Factors to be considered in credit rating
Credit rating is done on the basis of an analysis of financial statements, visits to the factory and office, holding of discussions with auditors, bankers, creditors etc., rendering of services by experts and detailed desk work are involved in considering various factors related to credit rating.
A credit rating agency accepts for analysis only reliable information collected from dependable sources. The key factors considered in credit rating are—
- Business Analysis
- Financial analysis
- Management evaluation
- Regulatory and competitive environment
- Fundamental analysis.
We shall briefly study about each factor.
1. Business analysis
Business analysis involves a scrutiny of various risks involved in the operations of the company. This includes industry risk, market position of the company, operating efficiency of the company and legal position of the company.
1. Industry risk relates to nature of competition, success factors, demand and supply position, structure of industry, Government policy etc.
2. Market position of the company relates to market share, competitive advantages, sales and distribution network, product and customer diversity,. etc.
3. Operating efficiency of the company relates to location advantages, labour co-operation, cost efficiency and operating margins.
4. Legal position is considered on the basis of terms of prospectus, details of the trustees and their responsibilities, systems for timely payment and protection against forgery, etc.
2. Financial analysis
The rating agency examines accounting quality, earning protection, adequacy of cash flows and financial flexibility.
1. Accounting quality
Accounting quality is judged by analyzing methods of depreciation, income recognition, treatment of bad debts, contingent liabilities, inventory valuation, etc.
2. Earning protection
Factors such as sources of future earning, profitability ratios, earnings in relation to fixed income charges, earnings per share etc., are considered while analyzing earning protection of the company.
3. Adequacy of cash flows
Adequacy of cash flows is reflected in working capital management, current ratio, inventory to sales, etc. So, these factors are studied to ascertain whether cash flows are adequate or not.
4. Financial flexibility
Financial flexibility can be assessed by examining capital financing plans, ability to raise funds, assets redeployment potential, etc.
3. Management evaluation
Management evaluation includes the evaluation of
1. Track record of the management,
2. Planning and control system,
3. Details of promoters and top executives, their qualifications and experience,
4. Firm’s capacity to adjust with flexibility,
5. Preparedness to meet adverse situations, etc.
4. Regulatory and competitive environment
Regulatory and competitive environment are studied in terms of the structure and regulatory framework of the financial system, the efficiency of operations of regulatory authorities, trend in regulation or deregulation and the reactions of the competitors to regulations, etc.
5. Fundamental analysis
Under fundamental analysis, the rating agency examines the following:
1. Liquidity Management
Liquidity management can be assessed in terms of capital, structure, debt leverage, long term solvency, matching of cash inflows to outflows and ratio analysis of the company. It will also study the quality of assets in terms of credit risk management, receivables to current assets, systems of monitoring the sector credit, risk of individual and management of problem credits.
2. Profitability and financial position
The company’s profitability and financial position is analyzed by considering historic profits, spread on funds employment, revenues on non-fund based services, accretion to reserves, profit margins, etc.
3. Interest and tax rates changes
Rating process involves an analysis of the impact of interest and tax rate changes on company’s profit. The interest as a proportion of cash inflows or of gross profits is useful in examining the interest burden. The potential for future earnings and the impact of debt burden are also analyzed.
- Factors to be considered in credit rating
- 1. Business analysis
- 2. Financial analysis
- 3. Management evaluation
- 4. Regulatory and competitive environment
- 5. Fundamental analysis