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.
No comments:
Post a Comment