Part-II Credit Rating

8/3/2019 Part-II Credit Rating

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Module VIModule VI

Part IIIPart III Credit RatingCredit Rating


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Prof. Suprio Ghatak, Amity Business School, Amiity University HaryanaProf. Suprio Ghatak, Amity Business School, Amiity University Haryana 2

Concept of Credit RatingConcept of Credit Rating

Difficult for investors to judge which investment

is safer & more reliable investment opportunity.

Credit risk evaluation.

Reflects borrowers accountability, expected

capability, inclination to pay interest & principal

in a timely manner .

Credit rating agency is an assessor.Guides investors in determining credit risk

associated with debt instruments.


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Concept of Credit RatingConcept of Credit Rating

Helps investors in taking investment decision.

Assigns various grade ratings.

Enables investors to identify risk levels of

different debt obligations.Helped corporate sector in India to diversify itscredit instruments by evaluating credit riskassociated with the entire range.

A qualitative expression of opinions of ratingagencies re: capability of issuing company toservice the debt.


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Types of Credit RatingTypes of Credit Rating

Instruments for Rating:

i. Equity shares

ii. Preference shares

iii. Bonds & debentures issued by corporates,

government etc.

iv. Commercial papers issued by companies,

banks and financial institutions for raisingshort-term loans.


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Types of Credit RatingTypes of Credit Rating

Instruments for Rating:

v. Fixed deposits raised for medium-term

ranking as unsecured borrowings.

vi. Borrowers who have borrowed money. vii. Individuals.


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Functions of Credit Rating AgencyFunctions of Credit Rating Agency

1. Provides unbiased opinion: An independentcredit rating agency provides an unbiased

opinion as to capability of the company to

service debt obligations for the following

reasons:

i. It has no vested interest in an issue unlike

brokers, financial intermediaries.

ii. Its own reputation is at stake.


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2. Provides quality & dependable information:A credit rating agency provides quality

information on credit risk which is more

authenticate & reliable because:

i. It has highly trained & professional staff who

has better ability to assess risk.

ii. It has access to a lot of information which

may not be publicly available.


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3. Provides information at low cost: Mostinvestors rely on the ratings assigned by the

ratings agencies while taking investment

decisions.

These ratings are published in the form of

reports and are available easily on the

payment of negligible price.

It is not possible for the investors to assess thecreditworthiness of the companies on their

own.


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5. Providebasisforinvestment:An investmentrated by a credit rating enjoys higher

confidence from investors.

Investors can make an estimate of the risk &

return associated with a particular rated issue

while investing in them.


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6. Healthy discipline on corporate borrowers:Higher credit rating to any credit investment

enhances corporate image & builds up goodwill

& induces a healthy discipline on corporate.


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7. Formation of public policy: Once the debtsecurities are rated professionally, it would be

easier to formulate public policy guidelines as

to the eligibility of securities to be included in

different kinds of institutional port-folio.


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BibliographyBibliography

Chapter-9: Credit Rating

Financial Services by Nalini Prava Tripathy


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Module VIModule VI

Part IIIPart III Credit RatingCredit Rating


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Advantages of Credit RatingAdvantages of Credit Rating

A guide or index for investors & creditors in

determining credit risk of debt instruments or

credit obligations.

By using credit rating symbols, borrowingcompany raises funds in capital market at

cheaper rates.

Helps companies in foreign collaborations.


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Encourages discipline among borrowing

companies.

Ensures greater liquidity for debt instruments in

secondary market.Helps government in safeguarding interests of

investors.


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Other Benefits:

Gives best information at low cost to investors.

Helps investors to take calculated risk in their

investments.

Encourages investment in companies giving

high returns.


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Other Benefits:

Investors need not depend on brokers &

merchant bankers & can take quick decisions

on basis of associated ratings.


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Other Benefits:

Investor gets benefit of ongoing surveillance.


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Disadvantages of Credit RatingDisadvantages of Credit Rating

No ratings of equity as equity shareholders aresupposed to take risks.

Bonds, debentures & other type of debt

instruments are only rated as indicators of risk.

Ratings become out of date soon. Need to be

updated every six months.


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Disadvantages of Credit RatingDisadvantages of Credit Rating

Fresh information or development may changethe grade of rating.

Ratings play a useful role when regulatory

authority takes no responsibility of companies

raising funds.

Credit rating agencies should have

professionally qualified people like CA, CS,

MBA, etc. who need to be permanent.


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Credit Rating MethodologyCredit Rating Methodology

Variables affecting quality of rating of debtinstruments of a company:

1. History: Ownership, size, geographical

spread, product spread, organizational

structure.

Size has some access to some source of funds

& some market segments.


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2. Accounting Quality: Accounting policies,concepts, principles & conventions of

accounting theory followed to ascertain a true

& fair view of financial state of affairs.

Accounting methods & practices not to be

manipulated.

No controversial practices followed to portray a

good balance sheet. Window dressing.


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3. Business Fundamentals:Assess competitiveposition as compared to competitors in similar

line.

Strategies, policies, strengths & weaknesses to

be analyzed as they affect the rating.

Diversification, track record of profitability,

future projections of demand.


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3. Business Fundamentals: If product is export-

oriented & import-substituted, debt issued for

the purpose influences rating decision.


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4. Liquidity Management : Sources & uses of funds.

Cost & availability

Innovativeness & competitive ability to attractcheaper funds.

Forex & interest rate risk associated with each

source.Management of such risk.


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4. Liquidity Management : Estimate probableimpact of credit quality.

Study of liquidity position by ratio analysis.

Current ratio & acid test ratio vis--vis debtors

turnover & stock turnover.

Projected income & expense statement,

balance sheet & cash flow statements.


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5. Quality of Management : Management team,HR policies, organizational structure,

delegation of authority & responsibility.

Support of group companies.

Managements attitude towards risk.

Track record in choice of segments, dividend

policy, accounting practices, funding policies,

etc.


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5. Quality of Management : Systems.

Statutory audit report indicate systematic

deficiencies.


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6. Quality ofAssets: Analyze issuers segmentof operation, competitive environment, market

share in each segment vis--vis their risk-

profile.

Prudential norms for credit concentration vs.

past performance. Understand effectiveness.

Non-performing assets (NPAs) & provisions

available.


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6. Quality of Assets: Investments, type of investments, disinvestment policies,

depreciation on investments.

Fixed assets turnover & fixed assets to net

worth ratio & rate of return on performing

assets.

Study fixed assets components as a portion of

net worth.


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6. Quality ofAssets: Study earning power of fixed assets of a company.

More earning power, more is source of funds

generated & more the positive impact.


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7. Profitability:

8. Return on Equity & Return on Investment:

ROE measures profitability of equity funds after

payment of taxes.

ROI measures percentage of earnings

remaining after payment of taxes.

Total investment = creditors + shareholders

funds


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8. Return on Equity & Return on Investment:Important bearing on credit quality of the

company.

Operating profit as a percentage of total funds

employed should not be less than the lending

rate of a commercial bank.


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9. Capital Structure: Companys borrowingshould not exceed two times its shareholders

funds.

Important indicator determining quality of rating

of debt.

Lower debt equity ratio = Higher degree of

protection enjoyed by creditors/lenders = Less

probability of insolvency.


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9. Capital Structure: Shareholders equity tofixed assets ratio.

If assets more than shareholders equity = part

of assets financed by borrowed capital = Bad

quality of ratings.

10. P ast performance: Increasing trend of

revenues, profit after taxes, net worth indicatefinancial strength.


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11. Effect of Normal Business Cycle: Considerstate of economic activity normal, recovery,

boom, recession & slump - when rating a debt

instrument.

Rating valid for and to be monitored over thelife of the debt.

Upon new information, rating may be retained,

upgraded or downgraded. Benefits creditor &

general public.


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12. Interest & debt coverage ratio: Interest &debt coverage ratio & payment of taxes.

Issuers policy of redemption of debt &

payment of taxes.

Provisions made for new debt.

Good index of long-term solvency.

Operating profit before interest & depreciation

should be three times the interestcommitments.


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Sovereign Credit RatingSovereign Credit Rating

The credit rating of a country or sovereignentity.

Give investors insight into the level of risk

associated with investing in a particular country

& also include political risks.

At the request of the country, a credit rating

agency will evaluate the country's economic &

political environment to determine a

representative credit rating.


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Obtaining a good sovereign credit rating isessential for developing countries to access

funding in international bond markets.


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Another reason for obtaining sovereign creditratings, other than issuing bonds in external

debt markets, is to attract foreign direct

investment (FDI).

To give investors confidence in investing intheir country, many countries seek ratings from

credit rating agencies like Standard and Poors,

Moody's, and Fitch to provide

financial transparency & demonstrate their

credit standing.


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Frequently Asked Questions on Credit Rating

Check the CRISIL website.

http://www.crisil.com/ratings/faqs.html


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BibliographyBibliography

Chapter-9: Credit Rating

Financial Services by Nalini Prava Tripathy

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Part-II Credit Rating

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