Chapter 4

THEORETICAL FRAMEWORK OF CREDIT RATING AND

FINANCIAL VARIABLES

4.1 Introduction

The cred~t rat~ngs are partly ass~gned by evaluat~ng the financ~al status

of the firms, seek~ng cred~t ratlng Th~s study trles to evaluate th~s content of

financlal lnformatlon In credit ratlng Initially a theoretical framework has been

drawn to develop a loglcal relat~onshlp between credrt ratlng and financ~al

var~ables Thls evolved log~cal relatlonsh~p could provide a base for exploring

the requlred lnformat~on through any other quantltatlve analysis Thls chapter

highlights the financlal varlables used In the study, and the~r relatlonshlp w~th

the cred~t rating T h ~ s logical relationsh~p IS also comprehensively explained

using graphs These graphs are plotted uslng the med~an value of 600

observations of financ~al variables and the credit ratlng

4.2 Variables Used in this Study

The company's speciflc varlables were chosen ~n accordance w~th

past emp~ncal literature on cred~t rat~ng and financ~al d~stress models The

study also uses new varlables, whlch have not been used ~n any other

studies These new var~ables were used w~th the expectat~on of improving

the predlctlve and dlscrlminatlng power of d~fferent statlstlcal models The

selected varlabies were grouped lnto different financial dimensions based on

the~r components The selected financlal var~ables conta~ned few absolute

varrables (TA and SALES) and the firm's age (AGE) The ~dent~fied 39

financlal var~ables were grouped Into 9 financ~al dimens~ons (table 4 1) The

computational details of the varlables are glven ~n append~x 4

4.3 Financial Variables and Credit Rating

The financ~al performance of a company can be analysed by carefully

examining the balance sheet and Income statement of the company The

Table 4.1

Literature

d, f a, d, e, f, g

a. c, d

d, e, h, 1

a, d, e, I a, c, d, e, f, I, k

a , b , d , e , g , ~ , i , I a, d, e, f, g,l

a, f, k

Variables

PBDITMS PBlTlNS PBITfTA PBlTlCE PBTlNS PBTrrA RPfTA DlVlPAT RPIPAT CASHICL CASH~TA CNCL WClNS WCKA QNCL CASHICA INVTURN INVICA 1 NVITA RECITA DRTURN CRTURN PBlTllNT PBDITANT CPIINT OCFIINT CAPlTL R S n L TBITL BBKB DEBfrB T A SALES AGE

Details of Financial Var~ables Financial

Dimension Prof~tablllty Profitab~l~ty Profitabrl~ty Profitab~lity Profitabtl~ty Profitabil~ty Profitability Profitability Profitab~llty Llquldlty Llquld~ty Llquldlty Llquldlty Llquldlty Llqu~dlty Llquldlty Actlvlty Actlvlty Act~vlty Actlv~ty Actlvlty Act~vlty Debt servlce coverage Debt servlce coverage Debt servlce coverage Debt servlce coverage L~ablllt~es structure L ~ a b ~ l ~ t ~ e s structure L ~ a b ~ l ~ t ~ e s structure L ~ a b ~ l ~ t ~ e s structure L~abilities structure S~ze S ~ z e Firm's age

Table 4.1 continued I I I

Variables

DIE TBITA

CGR NSITA

NS/CA

Financial Dimension I Literature I I

Leverage I I Leverage Leverage

Sales turnover Sales turnover

I a Falkenst~ n, Boral, and Ca* (2000j. b Khandanr, Lozano, and C a m (2001). c Led Mayr (20011 d Chen and Shrmerda (1981). f Crouhy, Galal, and Mark (2001j. g Altman (1968). h E5mrnister (19721, 1 Deakrn (1972), 1 Baever (1966). k Altman. Haldeman, and Narayanan (1977). 1 Wlnakorand Srnllh (1935)

BB Bank G%rowmgs, CAP Capltal, CGR Cap~tal Geanng RaDo, CP Cash Profib, D Debts, DIV Divrdend, E Equibes, INV Inventones, NS Net Sales, PAT Profit Afier Taxes, PBlT Prof# 3efore Interest, and Taxes, PA Qurck Assets, RP Relarned Profits, TA Total Assets, T L Total Liabilibes, CA Current Assets, CE Capital Employed, CL Cumnt Lrabibties, Ci'TURN Credrtors Turnover, DEB Debentures, DRTURN Debtors Tumover, INT lnteresr INWURN Inventones Turnover, OCF Operating Cash Flow PBDIT Profit Before Depmratron, Interest, and Taxes, PBT Profit Before Taxes. REC Recervables. RS Reserves and Surplus, TB Tolai Borrowings, WC Workrng Caprtal

larger quantities of data are made comprehensive and comparisons between

firms made possible uslng financial accounting rat~os The credit analysts In a

rating agency consider many attr~butes of a firm, financial as well as

managerla, and quantitat~ve as well as qual~tative The quantitative analysis

IS mainly tnanctal analysls and IS based on the firm's financial reports The

analysts escertain the financtal health of the firm, determines the sufictency

of earnlnss and cash flows to cover debt obligat~ons The quality of the firrn's

assets anc the ltquidlty position of the firm IS also ascerta~ned

The financ~al vartables are belng lncreaslngly used as simple

measures of complex financ~al relationships and In the predlct~on of cred~t

rat~ng and Rnanclal distress The financial variables were used to uncover the

financial irformatlon content of credit rat~ng, slnce they are the effective tool

for, (I) evauating firm's performance, (ti) sening benchmark or standards of

performarce, (111) htghlighting the areas that need to be improved, and (iv)

enabilng external part~es to assess the credtt worthiness and profitab~l~ty of

the firm Tne financtal lndtcators over the last two and the current year were

compared wlth the credit ratlng Thls comparison IS important for better

understanding of the Importance given to financial performance of firms In

cred~t ratlrg assignments The brief details of the financial dlrnensions and

the relat~cnship between the variables of the dimensions and the credit

ratings are expla~ned In the succeed~ng paragraphs

4.3.1 Profitability

A traditional indicator of success or fallure of any buslness endeavour

has been its ab~llty to add value to its wealth or generate profits The h~gher

profitab~l~ty ralses a firm's equlty value and also lmpi~es a longer way of

revenues The higher profitab~lity lmpl~es greater cush~on to debt holders

Profitab~lity also determines the market percept~ons, wh~ch has a bear~ng on

the suppct of shareholders and other lenders Th~s support can be an

important factor durlng stress The firms w~th lower profitabll~ty would

subsequently default more frequently The profitabll~ty of a firm w~l l have a

dlrect rela3onshlp w~ th cred~t ratlng (h~gher the prof~tab~lity, higher the cred~t

rat~ng) TPe more profitable the firm, the more resources ~t has to pay

debtors, and the lower its propensity to default Hence ~t IS expected, that

company's cred~t worthiness 1s positively related to its profitab~l~ty Profitabil~ty

IS a relative term It IS hard to say what percentage of profit represents a

profitable 5rrn The profit depends on d~fferent factors lhke the pos~tion of the

company and ~ t s products on the competit~ve cycle

A piofitablllty of firm IS convent~onally measured through financ~al

rat~os, ln \rbich the profit 1s measured as a percentage ~n the total assets, net

sales, an j cap~tal employed PBDITINS, PBITINS, PBITKA, PBITICE,

PBTINS, and PBTK are the rat~os which descr~be the profitability of the firm

and avo~d the volatility of earnlngs assoc~ated w~th extraordinary items A

h~gher va ue of these ratios ind~cates greater profitability and a positlve

relatlonsh 3 with cred~t ratlng Slnce a firm's ultlmate existence IS based on

the earnlna power of 11s assets, some of these ratlos appear to be particularly

appropria:a for studies deal~ng with default r~sk and cred~t ratlng

RPTTA, accounts for the proportion of total amount of reinvested

earnlngs andlor losses of a fin over ~ t s ent~re life The age of a firm IS

lmpl~c~tly wns~dered in these rat~os The relatively young firm w~l l probably

show a low RPrrA ratio because it had no time to bu~ld up ~ t s cumulative

profits It also measures the leverage of a firm, those f i n s w ~ t h h~gh retained

earnlngs to total assets, have financed the~r assets through retent~on of

profits and have not ut~lised as much debt The ratlos DlVlPAT and RPIPAT

measure the d~v~dend pollcy of firm These ratios were also used to study the

financial lnformatlon content in credit rating Fig 4 1 presents the graphical

relation between cred~t rat~ng and the med~an value of select profitab~lity

variables Almost all the var~ables show an ~ o s i t ~ e movement

4.3.2 Liquidity

L~qu~dity is an lnd~cation of the firm's abllrty to respond lmrnediately to

sudden cash payments There are many l~quidrty rat~os In common usage,

but at heart they measure similar things The more liqu~d assets a firm has,

the lower ~ t s propensity to default in short term L~quid~ty ratios as a relevance

to this study would measure the firm's abrl~ty to meet fixed cost expenses of

debt outstanding The l~qu~d~ ty pos~tion IS affected by the state of

cornpetltlons, Issuers market posit~on and pol~cles, and relationsh~p with

customers and suppliers The comparison of the liqu~dity d~rnens~on wlth

credit rating helps to identify the corporate pos~tion ~n meet~ng the fixed

expenses on cap~tal borrowings The fund~ng profile with respect to matchlng

of assets-liab~lity tenures also has an important bearing on the l~quid~ty

position

The cornpanes w~th higher current ratios and b~gger holdings of cash

and marketable securit~es tend to have lower default probability, leading to

higher credit ratlng Since the profitabil~ty and liquidity are two terms which

are ~nversely related, a company w~th h~ghes: profitabil~ty having a good

Credit Rating and Median Values of Profitability Variables

Fig 4.1 continued

Credit Rating and Median Values of Profitabil~ty Var~ables

~ i g 4 1 (e) PETINS

01,.

4 1 0 .

Jll.

F I ~ 4 1 (g) RPKA

OW,

am.

OW.

om-

:

Fe 4 1 (f) PBTKA

L l l .

D I O .

Fg4 1 (h) DNKA

0 51 -

00s.

Fig 4.1 continued

Credit Rating and Median Values of Profitability Variables

rating may not have hlgh liqu~dity Though tt is argued that higher the l~qu~d~ty

better the ratlng, rt is a relatlve term, which could be understood that

reasonable Iiqu~d~ty, better w~ll be the rating The ind~cators of l~quldtty tnc!ude

CASHICL, CASHTTA, CNCL, WClNS, WCmA. QAICL, and CASHlCA Fig

4 2 exh~brts the graphical relatlon between credit ratlng and the med~an value

of select l~qu~d~ ty variables These graphs explan a complex relat~on behveen

credit rat~ng and financ~al var~ables

4.3.3 Acbvity

The act~v~ty rat~os reflect how were the ftrm's assets are bring

managed The actlvlty rat~os are accounting ratios that reflect some aspects

of the firm, that have less straight forward relatlon to cred~t risk than other

var~ables The act~vity ratlos that use inventory In the numerator IS expected

to have a poslttve relat~onship wtth the default probability, as grcwlng

Inventory reveals h~ghest storage costs as well as non-l~qu~dity, lead~ng to a

Credit Rating and Median Values of Liquidity Variables

Fig 4.2 continued

Credit Rating and Median Values of Liquidity Variables

FlS 4 2 (gi CPSHICA

0 1

003

om

D O 1

0 m t!Q 2 2 ' ; E m u o

lower credt rating The debtors' turnover ratlo shows the firm's eficlency In

collect~ng cash from lts credlt sales Some of the actlvlty ratlos Include,

INVTURN, INVICA, INVTTA, RECTTA, DRTURN, and CRTURN Fig 4 3

shows the graphical relatlon between credlt ratlng and the med~an value of

select a c h t y variables These graphs explaln a remote relatlon between

cred~t rating and financial var~ables

4.3.4 Debt Service Coverage

Th~s d~mens~on of a firm IS considered to be a primary Importance to

the debt holders of a firm The level of these ratios reflects the result of

business nsk diverse and the fundlng polic~es Generally, h~gher the level of

coverage, h~gher IS the cred~t ratlng The bus~ness w~th lower level of

coverage can get h~gher rat~ngs ~f the earnlngs are steady (I e , bus~ness w~th

low Industry risk) As the debt lnstrurnents are fixed Income Instruments, the

rat~ng awarded to these Instruments are expected to be pos~t~vely related to

cred~t ratlng

PBDITIINT, PBlTllNT and OCFllNT measure the hrm's abiltty to

service ~ t s debt wlth Internally generated cash flows These ratios helps to

determine whether a business can meet all ~ t s operative needs and have

suffic~ent funds remalnlng to cover Interest requ~rements and d~vldends

Therefore a ratlo below 1 1 lnd~cates that the company must b o ~ o w funds to

meet s0rr.e of its financing obllgatlons Th~s ratlo also serves as an Indicator

of a company's capacity to Inquire add~t~onal debt The ratlo, CPJINT

measures the cash profit as a percentage to Interest to be pard, whlch

othew~se means the cash term earnlngs of the firms to se4le the fixed

expenses (interest) Fig 4 4 presents the graph~cal relatlon between cred~t

rat~ng and the medran value of select debt servlce coverage vanables These

graphs ex;llaln a positive relatlon between credlt ratlng and the financial

vanables

Fia 4.3

Credit Rating and Median Values of Activity Variables

Fig 4.3 continued

Credit Rating and Median Values of Activity Variables - -

F8g 4 3 (e) D R N R N

am

m

om > > < ; z = u o

F q 4 3 i O C R N R N

m

< ~ ' $ ~ D V C

4.3.5 Liabilities Stmcture

The components of the total l~abillt~es of a firm are also considered In

major financlal decls~ons made by the external parties to the firms More the

fixed cost capital (debt) component in the total I ~ a b ~ l ~ t ~ e s , h~qher will be the

probabil~ty of default The credit rat~ngs are expected h~gher for the firms w~th

less borrow~ng Usually the l~ab~li t~es structure IS studled uslng CAPffL,

RSnL, TBnL, BBRB, and DEBnB Fig 4 4 presents the graphical reatlon

between cred~t rating and the med~an value of select i ~ a b ~ l ~ t ~ e s strueure

var~ables These graphs expla~n a posltive relation between cred~t ratlng and

RSTTL, negatlve relation between credit rating and TBTTL, and a complex

relat~on between credit ratlng and other var~ables

4.3.6 Size

The firm's size IS a var~able that is correlated w~th many financlal

statement Inputs The typical proxles for firm slze are ~ t s TA and SALES It IS

Fia 4.4

Credit Rating and Median Values of Debt Service Coverage Variables

b Fg 4 4 (dl CCFIINT

Im

Am

2 m

3 m /!L o m j ~ . ~ ~ 3 u c

Fis 4.5

Credit Rating and Median Values of Liabil~ttes Structure Variables

Ftg 4 5 l c i T a m

0 Y

0 23

I t 0

0 m ;ILL ~ ~ * ~ ~ m u n

Fig 4.5 continued

Credit Rating and Median Values of Liabi l~t ies Structure Variables

expected that b~gger the firm, the more dlverslfied ~ t s assets and there fore ~ t s

default r1s4 IS lower The larger firms may default less frequently than the

smaller firms So a posltive relationship is expected between size and credlt

ratlng Fig 4 6 presents the graphical relatlon between cred~t ratlng and the

medlan value of select slze variables These graphs explan a positlve

relat~on between credlt rat~ng and financial variables

4.3.7 Firm's Age

The age of the firm also determines the value of figures In financial

statements A older firm may have more of reserves than a firm whlch IS very

young The age and track record of the f~ rm IS also considered In major

financ~al cscls~ons by the stake holders But the term 1s complex that a very

old firm w;;h poor perfomlance can have a very worst fundamental leading to

a poor credlt ratlng As thls d~menslon IS not a dlrect financial variable,

u Credit Rating and Med~an Values of S ~ z e Variables

L

FIQ 4 6 la) LOG SALES

1 1 )

> rc

P YI I;-- 0 rn j l c l s O u O

Fg 4 6 lb) LOG TA

110

> m

0 60

0 k 00 ~ 2 * ~ z = u o

relatlon between credlt rat~ng and firm's age are not clearly understood Fig

4 6 presents the graphlcai relat~on between credit ratlng and the medlan

value of firm's age var~able Thls graph explains a complex rela:~on between

cred~t ratlng and age var~able

4.3.8 Leverage

Leverage IS an important measure of the credrt r~sk of a firm slnce rt

measures the firm's abllrty to w~thstand unforseen clrcumstances The Rrms

with hlgh leverage will have high exposure to default rlsk and as propensty to

default Tne cred~t ratlng for the firms wlth h~gh leverage IS expected to be

lower, as the default probab~lrty IS hrgher The buslness rrsk IS a prrme dnver,

while gearlng has a secondary role in determlnlng the overall ratlng

(especrally long term) To ~llustrate, an Issuer who's geailng level IS

Fis 4.7

Credit Rating and Median Values of Firms' Age Variable

Fig 4 7 AGE

xl m

>om

om I!? 2 s < B 3 m u o

favourable but relat~ve buslness fundamental are weak IS unlikely to get a

favourable long-term rating Thls 1s so because gearlng IS considered to be a

"controllable" factor wh~le business factors are relatively dlficult to alter

s~gn~ficantly Usually leverage IS measured using (I) total borrcw~ngs as a

percentage of total assets, and (11) long term debt as a percentage of equity

DIE ratlo shows the extent to whlch a firm is relylng on debt to finance

~ t s Investments and operations, and how well it can manage the debt

obligat~ons, I e , repayment of pr~ncipal and period~c Interest If the company

IS unable to pay its debt, it will be forced lnto bankruptcy On the positive s~de

the use of debt IS beneficial as it prov~des tax benefits to the f~rm, and allows

~t to explolt business opportunltles and grow It also shows the firm's reliance

on external debt for financing The lower the ratlo, more conservative

Fig 4.8

Credit Rating and Median Values of Leverage Variables

Ftg 4 8 (a) DIE

3 ia : I f . 3m

0 n

om 3 : ' ~ s W u 0

FIQ 4 8 (c) CGR

cm

3 " ' f " " "

(probably safer) the company IS How ever ~f a company 1s not uslng debt, ~t

may be foregoing Investment and growth opportunltles Flg 4 8 shows the

graphical relatlon between cred~t ratlng and the med~an value of select

leverage var~ables These graphs expla~n a negat~ve relatlon between credlt

ratlng and financlal varlables

4.3.9 Sales Turnover

The assets turnover reflects the efflclency wlth whlch the available

capltal 1s used A hlgh N S n A and NSlCA ratlos are a pre requlslte to obtaln

hlgh returns wlth relatively low Investment and has a posltlve effect on the

l~qu~drty of the firm, therefore reduclng the default probablllty and

apprehending the credlt ratlng These ratlos show how much sales the firm

IS generating for every rupee of Investment In assets The hlgher the ratio,

the better the firm IS performing Fig 4 9 presents the graph~cal relatlon

between credlt ratlng and the medlan value of select sales turnover varlab!es

These graphs explaln a complex relatlon between credlt ratlng and financlal

Credlt Rating and Median Values of Sales Turnover Var~ables

Fig 4 9 (a) NSIT A

2 s , = = = t i - : -

Ftg 4 9 (b) NSlCA

I m p, 0 m

C b O

0 4 0

0 21

r m 3 $ < : g * " o

4.4 Chapter Summary

The credlt analysts ln a rat~ng agency cons~der many anr~butes of a

firm, financlal as well as managerial, quantitatlve as well as qua~tatlve The

quantitatlve analysls IS malnly financ~al analysis and 1s based on the firm's

financ~al reports The analysts ascertain the financlal health of the firm,

determines the sufficiency of earnings and cash flows to cover debt

obl~gat~ons The quality of the firm's assets and the llquid~ty pos~t~on of the

firm are also ascertained The profitabll~ty of a firm will have a dlrect

relat~onshlp wlth cred~t ratlng The more profitable the firm the more

resources d has to pay debtors, and the lower its propenslty to default Hence

~t IS expected, that company's cred~t worthiness IS posltlvely related to ~ t s

profitabllltj The more Itquid assets a firm has, the lower ~ t s propenslty to

default ~n short term

The actlvlty ratlos are accounting ratlos that reflect some aspects of

the firm that have less straight forward relat~ons to credit r~sk than other

var~ables Generally, h~gher the level of coverage, h~gher 1s the cred~t ratng

The bus~ness w ~ t h lower level of coverage can get hlgher ratlngs ~f the

earnlngs are steady The cred~t rat~ngs are expected h~gher for the firrns w~th

more borrcwing The larger firms may default less frequently than the smaller

firms The age and track record of the firm is also cons~dered in major

financlal decisions by the stake holders The firms w~th h ~ g h leverage will

have h~gh exposure to default r~sk and as propensity to default A hlgh NSfrA

and NSICA rat~os are a pre-requlslte to obta~n high returns wlth relatively low

Investment and has a positlve effect on the l~quldity of the f i n , therefore

reduc~ng the default probab~l~ty and apprehending the credlt ratlng

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