Corporate Credit Worthiness And Credit Rating. Sitting with a mug of coffee & the topics list for the National Convention, my eyes fell on the topic ‘Corporate Credit Worthiness & Credit Rating’ & I remembered the time, when I was reading in the newspaper about how the stock markets have crashed due to the S&P rating of the Indian Economy as ‘Poor’.
The thought that how can the rating by any agency could lead to volatility in the market & make it react so sharply was always a big curiosity for me until I came upon this topic & finally decided to do some R&D on it & derive some conclusions out of it.
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Corporate Credit Worthiness And Credit Rating
Traditionally, loans were granted to a company or Investments were made in the company on the basis of financial statements alone. The other essential factors for assessing the Credit Worthiness like Market Scenario, Risk Element and Industry Specific Scenario were not the part of the Investment/ Credit Assessment. The increasing defaults & failures have further led to the realization that these factors are equally or rather all the more important in Investing or Lending Decisions. Before I jump on the issue of credit rating & the role of CA’s in this context, let me cover some preliminary concepts involved here.
Before credit rating, we need to know the concepts of credit worthiness & what does it mean!
WHAT’S CREDIT WORTHINESS??
- Credit worthiness implies the ability to borrow money.
- It is an assessment of the probability that a borrower will default in their debt obligations.
- According to the most commonly prevailing practice, credit worthiness differs for an individual vis-a-vis a corporate.
- Individual creditworthiness is measured by a *‘FICO score’ while a Corporate’s creditworthiness is measured by its credit rating.
- Credit Worthiness is based upon factors, such as their history of repayment and their credit score.
- Credit Worthiness is more important from the lender’s perspective & is taken into consideration to determine the possibility of default.
*FICO Score: (Fair Issac Corporation) A way of measuring an individual’s creditworthiness. A FICO score ranges between 350 and 850. In general, a score of 650 is considered a “fair” credit score, while 750 or higher is considered “excellent.”
Whats’s Credit Rating??
- Credit Rating is an assessment of the credit worthiness of a borrower in general terms or with respect to a particular debt or financial obligation as well.
- There are the agencies like CRISIL, CARE, etc. who do the Credit assessment and evaluation for companies and governments.
- These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.
- Credit ratings are based on substantial due diligence conducted by the rating agencies.
Who Can do the credit Ranting??
- Credit Rating could be either Internal or External.
- Internal Credit Rating is usually done by the Banks before providing loans to their clients. All banks/DFIs are required to assign internal risk ratings across all their credit activities including consumer portfolio.
- While External Credit Rating is usually done by a Credit Rating Agency. A CRA is a company that assigns credit ratings – rating of the debtor’s ability to pay back the debt by making timely interest payments and of the likelihood of any prospective default.
ABOUT CREDIT RATING AGENCIES:
Few Global Credit Rating Agencies are:
- Standard & Poor’s (S&P),
- Moody’s,
- Fitch Group.
Few Indian Credit Rating Agencies are:
- CRISIL Limited
- ICRA
- ONICRA
- Credit Analysis & Research Ltd. (CARE)
Now after knowing about the basics of credit worthiness & credit rating, let us have a look on how can we determine the credit worthiness of a corporate:
THE ‘5 C’ INDICATORS WHICH DETERMINE CREDIT RATING & CREDIT WORTHINESS ARE:
- capacity to generate sufficient cash flows to service the loan;
- collateral to secure the loan in case the borrower defaults;
- capital that shareholders have invested in the business;
- conditions prevailing in the borrower’s industry and broader economy; and
- character and track record of the borrower and the borrower’s management.
Let’s consider each of the five criteria’s in a little more detail:
1. Capacity:
- Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness.
- To satisfy itself of the borrower’s capacity, the lender will consider various factors including:
(i) Profitability: What are the revenues and expenses of the borrower?
(ii) Debt levels: How much debt does the borrower have? How much debt can the borrower afford to repay?
(iii) Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry?
(iv) Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will evaluate before lending money: e.g. debt equity ratio, debt asset ratio, current ratio, quick (acid test) ratio, operating cash flow ratio, working capital ratio, etc.
(v) Let us have a look on some of the most important ratios:
1. Debt Service Coverage Ratio:
- One of the basic measure of a company’s creditworthiness is the debt service coverage ratio (DSCR), which shows a firm’s ongoing ability to keep in control both debt and interest.
- The DSCR, defined as earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by a firm’s current portion of long-term debt and interest expense, is an extremely important metric for predicting default.
- More than half of the banks in the recent Pepperdine Capital Markets Survey said this statistic was very important in their lending decisions.
2. Net Income to Sales:
- The net income to sales ratio is a fundamental measure of how profitable your business clients are.
- The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.
- Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also effective for measuring past performance of a company.
DEBT TO EBITDA
- EBITDA is widely used as a proxy for pre-interest, pre-tax cash flow from operations.
- Comparing EBITDA to a company’s assets helps show profitability – how much income, or cash, a company can generate from its equipment, property, and other assets.
Besides these, there are many other ratios which are used to determine the capacity of an entity.
2. Collateral:
- While cash flows are the primary source for the repayment of a loan, collateral provides lenders with a secondary source of repayment.
- Collateral represents the assets that are provided to the lender to secure a loan.
- In the event that the borrower fails to repay the loan, the collateral may be seized by the lender to repay the loan.
3. Capital:
- Capital is the money that shareholders have personally invested in the business.
- Capital represents the money that shareholders have at risk if the business fails.
- If the business runs into a financial difficulty, then the capital of the business provides a cushion for repayment of the loan.
- On a lighter note, the bank will lend you the finance only if you are able to prove the bankers that you don’t need the capital!!
4. Conditions:
- Conditions refer to two factors that the lender will take into account.
- Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally, that could affect the borrower’s ability to repay the loan. In considering the overall economic climate a lender may consider various questions including:
- What are the trends for the borrower’s industry? How does the borrower fit within them?
- What is the short and long-term growth potential in the industry?
- How is the market characterized? Is it an emerging or mature market?
- Are there any economic or political hot potatoes that could negatively impact the borrower’s growth?
- Secondly, conditions refer to the intended purpose of the loan.
- Will the money be used to replenish working capital to prepare for a seasonal inventory build-up?
- Will the money be used to buy new equipment for expansion?
5. Character:
- Character refers to the general impression that the borrower makes on the prospective lender.
- Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include:
- What reputation does management have in the industry and the community?
- What educational background and level of experience does management have?
- What is the overall consumer perception of the borrower?
- Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions?
- Does the borrower have a track record of fulfilling its obligations in a timely manner?
WHAT ARE THE ISSUES INVOLVED IN DETERMINING THE SCREDIT WORTHINESS??
- The methodology of assigning credit ratings by an agency has a significant undisclosed part which includes expert evaluations that are often used in the reports in a non-transparent & ambiguous way.
- The Corporate being rated may not disclose certain material facts to the agency’s investigating team. This can affect the quality of rating.
- The rating does not always represent the real financial picture. Also, negative ratings can adversely affect the image as well as the investment decisions in a corporate.
- Different ratings by different agencies for the same entity or instrument can cause confusion in the minds of the investor.
- If the analysis is explained in a detailed way in the reports, these issues can be resolved in an effective way.
In spite of all these lacunas, Credit Rating is still the Talk of the Day. So the question arising here is Why Credit Rating?
‘Some of the Many’ Benefits of Credit Rating are:
- It is important for each person to keep track of their credit score because this is the main metric used by the institutions when determining if the individual is worthy of a favorable rate.
- Credit ratings enable an investor to save his time and effort in analyzing the financial strength of an issuer company. This is because the investor can depend on the rating done by professional rating agency, in order to take an investment decision.
- Credit rating enables a company to grow and expand. This is because better credit rating will enable a company to get finance easily for growth and expansion.
- A good credit rating proves the creditworthiness of a corporate & helps to build confidence among the various stakeholders.
The most important question which has still occupied a place in my mind is how do these agencies determine the creditworthiness of a corporate? Analyzing the creditworthiness of a corporate & assigning it a suitable credit rating involves a detailed understanding of the business, the risks & rewards associated with it, the industrial & market scenario & the economy as well.
The importance of credit rating today is significant; overlooking this fact can be very detrimental to your financial health. Being aware of how your credit score is calculated is essential. In this context, I believe that no one can disagree with me to the fact that CA’s are the best brains when it comes to understanding such crucial parameters. No one can beat the core competency possessed by the Chartered Accountants. Thus the CA’s have a vital role to play in this emerging aspect of Corporate Creditworthiness & Credit Rating.
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