Pitfalls of U.S. PensionAccounting and Disclosure,” again).Companies sometimes make contributions toavoid this reporting effect, particularly iffinancial covenants might thereby be violated.

In the U.S., there are some tax-effectivemeans of prefunding retiree medical benefits.One funding vehicle is the so-calledVoluntary Employees’ Beneficiary Association(VEBA) trust. As with pensions, contributionsto a VEBA trust generally are tax-deductibleup to a certain limit, and earnings on trustinvestments are tax-exempt. VEBA trusts aremore flexible than pension trusts: AlthoughVEBA funds cannot be reverted directly bythe corporate sponsor, they can be used topay for a variety of current benefits-relatedexpenses, thereby freeing up other cash. Forthis reason, though, if a company is at allinclined to use its VEBA assets in this way,Standard & Poor’s tends to view the asset asan extension of the company’s ready liquidityposition, rather than as offsetting a portionof the retiree medical liability.

In some cases, companies issue debt tofinance their benefit plan contributions. Inassessing the effect on credit quality,Standard & Poor’s considers:� Any loss of payment-timing flexibility.

For example, if the company issues debtwith a five-year term to satisfy fundingcontributions that could otherwise bespread over up to 10 years, this couldwell be viewed negatively;

� The maturity of the new obligation com-pared with the terms of the obligations itreplaces. For example, if the company isable to eliminate looming, near-term fund-ing requirements with a long-term debt issue, this could be a positive development;

� Tax consequences, such as the cash flowbenefit of accelerating a tax-deductiblecontribution; and

� The implications for the company’s debtissuance capacity, to the extent the company might have other borrowingrequirements.



In most countries, companies are permittedto contribute limited amounts of their ownstock to their benefit plans, substituting foror supplementing cash contributions.Standard & Poor’s views such transactions assimilar—in their beneficial effect—to thecompany’s issuing common stock and usingthe proceeds to reduce financial obligations.One difference, however, is the correlationrisk that results: If the company encounterssignificant setbacks, this would presumablybe reflected in a weaker share price, whichcould cause deterioration in benefit-fundinglevels and precipitate accelerated fundingrequirements. (For this reason, funding regu-lations generally set some limit on contribu-tions of so-called employer securities. Forexample, under ERISA, such contributionscannot exceed 10% of the fair value of planassets, as determined through a closely scruti-nized valuation process.)

Ultimate recovery considerationsFor companies with significant unfundedpostretirement benefit obligations, the stand-ing of such obligations in bankruptcy can bean important consideration for creditors. Itmay affect their willingness to lend, as itobviously has a bearing on ultimate recoveryin a reorganization or liquidation. Analysisof this matter is highly specific to the legalsystem and type of benefit in question, aswell as to the legal structure of the corpora-tion. In the U.S., unfunded pension liabilitiestypically have the standing of general unse-cured claims. (The PBGC or the companygenerally terminates the plan, and then thePBGC pursues a claim against the companyfor the funding shortfall.) Companies infinancial distress could have been grantedfunding waivers by government regulators inreturn for liens on assets in advance of abankruptcy filing, but this is rare amongrated companies.

The standing of retiree medical liabilities inthe U.S. is less clear-cut because these do notenjoy the same degree of protection underERISA. If, however, the benefits are owedunder the terms of a labor contract, the com-pany’s voiding of the contract in bankruptcywould give rise to a general unsecured claimby employees and retirees. If the company

were to reorganize rather than liquidate, thisclaim would most likely be settled throughthe continuation of the benefit, albeit perhapsin a reduced form, rather than a monetarypayout. This would—at least, in theory—stilldilute the recovery of other senior unsecuredclaims, because the liability in its new capitalstructure would limit the reorganized compa-ny’s debt capacity.

Pitfalls of U.S. pension accounting and disclosureAll areas of financial reporting require man-agement to make estimates and judgments,but this is particularly true of accounting fordefined-benefit pension plans. Given theprospective and variable nature of the prom-ise companies make to provide pension ben-efits to retirees, pension accounting relies onnumerous subjective assumptions (e.g.,employee turnover, mortality rates, compen-sation levels, discount rates, and investmentreturns). Moreover, the standards that cur-rently govern pension accounting under U.S.GAAP—Statement of Financial AccountingStandards No. 87, “Employers’ Accountingfor Pensions” (SFAS 87)—were issued in1985, despite intense opposition from manycompanies. The Financial AccountingStandards Board (FASB) responded with var-ious compromise provisions to smooth theeffect on earnings and on the balance sheetof pension-related factors. Consequently,some aspects of the financial reporting for pensions are incongruent with the analytical perspective.

Aspects of the current accounting frame-work that represent potential pitfalls for ana-lysts include the following.

Balance-sheet aspectsSFAS 87 defines the pension liability two ways:� The accumulated benefit obligation (ABO)

is a measure of the present value of all ben-efits earned to date and includes nonvestedand vested benefits attributable to servicesrendered through the balance sheet date. Itapproximates the value of benefits thatwould be payable if the company were toterminate the plan, so it represents a shut-down perspective.


� The projected benefit obligation (PBO)also is a measure of the liability for accu-mulated service, but, unlike the ABO, italso accounts for the effect of salary andwage increases on benefit payouts that arelinked to future compensation levels bysome formula (for example, where thebenefits are based on a fixed percentage ofthe average annual compensation over thefive years prior to the employee’s retire-ment). The PBO thus values the pensionpromise at the amount for which it willultimately be settled as the company con-tinues as a going concern.Measurement of the ABO and PBO

requires the company to make many assump-tions. Most important, because the liability iscalculated as the present value of estimatedfuture payments to plan beneficiaries, the lia-bility valuation is highly sensitive to the dis-count rate used. (The lower the discount rate,the higher the liability, and vice versa.) SFAS87 directs companies to “...look to availableinformation about rates implicit in currentprices of annuity contracts that could be usedto effect settlement of the obligation [and]also...to rates of return on high-quality fixed-income instruments currently available andexpected to be available during the period tomaturity of the pension benefits.”

The discount rate therefore should differamong companies, to the extent they operatein regions with different prevailing interestrates and have different workforce demo-graphics. In actuality, though, as manyobservers have noted, discount rate assump-tions vary significantly more widely amongcompanies than underlying differences inthese variables would justify. If the ultimatepension benefit payout is linked to compensa-tion levels, the assumption regarding salaryor wage increases also is crucial. In theory,this assumption should bear a close correla-tion to the discount rate because both reflect,at least partly, the expected inflation rate. Ifthe discount rate is significantly higher thanthe rate of compensation increases, this maywell reflect an overly optimistic view by man-agement about its ability to contain salaryand wage cost increases.

Under the framework of SFAS 87, the PBOis the basis for expense recognition—i.e., the

accounting seeks to spread the total costreflected in the PBO over the working careersof the employees earning pension benefits. Inthe pension footnote, the PBO is comparedwith the fair value of plan assets to derive thefunded status of the plan. (Note: companiescan use a measurement date up to 90 daysearlier than the balance sheet date to facili-tate preparation of the financial statements.This can distort comparisons between thefunded status of different companies.) ThisPBO-related funded status is the best measureof a company’s pension-related liability orsurplus, and therefore is the one upon whichStandard & Poor’s focuses.

However, the ABO, not the PBO, serves asthe basis for balance-sheet recognition of anyunfunded liability. Under the rules of SFAS87, the relationship of different balance-sheetaccounts to the underlying economic realityof the plan is sometimes tenuous. In the nor-mal course of affairs, a company records aliability on the balance sheet to the extentthat its pension expense exceeds its plan con-tributions. To the extent that a company’splan contributions exceed its accruedexpense, the company records a prepaid pen-sion asset on the balance sheet.

Strangely, an asset also can be created as aresult of benefits enhancements that increasethe value of the liability: This intangible assetreflects the presumed economic benefit theemployer derives from the plan improve-ment—for example, better labor productivityfrom a happier workforce. From an analyst’sperspective, the increase in the amount of theliability is more prudently interpreted as asunk cost. However, if at the end of a fiscalyear the fair value of plan assets is less thanthe ABO, the company must record a so-called minimum liability by increasing anyexisting balance sheet liability to the level ofthe unfunded ABO and eliminating any exist-ing asset accounts, with the offset being anafter-tax charge to equity (which flowsthrough “other comprehensive earnings,”rather than net income). In other words, theadditional liability is ABO less (the marketvalue of plan assets plus already accrued lia-bilities less already accrued assets).

As Table 1 illustrates, this requirementmeans a nominal change in the funding status



Table 1—Quirks of Liability and Asset Recognition

Under SFAS 87*

Example 1

—Year ended Dec. 31—(Mil. $) 2001 2002

Accumulated benefit obligation (ABO) 80 100

Plan assets 80 80

Unamortized prior service cost 0 15

Pension-related assets — —

Prepaid pension assets 0 0

Intangible assets 0 15

Pension-related liability 0 20

Change in net worth 0 (5)

At year-end 2001, the company's pension plan was fully funded relative to the ABO. During 2002, the ABO increased by $20 million: $15million because of plan amendments and $5 million because of variances from actuarial assumptions. Thus, at year-end 2002, the companyrecorded a liability of $20 million. Offsets: the $15 million of the $20 million increase in the ABO resulting from plan amendments givesrise to a $15 million intangible asset, and the balance reduces net worth.

Example 2


Accumulated benefit obligation (ABO) 100 —

Plan assets 80 80

Unamortized prior service cost 0 —






In this example, there also was a $20 million increase in the ABO. The entire increase results from actuarial losses, however. Thus, networth is reduced by the entire $20 million.

Example 3



Plan assets 80 80







In this example, the facts are exactly the same as in Example 2, except that the company already had accrued expense on the balancesheet of $15 million. Thus, it is necessary to record only another $5 million to increase the balance sheet liability to a total of $20 million.


could result in a huge reduction in equity.Analysts must be especially alert to the poten-tial for a charge to equity in cases wherecompanies have financial covenants tied tobook equity levels. Yet, although the ABO isthe crucial benchmark for triggering such acharge, companies are not required to dis-close the ABO (except, indirectly, if a compa-ny has already had to book a minimumliability)—only the PBO.

Income-statement aspectsAlthough the PBO and ABO are subject tovolatile year-to-year fluctuations, SFAS 87

was structured to minimize earnings volatil-ity. Pension expense consists of a number ofcomponents, which can be grouped intofour categories:� Service cost. This is the value of benefits

earned by active employees during the peri-od. From an analytical perspective, this isakin to a normal operating expense;

� Interest cost. This results from the “aging”of the liability within the present-valueframework. The discount rate is applied tothe PBO at the beginning of the period.From an analytical perspective, this is akinto a financing charge;


Table 1—Quirks of Liability and Asset Recognition (continued)

Example 4



Plan assets 100 100






Change in net worth 0 0

In this example, the company had a $20 million pension funding surplus at Dec. 31, 2001, and a $30 million prepaid pension asset accountbecause, historically, its plan contributions had exceeded its accrued expense. (Under SFAS 87, there is no direct connection between theactual size of the surplus and the amount of the prepaid asset account.) During 2002, the ABO increased to $100 million (because ofactuarial losses), eliminating the funding surplus. Because the plan was still fully funded at Dec. 31, 2002, however, there was no write-down of the prepaid asset account. A $30 million prepaid asset account remains, even though there is no pension funding surplus. (Hadthis been a $30 million intangible asset, the treatment would have been the same.)

Example 5



Plan assets 100 99







In this example, the facts are same as in Example 4. However, apart from the increase in the ABO, there was a $1 million decrease in thevalue of plan assets. Thus, the plan was underfunded by $1 million at Dec. 31, 2002, relative to the ABO. The company's balance sheetmust now show a $1 million net liability, the shortfall of plan assets compared with the ABO. Thus, the company must record a $31 millionliability to offset the $30 million prepayment. Had the $30 million prepaid asset been an intangible asset instead, this would have beenwritten off against equity, and only a $1 million liability would have been recorded. *All examples ignore tax effects.


� Expected return on plan assets. This ismanagement’s long-range expectationabout the performance of the investmentportfolio, rather than the actual return gen-erated during the reporting period, basedon planned asset allocations. Companiesare given little guidance in the accountingliterature for setting this assumption, andthe assumptions used vary widely. From ananalytical perspective, this is a dubiousproposition at best. (Imagine if plain vanil-la operating earnings were reported basedon management’s long-range expectations.)Moreover, as an alternative to being basedon the fair value of assets at the beginningof the period, the assumed return rate canbe applied instead to the market-relatedvalue of plan assets—i.e., on a basis thatsmoothes out market fluctuations over aperiod of up to five years; and

� Amortization cost. Any changes in the liabil-ity resulting from plan amendments are gen-erally amortized over the expected averagefuture service of employees who are active atthe date of the amendment. In addition, anychanges in the liability resulting from actualexperience that is different from the assump-tion—beyond a threshold (i.e., 10% of eitherthe PBO or the market-related value of planassets, whichever is larger)—also are amor-tized over an extended period. Examplesinclude shortfalls in investment performance,the effect of unanticipated early retirementprograms, variances in mortality, andchanges in the discount rate. From an ana-lytical perspective, these all represent itemswithout economic substance: all are losses orgains that have already been realized in eco-nomic—if not accounting—terms.The reliance on expected investment

returns is the element of SFAS 87 that hasdrawn the harshest criticism of late, as com-panies have clung to return assumptions thatseem aggressive after three years of negativeactual returns. For one thing, although theseassumptions may be justifiable based on avery long-range view, minimum fundingrequirements under the Employee RetirementIncome Security Act (ERISA) will in someinstances necessitate substantial funding overmuch a shorter timeframe, barring a dramaticrebound in the stock market.

Separately, even without making aggressiveinvestment return assumptions, some compa-nies are reporting sizable net pension credits(that is, the expected return on plan assetsmore than offsets the other cost components),generally reflecting the significant overfund-ing of their pension plans. Overfunded bene-fits plans are a positive factor from a creditperspective. Yet, the advantages this providesmay well be overstated by the credits (given,for example, the practical inability of mostcompanies to directly revert the surplus), andStandard & Poor’s takes this into accountwhen arriving at a rating.

Under SFAS 87, all the cost componentsare aggregated, although from an analyticalperspective, as mentioned above, the interestcost and investment returns are more appro-priately viewed as financing items. In addi-tion, the accounting literature contains nodefinitive guidance on how to display thepension cost on the income statement, so it isvariously classified with cost of goods sold,SG&A, R&D, etc. Companies are notrequired to disclose how they have allocatedpension cost among these accounts.

Cash-flow aspectsThe elements of accrual accounting thatmake the balance sheet and income state-ment aspects of SFAS 87 problematic do nothave the same effect on the statement ofcash flows, which reverses noncash accrualsand reflects only the cash flows related tothe pension plan. There is no standardiza-tion regarding where pension plan contribu-tions should be presented on the statementof cash flows, however, nor any requirementthat these be identified separately. As dis-cussed in the related article mentionedabove, funding that significantly exceeds orfalls short of the normal period pension cost(net of financing costs) is most appropriatelyviewed from an analytical perspective as afinancing item, but adjusting for the distor-tions that otherwise can result is greatlycomplicated by the lack of better disclosure.

Ultimately, if a company has a significantunfunded pension liability and faces materialrequired pension fund contributions, itsfunding position as defined under ERISA—rather than SFAS 87—is the most relevant


analytical consideration. Yet, companies arenot specifically required by the SEC to dis-close their ERISA funding positions or theirexpected future minimum contributions asdetermined under ERISA. Likewise, the con-tributions necessary to avoid Pension BenefitGuaranty Corp. (PBGC) variable-rate premi-ums, even though avoiding these can also bea powerful incentive for companies to makeplan contributions.

Adjusting financials for postretirement liabilitiesStandard & Poor’s uses certain financialadjustments and ratio definitions to helpensure that ratings on industrial companiesfully reflect unfunded, defined benefit pen-sion and other postretirement obligations,including health care obligations, retireelump-sum payment schemes, and otherforms of deferred compensation, whetherpartially funded or completely unfunded. Ifbenefits-related matters are material,Standard & Poor’s we will calculate capital-ization and cash flow protection measuresthat fully reflect such unfunded benefitsobligations. Also, in its analysis of prof-itability, Standard & Poor’s will undo cer-tain distortions that result from currentaccounting standards and their application.

Given the intricacies of benefits-related reg-ulations and financial reporting, Standard &Poor’s must strike a balance between what,on one hand, might seem like the most cor-rect approach and, on the other hand, whatis feasible in light of the practical limitationsof the analytic process.

In any event, if benefits obligations consti-tute a major rating consideration, ratio analy-sis will not substitute for a closeconsideration of the issuer’s particular cir-cumstances and its benefits plans. Note:Funding and liquidity considerations maywell be much more important than the finan-cial-statement analysis matters covered here.

In approaching benefits-related adjustmentsand ratio calculations, the following guidingassumptions are made:� Standard & Poor’s treats unfunded pension

liabilities, health care obligations, and allother forms of deferred compensation asdebt-like;

� To simplify the analysis, Standard & Poor’scombines all benefits plan assets and liabili-ties, netting a company’s overfunded plansagainst its underfunded plans. In theory,companies with multiple plans can curtailover the long term funding of overfundedplans and direct contributions to under-funded plans. In actuality, there is often lit-tle tax incentive to fund certain plans.Also, companies have very limited practicalability to tap funding surpluses; it is evenpossible for companies to face onerousnear-term cash contribution requirementsrelated to certain plans while other plansare overfunded. When near-term cashrequirements are the central focus, though,ratio analysis is likely to be of secondaryimportance; and

� Standard & Poor’s emphasizes the fullestmeasure of the unfunded liability available.Generally, for pensions, this is the so-calledprojected benefit obligation (PBO) underU.S. GAAP, which takes account of thevalue at which the liability ultimately willbe settled (including the effect of expectedwage increases if the benefit is tied toemployee compensation according to someformula) and views the company as a goingconcern. It should be noted, however, thatfor collectively bargained labor contracts,the PBO does not take account of expectedwage increases beyond the term of theexisting contract. The PBO is a broadermeasure than the accumulated benefit obli-gation (ABO) or vested benefit obligation,which instead reflects a shutdown valueperspective. For postretirement medical lia-bilities, the measure equivalent to the pen-sion PBO under U.S. GAAP is theaccumulated postretirement benefit obliga-tion (APBO).

Capital structure analysisStandard & Poor’s emphasizes the followingas an important measure of capitalization:� (total debt + unfunded benefits obligations)

÷ (total debt + unfunded benefits obliga-tions + adjusted equity)Unfunded benefits obligations are factored

in as debt equivalents.Given the point made above, our benefits-

adjusted capitalization ratio is based on the



unfunded PBO rather than on the amount rec-ognized on the balance sheet. There often is asubstantial gap between the two, given theaccounting approach of amortizing the effectsof variances in investment or actuarial per-formance compared with assumptions, or ofchanges in plan benefits, over an extended peri-od. For companies with net underfunded plans,Standard & Poor’s increases or reduces the bal-ance sheet liability to equal the unfunded PBO,with the offsets to the incremental change inthe liability being to deferred tax assets (whereapplicable) and equity (see table 2). Any transi-tion assets, intangible assets stemming frombenefits enhancements, or prepaid assetamounts are deducted from equity becauseStandard & Poor’s believes such assets lackeconomic substance.

We factor benefits liabilities in on anafter-tax basis, using the marginal tax rate,in countries where plan contributions—ordirect payments to retirees or third-partyinsurers—are tax-deductible. This distin-guishes benefits liabilities from debt, repay-ment of which does not generate tax credits.Again, the emphasis assumes the company isa going concern and can pay its taxes.

If a company is experiencing financial dis-tress, the tax benefits related to requiredplan contributions are unlikely to be real-ized, and the analyst may then choose toexclude a tax benefit from the calculations.(In such cases, liquidity—rather than capitalization—normally would be the main area of emphasis in Standard & Poor’s analysis.)

Table 2—Capitalization Adjustments

XYZ Co.*

Debt totals $1.0 billion and equity $600 million at Dec. 31, 200X. Tax rate: 33%-1/3%. Projected benefits obligation (PBO) exceeds fairvalue of plan assets by $1.1 billion at year-end 200X, up from $700 million at the previous year-end.

Change in benefits obligation (Mil. $)

PBO, beginning of year 2,000.0

Current service cost 60.0

Interest cost (7% x 2,000) 140.0

Actuarial adjustments 100.0

Benefits paid (300.0)

PBO, end of year 2,000.0

Change in plan assets

Fair value of plan assets, beginning of year 1,300.0

Actual return on plan assets (100.0)

Benefits paid (300.0)

Fair value of plan assets, end of year 900.0

Unfunded PBO 1,100.0

Assuming only $800 million of the $1.1 billion unfunded accumulated benefits obligation was recognized on the balance sheet at Dec. 31,200X, adjusted debt leverage is computed as follows:

Adjusted debt and Total debt + [(1 - tax rate) x $1.0 bil. + (66-2/3% x $1.1 bil.)debt-like liabilities = (unfunded PBO)] = $1.733 bil.

Adjusted equity = Book equity - [(1 - tax rate) x (unfunded PBO - $600 mil. - [66-2/3% x liability already recognized on balance sheet)] ($1.1 bil. - $800 mil.)] = $400 mil.

Adjusted debt and debt-like $1.733 bil./($1.733 bil. + liabilities/total capitalization = $400 mil.) = 81.2%

This compares with unadjusted $1.0 bil./($1.0 bil. + $600 mil.) = 62.5%total debt to capitalization of:

*XYZ Co. operates in a country where benefits plans are prefunded and plan contributions are tax-deductible. Any intangible pension asset account relating toprevious service cost would be eliminated against equity. This would also be tax-effected.


Note: Given the latitude companies haveunder some accounting systems to choose thediscount rate, and the significant sensitivity ofthe liability measurement to the rate used, itwould in theory be desirable to normalize fordifferent discount rate assumptions, puttingall companies in the same region, with thesame workforce demographics, on the samebasis. This is, however, as a practical matterextremely difficult to do with any accuracy,without knowing the underlying cash flowassumptions on which the company’s liabilitymeasurement are based. Standard & Poor’speriodically will survey companies’ disclo-sures to help ascertain which discount rateconstitutes the norm. Where companies varymaterially from the norm, Standard & Poor’s

will seek sensitivity information from man-agement to facilitate the analysis.

Cash-flow analysisWhere benefits obligations are material,Standard & Poor’s calculates the followingratio:� Funds from operations ÷ (Total debt +

unfunded benefits obligations)The denominator is adjusted as described

above. Funds from operations (FFO) isdefined as net income from continuing opera-tions plus D&A, deferred income taxes, andother non-cash items.

Standard & Poor’s makes an additionaladjustment to FFO for companies withunfunded benefits obligations that make


Table 3—Cash Flow Adjustment

ABC Co.*

The company makes “catch-up” plan contributions that significantly exceed period expense. Tax rate: 33-1/3%. The company had a sizable unfunded PBO at the previous year-end and contributes $400 million to benefits plan during 200X. The actual return on plan assetsis $30 million.

Pension expense for 200X (Mil. $)

Service cost 50

Interest cost 150

Expected return on plan assets (140)

Amortization of previous service cost, other unrecognized gains or losses 40

Net periodic benefits cost 100

By contributing more than the combined service cost and net interest cost ($50 million + $150 million - $30 million), ABC Co. is viewed asretiring a portion of its unfunded benefits obligation. The amount of cash needed to satisfy the combined service and net interest cost istreated as a normal cash operating expense. The balance of the cash flow effect of the $400 million contribution is reclassified as afinancing item.

Reported 200X statement of cash flows

Net income 100

Adjustments for items not affecting cash from operating activities

Depreciation 200

Deferred income taxes 50

Other 100

Funds from operations§ 450

Adjustments: The $400 million contribution depressed reported FFO by $266 million: $400 million - (33-1/3% x $400 million). The tax-effected overage: [($400 million - ($50 million + $150 million - $30 million)] x (1 - 33-1/3%) = $153 million, is added back to FFO and sub-tracted from financing sources/uses:

Reported FFO 450

Adjustment 153

Adjusted FFO 603

*ABC Co. operates in a country where benefits plans are prefunded and plan contributions are tax-deductible. Includes ($266 million) after-tax effect of $400million contribution. §Management input may be required to differentiate FFO effects of the contribution from the working capital effects.


“catch-up” contributions to reduce theirunfunded liabilities. Otherwise, FFO wouldappear depressed as a result of a cash outflowthat Standard & Poor’s would view as afinance item (akin to debt amortization) ratherthan a cash operating expense. Specifically, asshown below, plan contributions that arematerially greater than benefits-related serviceand net interest cost accrued during the period(that is, net of actual pension investmentreturns) are added back to FFO. (Note thatthis adjustment is capped at zero, given what

would otherwise be the distorting effect of netpositive cash inflows.)

Conversely, if the company is funding itspostretirement obligations at a level sub-stantially below its accrued expense, thismay be interpreted as a form of borrowingthat artificially bolsters reported cash flowfrom operations. Standard & Poor’s alsoadjusts cash flow to normalize for invest-ment return performance viewed as nonre-curring in nature, whether abnormally highor low (see table 3).

Table 4—Application/Expansion of Core Earnings Framework

UVW Co.

The company used 10% in 200X as its expected return on plan assets assumption. Plan assets totaled $3.5 billion at the beginning of theyear. Actual return was 2% ($70 million).

200X income statement (Mil. $)

Net sales 2,000

Operating expenses —

Pension expense 200

D&A 1,000

All other operating expenses 600

Oper. income (after D&A) 200

Interest expense 120

Pretax income 80

Pension expense for 200X

Current service cost 50

Interest cost 300

Expected return on plan assets (10% x $3.5 bil.) (350)

Amortization of unrecognized gains or losses 200

Net pension expense 200

The income statement would be adjusted as follows:

As reported Adjustments Adjusted

Net sales 2,000 2,000

Operating expenses

Pension expense* 200 (150) 50

D&A 1,000 1,000

All other operating expenses 600 600

EBIT 200 350

Interest expense 120 230 350

Pretax income 80 0

EBIT fixed-charge interest coverage (x) 200/120 = 1.7 350/350 = 1.0

*All but the current service cost ($50 million) are eliminated from benefits expense. Benefits-related interest cost, less the actual return on plan assets ($300million - $70 million) is combined with other interest expense.


Profitability AnalysisIn analyzing profitability (including EBIT-DA), as illustrated below, it is appropriateto disaggregate the benefits cost compo-nents that are combined in financial report-ing and eliminate those with no economicsubstance, in accordance with the approachof Standard & Poor’s Core Earnings frame-work. The so-called “service cost”—reflect-ing the present value of future benefits

earned by employees for services renderedduring the period—is viewed as an operat-ing expense, and treated as such.

The components that represent accountingartifacts and stem from the smoothingapproach of the accounting rules—e.g.,amortization of variations from previousexpectations regarding plan benefits, invest-ment performance, and actuarial experi-ence—are eliminated (consistent with the


Table 5—Profitability Adjustment for Overly Optimistic Expected Return on Plan Assets

UVW Co.

The company used 10% in 200X as its expected return on plan assets assumption. Standard & Poor’s views 8% as a more realistic long-range expected annual return. Plan assets totaled $3.5 billion at the previous year-end.

200X income statement (Mil. $)

Net sales 2,000

Operating expenses —

Pension expense 200

D&A 1,000

All other operating expenses 600

Oper. income (after D&A) 200

Interest expense 120

Pretax income 80

Pension expense for 200X

Current service cost 50

Interest cost 300

Expected return on plan assets

(10% x $3.5 billion)* (350)

Amortization of unrecognized gains and losses 200

Net pension expense 200

The income statement would be adjusted as follows:

As reported Adjustments Adjusted

Net sales 2,000 2,000

Operating expenses

Pension expense 200 70 270

D&A 1,000 1,000

All other operating expenses 600 600

EBIT 200 130

Interest expense 120 120

Pretax income 80 10

EBIT fixed-charge interest coverage (x) 200/120 = 1.7 130/120 = 1.1

*Under U.S. GAAP, the expected return on plan assets may not be based on the fair value of plan assets at the previous year-end, but on a "market-basedvalue," i.e., a smoothed value averaging values of several previous years. The adjustment should always be based on the fair value of plan assets at theprevious year-end. The expected return on plan assets is reduced by (10% - 8%) x $3.5 billion = $70 million, thereby increasing pension expense by $70 million.


immediate recognition of these unamortizedamounts in the treatment of capitalizationdiscussed above).

Any increase or decrease in the plan liabili-ty resulting from plan benefit changes is rec-ognized immediately as an operatingexpense/credit. Interest expense, which is theresult of the application of the discount rateto the PBO to “age” the liability with thepassage of time, is essentially a finance chargeand is reclassified as such. (As discussedabove, sensitivity analysis taking account ofdifferent discount rates is appropriate.)

The expected return on plan assets also iseliminated and replaced by a much moremeaningful amount: the actual return on planassets during the reporting period. The actualreturn on plan assets is netted against interestexpense up to the amount of the interestexpense reported, but not beyond in the caseof fully funded plans, as the economic bene-fits to be derived from such overage are limit-ed. If the actual return is negative, though,the full amount in excess of interest expenseis treated as an addition to interest expensebecause, unfortunately, the resulting econom-ic detriment to the company is quite tangible(see table 4).

In practice, however, the profitabilitymeasures that result from the use of this

approach can be extremely volatile, withbenefits-related effects often obscuring oper-ating results. For this reason, we view suchmeasures as supplementary. Just as in otheraspects of its analysis, we look beyondchanges considered temporary in nature. Inapproaching its conventional profitabilityratios, we adjust for the effects of expectedinvestment return assumptions that are sig-nificantly higher than the norm, where thishas a material effect on reported earnings(see table 5).

Moreover, we are alert to cases where com-panies have net pension credits that are amaterial source of overall earnings. Net pen-sion credits generally reflect a healthy benefitsfunding picture, but such credits exaggeratethe economic advantage to the company ofthis overfunding status and can distort period-to-period and peer comparisons.

At this time, we do not intend to recalcu-late its published key industrial and utilityfinancial ratios as described here. Becausemost U.S. companies’ pension plans werefully funded through the latter half of the1990s, we believe such adjustments wouldnot make a substantial difference to the pub-lished medians. If, however, current, broadlydepleted funding levels persist, we willreassess the basis for statistical data. ■


Asset Retirement ObligationsAROs are legal commitments to incur restora-tion and removal costs while disposing of, dis-mantling, or decommissioning long-livedassets. They are legal obligations that have acall on future cash flows of an enterprise,much like debt and similar obligations.Examples include the costs of plugging anddismantling on- and off-shore oil and gas facil-ities; decommissioning nuclear power plants;and capping mining and waste disposal sites.

AROs typically also meet accounting crite-ria to be reflected as liabilities in a company’sfinancial statements. Yet, several characteris-tics distinguish AROs from conventionaldebt, including timing and measurementuncertainties; tax implications; and the stand-ing of claimants in bankruptcy. The measure-ment of AROs involves a high degree ofsubjectivity and measurement imprecision.For example, the amounts that will be paidultimately to settle an ARO often depend onfuture legislation.

In certain cases, ARO costs are reimbursedto the entity or assumed by other parties.This occurs when an asset operator costs’ arereimbursed by a local government, or—as for

many regulated entities—the costs are recov-ered via the rate-setting process. In suchinstances, the entity does not bear all of theeconomic risks. (Please see “Asset-RetirementObligations: How SFAS 143 Affects U.S.Utilities Owning Nuclear Plants,” publishedon RatingsDirect on March 31, 2004).

How Standard & Poor’s views AROs in its analysisBecause we consider AROs to be debt-like,the after-tax amount of AROs is added to ourdebt-based measures. Our analysis beginswith the reported liability amount, which isadjusted for anticipated reimbursements andtax reductions, and for any assumptions weview as unrealistic.

To a large degree, Standard & Poor’sagrees with the accounting view that retire-ment costs are encompassed in the value ofthe fixed asset to which they relate. Frommanagement’s perspective, the return on theasset is expected to be satisfactory, inclusiveof ARO costs. We believe economic reality tobe best depicted by including all the relevantcosts in the asset’s carrying value. However,adjustments to the asset value may be war-

Corporate Asset-RetirementObligations

Asset-retirement obligations (AROs) have for some time been

viewed as debt-like liabilities in Standard & Poor’s Ratings

Services’ analysis. Recent changes to accounting and disclosure

standards under IFRS and U.S. GAAP have yielded more reliable

information on the value, nature, and timing of these obligations,

allowing for a more systematic analysis.


ranted in our analysis, in cases where webelieve future recoverability is in doubt.Conversely, salvage asset values can some-what mitigate the ARO burden (e.g., oil-pro-ducing assets, which may have a significantresidual value when sold, as they often are).

Measurement and timing uncertainties of AROsBecause most AROs involve obligations toincur costs that may extend well into thefuture, uncertainties are inherent in their esti-mation. These include the estimated amountof the ultimate cost; timing of asset retire-ment; and the discount rate to be used in thepresent value calculation.� The actual cost of abandonment will

depend, notably, on the relevant country’slaws, and asset-specific environmental reg-ulations at retirement; the condition of themarkets for the specific assets’ retirementservices; possible economies of scale for theoperator; and whether the activities ulti-mately are performed by the operator or bya third party (the accounting measureassumes a third party would perform, andaccordingly incorporates a profit element).

� The timing of asset retirement also is sub-ject to assumptions that can change mate-rially. In extractive industries, forexample, retirement timing also dependson expectations for hydrocarbon or min-erals prices, which are volatile. Duringperiods of depressed pricing, the value ofthe abandonment obligation likely wouldincrease, because the retirement of theasset could be accelerated. For power gen-erators, asset-retirement timing dependsnotably on local legislation, which mayeither result in an impact that is favorable(i.e., in the case of an operating licenseextension) or unfavorable (i.e., in the caseof an early mandated closure).

� The requirement to use an entity-specificdiscount rate under U.S. GAAP also hin-ders comparability across companiesusing U.S. GAAP, as opposed to IFRS-reporting companies, which use market-related rates adjusted to risk-specificfactors attributable to the liability. As anexample, for two companies reportingunder U.S. GAAP, with different credit

quality and equal interests in the sameoil-field, the present value of the AROscould be higher for the stronger company,merely because that company uses alower discount rate. (Ultimately, however,both companies should incur the samecosts at retirement.) Conversely, the peri-odic accretion expense would be higherfor the weaker company. Information isnot available to allow for adjusting forthese differences, nor would it be practi-cal. Standard & Poor’s Ratings Services issensitive to the potential for ‘understate-ment’ of the obligations for weaker com-panies, but in most cases, we do notexpect it to be a material rating factor.AROs are recorded on a pretax basis under

most accounting standards. Any expected taxbenefits generally are reflected as a separatedeferred tax asset on the balance sheet(because the ARO-related asset is depreciated).In most cases, tax-related cash flows (or taxsavings) substantially coincide with the AROpayments, thereby mitigating part of the cashcosts. In considering the ultimate cash flowsassociated with AROs, these tax effects mustbe considered. We analyze the company’s prof-itability prospects and its tax position other-wise, in considering the adjustment related totaxation effects. (Occasionally, governmentsmay provide benefits to companies—such asreduced royalty or income tax rates—toextend the useful life of a field, to avoid writ-ing a refund check.)

Basic numerical adjustments to derivecomplementary ratiosOur analysis includes debt-like obligations(such as for operating leases and postretire-ment benefits) when calculating credit ratios.For AROs, and subject to data availabilityand materiality, our approach—which to asignificant extent mirrors that on postretire-ment benefits—is as follows:� The obligation, net of any dedicated retire-

ment-fund assets, salvage value, and antici-pated tax savings, is added to debt. Weevaluate the estimates and assumptionsunderlying the obligation over time for rea-sonableness. In those cases where we feelthe balance-sheet recognition misrepresentsthe obligation, we would make correspon-


Corporate Asset-Retirement Obligations

ding adjustments. Adjustments are madeon a tax-effected basis in cases where it isprobable that the company will be able toutilize the deductions. We further considerthe investment risk associated with anyinvestment portfolio specifically set asideagainst the obligation (such as a decommis-sioning trust) when netting such amountsagainst the liability.

� The accretion of the obligation reflects thetime value of money and is akin to noncashinterest. Thus, if the accretion amount isreported as an operating charge in reportedstatements, we reclassify it as interestexpense for both income-statement andcash-flow statement analysis.

� Because the liability is considered net oftax, the ARO-related deferred tax asset isreduced (or the ARO-related asset, if thereare insufficient related tax assets).

� Cash expenses for abandonment and contri-butions into dedicated funds that exceed theobligations newly incurred during the peri-od are reclassified as principal repayment ofa debt-like obligation, thus increasing oper-ating cash flow and funds from operations.If dedicated funding is in place and therelated returns are not entirely reflected inreported earnings and cash flows, the unrec-ognized portion of the return on these assetsis credited to earnings.

AROs affect a company’s debt-servicecoverage ratios (e.g., funds from operationsor operating cash flows to total debt andinterest-cover ratios) as well as leverageratios (e.g., total debt to total capital).Liquidity implications typically are second-ary to the analysis, as long as these obliga-tions remain long term, and entail onlylimited prefunding requirements.

A Post-Default Perspective: AROsAs Priority Obligations, RatherThan Senior Unsecured Lenders The laws that govern the status of AROs inbankruptcy are diverse, asset- and jurisdic-tion-specific, and—occasionally—evolvingand uncertain. In some cases, it is clearAROs cannot be rejected through the bank-ruptcy process and likely will rank senior tounsecured creditors. In such cases, AROsare viewed as “priority obligations” in thecalculation of ratios used for notching thecompany’s individual obligations up ordown to reflect their relative position (andrelative recovery prospects) in a company’scapital structure. (For a more detailed dis-cussion on notching, see Standard & Poor’sCorporate Ratings Criteria, onRatingsDirect.) ■


The linkages between credit quality and corporate gover-

nance—or, more correctly, certain elements of corporate gov-

ernance—can be extensive. Governance issues that are

germane—such as ownership structure, management practices,

and financial disclosure policies—are regularly examined as part

of the credit ratings methodology, although they have not tradi-

tionally been labeled with corporate governance nomenclature.

Credit rating analysis has focused on many specific corporate

governance elements but has not aggregated these into one

category or attempted to arrive at an overall assessment of

corporate governance.

Until recently, greater emphasis has beenplaced on corporate governance factors in therating analysis in countries with less-devel-oped capital markets. However, given therecent spate of management scandals in theU.S. and Europe, Standard & Poor’s RatingsServices is subjecting these issues to greaterscrutiny globally.

It is clear that weak corporate governancecan undermine creditworthiness in severalways and should serve as a red flag or warn-ing indicator to credit analysts. Alternatively,strong corporate governance, demonstrated inpart by the presence of an active, independentboard that participates in determining andmonitoring the control environment, whilenot an enhancement to creditworthiness, can

serve to support the credibility of financialdisclosure and, more broadly, management.

Recent examples of poor corporate gover-nance, which contributed to impaired credit-worthiness, include:� Uncontrolled dominant ownership influ-

ence that applied company resources topersonal or unrelated use.

� Uncontrolled executive compensation programs.

� Management incentives that compromisedlong-term stability for short-term gain.

� Inadequate oversight of the integrity offinancial disclosure, which resulted inheightened funding and liquidity risk.Standard & Poor’s Governance Services

group offers full-scope corporate governance

The Role of CorporateGovernance in Credit Rating Analysis


analysis and scores. These services are gearedlargely to the equity investor’s perspective. Inaddition, the credit ratings and governancegroups at Standard & Poor’s may collaboratein the analysis of specific companies.Moreover, to ensure a methodological consis-tency of approach relating to broad corporategovernance issues, collaboration at a techni-cal level between credit and governance ana-lysts does occur to review points of generalanalytical criteria.

The following elements of corporate gover-nance traditionally have formed part of rat-ings analysis. The significance of eachelement as a rating factor can vary greatly.

OwnershipIdentification of the owners is an obviousrequirement. It is a fundamental rating crite-rion that entities are never rated on a stand-alone basis; links to parent companies oraffiliates are important considerations.Ownership by stronger or weaker parentssubstantially affects the credit quality of therated entity. The nature of the owner—gov-ernment, family, holding company, or strate-gically linked business—also can holdsignificant implications for both business andfinancial aspects of the rated entity.

ControlThe existence of more than one owner intro-duces additional issues regarding potentialconflicts over control. Joint owners mightdisagree on how to operate the business.Even minority owners can sometimes exer-cise effective control or at least frustrate thewill of the majority owners. Whenever con-trol is disproportionate to the underlyingeconomic interest, the incentives for thestakeholders could diverge. This could resultfrom existence of classes of shares withsuper voting rights or from owning 51% ineach of multiple layers of holding compa-nies. In either example, control might restwith a party that holds only a relativelysmall economic stake. Cross-shareholding ofindustrial groupings and family-controllednetworks are commonplace in certain partsof the world. Such group affiliations canhave positive or negative implications,depending on the specific situation.

Conventional, equity-oriented corporategovernance analysis is very sensitive to sharestructure (asking, for example, whether eachtype of share provides representational vot-ing), out of concern that actions will beundertaken to the detriment of minorityshareholders. Although this concern is not thedirect focus of credit analysis, there is apenalty for companies considered abusive tominority holders. Perception of such conductwould, obviously, impair the company’saccess to investment capital. Furthermore, if acompany mistreated one set of its stakehold-ers, there would be serious concern that thecompany could later try to shortchange otherstakeholders, including creditors.

Management and OrganizationAssessment of management is an especially sig-nificant determinant of credit-rating assign-ments. Rating analysis considers many factorsthat pertain to management, including:� Track record and competence;� Management background and reputation;� Management depth and turnover;� Professional or entrepreneurial style of

management; and� Any tensions among operating functions, the

finance function, or shareholder interests.

Policies and StrategiesFinancial policies are assessed for aggressive-ness or conservatism, sophistication, and con-sistency with business objectives. Policiesshould optimize for the typically divergentinterests of the company’s stakeholders—shareholders, creditors, customers, andemployees, among others. Specifically, thecompany’s goals with respect to its credit rat-ing need to be consistent with the balancingof those interests.

Business strategies are evaluated for real-ism, comprehension of competitive risks, andcontingency planning. Comparisons of poli-cies and projections with a company’s trackrecord form the basis for judging manage-ment credibility.

Information Disclosure and Financial TransparencyRatings are based on audited financial dataplus supplemental data (including detailed

The Evolving Role of Corporate Governance in Credit Rating Analysis


financial projections) that might be provid-ed confidentially. Ratings agencies enjoyunique access to data given their statusunder disclosure regulations in many juris-dictions and their impeccable track recordregarding confidentiality.

In judging the reliability of data, we con-sider the accounting standards used as thebasis of the financial statements, the reputa-tion of the auditor, and the degree of open-ness of the local business practice. Qualmsabout data quality (dubbed “informationrisk”) would translate into a lower rating andpreclude a rating in the upper part of the rat-ing spectrum.

A review of accounting quality is a criticalprerequisite of the financial analysis.Comparisons of financial measures need acommon frame of reference. Consolidationstandards, revenue recognition methods, anddepreciation methods are all scrutinized, asis off-balance sheet financing, such as leas-ing, securitizations, trust vehicles, and con-tingent liabilities. Adjustments are regularlymade to recast the financial statements—andthe credit ratios based thereon—to betterreflect economic risks and to allow betterbenchmark comparisons.

However, Standard & Poor’s does not con-duct audits, and there are limitations to ana-lytical methods. A company bent ondeception might succeed in misleading bothits auditors and the rating analysts.

Apart from disclosure to Standard &Poor’s analysts, though, public disclosure andtransparency can be important. If a companymaintains an aura of secrecy, investors will besuspicious and skittish. In addition, the com-pany is more prone to so-called headline risk,the consequences of which can be very dam-aging, especially in the current environment.

Intercompany and Affiliated Party TransactionsThese activities pose special challenges,because it is difficult to ascertain that they

are done on a truly arms-length basis. Apropensity to engage in deals with inside par-ties would give rise to skepticism about thecompany’s conduct of its affairs, even if theywere fully disclosed.

A component of corporate governance thathistorically has not figured prominently in therating process is board structure and involve-ment. Of course, if it is evident a company’sboard of directors is passive and does notexercise the normal oversight, it weakens thechecks and balances of the organization andrepresents a negative credit factor. But consid-erations such as the proportion of independ-ent members on the board of directors,presence of independent directors in board-level audit committee, and direct reporting ofinternal auditor to board or independentinternal audit committee at board level havenot been systematically examined.

Similarly, relatively little attention has beenpaid to the compensation of directors and sen-ior management teams. It can be difficult todetermine objectively if a given level of com-pensation is excessive or will result in a compa-ny strategy that is overly aggressive or mainlyfocused on short-term performance.

As business practices change in the wake ofmanagement and accounting abuses—anddirectors take on a more active role in the com-pany direction and oversight—more weight tothe role of the board of directors could be war-ranted from the perspective of credit rating.

Quite obviously, strong corporate gover-nance does not, by itself, indicate strongcredit worthiness—just as a company beingopen and fair does not equate with the com-pany being well managed. In addition, com-panies with high credit ratings could havegovernance standards that are problematic,particularly from the perspective of minorityshareholders. In the end, weak corporategovernance practices can undermine credit-worthiness, but it would depend on the spe-cific aspects of governance that led to thepoor assessment. ■


Asset securitization is a form of financingthat has been widely used across industriesand across the rating spectrum.Securitizations are important financingsources for many companies, often provid-ing both lower cost and more diversesources of funding and liquidity than avail-able to the company otherwise. The abilityto securitize assets provides additionalfinancial flexibility and is regarded as a pos-itive credit factor. Apart from this, though,securitizations do not ordinarily transformthe risks or the underlying economic realityof the business activity—that is, providewhat is commonly referred to as “equityrelief.” Equity relief is rarely achieved whena company has a recurring financingrequirement, in contrast to one that usessecuritization only as a means to monetize anon-core asset on a one-time basis. If securi-tization is used to supplant other debt, itseffect on credit quality is likely to be closeto neutral. Because the accounting treatmentof securitization frequently is not congruentwith Standard & Poor’s analytical perspec-tive, adjustments to the reported financialsare necessary.

In the event of a bankruptcy, an issuer’sreliance on securitization can be detrimentalto the ultimate recovery prospects of unse-cured creditors—and so may well warrantnotching down of unsecured debt issue rat-ings from the issuer credit rating.

What Is Securitization?A securitization is a means of obtainingfinancing, but it is not accomplished througha borrowing arrangement in the traditionalsense. In a securitization, an asset or pool ofassets is sold in a “true sale” to a bankrupt-cy-remote entity, variously referred to as asecuritization trust, special-purpose vehicle(SPV), special-purpose entity (SPE), or vari-able-interest entity (VIE). This entity fundsthe transaction by issuing debt, equity, orother forms of beneficial interests.Subsequently, the debt is serviced exclusivelywith cash flow generated from the trust’sassets. Because the trust is bankruptcy-remote, its debtholders are insulated from thedefault risk of the issuer. (Securitizations areoften effected using a series of trusts toachieve the desired legal isolation.)

Securitization’s Effect OnCorporate Credit Quality

The focus of this article is on securitizations undertaken by

industrial companies—not by financial institutions, which use

securitization extensively to fund mortgage and credit card loans,

as well as other types of finance assets. Nevertheless, Standard &

Poor’s Ratings Services’ fundamental approach to analyzing secu-

ritization is the same in both the industrial and banking sectors.


Further protection is afforded to trustdebtholders through “enhancement” in theform of overcolleralization. That is, thedebt issued by the securitization trust is lessthan the value of the assets, and the differ-ence between the two is the so-called “first-loss” exposure. This exposure can takedifferent forms, including subordinatedinterests in trusts, cash reserves, anddeposits due from trusts.

Another form of enhancement can be theaccumulation by the trust of excess cashflow, also referred to as “excess spread” or“interest-only strips.” This is the differencebetween cash inflows from the securitizedassets and cash outflows related to debtservice, servicing fees, and other expenses.Some securitizations “trap” a portion ofthis cash within the deal structure to furtherprotect debtholders.

Securitizations also frequently incorporateenhancements provided through third par-ties, including bond insurance, liquidityfacilities, and credit derivatives.Furthermore, securitizations commonlyinclude performance-based early amortiza-tion and reserve funding triggers.

Securitizations can be amortizing, inwhich one asset or pool of assets is sold atthe initiation of the transaction and then isliquidated over a stipulated period. Or, theymay be “revolving” in the sense that liqui-dating assets are replaced by new assets soldby the issuer into the trust. Securitizationtrusts may be associated with a single corpo-rate seller of assets (single-seller conduits) orincorporate several corporate sellers (multi-seller conduits).

Corporations commonly securitize a widerange of assets, including-–to give just a fewexamples—finance and lease receivables, tradereceivables (including existing and futureexport receivables), inventory, transportationequipment, timberlands, trademark licenses,royalties, receivables from tax authorities, andstranded costs of electric utilities.

Benefits Afforded By SecuritizationSecuritizations are important financingsources for many issuers, adding to the rangeof other secured and unsecured funding alter-

natives. For some marginal or distressed com-panies, securitization may be the only accessi-ble form of obtaining financing; investorsmay be too wary of the company’s poorprospects to lend directly, but might still bewilling to lend against the company’s discreteassets when coupled with all the structuralprotections afforded by securitization.

In addition, securitization may facilitatematch-funding, as the term of securitizeddebt generally mirrors the life of the under-lying assets.

Securitization also provides access to rela-tively low-cost financing in many instances.However, the cost of the securitization trans-action encompasses more than just thecoupon rate of the securitized debt: the costsrelated to all the different forms of creditenhancement must also be weighed, as wellas incremental administrative costs.Moreover, securitization may weigh on thecost of other financings because the overcol-lateralization enjoyed by securitized debthold-ers can put unsecured creditors at adisadvantage, as discussed below.

In thinking about the financial flexibilitybenefits provided by securitization, onemust also be sensitive to the risks posed byfinancial covenants or other credit triggersincluded in the securitization. In revolvingsecuritizations, triggers are commonly tiedto the performance of the underlying assets,which, when triggered, stop the sale ofadditional assets and cause all cash flow ofthe securitization to be used for debt amor-tization. This can result in liquidity chal-lenges and cause a “credit cliff” situationfor the company.

Does Securitization Bring Equity Relief?Many market participants think of securitiza-tion’s effect on an issuer’s credit qualityalmost exclusively in terms of “equity relief,”that is, the notion that by having completed asecuritization, the issuer is able to retain lessequity, or incur more debt, than would other-wise have been the case, without any changein its credit quality.

For Standard & Poor’s, equity relief is onepotential aspect of the analysis of a securiti-


zation’s effect on an issuer’s credit quality. Wegauge equity relief in terms of risk transfer:equity relief is achieved only to the extent therisk related to securitized assets is transferredto the securitization debtholders. We do notapproach this matter in black-and-whiteterms, but instead view the potential out-comes along a spectrum. To the extent thatthe securitization accomplishes true risktransference, the transaction is interpreted asresembling an asset sale, whereas in the muchmore common case where the issuer retainsthe bulk of risks related to the asset, thetransaction is akin to a secured financing.

Key considerations include the following:� The riskiness of the securitized assets. The

only risk that can be transferred is thatwhich existed in the first place. If, as isoften the case, an issuer securitizes its high-est-quality or most liquid assets, that limitsthe extent of any meaningful equity relief.

� First-loss exposure. The issuer commonlyretains the first-loss exposure, therebyenhancing credit for the securitized debt.For the securitized debt to be highly rated,the extent of enhancement must be a multi-ple of the expected losses associated withthe assets. The first-loss layer thus encom-passes the preponderance of risk associatedwith the securitized assets, and the issuer’stotal realizations from the securitizationwill vary depending on the performance ofthe assets. Often, only the risk of cata-strophic loss is transferred to third-partyinvestors–-risk that is generally of little rel-evance in the corporate rating analysis.

� Moral recourse. This refers to how the com-pany would behave if losses did reach cata-strophic levels. Empirical evidence suggeststhat companies often feel they must bail outtroubled financings (for example, by repur-chasing problematic assets or replacing themwith other assets) to preserve access to thisfunding source and, more broadly, to pre-serve their good name in the capital mar-kets, even though they have no legalrequirement to do so. Moral recourse ismagnified when securitizations represent asignificant part of a company’s financingactivity or when a company remains linkedto the securitized assets by continuing in therole of servicer or operator.

� Ongoing funding needs. Even if it were cer-tain that the risks related to a given pool ofassets had been fully transferred and theissuer would not support failing securitiza-tions, equity relief still would not necessari-ly have been achieved. If, for whateverreason, losses related to the securitizedassets rose dramatically higher than initial-ly anticipated, and if the issuer has a recur-ring need to finance similar assets, futureaccess to the securitization market wouldbe dubious–-at least economically. Futurefunding needs would then have to be metby other means, with the requisite equity tosupport them. Thus, even if a companyseparately sells the first-loss exposures, orsells the entire asset without retaining anyfirst-loss exposure, it may achieve littleequity relief. (See “Auto Whole Loan SalesBolster Automakers’ Funding Flexibility,”published March 15, 2004, onRatingsDirect, Standard & Poor’s Web-based research and credit analysis system.)Our experience has been that expectations

regarding equity relief are often exaggerated.The fact is, minimizing funding costs for theissuer while transferring significant risk to theinvestor tend to be mutually exclusive.

Accounting AspectsConvoluted and form-driven accounting rulesunder U.S. GAAP complicate the task ofassessing companies’ uses of securitizations.Under SFAS 140 (“Accounting for Transfersand Servicing of Financial Assets andExtinguishments of Liabilities”), certainspecifically defined securitizations effectedthrough securitization trusts termed “qualify-ing special-purpose entities” (QSPEs) aretreated as asset sales, with the securitizedassets and related debt being off-balance-sheet. Yet, QSPEs, which are “passive” innature and narrow in scope of activities,include securitizations of recurring financereceivables–-a securitization type where thereis typically little basis for supposing risktransfer has occurred, based on the factorsenumerated above.

Otherwise, under FASB InterpretationNumber 46-Revised (FIN 46R;“Consolidation of Variable Interest Entities”),

Securitization’s Effect On Corporate Credit Quality


a company must consolidate a securitizationtrust—here termed a VIE—if the company isdeemed to be the “primary beneficiary” ofthe VIE trust (unless the VIE is a QSPE underSFAS 140). Under FIN 46R, a company isconsidered the primary beneficiary if it holdsa variable interest(s) in the VIE, which willabsorb most of its expected losses, receivemost of the expected residual returns, orboth. Variable interests are defined in termsof the rights and obligations that convey eco-nomic gains or losses from changes in the val-ues of the VIE’s assets and liabilities.According to FIN 46R, a company with themajority of the risks or rewards associatedwith a VIE’s activities is essentially in thesame position as the parent in a parent/sub-sidiary relationship.

Applying the rules for tallying variableinterests is highly subject to judgment andestimates. In addition, some companies tailorthe terms of securitizations specifically to failthe tests for off-balance-sheet treatment—which can be achieved without substantiallymodifying the underlying economics of thetransaction—feeling their financial statementsare thereby more transparent. Other compa-nies prefer the minimization of apparentfinancial leverage that can result from off-bal-ance-sheet treatment.

Management’s accounting objective mayalso be influenced by income statement-relat-ed considerations: some companies prefer toavoid the volatility associated with upfrontgain recognition, preferring the moresmoothed earnings recognition pattern gener-ally afforded by on-balance-sheet accountingfor securitizations. (Note: FASB has recentlyproposed an amendment to SFAS 140 thatwould require companies to record upfrontgains on sales and mark-to-market all securi-tized assets and liabilities [including anyretained portions], as well as affordingoptional fair-value or amortized cost account-ing for servicing rights.)

Further muddying the waters: the IFRSframework is very different from that of U.S.GAAP. Thus, even when transactions havethe same economic substance, the accountingtreatment can vary.

Analytical AdjustmentsOur analytical treatment of securitizations isnot dictated by the accounting treatment.Rather, we seek to understand the economicsubstance of the transactions. In calculatingfinancial ratios that assist us in assessing debtleverage, profitability, and cash flow, weadjust financial statements as necessary to bein accordance with our analytical perspectiveand to enhance comparability among issuers.

Capital structureFor capital structure ratio calculations, theanalytical treatment will vary depending onthe degree to which risks are transferred. Fortransactions in which a company retains thepreponderance of risks (including those relat-ed to ongoing funding needs), we calculateratios where the outstanding amount of secu-ritized assets are consolidated, along with therelated securitized debt—regardless of theaccounting treatment. If securitization is usedessentially to transfer risk in full and thereare no contingent or indirect liabilities, weview the transaction as the equivalent of anasset sale. When necessary, then, we recastthe assets, debt, and shareholders’ equityaccordingly, including adjusting for deferredtax effects. (In some cases, the securitizationgives rise to a deferred tax liability thataccrues over the life of the transaction and isultimately payable when the transactionmatures. Given the visibility of this liabilityand the high likelihood that it will ultimatelybecome payable, in contrast to deferred taxliabilities in general, it may be appropriate totreat this as a form of debt.)

ProfitabilityWhen securitizations are accounted for assales, they commonly give rise to upfront“gain-on-sale” effects, which represent thepresent value of the estimated differencebetween the asset yield and the securitizationfunding rate and other securitization-relatedcosts. For securitizations in which a companyretains the preponderance of risks, it isappropriate to back out such gains andspread them out over the life of the securiti-zations, given the uncertainty about whetherthe earnings will ultimately be realized as


expected and to give a clearer picture of thecompany’s recurring earnings.

In theory, it may be desirable to fully recastthe income statement—for example, consoli-dating off-balance-sheet securitization trans-actions not involving risk transference. As apractical matter, though, this is difficult toaccomplish without the detailed assistance ofmanagement. Some companies have voluntar-ily included such pro forma schedules in theirpublic disclosures.

Cash flowIn accordance with SFAS 95 (“Statement ofCash Flows”), any cash inflows/outflowsrelated to working capital assets or liabilities,or finance receivables, are classified as “oper-ating” in nature on the statement of cashflows. Hence, inflows/outflows from relatedsecuritizations affect operating cash flow,with particularly significant effects possible inreporting periods when securitizations are ini-tiated or mature. The reporting conventionvaries, though, in line with the balance sheetclassification. If the securitization is consoli-dated, the related borrowings are treated as a“financing” activity. If the securitization isnot consolidated, it is as if the assets self-liq-uidated on an accelerated basis: no debtincurrence is identified separately, either as anoperating or financing source of cash.

When our analytic view is that securitiza-tions should be consolidated (or, in rare sit-uations, when those that are consolidatedshould not be), it would be desirable torecast the statement of cash flow according-ly—to smooth out the variations in operat-ing cash flow that can result from the saletreatment of the securitization, which cangive a distorted picture of recurring cashflow. Again, though, as a practical matter,this can be difficult to accomplish withoutthe company’s assistance.

Ultimate Recovery AspectsUse of securitization may pose concernsregarding ultimate recovery prospects forunsecured debt in the same way that securing

some debt with valuable assets relegates theunsecured debt to junior status. Thus, wheresufficiently material, this may warrant notch-ing down of unsecured debt issue ratings andneeds to be taken into account in assigningrecovery ratings to other debt issues.

Like secured debtholders, securitizationdebtholders have a priority claim to a desig-nated pool of assets. If the issuer becomesinsolvent, unsecured debtholders wouldreceive a direct benefit from the encumberedassets only if the value of those assets wasmore than sufficient to meet the secured/secu-ritized debtholders’ claims. This implies “sub-ordination” of unsecured debt and of debtsecured by lower-quality assets, whichbecomes potentially more threatening thegreater the percentage of assets that are secu-ritized. In the case of securitization, however,if the value of the encumbered assets is insuf-ficient to satisfy the claims of the securitizeddebtholders, those debtholders have no claimon the issuer’s unencumbered assets (that is,as long as the company does not extend anyguarantee to the securitization). (Note:Whether the securitization has been consoli-dated or deconsolidated for financial report-ing purposes has no bearing on the legaltreatment in bankruptcy.) Therefore, as longas the securitized and unsecuritized assets areof roughly uniform quality, i.e., equally sub-ject to erosion in value, the securitizationtransactions should not be detrimental to theultimate recovery prospects of unsecuredcreditors, particularly if the securitizationproceeds are used to repay unsecured debt.

If the securitization transactions are morehighly leveraged than those of the rest of theissuer, securitization creates a potential rela-tive benefit for the unsecured debtholders.Obviously, though, if better-quality assets aresecuritized while inferior ones are left unen-cumbered on the balance sheet—which ismost often the case—the result is that unse-cured debtholders are disadvantaged.

Particularly in view of the increasing useof securitizations by corporates, we invitecomments from any market participantsregarding this article. ■

Securitization’s Effect On Corporate Credit Quality


Near-term credit factors are often similar tolonger-term credit factors, and Standard &Poor’s always considers credit issues over avariety of time horizons in assigning long-termratings. However, for speculative-grade issuers,the short-term horizon can be particularly crit-ical, in terms of liquidity, event risk, and sus-ceptibility to changes in business conditions.

Standard & Poor’s short-term speculative-grade ratings are intended to give market par-ticipants an additional indicator ofcreditworthiness. Short-term ratings for spec-ulative-grade issuers focus first and foremoston liquidity, which is the leading driver ofcreditworthiness over the short term for themajority of corporate issuers in the specula-tive-grade category. In addition to liquidity,Standard & Poor’s considers various otherfactors in determining the short-term rating.

The business factors will vary by industryand, for example, might address the follow-ing: cyclical factors such as commodity pric-ing environment, potential regulatory changesor rate reviews, potential legal issues, poten-tial new products, or potential sources ofdelay in introducing products, such as regula-tory approvals, potential entry into new busi-ness line or exit from existing lines,significant potential competitive develop-ments, near-term country risk factors facedby material emerging market subsidiaries, orother potential event risk.

Short-term speculative-grade ratings areassigned as an “issuer” rating, i.e., one thataddresses relevant short-term credit factorsfor a particular company. Standard &Poor’s would also assign ratings to specific

Short-Term Speculative-GradeRating Criteria

Short-term speculative-grade ratings represent Standard &

Poor’s Ratings Services’ opinion of the relative creditworthi-

ness of an obligor with specific reference to a short-term time

horizon, generally the following 12 months (on a rolling basis).

For issuers with long-term ratings of ‘BB+’ or lower, their short-

term ratings fall in a range, including ‘A-3’, ‘B-1’, ‘B-2’, ‘B-3’, ‘C’,

and ‘D’. For corporate issuers (industrial and utility sectors), the

emphasis for short-term speculative-grade ratings is cash flow

analytics, liquidity (including loan covenant analysis), and rele-

vant near-term business factors.


short-term notes or loans (i.e., issue ratings)upon request.

All else being equal, companies with excep-tional liquidity characteristics are those mostlikely to have short-term ratings at the upperend of the scale, since they can rely on theirliquidity cushion to shelter them from near-term risks. Companies with corporate creditratings of ‘BB+’ may even achieve an ‘A-3’short-term rating, which is equivalent to the‘A-3’ rating assigned to investment-gradeissuers. Despite strong liquidity and what maybe favorable near-term industry conditions,these companies’ speculative-grade long-termratings indicate exposure to significant risksover time, for example: vulnerability to adownturn in the domestic economic cycle,product obsolescence risk, expected medium-term competitive developments, regulatoryrisk, legal risk, or other types of event risk.

Liquidity analysis is naturally a key focusfor both short- and long-term speculativegrade ratings. The sections below will reviewthe cash flow and liquidity analytics focus forthe short-term rating.

Internal Sources Of Liquidity

Cash, marketable securitiesA company’s cash position is of course themost reliable source of liquidity. However,not all of the cash position can be viewed assurplus: virtually every company has somebase amount of cash that must be retainedfor day-to-day operating purposes. In addi-tion, balance-sheet figures cannot be taken atface value: information on published balancesheets may be stale; cash may be held atoperating subsidiaries and not available tothe holding company, due to covenant restric-tions, cross-border tax inefficiencies, or for-eign-exchange restrictions for emergingmarket subsidiaries; or cash may be pledgedto a certain facility. What companies classifyas “marketable securities” may in fact bemore or less liquid, may be subject to signifi-cant swings in value, and depending on theaccounting jurisdiction, may or may not bemarked to market on a regular basis.Marketable securities also need to be scruti-nized for risk concentrations (credit risk;

country risk; and currency risk). For weakercredits, signs of a deliberate strategy to builda cash-cushion prior to a filing for reorgani-zation (such as Chapter 11 in the U.S.) needto be considered.

Therefore, in analyzing a company’s cashposition as a source of liquidity, Standard &Poor’s evaluates the quality and availabilityof the cash position, taking into account thefactors previously mentioned. Carefulreview of the notes to financial statements,other regulatory disclosures, understandingmanagement’s liquidity investment policy,and questioning management directly aresources utilized.

Cash flowA company’s ability to generate free cashflow (cash flow after working capital needsand capital expenditures) is a key source ofliquidity. Building blocks for the cash flowanalysis include:

Funds from operations. This basic cash flowindicator (cash flow before working capitaladjustments and capital expenditures) is scru-tinized for historical and projected annuallevel and relative volatility, including seasonalor commodity price-related fluctuations.

Working capital/operating cash flow.Working capital can be a critical use orpotential source of cash flow, depending onthe nature of the company and its operatingcycle. Standard & Poor’s reviews companieswith a high degree of seasonality and work-ing capital variation, such as retailers, forpeak and trough levels of working capitalusage and related liquidity needs and sources.A company may also be able to extract cashfrom working capital at least temporarily, forexample, by monetizing receivables throughfactoring or securitization, liquidatingunneeded inventories, or stretching out pay-ments to suppliers. Each of these techniqueshas potential drawbacks, however, in terms oftime needed to execute, or—in the case ofstretching out payments—sending potentiallyalarming signals to suppliers.

Capital expenditures/free cash flow. Standard & Poor’s expectations about acompany’s required maintenance capitalexpenditures, as well as likely growth-relat-ed capital expenditures, are factored intothe cash flow analysis to arrive at projectedfree cash flow. The relative flexibility the

Short-Term Speculative-Grade Rating Criteria


company may have to cut back on capitalexpenditures, if needed, is also analyzed.

External/Other Sources Of Liquidity

Bank lines of creditKey factors reviewed are total amount offacilities; whether they are contractually com-mitted; facility expiration date(s); current andexpected usage and estimated availability;bank group quality; evidence of support/lackof support of bank group; and covenant andtrigger analysis.

Financial covenant analysis is critical forspeculative-grade credits. Standard & Poor’srequests copies of all bank loan agreementsand bond terms and conditions for rated enti-ties, and reviews supplemental informationprovided by issuers for listings of financialcovenants and stipulated compliance levels.Standard & Poor’s reviews historical covenantcompliance as indicated in compliance certifi-cates, as well as expected future complianceand covenant headroom levels. Entities thathave already tripped or are expected to tripfinancial covenants will be reviewed for theirability to obtain waivers or modifications tocovenants. Penalties for violating financialcovenants are also reviewed as to whetherthey trigger an event of default (most severe)or a debt incurrence limitation. Materialadverse change clauses are also reviewed forpotential ability to affect bank group behaviorduring a liquidity or other crisis.

Ratings triggers are less common for specu-lative-grade issuers than for investment-gradeissuers. Nevertheless, rating triggers aresometimes found at the ‘BB’ or ‘B’ level (i.e.,a downgrade from ‘BB-’ to ‘B+’ may trigger aput option or immediate unavailability of abank facility for future borrowings).

Market accessAlthough market access cannot be taken forgranted, companies are reviewed for theirtrack record in ability to access debt andequity markets. Particularly outside the U.S.,a company’s role in the national economy canenhance its access to bank and capital mar-kets. Near-term, well-defined, highly exe-cutable bank or capital market financings are

included in Standard & Poor’s near-term cashflow projections, while potential executionrisks are also considered.

Ability to access securitization markets onan ongoing basis should also be considered.This assessment should take into account thecurrent and anticipated liquidity in securitiza-tion markets, as well as the nature of assetsavailable to be securitized (amount, quality,and salability). Committed multi-seller andsingle-seller bank conduit facilities should beconsidered where applicable.

Ability to sell nonstrategic assetsIdentified, marketable nonstrategic assets maybe considered as a form of backup liquiditysupport. However, execution risks may beconsiderable; timing of the closing of suchtransactions (i.e., receipt of funds) can benotoriously unpredictable.

Parent supportParent support may be considered as a poten-tial source of liquidity, albeit with a healthydose of skepticism. The track record of theparent in supporting the subsidiary or othersimilar subsidiaries, the strategic nature of thesubsidiary, or the presence of cross defaultsrelated to the subsidiary in parent debt agree-ments all may lead Standard & Poor’s to con-clude that temporary liquidity support from amore highly rated parent is likely. However,parents often change their views with regardto the relative importance of keeping a sub-sidiary out of default or bankruptcy, as theparent company’s own business and financialstrategies evolve.

Uses Of CashIn addition to working capital and capitalexpenditures, expected near-term uses of cashmay include the following:

Debt maturitiesA company’s debt maturity schedule is care-fully reviewed, with particular scrutiny ofshort-term debt (debt with original maturitywithin one year) and the current portion oflong-term debt (the portion of bond or long-term bank debt maturing within one year).For most speculative-grade companies, market


access is not guaranteed. Periods of marketilliquidity or temporary spikes in creditspreads may make market access difficult,expensive, or both. Short-term bank debtrollovers also cannot always be taken forgranted. Companies with the highest short-term ratings will have sufficient cash to covernear-term maturities or a refinancing plan thatwe view as having little execution risk (suchas planned market access with committedcredit facilities as a backup). While the focusis 12 months forward on a rolling basis, thisdoes not mean debt maturities just beyondthis horizon are ignored in the short-term rat-ing analysis. Standard & Poor’s would wantto see that the company has a credible strate-gy for repaying or refinancing debt maturingup to 18 months for companies to achieve thehighest short-term ratings. As maturities moveinto the forward 12-month time horizon,Standard & Poor’s will start placing moreweight within the short-term rating analysison the materiality of upcoming maturities andthe company’s refinancing strategy and execu-tion ability. Debt maturing within six months,depending on materiality relative to liquiditysources, would be weighted quite significantlyin the short-term rating, with proportionallyless credit given to refinancing strategies notyet executed.

Particularly for companies in the weakershort-term rating categories, the specific tim-ing of debt maturities can be critical.Maturities are scrutinized by month, and forcompanies with severe liquidity problems,constructing a day-by-day schedule of materi-al maturities may be needed.

Besides bank and bond debt, other finan-cial obligations are considered, including leas-es and contingent obligations.

DividendsExpected common and preferred dividendsare factored into projected use of cash.Standard & Poor’s will also consider a com-pany’s flexibility to reduce dividends if need-ed. Companies may find it difficult to reducedividends if they have maintained a long trackrecord of maintaining or increasing dividendsper share, which in turn is considered criticalto maintaining access to equity markets.

Acquisitions.Expected near-term acquisitions (and fundingstrategy) are factored into cash flow projec-tions. For particularly acquisitive companies,Standard & Poor’s may make a base-caseassumption about acquisitions in our fore-cast, although no specific acquisition targetmay have been identified.

Other projected uses of cash may include:� Pension funding � Obligations arising from derivatives (mar-

gin calls)� Take or pay obligations� Debt buybacks� Litigation� Environmental obligations

Guidelines For Speculative-GradeShort-Term Issuer RatingsStandard & Poor’s considers the variousfactors listed below for each rating category.The final rating incorporates a qualitativeweighting of these and other industry riskfactors; therefore, the guidelines are notmeant to be definitive.

‘A-3’A small portion of speculative-grade credits,those with outstanding short-term credit-worthiness, may obtain an ‘A-3’ short-termrating (i.e., cross-over to investment gradefor their short-term rating). These issuersshould have relatively low default risk overthe near term, despite speculative-gradecharacteristics over the medium to longterm. They must have a combination of out-standing liquidity and lack of near-termevent risk. In particular, the issuer shouldexhibit a combination of most of the fol-lowing characteristics:� Free cash flow positive for prior (rolling)

12 months and per Standard & Poor’s pro-jections for next (rolling) 12 months;

� Cash and easily liquidated short-terminvestments more than cover short-termdebt maturities (i.e., no refinancing risk inthe near term);

� Has ample backup liquidity from unutilizedlines of credit and no chance of covenantbreech or rating trigger activation;



� Enjoys very good access to external financ-ing, including debt (bank, securitization,and other debt markets), and equity.

� Event risk over the short term (acquisi-tions, industry downturn, adverse regulato-ry/legal rulings, adverse competitivedevelopments) should be minimal.

‘B-1’Issuers with a ‘B-1’ short-term rating haveabove-average creditworthiness over the shortterm compared to other speculative-gradeissuers, despite credit concerns over the medi-um to long term. They should have a combi-nation of very strong liquidity and limitednear-term event risk. In particular, suchissuers should exhibit the following:� Should be free cash flow positive for

prior (rolling) 12 months and perStandard & Poor’s projections for next(rolling) 12 months;

� Cash and easily liquidated short-terminvestments should nearly cover short-term debt maturities (i.e., limited refinanc-ing risk). Alternatively, backup liquidityfrom unutilized lines of credit may helpcover short-term debt maturities, if thereis virtually no chance of covenant breachor rating trigger activation;

� Have ample backup liquidity from unuti-lized lines of credit and little chance ofcovenant breech or rating trigger activation;

� Total liquidity (cash, marketable securi-ties, unutilized bank lines, projected 12-month funds from operations) shouldwell exceed total near-term uses (workingcapital requirements, capital expenditures,dividends, pension funding requirements,debt maturities);

� Typically enjoy good access to externalfinancing (debt-including securitizationfacilities), equity, or both); and

� There may be some event risk over theshort term (acquisitions, industry down-turn, adverse regulatory/legal rulings,adverse competitive developments), butassessed potential impact should be mini-mal. There may be more significant eventrisk identified over the medium term.

‘B-2’Issuers with a ‘B-2’ short-term rating haveaverage speculative-grade creditworthinessover the short term. They should have ade-quate to good liquidity and may have limitednear-term event risk. In particular, theseissuers should have the following traits:� May be neutral to slightly free-cash-flow-

negative (for prior [rolling] 12 months andper Standard & Poor’s projections for next[rolling] 12 months);

� Cash and easily liquidated short-terminvestments, plus backup liquidity fromunutilized lines of credit, should nearlycover short-term debt maturities (i.e., mayhave some refinancing risk);

� Have some backup liquidity from unuti-lized lines of credit. There may be somechance of covenant breach, although limit-ed impact is expected (i.e., either lines ofcredit are not critical liquidity sources, orbanks are expected to waive);

� Total liquidity (cash, marketable securities,unutilized bank lines, projected 12-monthfunds from operations) should cover totalnear-term uses (working capital require-ments, capital expenditures, dividends, pen-sion funding requirements, debtmaturities). Some reliance on rollovers(particularly for bank lines where covenantcoverage is ample) may be factored in;

� Typically enjoy access to external financing(debt, equity, or both), but disruptions canbe anticipated; and

� There may be some event risk over theshort term (acquisitions, industry down-turn, adverse regulatory/legal rulings,adverse competitive developments), butassessed potential impact should be moder-ate. There may be more significant eventrisk identified over the medium term.

‘B-3’Issuers with a ‘B-3’ short-term rating haveweak speculative-grade creditworthiness overthe short term (next 12 months). They mayhave poor to merely adequate liquidity andhave significant near-term event risk. In partic-ular, the issuers should exhibit the following:� May be neutral to significantly free cash

flow negative (for prior [rolling] 12 months


and per Standard & Poor’s projections fornext [rolling] 12 months);

� Cash and easily liquidated short-terminvestments, plus backup liquidity fromunutilized lines of credit cover only a frac-tion of short-term debt maturities (i.e., mayhave significant refinancing risk);

� Have some backup liquidity from unuti-lized lines of credit. There may be a signifi-cant chance of covenant breach, althoughsuch a breach should not lead to an imme-diate liquidity crisis;

� Total liquidity (cash, marketable securities,unutilized bank lines, projected 12-monthfunds from operations) should nearly covertotal near-term uses (working capitalrequirements, capital expenditures, divi-dends, pension funding requirements, debtmaturities). Some reliance on rollovers

(particularly for bank lines where financialcovenant compliance is comfortable) maybe factored in;

� Typically have only sporadic access to exter-nal financing (debt, equity, or both); and

� Typically there is some identified event riskover the short term (acquisitions, industrydownturn, adverse regulatory/legal rulings,adverse competitive developments);assessed impact would be significantly neg-ative. There may be more significant eventrisk identified over the medium term.

‘C’Issuers with a ‘C’ short-term rating have veryweak creditworthiness over the short term.They have a combination of poor liquidityand/or significant event risk, suggesting ahigh near-term default risk. In particular,these issuers should have the following: � Be typically free-cash-flow-negative;� Have no capital market access and limited

bank line availability. They also havelarge near-term maturities. Covenantbreach may be expected in the near term,with a high level of uncertainty byStandard & Poor’s over the issuer’s abilityto obtain bank waivers;

� Have high near-term event risk (such asmaterially adverse litigation result expect-ed); and

� Default is highly probable in the near term,unless a significantly positive developmentmaterializes that is not in our base case(i.e., external sources of liquidity foundthrough asset sales, cash injection fromparent, acquisition by a stronger company,event risk is reversed).Note: Speculative-grade short-term ratings

have a certain natural correlation with long-term ratings. However, with certain excep-tions, several short-term rating outcomes arepossible for an issuer with a given long-termrating. Issuers with long-term ratings of ‘BB’and lower are not expected to achieve ashort-term rating of ‘A-3’ or higher; issuerswith long-term ratings of ‘CCC+’ and lowerare not expected to achieve a short-term rat-ing higher than ‘B-3’. �


BBB-

A-3

B-1

B-2

B-3

C

BB+

BB

BB-

B+

B

B-

CCC+

CCC

CCC-

CC

D

Chart 1—Short-Term Speculative-Grade

Ratings: Correlation With

Long-Term Ratings

D

SDSD

corporate ratings criteria

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