3 Credit Rating Process and Methodology

Credit Rating Process and Methodology

By: Dimple Agrawal (Institute of Management Studies, Indore)

What is a credit rating?

Credit rating is an alphanumeric symbol that provides the opinion about the safety and creditworthiness of an entity or an instrument. It gives a comprehensive picture of the risk associated with the financial instrument or the issuer, taking into consideration the past performances, present projects and future prospects. Credit rating agencies use both qualitative and quantitative data in analysing and evaluating the creditworthiness of borrowers.

Credit Evaluation Processes

Credit Rating Methodology

The rating methodology is categorized under four sections viz., Industry Risk Assessment, Business Risk Assessment, Financial Risk Assessment and Management Risk Assessment.

A. Industry Risk,

Industry Risk Assessment: the industry in which a firm is operating is assessed. The riskiness of an industry is governed by following factors:

Growth Prospects: Here the growth of an industry is assessed considering the aspects of sustainability of long-term growth and sources of volatility.

Cyclicality: Cyclical industries fortune are depended on shift in economy and commodity prices, because of difficulty in predicting timing and severity of downturn. Thus, the stable demand and realization patterns industries are preferred over firms in cyclic industries.

Intensity: The more the intense competition the less the revenues and profits. Thus, the industry competitiveness is assessed which is generally by factors like nature of product or service, production capacity, low entry and high exit barriers.

A. Business Risk,

The entity’s own business position remains one of the primary drivers of credit risk. Following are the factors of such risk:

Relative Scale: The rating agency evaluate scale of an industry with relation to competitors in market which can be on the basis of revenues, asset base, net worth or capital.

Competitive Position: Here the competitive position is analyzed on the basis of brand, distribution network, location, customer relations & technology.

Diversification: It is an effective way to deal with cash flow volatility & possible disruptions. Here the diversification of customer, geographic, product and supplier concentration are considered.

Operating Efficiency: The rating agency assess this by elements of variable cost and fixed cost of a firm.

Project Risks: Here the risk of project is ascertained by understanding entity’s rationale for undertaking new investments.

A. Financial Risk,

The various financial metrics assessed by a rating agency could be divided into four categories viz., Profitability, Leverage, Coverage and Liquidity. Profitability: Measure of earnings generated by an entity by analyzing an entity’s ratios of operating profit margin, net profit margin and return on capital employed.

Leverage: It is a measure of entity’s dependence on borrowed funds. It is analyzed by the ratios of gearing, total indebtedness ratio, debt to profit ratio and accruals to debt ratio.

Coverage: It is a measure of an entity’s debt servicing ability. It is measured by interest coverage ratio and debt service coverage ratio.

Liquidity and Cash flows: It is a measure of entity’s ability to meet short term cash obligations from internal and external resources. It is measured by current ratio, gross cash conversion cycle, working capital cycle and working capital intensity.

A. Management Risk,

Rating Agency incorporate an assessment of the quality of the rated entity’s management, the financial policies and the governance practices. Quality of Management; and Financial Policies: Rating company undertakes discussions with the rated entity’s management to understand its views on past performance as well as its future plans and strategies. The points assessed here are promoter’s experience, commitment, risk appetite, policies on leveraging, and also management’s plan on new projects.

Governance practices: A sound corporate governance structure attempts to make clear the distinction of power and responsibilities between the Board of Directors and the management. The rating agency assess qualitative understanding of entity to follow transparent and credible practices.

Credit Rating Example

Care Rating Limited: Credit Rating of Mahindra & Mahindra Limited as on August 3, 2021 About: incorporated in 1945, Mahindra & Mahindra Limited (M&M) is the flagship company of the Mahindra group. M&M enjoys a dominant position in its leading business segments. It is the largest tractor company in India with a market share of 38.2% in tractor segment in India in FY20.

Instrument Type Rating Complexity Indicator

Fund-based - LT-Cash Credit Long-term CARE AAA; Stable Simple Fund-based - LT-Term Loan Long-term CARE AAA; Stable Simple

Key Rating Indicators:

Financial Indicators FY20 FY21

Total operating income 44,865.52 44,574.44 PBILDT 6,350.56 6,976.57

PAT 739.71 922.94

Overall gearing (times) 0.12 0.26 Interest coverage (times) 51.00 17.33

Credit Strengths:

 Strong Market Position: M&M has held leadership position in tractor segment over the past 38 years; with a market share of 38.2% in FY21. Its market share in the UV segment declined in

FY21 to 14.7% due to new launches being made in the UV segment over the past couple of years.  Experienced management: M&M have strong competent management team of a long track record in the industry, has ensured strong corporate governance practices and a prudent approach to management.  Stability in the operating performance: Diversification in the revenue across auto and farm has helped the company to maintain stability in its operating performance despite challenges. The company reported 17.4% growth in exports due to good monsoons, and the farm machinery segment reported 45% revenue growth.  Financial risk profile: M&M had robust debt coverage indicators marked by overall gearing, although deterioration in the debt coverage indicators was due to higher debt availed to shore up liquidity.  Strong Liquidity: M&M had cash and cash equivalents and current investments of

Rs.10,691.31 crore as on March 31, 2021 and its fund based working capital limits are largely unutilized. Also, cash profit of Rs.6,900 crore expected to be earned in FY22. The liquidity profile is expected to remain strong despite the planned capex and investments.

Credit Challenges:

 Auto business prone to macro-economic factors: The variation in revenues is seen in CV business of M&M, i.e., highly correlated with economic cycles; although passenger vehicles are more stable in comparison. M&M has been adversely impacted by the significant increase in competition especially in the UV segment. CARE Ratings believes new models launch will help company boost, over long term.  Exposure to group companies: The company follow approach towards investment in companies yielding at-least 18% Return on Equity. Also, it has guided for investment of

Rs.1,500 crore in auto and farm companies and Rs.3,500 crore in other group companies over

FY22-FY24, which will require monitoring.

Outlook:

The ratings assigned to the bank facilities of M&M reflect its dominant market position in the Indian Tractor industry and Light Commercial Vehicles segment. The ratings also favorably factor its strong financial risk profile driven by low leverage, strong debt coverage indicators and high financial flexibility supported by superior liquidity position, with cost control measures being undertaken. The Company is also exposed to risks on account of investments in subsidiaries.