A large number of variables affect the quality of writing of a debt instrument of an organization. The credit rating methodology should include these variables.
The variables are history, quality of management, business fundamentals, accounting quality, liquidity management, quality of the assets, profitability, return on equity and investment, capital structure, past performance, effect of normal business cycle, and interest and debt coverage ratios.
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Credit Rating Methodology
Variables considered in the methodology of credit rating are:
1. History
The credit rating agency must understand the ownership, size, geographical spread, product spread, and the organizational structure of the issuer.
The size of the issuer can have some access to some sources of funds and to some market segments and thus impact credit quality.
The history of the issuer could establish its export in certain product markets and thus have a bearing in credit quality.
2. Accounting Quality
The accounting policies followed should strictly adhere to the concepts, principles, and conventions of accounting theory so as to ascertain a true and fair view of the financial state of affairs of the company.
Neither should the accounting methods be manipulated nor there should be any chance of doing so in the accounting practices followed by the issuer company.
No controversial accounting practices should be followed by it just to portray a good balance sheet.
3. Business Fundamentals
Under this category, the issuer company is assessed in the area of its competitive position as compared to the competitors operating in the similar line.
Its strategies, policies, strengths, and weaknesses and goals have to analyzed as they have some sort of bearings in measuring the credit ratings of organizations.
Its diversification activities having a sound track record of profitability in the industry and future projections of demand for output can have an important bearing in credit rating the debt instruments issued.
4. Liquidity Management
The issuer’s sources and uses of funds in terms of cost and availability have to be studied in relation to the debt issues.
Volatility trends of these parameters are also studied. The issuers’ innovativeness and competitive ability to attract cheaper funds are also analyzed.
Foreign exchange and interest rate riks associated with each source and management of such risk are scrutinized to estimate the probable impact of credit quality.
To understand the liquidity of the issuer, the maturing match between sources and deployment of funds is studied he rating agency must understand the quality and quality of liquid assets, past trends, unutilized re-finance limit available, and issuer’s standing in the financial market to raise resources quickly.
Key Pros and Cons of Credit Rating (With Examples).
5. Quality of Management
This is judged by the team of executives, human policies, organizational structure, and the extent of delegation of authority and responsibility.
The support of group companies could also be important in determining their success.
The management attitude towards risk is measured as revealed by the track record in the choice of segments, dividend policy, accounting practices, and funding policies.
Systems also pay an important role in determining the credit quality of the issuer. the statutory audit report can be studied to detect any systematic deficiencies.
The status of reconciliation of subsidiary books and intr bank accounts is analyzed to determine the efficiency of the system.
6. Quality of Assets
Credit rating agencies should analyze the issuer’s segment of operation, its competitive environment, and market share in each segment vis a vis the risk profile of each segment.
The quality of the assets in investments is judged by analyzing the type of investment, the internal system for management of investments, policies in respect of disinvestment, and charging depreciation in the value of the investments.
In this connection, fixed assets turnover and fixed assets to net worth ratio and the rate of return on performing assets must be computed to study the components of the fixed asset as a portion of net worth or to study the earning power of fixed assets of the firm.
The more the earning powers of the fixed assets, the more will be the source of funds generated to the company, and more will be the positive impacts felt in assessing the quality of the debt instruments.
7. Profitability
Since non-fund based income plays an important role in boosting the learning of the issuer, the rating agency should determine the probability of continuance of such income in relation to sales, component-wise expenses ratios, operating expenses ratio, and operating net profit ratios determined in the past and budgeted figures in the future would also affect the quality of rating.
Related:
Major Steps Involved in Credit Rating Process.
8. Return on Equity and on Investment
Return on equity measures the profitability of equity funds invested in the firm after payment of taxes whereas the return on total investment measures the percentages of earnings remaining after payment of taxes.
The total investment comprises creditors and shareholders fund and is a product of net profit ratio and investment turnover ratio.
This aspect has an important bearing on the credit quality of the company.
As a matter of rule of thumb, operating profit as a percentage of total funds employed should not be less than the lending rate of the commercial banks.
9. Capital Structure
The most important indicator in analyzing the capital structure is the capital adequacy ratio.
To warrant adequate safety the borrowing of the company as a rule of thumb should not exceed two times its shareholder funds.
This is also an important indicator that determines the quality of the rating of debt issues.
Lower debt-equity indicates a higher degree of protection enjoyed by the debt instruments and vice versa.
Then shareholder equity, means that apart of the assets has been financed by the borrowed capital and hence, the world deteriorates the quality of credit ratings of debt issues.
Key Characteristics of Ideal or Optimal Capital Structure.
10. Past Performace
The increasing trend of revenues, profit after taxes, net worth, and net asset value of the firm keeping the total investments, constantly indicate the financial strength of the firm.
These variables are also useful in judging the assignment of ratings to the issuance of the debt instrument.
The variables linked with cashflow statements will have a favorable bearing n the rating of the debt instruments.
Therefore a credit rating agency should carefully analyze these indicators prior to assigning any rating to the instruments issued by a company.
11. Effect of Normal Busines Cycle
The business activities of the firm can be categorized as normal, recovery, boom, recession, and slump.
So the rating agency has to consider the state of economic activity facing the company sat the time of assigning a credit rating to the debt instruments.
This is one of the important factors which the credit rating agency ignores prior to deciding the worth of the debt instrument.
12. Interest and Debt Coverage Ratio Including Tax Considerations
Past trends in connection with interest and debt coverage ratio and payment of taxes are carefully scrutinized to understand the issuer’s policy of redemption to be debt and payment of taxes in the past and provision made to do so for the new debt which is food index of long term solvency of the firm.
This is considered a pivotal factor in influencing the judgment ion rating assigned by various credit rating agencies.
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