Transfer Prices

A transfer price is a price used to measure the value of goods/services furnished by a profit centre to other responsibility centres within a company. When internal exchange of goods and services take place between the different divisions of a firm, they have to be expressed in monetary terms. The monetary amount for these inter-divisional exchanges or transfers is called the transfer price. The implication of the transfer price is that for the selling division it will be a source of revenue, whereas for the buying division it is an element of cost. It will, therefore, have a significant bearing on the revenues, costs and profits of responsibility centres.

The transfer price should be determined objectively. It should be equal to the value of the intermediate products being transferred, that is, the transfer price should reward/compensate the transferring division and charge the buying division in keeping with the value of the functions performed and the value of the product exchanged. The transfer price should be compatible with the policy that maximises attainment of company goals and evaluation of segment performance. Transfer prices can be either cost-based or market-based.

Hire Purchase System

Hire purchase system is a system whereby the owner of the goods lets them on hire for periodic payments by the hirer upon an agreement that when a certain number of payments have been completed, the absolute property in the goods will pass to the hirer, but so that the hirer may return the goods at any time without any obligation to pay any balance of rent accruing after return; until the conditions have been fulfilled the property remains in the owner.

In a hire purchase transaction certain goods are delivered by the owner, called the hire vendor to a person called the hire purchaser or hirer with a condition that the hire purchaser will pay the agreed price of the goods which is inclusive of certain amount of interest. The hire purchaser acquires the goods immediately on signing the hire purchase agreement but ownership or title of the same is transferred only when the last instalment is paid. The effect of this arrangement is that the hire vendor can repossess the goods if the hire purchaser fails to pay any instalment at any stage. The goods can be taken back even when sold to third party by the hire purchaser. The sums paid by the hire purchaser prior to the repossession of goods by the hire vendor are treated as hire charges for using the property and the same are not refundable if the hire purchaser does not want to continue the hire purchase agreement.

Last-In, First-Out Inventory Valuation Method

According to Last-In, First-Out (LIFO) inventory valuation method the cost of goods sold is the cost of those goods that have been purchased last. The ending inventory is valued at the earlier cost. It is based on the assumption that the goods sold are those that have been acquired last and the goods that remain unsold (ending inventory) are those that have been acquired first. So cost of goods sold is based on the price of recently purchased goods and the ending inventory represents the cost of earlier purchases.

The main purpose of inventory valuation is to match costs of goods sold or produced with the revenues they generate. LIFO method aims to match the current costs of acquiring or producing the goods with the current revenues from the sales. The cost of goods sold under this method represents the cost of recent purchases with the result that there is better matching of current costs with current revenues. However, this method of inventory valuation understates the assets because the ending inventory on the assets side of the balance sheet is valued at old and out of date unit costs.

First-In, First-Out Inventory Valuation Method

First-In, First-Out (FIFO) inventory valuation method is based on the assumption that cost should be charged to revenue in the order in which they are incurred, that is, first units received are the first ones to be sold or the units sold in the order in which they were acquired. The flow of costs is presumed to be the same as usual flow of goods. The ending inventory is assumed to be consisting of goods most recently purchased. The FIFO formula assumes that the items of inventories which were purchased or produced first are consumed or sold first and consequently items remaining in inventory at the end of the period are those most recently purchased or produced. In sum, FIFO assigns the cost of the earliest units acquired to the issues and the cost of the most recent acquisition to the ending inventory. The assumption that goods purchased first are sold first is in accord with the good and efficient management practice that minimises losses from spoilage and deterioration. The cost of goods sold closely follows the price trend in market as the goods purchased are assumed to have been sold first.

The Efficient-Market Hypothesis

There are three forms of efficient-market hypothesis, namely, the weak form, the semistrong form and the strong form.

The weak form says that the current prices of stocks already fully reflect all the information that is contained in the historical sequence of prices. The weak form of the efficient-market hypothesis is popularly known as the random-walk theory.

The semistrong form of the efficient-market hypothesis says that current prices of stocks not only reflect all informational content of historical prices but also reflect all publicly available knowledge about the corporations being studied. The semistrong form of the efficient-market hypothesis maintains that as soon as information becomes publicly available, it is absorbed and reflected in stock prices.

The strong form of the efficient-market hypothesis maintains that not only is publicly available information useless to the investor or analyst but all information is useless. The strong form of the efficient-market hypothesis maintains that no information that is available, be it public or inside can be used to earn consistently superior investment returns.

Enlightened Marketing

The philosophy of enlightened marketing holds that a company’s marketing should support the best long-run performance of the marketing system. Enlightened marketing consists of five principles: consumer oriented marketing, innovative marketing, value marketing, sense-of-mission marketing, and societal marketing.

Consumer oriented marketing means that the company should view and organize its marketing activities from the consumer’s point of view.

Innovative marketing requires that the company continuously seek real product and marketing improvements.

According to the principle of value marketing, the company should put most of its resources into value building marketing investments.

Sense-of-mission marketing means that the company should define its mission in broad social terms rather than narrow product terms.

Following the principle of societal marketing, an enlightened company makes marketing decisions by considering consumers wants and long-run interests, the company’s requirements and society’s long-run interests.

Sugar Futures

Like any futures contract, sugar futures allow the sale or purchase of sugar at a predetermined price for delivery at a future date. Futures allow physical market stakeholders, including producers, traders, processors, importers and exporters, to hedge themselves against the price volatility and risk. Apart from hedgers, speculators participate in a futures market by taking on the risk that hedgers seek to cover themselves against.

A speculator is one who normally tracks the market and takes an informed decision. In an ideal market, the proportion of hedgers and speculators should be 50:50 but this does not always happen. It remains a fact though that speculators help impart liquidity to a market and reduce the impact cost by narrowing the bid (buy)-ask (sell) spread.

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Responsibility Accounting

In a responsibility accounting system, costs are classified or identified with the persons responsible for their incurrence commonly referred to as responsibility centres. The virtue of this manner of collecting cost data is that they not only indicate what costs have been incurred but also who is responsible for them so that responsibility can be localised in case actual costs exceed budgeted costs. The head of each responsibility centre is expected to prepare a budget of the costs over which he has control and the authority to incur, and he is expected to operate within the limits of the budget. The responsibility accounting concept is important for controlling cost. The individuals in the organisation are held accountable only for those costs over which they have control and the authority to incur. They are not accountable for costs which they cannot control.

Responsibility accounting, as a control device, is relevant to divisional performance measurement. Responsibility accounting focuses on responsibility centres. A responsibility centre is a sub-unit of an organisation under the control of a manager who is responsible for the activities of that responsibility centre. For the purpose of measuring divisional performance, the responsibility centres are divided into:

·         Expense centres;

·         Profit centres; and

·         Investment centres.

An expense centre is a segment whose financial performance is measured in terms of cost.  The profit centre is that division of an organisation in which financial performance is measured on the basis of profit, that is, revenue - expenses. The measure of performance in an investment centre is based on the relationship between the segment profit contribution and segment assets.

Rate Corridor

Repo rate is the rate of interest charged by the central bank when banks borrow money from it. It is the tool through which the central bank in-fuses funds into the system by lending to banks against pledging of securities.

The reverse repo is the rate the central bank offers to banks when they deposit funds with it. The central bank drains out liquidity from the financial system through reverse repo by releasing bonds to the banks. This is a daily operation by the central bank to manage liquidity over a longer time.

Interest rate corridor refers to the window between the repo rate and the reverse repo rate wherein the reverse repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the overnight interbank call money market, where lending and borrowing is unsecured, should move within this corridor. However, when banks are short of funds and the overnight call money rates are high and above the repo rate, banks approach the central bank to borrow under the repo window.

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Margin of Safety

The excess of the actual sales revenue (ASR) over the break-even sales revenue (BESR) is known as the margin of safety. Symbolically,

Margin of Safety = ASR – BESR

When the margin of safety is divided by the actual sales, the margin of safety ratio is obtained. Symbolically,

M/S ratio = Margin of Safety/ASR

The M/S ratio indicates the percentage by which the actual sales may be reduced before they fall below the break-even sales volume. The higher the margin of safety ratio, the better it is from the point of view of the company.

The amount of profit can be directly determined with reference to the margin of safety and P/V ratio. Symbolically,

Profit = Margin of safety in amount x P/V ratio

Economic Order Quantity (EOQ)

The determination of the appropriate quantity to be purchased in each lot to replenish stock as a solution to the order quantity problem necessitates a resolution of conflicting goals. Buying in large quantities implies higher average inventory level which will assure smooth production/sale operations and lower ordering or set up costs. But it will involve higher carrying costs. On the other hand, small orders would reduce the carrying costs of inventory by reducing the average inventory level but the ordering costs would increase as also there is a likely interruption in operations due to stock outs. A firm should place neither too large nor too small orders. On the basis of a trade-off between benefits derived from the availability of inventory and the cost of carrying that level of inventory, the appropriate or optimum level of the order to be placed should be determined. The optimum level of inventory is referred to as the economic order quantity (EOQ).It is also known as the economic lot size.

The economic order quantity may be defined as that level of inventory order that minimises the total cost associated with inventory management. EOQ refers to the level of inventory at which the total cost of inventory comprising acquisition/ordering/set-up costs and carrying costs is the minimum.

Cheque Truncation

Cheque truncation is a system between clearing and settlement of cheques based on electronic images. This form of clearing does not involve any physical exchange of instrument. The physical cheque is truncated within the presenting bank itself. Settlement is generated on the basis of current MICR code line data. These images will be archived electronically and be preserved for eight years. A centralised agency per clearing location will act as an image warehouse for the banks.

Bank customers would get their cheques realised faster as local cheques are cleared almost the same day as the cheque is presented to the clearing house, while intercity clearing happens the next day. Besides speedy clearing of cheques, banks also have additional advantage of reduced reconciliation and clearing frauds. It is also possible for banks to offer innovative products and services based on CTS.

Though MICR technology helped improve efficiency in cheque handling, clearing is not very speedy as cheques have to be physically transported all the way from the collecting branch of a bank to the drawee bank branch.

The CTS is more advanced and more secure. Many countries have sought to address this issue with cheque truncation, in which the movement of the physical instruments is curtailed at a point in the clearing cycle, beyond which the process is completed, purely based only on the electronic data and images of the cheques.

Denmark and Belgium are pioneers in CTS. They adopted complete cheque truncation system more than two decades ago. Sweden is the typical example for having achieved complete truncation where all the cheques can be presented and encashed at any branch; irrespective of the bank on which they are drawn. CTS also take care of the needs of future electronic transactions. .

Business Markets

The business market consists of all the organisations that buy goods and services to use in the production of other products and services that are sold or supplied to others. It also includes retailing and wholesaling firms that acquire goods for the purpose of reselling or renting them to others at a profit.

The business market is vast. In many ways, business markets are like consumer markets, but business markets usually have fewer, large buyers who are more geographically concentrated. Business demand is derived, largely inelastic and more fluctuating. The business buying decision process itself consists of eight stages: problem recognition, general need description, product specification, supplier search, proposal solicitation, supplier selection, order routine specification and performance review. More buyers are involved in the business buying decision and business buyers are better trained and more professional than are consumer buyers. In general, business purchasing decisions are more complex, and the buying process is more formal than consumer buying.

Break Even Analysis

Break-even analysis shows the relationship between the costs and profits with sales volume. The sales volume which equates total revenue with related costs and results in neither profit nor loss is called the break-even volume or break-even point (BEP). If all costs are assumed to be variable with sales volume, break-even point would be at zero sales. If all costs were fixed, profits would vary disproportionately with sales and the BEP would be at a point where total sales revenue equalled fixed costs. In other words, the no-profit-no-loss point is BEP at which losses cease and beyond which profits begin.

BEP = Fixed cost/(Sales price – unit variable cost)

ABC System of Inventory Control

The ABC system is a widely used classification technique to identify various items of inventory for purposes of inventory control. This technique is based on the assumption that a firm should not exercise the same degree of control on all items of inventory. It should rather keep more rigorous control on items that are most costly and/or slowest turning while items that are less expensive should be given less control effort.

On the basis of the cost involved the various inventory items are according to this system, categorised into three classes: A, B and C. The items included in group A involve the largest investment. Therefore, inventory control should be the most rigorous and intensive and the most sophisticated inventory control techniques should be applied to these items. The C group consists of items of inventory which involve relatively small investments although the number of items is fairly large. These items warrant the minimum attention. The B group stands midway. It deserves less attention than A but more than C. It can be controlled by employing less sophisticated techniques.

Instruments of credit rating in India

As per guidelines issued by Government /SEBI credit rating is mandatory for the following instruments:

1.      Debt Instruments

Any public/rights issue of debt instruments (whether fully convertible debentures or partly convertible debentures or non-convertible debentures) shall have to be compulsorily rated by the approved credit rating agency irrespective of their maturity/conversion period. Moreover, according to directive issued by SEBI on March 19, 1999 for all public and right issues of debt securities of issue size greater than or equal to Rs. 100 crores, two credit ratings from different credit rating agencies was mandatory.

However, in order to facilitate development of a vibrant primary market for corporate bonds in India, certain provisions of the SEBI (Disclosure and Investor Protection) Guidelines, 2000 were amended in December 2007. The amendments were:

i. Requirement of Credit Rating: For public/ rights issues of debt instruments, SEBI (Disclosure and Investor Protection) Guidelines, 2000 presently stipulate credit rating to be obtained from not less than two credit rating agencies. With a view to reduce the cost of issuance of debt instruments, it has now been decided that credit rating from one credit rating agency would be sufficient.

ii. Below Investment Grade debt instruments: SEBI (Disclosure and Investor Protection) Guidelines, 2000 currently require that the debt instruments issued through a public/rights issue shall be of at least investment grade. In a disclosure-based regime, it should be left to the investor to decide whether or not to invest in a non-investment grade debt instrument. Given this, and in order to develop market for debt instruments, it has been decided to allow issuance of bonds, which are below investment grade to the public to suit the risk/return appetite of investors.

2.      Commercial Paper

Commercial paper can be issued in India, inter-alia, if the programme has a rating not below ‘A2’ from ICRA or ‘P2’ from CRISIL (or its equivalence from other rating agencies).

3.      Collective Investment Schemes

According to SEBI (Collective Investment Schemes) Regulations, 1999, no scheme shall be launched by the Collective Investment Management Company without obtaining rating from a credit rating agency.

4.      Acceptance of Public Deposits by Non-Banking financial companies

According to Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 1998 issued by Reserve Bank of India on January 31, 1998

(i)     No non-banking financial company having net owned fund of 25 lakh of rupees and above shall accept public deposit unless it has obtained minimum investment grade or other specified credit rating for fixed deposits form anyone of the approved credit rating agencies at least once a year and a copy of the rating is sent to the Reserve Bank of India along with return on prudential norms.

(ii)    In the event of upgrading or downgrading of credit rating of any non-banking financial company to any level from the level previously held by the non-banking financial company, it shall within 15 working days of its being so rated inform in writing of such upgrading/downgrading to the Reserve Bank of India

The names of approved credit rating agencies and the minimum credit rating shall be as follows: -

Name of the Agency                                    Minimum Investment Grade

       Rating

      CRISIL                                                                          FA-

      ICRA                                                                            MA-

CARE                                                                           CARE BBB-

FITCH INDIA                                                                  tA(ind)-

                                                                                   

5.   LPG/Kerosene Dealers/Firms

The Ministry of Petroleum and Natural Gas recommended a mandatory evaluation of all private companies selling LPG and/or Kerosene. According to the order, one cannot commence operations in the LPG business without getting a rating and the existing players had to secure the rating before the end of September 1995. Rating certifications have to be taken from CRISIL/CARE/ICRA. The objective is to help the consumers to identify the genuine companies before applying for a connection. The companies would be graded numerically into four grades. Good (1), Satisfactory (2), Low risk (3) and High risk (4). The rating certificate has to be renewed every year.

It is mandatory for every parallel marketer to disclose the company’s rating in every advertisement and promotion campaign. Any company violating the rules of the order is liable for punishment – fine or imprisonment – under the Essential Commodities Act.

6.   IPO Grading

According to SEBI guidelines, it has been made mandatory for all IPOs to obtain grading. The grading shall be done by credit rating agencies, registered with SEBI under the SEBI (Credit Rating Agencies) Regulations, 1999. It shall be mandatory to obtain grading from at least one credit rating agency. The issues shall be required to disclose all the grades obtained by its IPO in the prospectus, abridged prospectus, issue advertisements and all other places where the issuer is advertising for the IPO.

7.  Securitised Debt Instruments

SEBI has notified SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 on May 26, 2008 for issuance of securitised debt instruments. The special purpose distinct entity i.e. issuer of securitised debt instruments shall be in the form of a trust; the trustees thereof will require registration from SEBI. According to these Regulations:

No special purpose distinct entity shall offer securitised debt instruments to the public unless credit rating is obtained from not less than two registered credit rating agencies. All credit ratings obtained by a special purpose distinct entity on the securitised debt instruments shall be disclosed in the offer document, including unaccepted credit ratings.

8.   Bank Loan Rating    

Bank loan ratings indicate the degree of risk with regard to timely payment of interest and principal on the facility being rated. On April 27, 2007, The Reserve Bank of India (RBI) issued new guidelines on capital adequacy for banks based on Basel II framework. These guidelines require banks to link the minimum size of their capital to the credit risk in their portfolios. To determine credit risk in their loan portfolios, banks will need to use credit ratings assigned by approved External Credit Assessment Institutions (ECAIs) such as recognized credit rating agencies.

Advent of credit rating in India

Credit rating emerged in India with the birth of Credit Rating Information Services of India Ltd. (CRISIL) in 1987, which commenced its operations in January 1988. Corporate sector enterprises have depended in India for expansion of existing projects upon the financial institutions and banks. The need for credit rating agency has been felt much more now when the capital market is growing. A move in the corporate sector from debt-age to free market-finance-age has further increased the chances for more Credit Rating Agencies. This is the time for investors to measure risk as well as for the corporate units to use credit rating as a marketing tool. The growth of the capital market is discernible from the fact that there are 22 stock exchanges besides the OTC exchange of India and NSE, operating in India with over 10000 listed companies and more than 1.5 crores individual investors with increasing trend of investible funds and increasing   demand for funds from the industry. Investors have to rely upon rated instruments rather than following the advices of the financial intermediaries.

Credit rating agencies in India

The following are the credit rating agencies in India: -

1.      The Credit Rating Information Services of India Limited (CRISIL)

2.      Investment Information &Credit Rating Agency of India Limited (ICRA)

3.      Credit Analysis  & Research Limited (CARE)

4.      Fitch India Private Limited.

5.      Brickwork Ratings India Private Limited

Budgeting

Budgeting is a tool of planning. Planning involves specification of the basic objectives that the organisation will pursue and the fundamental policies that will guide it.

A budget is defined as a comprehensive and coordinated plan, expressed in financial terms, for the operations and resources of an enterprise for some specified period in the future. The essential elements of a budget are: plan, financial terms, operations and resources, specific future period, comprehensive coverage and coordination. As a tool, a budget serves as a guide to conduct operations and a basis for evaluating actual results. The main objectives of budgeting are: explicit statement of expectations, communication, coordination and expectations as a framework for judging performance.

The overall budget is known as the master budget. It has the following components: sales budget, production budget, purchase budget, direct labour budget, manufacturing expenses budget, administrative and selling expenses budget, budgeted income statement, cash budget and budgeted balance sheet.

Budgets prepared at a single level of activity, with no prospect of modification in the light of changed circumstances, are referred to as fixed budgets. The alternative to fixed budgets is flexible or variable budgets. A flexible budget estimates costs at several levels of activity. Its merit is that instead of one estimate, it contains several estimates in different assumed circumstances.

Unit Costing

Unit cost is a method of costing used in those industries which are engaged in manufacturing exclusively one homogeneous product or a few grades of the same product. It is also referred to as single/ output costing. The examples of industries in which this type of costing is applicable are cement, paper, sugar, steel, quarries, breweries etc. The unit cost is the average cost, i.e., the total cost divided by the number of units produced. The unit cost may be expressed in terms of number, weight, volume and time, etc. The following is a list of some industries and the corresponding cost units adopted by them:

Type of Industry                                                               Cost Unit

Steel Manufacture                                                               per tonne

Cement, Coal                                                                     per tonne

Paper                                                                                per kg-tonne

Brick making                                                                      1,000 bricks made

Paint manufacture                                                               per litre

Gas works                                                                           per 1,000 cubic metres produced

Electricity undertakings                                                       per kilowatt hour            

Rating Process

The agency commences a rating exercise only at the request of a company. It employs a multi layered decision-making process in assigning ratings. The following steps are taken for rating the issuer’s instruments for the first time before going public.

1.   Initial Contact and Rating Agreement

     The process of rating starts with the issuer or its representative contacting the principal officer of the agency in person or through the rating request letter by the issuer. Such a request shows the issuer intention to obtain rating for a particular debt obligation to be issued by it for raising funds from the public. After this, a rating agreement is entered into between the issuer and the agency.

2.  Assignment of the Analytical Team

The agency assigns an analytical team comprising of at least two analysts of whom one would be the lead analyst and would serve as the issuer’s primary contact. The analysts who have expertise in relevant business area will be responsible for carrying out the rating assignment. The analytical team obtains and analyses information relating to the issuer’s financial statements, cash flow projections and other relevant information.

3.  Management Meetings

The analytical team then proceeds to have detailed meetings with the company’s management. The agency strongly believes that interest of investors are best served if a direct dialogue is maintained with the issuer, as this enables the agency to incorporate non-public information in a rating decision and also enables the rating to be forward looking. For proper discussions with the management, the company should provide various documents such as:

1.            Two copies of annual reports for past 5 years;

2.            Two copies of latest prospectus;

3.      Consolidated financial statements for the past 3 fiscal years by principal, subsidiary or division;

4.      Two copies of statements of projected sources and application of funds, and operating statements for at least next 3 years along with assumptions on which projections have been based;

5.      A copy of existing loan agreement along with recent compliance letter, if any;

6.      A certified copy of the resolution adopted by the Board of Directors of the company authorizing the issuance of debt instruments;

7.      Biographical information on the company’s principal officers and the name of the Board members.

Besides, these documents the agency may ask for other information also required by it for proper rating. Thus, topics discussed during the management meeting are wide ranging including competitive position, strategies, financial policies, historical performance and near and long-term financial and business outlook. Equal importance is placed on discussing the issuer’s business risk profile and strategies, in addition to reviewing financial data. The rating process ensures complete confidentiality of the information provided by the company. All information is kept strictly confidential and is not used for any other purpose, or by any third party other than the agency.

4. Analysts Report

After meeting with management, analytical team carries out the detailed analysis of the above information and review additional material, if any received from the issuer. The analysts then present their report to a Rating Committee, which then decides on the rating.

5. Rating Committee

The rating committee is formed to decide the rating. These committees vary widely in size and duration depending on the nature of each rating problem. The rating committee meeting is the only aspect of the process in which the issuer does not participate directly. The rating is arrived at after a composite assessment of all the factors concerning the issuer, with the key issues getting greater attention from the rating committee.

6. Communication to the Issuer

 After the committee has assigned the rating, the rating decision is communicated to the issuer along with the reasons or rationale supporting the rating.

The agency is always willing to discuss with the management the critical analytical factors that the committee focused on while determining the rating and also any factors that the company feels may not have been considered while assigning the rating.

7. Appeal

 In the event, that the issuers disagrees with the rating outcome, they may appeal the decision for which new/additional information which is material to the appeal and specifically addresses the concern expressed in the rating rationale, need to be submitted to the analyst. Subsequently, a note is put up once again before the rating committee where the rating may or may not undergo a change.

8. Dissemination to the Public

Once the rating is given, it is disseminated by the rating agency to the public along with the rationale through print media and websites of the agencies.  As per the SEBI (Credit Rating Agencies) Regulations 1999, the issuer has to disclose, in the offer document:(i) the rating assigned to the issuer’s listed securities by any credit rating agency during the last three years and (ii) any rating given in respect of the issuer’s securities by any other credit rating agency, which has not been accepted by the client.

9. Surveillance and annual review

After a rating has been assigned, the agency is required to monitor the rating over the life of the debt instrument. The agency keeps the rating under continuous surveillance, monitoring both the on-going performance of the issuer’s and the economic environment in which it operates.

The agency typically conducts a formal annual review of the rating, which involves a meeting with the issuer. These review meetings focus on developments over the period since the last meeting and outlook for the coming year, enabling analysts to stay abreast of current developments, discuss potential problem areas, and the appraised of any changes in issuer’s plan.

Following a full review, the rating may either be affirmed or changed and any change effected is made public by the agency. In some instances, a credit rating may be placed on “RATING WATCH/CREDIT WATCH”. A rating watch listing highlights an emerging situation, which may materially affect the profile of a rated entity and can be designated with positive, developing or negative implications. The announcements of a merger or acquisition or the occurrence of an event that could result in a substantial change in the issuing entity’s risk profile are some of the instances where an entity’s rating may be placed on rating watch. The rating process, from the initial management meeting to the assignment of the rating, normally takes three to four weeks.

Standard Costs

Standards may be defined as measured quantities which should be attained in connection with some particular operation or activity. Standards are performance expectations. Stated in terms of a test of efficiency, a standard is a precise measure of what should occur if the performance is efficient. For example, a certain percentage of marks may be a standard to qualify in a certain examination or to obtain a certain grade. Standards describe an approach to implement and achieve the goals of the firm. The standards are set by management in accordance with the best judgement. Standards can be set only for repetitive tasks, that is, for work which is repeated again and again. Standards cannot be set for tasks which are not performed regularly and continuously.

Standard cost may be defined as a criterion or measure of acceptable cost performance. Standard costs may be ideal, expected, and normal. The ideal standard cost refers to estimates of costs under ideal or perfect conditions without any wastage or scrap. The expected standard cost is based upon the most likely attainable result. It is really not a standard as there is no inherent element of efficiency which is the basic consideration underlying standard costs. Normal standard costs are costs which are attainable but their achievement requires that operations and activities are efficient.

Standard costs represent a control technique. They are a target which the management attempts to achieve. The control process involves a comparison of the actual performance with the standards set by management. The extent of success would be revealed by the relationship between the actual and the standard. If the actual performance coincides with the target, the performance can be said to be satisfactory. In case of deviations, management would have to analyse the causes. These deviations are referred to as variance.

Risk

Risk in holding securities is associated with the possibility that realized returns will be less than the returns that were expected. Forces that contribute to variations in return constitute elements of risk. Some influences are external to the firm, cannot be controlled and affect large numbers of securities. Other influences are internal to the firm and are controllable to a larger degree. Those forces that are uncontrollable, external, and broad in their effect are called sources of systematic risk. Conversely, controllable, internal factors somewhat peculiar to industries or firms are referred to as sources of unsystematic risk.

Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks and bonds to move together in the same manner. For example, if the economy is moving toward a recession and corporate profits shift downwards, stock prices may decline across a broad front. Nearly all stocks listed on the stock exchange move in the same direction as the index.

Unsystematic risk is the portion of total risk that is unique to a firm or industry. Factors such as management capability, consumer preferences, and labour strikes are some of the examples of unsystematic risk. Unsystematic factors are largely independent of factors affecting securities markets in general.

Factors to be considered in rating

The basic objective of rating is to provide an opinion on the relative credit risk (or default risk) associated with the instrument being rated. The agency assigns a rating after assessing all factors that could affect the credit worthiness of the borrowing entity. The rating methodology involves an analysis of the industry risk, the issuers business and financial risks. Typically, the industry risk assessment sets the stage for analyzing more specific company risk factors and establishing the priority of these factors in the overall evaluation. For example, if an industry is determined to be highly competitive, careful assessment of the issuer’s market position is stressed. If the company has large capital requirements, examination of cash flow adequacy assumes major importance.

 This also includes, estimating the cash generation capacity of the issuer through operations (primary cash flows) vis a vis its requirements for servicing obligations over the tenure of the instrument. Additionally, an assessment is also made of the available marketable securities (secondary cash flows), which can be liquidated if required, to supplement the primary cash flows. It may be noted that secondary cash flows have a greater bearing in the short-term ratings, while the long-term ratings are generally entirely based on the adequacy of primary cash flows. All the factors, which have a bearing on future cash generation and claims that require servicing, are considered to assign ratings.

Rating is a search for fundamentals and the possibilities of change in these in the long term. All the credit agencies follow broadly the same analytical framework of rating methodology. It comprises of two broad sets of factors: (i) business analysis in terms of analysis of industry risk, market position, operating efficiency, management evaluation and new projects risk; (ii) financial analysis on the basis of consideration of accounts quality, earnings protection, adequacy of cash flows and financial flexibility. The assessment of financial companies lays emphasis on the financial analysis and management evaluation. Though the financial analysis and management evaluation is similar as for the manufacturing companies, more emphasis is on the following factors: capital adequacy, resources, asset quality, liquidity and earnings quality. The rating agency gives importance to analysis of both quantitative and qualitative factors for bond rating. The financial evaluation and business risk are the two most important quantitative factors and ratio analysis is used for their measurement. Important ratios for operationalisation of financial factors include return on capital employed for profitability, debt service and interest for coverage, debt equity for gearing current ratio for liquidity position and cash flow analysis for cash position. For the operationalisation of business factors, market share and industry growth rate are of prime importance.

The rating agencies consider same factors for commercial paper rating (short-term instrument) and fixed deposit rating (medium term instrument) as being used for long term bond rating, though the relative importance for these factors shift for different instruments. However, there is no fixed formula for analysis of the qualitative factors. The agencies rely on subjective judgment while evaluating those factors.

Rating analysis is primarily aimed at determining the quantum and stability of the company future cash flows in relation to its debt servicing requirements. The ratings are based on current information provided to the agency by the borrowing company or factors obtained by the agency from sources it considers reliable. It also involves analysis of the past performance of the company as well as assessment of its future prospects. . In evaluating and monitoring the ratings, the agency employs both qualitative and quantitative criteria in accordance with the industry practice.

Rating methodology involves intensive analysis of business, financial and management risk profile of the company. With changing environment and more complex corporate landscape, including the availability of ever more complicated securities, the rating practices of the agencies should evolve over time to reflect greater complexity and volatility facing companies. Thus, developing of rating criterion is presumed to be a continuous process, and keep changing to adapt the changed environment.