“Credit Rating Process”

Learning Objective

Pricing the Risk!!!

Presented By:

Asif Naqvi

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

• 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:

• AAAAAA• AA+AA+• AAAA• AA-AA-• A+A+• AA• A-A-• BBB+BBB+• BBBBBB• BBB- etc (Please refer to notes)BBB- etc (Please refer to notes)

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 Sectors where Credit Rating Plays a Vital Role:Role:

– Commercial Banks:

– Mutual Funds:

– Investment Banks:

– Leasing Companies:

– Insurance Companies:

– Bonds & Securitization etc.

The Rating Process: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 MethodologyRating 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 RiskI - 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.

II - Market Position:II - 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?

III – Ownership & SupportIII – 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 capital markets.

IV- 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…

IV- Earnings & Performance

• Profitability and 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.

V – 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…

V – Cash Flows

• Volatility of 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. .

VI – 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.

VII – 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.

VIII – Funding & FlexibilityThe 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 & FlexibilityThe 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.

IX – 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

X – 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

The House is Open to Any Number of QuestionsThe House is Open to Any Number of Questions

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