Credit Rating

Dr. Kanhaiya Singh

 Credit Rating
Process”
Learning Objective
Pricing the Risk!!!
 What is a Rating:
• Grade summarizing the willingness and
ability to repay.
•Ability to pay-quantitative
•Willingness to pay-qualitative
•Letter Grades
•Sub-categories of grades.
Major Credit Rating Companies: S &
P, Moody’s,
Fitch etc.
•Locally: JCR-VIS & PACRA
CRISIL,ICRA,CARE
•Why Credit Rating???
 A rating is NOT:
•A judgment or statement regarding any aspect of
public policy.
•A political statement in favor of or against a
particular
person or administration.
•A dictate of which should be done or how a matter
should be handled.
Why bother a rating/rating agency:
• •Increase investor acceptance.
Increase investor acceptance.
•Current economic environment.
Current economic environment.
•Current capital market environment.
Current capital market environment.
•BOTTOM LINE: Lower Interest Cost.
BOTTOM LINE: Lower Interest Cost.
 Types of Credit Ratings:
• •Sovereign Ratings: Assess the country
Credit risk
and is used as a point of reference for
country
borrowings from WB, IMF, ADB, IDB etc
•Entity Ratings: Risk ratings of Corporate
entities.
 Instrument Ratings:
• Ratings of the Bonds issued by
different corporations and municipalities.

Rating Terminologies – Long Term

 Rating Terminologies
• Short Term:
•A1+:
A1+:Obligations supported by the highest capacity for
timely
Obligations supported by the highest capacity for timely
repayment.
repayment.
•A1:
A1: Obligations supported by a strong capacity for timely
repayment.
•A2: Obligations supported by a satisfactory capacity for
timely
repayment, although such capacity may be susceptible to
adverse changes in business, economic, or financial
conditions.
•A3: Obligations supported by an adequate capacity
for timely
repayment. Such capacity is more susceptible to
adverse
changes in business, economic, or financial
conditions than for
obligations in higher categories.
•B: Obligations for which the capacity for timely
repayment is
susceptible to adverse changes in business,
economic, or
financial conditions.
•C: Obligations for which there is
an inadequate capacity to
ensure timely repayment.
•D:Obligations which have a high
risk of default or which are
currently in default.
 Sectors where Credit Rating Plays a Vital
Role:
• –Commercial Banks:
–Mutual Funds:
–Investment Banks:
–Leasing Companies:
–Insurance Companies:
–Bonds & Securitization etc
 The Rating Process:

• –Step I: Decision and documents

–Step II: Rating Presentations – meetings,
conference
calls, and /or site visits
–Step III: Rating Committee,
communication, press
release, report
–Appeal process, if necessary
–Surveillance
 Rating Methodology
• Following major factors are assessed in the Credit
Rating
Process:
•Industry Risk
•Market Position
•Ownership & Support
•Earning & Performance
•Cash Flows
•Management Evaluation
•Capital & Debt Structure
•Funding & Flexibility
•Corporate Governance
•Additional Factors for Financial Institutions
 I - Industry Risk
• •Economic importance of the industry to the country.
•Potential for support.
•Employment significance.
•Industrial relations record.
•Significance of legislation: protective and harmful,
relationship with government.
•Maturity of the industry.
•International competition.
•Barriers to entry.
•Competitive situation domestically: monopoly, oligopoly,
fragmentation.
•Nature of the industry: capital intensity, product lifespan,
marketing
requirements.
 Cyclic factors:
• demand, supply, implications for price
volatility.
•Industry cost and revenue structure:
susceptibility to energy prices, interest rate
levels, government policies.
•Important developments and trends in the
industry.
 Market Position
•Competitive position within the industry: size,
market share & trend, price-setting ability.
•Major product importance.
•Product lives and competition.
•Degree of product diversification.
•Significance of R&D expenditure and of new
product development.
•Geographic diversity of sales and
production.
•Significance of major customers.
•Dependence on major suppliers and
access to alternatives.
•Marketing needs.
•Distribution network, control and
susceptibility to external factors.
•What are the growth trends, and sources of
growth?
 Ownership & Support
• The specific issues include:
•Ownership of the entity.
•Relationship with owners, autonomy, control.
•Financial strength of owner (s).
•Potential for support or for funds withdrawals.
•Structure of ownership.
•Other benefits: access to technology, products.
•Access to ca ital markets.
 Earnings & Performance
• The specific issues include:
•Consistency and trend of core earnings.
•Earnings mix by activity and geography.
•Exceptional and extraordinary items: non-
recurring impacts on
past earnings levels.
•True earnings levels available for cash flow:
equity accounting,
restrictions on profit repatriation.
•Internal growth versus acquired earnings.
Contd…
•Profitabilityand protection measures.
•Profit margins.
•Interest & pre-tax coverage measures.
•Dividend cover, payment levels and
future policy.
•Taxation situation: effective tax rate,
specific relief.
•Sufficiency of retained earnings to
finance growth internally.
 Cash Flows
• Relationship of cash flow to leverage and ability to internally
meet all cash requirements is evaluated. The volatility of cash
flow over time and the impact of seasonality on cash flow is
also assessed.
The specific issues include :
•Adequacy of cash flow to maintain the operating capacity of
the
business: working capital levels, replacement of fixed assets.
•Contribution from cash flow towards expansion: major capital
spending projects, acquisitions.
•Discretionary spending included in cash flow including
advertising, exploration, research & development
expenditure.
contd…
•Volatilityof cash flow over time.
•Relationship between cash flow and total
debt.
•Restrictions on cash flow : limits on
repatriation, potential

taxation effects, access to dividends from

subsidiaries.
•Liquidity levels and fluctuations:
seasonality, sensitivities.
•Working capital management and
measurements
 Management Evaluation
• The specific issues include:
•Record to date in financial terms.
•Corporate goals and outlook: aggressive
stance, attitude to risk.
•Experience, background, credibility.
•Depth of management: key individuals,
succession.

•Record compared with peers.

 Capital & Debt Structure
• The specific issues include:
•Debt/Equity measures: historic, present and projected.
•Leverage (total liabilities/equity) measures: historic,
present and
projected
•Sensitivity Analysis on projected levels
•Seasonal variations
•Coverage measures on interest & leasing
•Adjustments for off-balance sheet items.
•Appropriateness of capital structure for the business:
over-
reliance on short term funding, sensitivity to interest rate
changes.
 Debt Structure
• Type, maturity, currency, service
schedule,
covenants, security, default clause
 Funding & Flexibility
• The specific issues include:
•Flexibility of planned financial needs : capital spending,
dividend
levels, acquisitions.
•Ability to raise additional financing under stress.
•Back-up and standby lines of credit : periods and covenants
of
underwriting facilities and committed lines, bank
relationships
generally.
•Ability to attract capital : shareholder make-up, access to
equity
markets.
•Capital commitments.
Cont..
The specific issues include:
•Flexibility of planned financial needs : capital spending, dividend
levels, acquisitions.
•Ability to raise additional financing under stress.
•Back-up and standby lines of credit : periods and covenants of

underwriting facilities and committed lines, bank relationships

generally.
•Ability to attract capital : shareholder make-up, access to equity
markets.
•Capital commitments.
Cont..

VIII – Funding & Flexibility

•Margin of safety in present and planned gearing/leverage levels.
•Asset make-up : nature of assets and potential for reductions or
disposals under stress, scalable units.
•Off-balance sheet assets and liabilities : goodwill or other intangibles written off,
undervalued assets, pension under funding.
 Corporate Governance
• •The independence and effectiveness of the board of
directors
•Oversight of related party transactions that may lead to
conflicts of
interest.
•Board oversight of the audit function.
•Executive and director remuneration.
•Complex holding company structures.
•Ownership by private individuals and families.
•Also examine other aspects of corporate governance
whose impact on
bondholders is less clear cut; these include equity
ownership by
executives and directors
 Additional Factors for Financial
Institutions
• •Quality of the asset portfolio
•Stability of earning
•Sources and cost of funds
•Asset / liability structure
•Capital adequacy and liquidity
•Market environment and strategy
•Prospects