Credit Ratings are an opinion on the relative ability and willingness of an issuer to repay debt in a timely manner. For a layman, credit rating of a company gives an idea regarding the repayment strength, just like individual credit scores. To have meaningful interpretation of the corporate ratings, it is essential to understand how the final rating is arrived at. There are broadly four to five aspects which a typical rating assignment will involve. It takes the form of an inverted pyramid approach, wherein it starts with the broad industry outlook, performance of peer companies within the industry and funnels down to the company specific aspects like business related risks, financial ratios, strength of the management, etc. So, though the financial statements like P&L, balance sheet and cashflows are important and considered for arriving at ratings, it is not the only driving force. There have been multiple instances wherein the entity will be generating negative cash flows, and the company will not have a default rating (lowest rating) because there are other factors like support of the parent, existence of experienced management, liquidity profile, past trends etc driving them.
Deep diving into the numbers that matter
Financial ratios are not an ‘end’ by themselves but a ‘means’ to understand the fundamentals of an entity. The basic set of numbers that the analyst looks into can inturn be grouped into five broad categories: Growth, Profitability, Leverage & Coverage, Turnover and Liquidity ratios. There are also certain ratios specific to the industry like real estate, construction, infrastructure companies, etc. or certain specific adjustments are made for evaluating entities in that sector.
Growth Ratio: The ability of an entity to sustain its market share, profitability and operating efficiency is reflected in its growth rates in income and profitability relative to the industry. The numbers analysed include growth in net sales, Earnings before interest tax depreciation and amortization (EBITDA), Profit after tax (PAT). For example, if a company’s revenue has increased from Rs. 200 crores to Rs. 250 crores, the year-on-year growth rate is 25%.
Profitability Ratios: The ultimate outcome of business operations is profitability, and it also determines the position of an entity in the value chain. Measures of profitability includes EBITDA as a % of sales, PAT as a % of sales, PAT on net worth and return on capital employed. For example, if a company has sales of Rs. 200 crores and after subtracting all the expenses, the profit is only Rs. 20 crores, the PAT margin is 10%.
Leverage and coverage Ratios: Leverage refers to the use of borrowings or loans as a means of finance. While leverage ratios help in assessing the risk arising from the use of debt capital, coverage ratios show the relationship between debt servicing commitments and the cash flow sources available for meeting these obligations. The commonly used ratios are debt to equity, overall gearing, interest coverage (EBITDA or profit before interest and tax divided by interest costs), total debt divided by cash profits etc. For example, if a company has Rs. 100 crores of equity and Rs. 50 crores of debt, the debt-to-equity ratio will be 0.5x.
Turnover ratios: Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by the entity. These ratios are based on the relationship between the level of activity, represented by sales or cost of goods sold, and level of various assets, including inventories and fixed assets. For example, if a company generates revenue or Rs. 200 crores and the fixed assets are Rs. 400 crores, the fixed assets turnover ratio will be 0.5x.
Liquidity ratios: Liquidity broadly means how much cash and assets which are readily convertible into cash the company has. Liquidity ratios such as current ratio and quick ratio are broad indicators of liquidity level and are important ratios for rating short-term instruments.
Quantifying the qualitative aspects
While the financial aspects are pretty straight forward, the analysis of the qualitative aspects are a bit more complicated. Especially with regard to factoring how much the ratings should differ when a company is part of an established group, having the support of an experienced management, level of interdependence, economic importance of the company to its parent, whether the instrument or facility is backed by a guarantee from a stronger entity etc. These are often based on the judgment of the analytical team, industry insights and business acumen. A credit analyst will examine these intangibles, convert them into binaries and incorporate them in the final ratings. Quantifying these on a scale can be tricky but it is also the factor which makes credit rating challenging and engaging!
To sum it up, credit ratings given to a company is much more than just the strength of its reported numbers because in reality companies do not operate in isolation. Ratings takes a much more wholistic approach and acknowledges the intangibles as well.
Disclaimer
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About the Author
Samyuktha R is an accomplished professional with around 8 years of expertise in credit rating and equity research. She is currently serving as an Assistant Director at CARE Ratings, one of India's premier credit rating agencies, specializing in handling credit risk assignments for large corporates belonging to the pharmaceutical, manufacturing, and other segments.
Her journey began with CRISIL's Global Research and Analytics team, where she honed her skills and developed a deep understanding of the intricate dynamics of financial analysis. As a qualified Chartered Accountant and Company Secretary, Samyuktha possesses a remarkable combination of analytical proficiency and regulatory expertise, empowering her to offer invaluable perspectives on investment opportunities and assess credit risk.
With a passion for delivering accurate and insightful analysis, Samyuktha remains committed to driving excellence in the field of credit rating. Staying informed about market trends and upholding professional integrity, contributes to her respected position within the financial community.