The computation of various financial ratios based on the Profit & Loss Account and Balance Sheet of a company/business entity and the most meaningful interpretation of the same play a very significant role in any credit rating exercise, although the overall credit analysis encompasses many other factors like business risk, quality of promoters & management, group support, quality of governance practices and industry scenario & outlook. Further, none of the ratios individually reflect the financial risk of an entity in its entirety. Hence, a collective analysis is undertaken to take anoverall view of the financial condition of an entity. While the financial ratios are not exhaustive by themselves for the purpose of financial analysis even, these provide an indication about the trend in performance and helps to compare the same with its peers. Generally for the purpose of financial analysis, the last three years results are considered alongwith the projections for the tenure of the instrument or for the future five years, whichever is lessdx. The major financial ratios considered for non-financial sectors are as under:
The growth pattern in overall revenue of the corporate/business entity over a particular time horizon vis-a-vis the same in the concerned industry indicates ability of the corporate/business entity to hold its market position, to contain various expenses & overheads and to maintain its operating efficiency and profitability. While analysing the trend, the extra-ordinary factors, if any, pertaining to the industry (both domestic and global, if there is overseas linkage), economy and/or the corporate/business entity is also considered to assess the sustainability. A corporate may outperform the industry due to its superior brand penetration, better product mix, competitive cost structure, wide reach and so on.
Ability of a corporate/business entity to earn a decent level of profit and sustainability thereof indicates the extent of protection available for servicing debt. While the volume of profit is pivotal vis-a-vis the level of debt, the trend in margin brings a comfort or otherwise for the investors/lenders. The profitability, the ability to mobilise resources in a cost effective manner and optimum utilisation of resources to generate reasonable return are looked at in the context of industry in which it operates, the business model and the peer group.
It may be necessary for an enterprise to invest in capex regularly or in product developmentfor holding its market position. Higher profitability always helps to do the same out of internal generation, rather than depending on outside borrowings. Further, entities with higher profitability have better shock absorbing capacity in case of economic downturnor in case of any eventuality
EBIDTA margin denotes the operating efficiency of a corporate/business entity without factoring the effect of capital structure. This is the ultimate effect of various factors like capacity utilisation, market share, pricing power, optimum sourcing of inputs, level of technology and so on. However, this ratio is impacted by the credit period it enjoys with its suppliers and the credit period extended to its customers, because these determine the ultimate raw material prices and sale price of products. The PAT level negates the effect of this through the carrying cost of working capital.
PAT reflects the final profit of the corporate/business entity after netting of all revenue expenses, depreciation and interest expenses, tax obligations and extra-ordinary items, if any. Therefore, the PAT margin reflects net earning capacity and this is considerably influenced by the capital structure and the borrowing cost. Creditworthiness of the promoter group, track record, bargaining power - all play significant role in influencing the borrowing cost. While analysing with reference to peer group and year-to-year comparison, Infomerics takes out the effect of extra-ordinary items. The business entity/corporate having higher PAT margin is viewed more favourably, although the overall volume of PAT is considered equally important particularly when the industry characteristics indicates a low margin high volume nature because from credit perspective volume of PAT is important for future capex and debt servicing.
ROCE indicates the efficient deployment/use of resources (both networth and borrowed funds). This ratio is independent of capital structure and can be compared across industries to evaluate the industry characteristics impacting the earning ability. However, ROCE, in isolation, is bit misnomer at times because in certain businesses like real estate both ROCE and cost of capital are high and hence, the difference between the two assumes significance. The ability of an enterprise to consistently generate ROCE over its cost of capital speaks favourably about its long-term business viability. ROCE (Operating) stands for Return on Operating Capital Employed i.e., the assets which are not ready for revenue generation are taken out from Capital Employed like Capital Work-in-progress representing amount spent on capex. Infomerics also takes into account the impact on ROCE of an entity’s policy or practice of stretching payments to its vendors and/or other service providers. Stretching vendor payments may be on account of enterprise having higher bargaining power or due to stressed liquidity.
RONW indicates the net earning ability of an enterprise on best use of networth. If the company is highly leveraged, then the PAT will be lower due to higher interest expenses. Sometime this ratio appears distorted in case significant amount of equity is infused by way of right issue/public issue or through private placement towards the end of the year.
The average cost of borrowings reflects the ability of the corporate/entity at which it accesses borrowings which is the outcome of various factors like group & promoter stature, fundamental strength, financial position, scenario & outlook of the industry the corporate/entity belongs to and its bargaining power. However, sometime the ratio gets distorted due to borrowing being skewed towards the end of the year and/or due to capitalisation of interest during the project implementation period. This effect, of course, gets negated over a three years time span.
(C)Leverage and Coverage Ratios
Long-term debt equity ratio and the overall gearing indicate the capital structure of the company and the working capital sensitiveness. An entity, despite of having a comfortable capital structure as reflected in low long-term debt equity ratio, has high overall gearing due to high level of short-term borrowings to finance working capital due to working capital sensitiveness or improper working capital management. While low Long-term debt equity ratio and the overall gearing are perceived as satisfactory feature as interest is a real burden in lean and/or adverse period, these parameters need to be evaluated in the context of profitability. An entity, even after having a moderate capital structure, may be comfortable in debt servicing due to adequate profit level.
Infomerics applies the first seven ratios for the past analysis, while the aforesaid first eight ratios are used for future analysis purpose. Interest coverage calculated as EBIDTA/Interest Expense shows the adequacy of Cash Operating Profit vis-à-vis Interest expense, while Long-term Debt/GCA and Long-term Debt/EBIDTA indicate the adequacy of cash profit and EBIDTA to service the principal debt repayment obligations. For the future, DSCR ultimately reflects the overall debt servicing ability of the entity over a time span of three to five years. Infomerics also does a sensitivity exercise on the projected DSCR anticipating certain probable adverse scenarios to see the flexibility of its financials. Preference dividend coverage ratio is used in case of rating of Redeemable Preference Share which is computed as PAT/Preference Dividend.
An entity with lower leverage typically has higher financial flexibility to raise incremental external capital (debt or equity) for deployment in business or to overcome temporary funding shortfalls. An entity with lower leverage is also better equipped to withstand volatility in cash flow generation in case of economic adversities, unexpected costs, changing consumer habits/preferences, or regulatory changes.
Liquidity ratios which are generally used for rating short-term instruments are measured in terms of the above. While the above ratios being above unity signify the ability of the entity to pay of immediate payment obligation (falling due within next 12 months), these ratios are not exhaustive by themselves because large & strong companies sometime lengthen the creditors payment to get the benefit of float and in such cases, these ratios fall below unity and do not meaningfully indicate the actual liquidity position. This is why and even otherwise, the cash flow statements and utilisation of fund-based bank limit are also considered for evaluating the liquidity of a corporate/entity.
These ratios essentially indicate the efficient management of working capital or otherwise. While the industry related characteristics have an impact on these ratios, the efficiency of the entity in asset deployment matter a lot. The working capital turnover ratio signifies the entity’s efficiency in managing working capital, however other ratios indicate such efficiency with reference to each major current asset and creditors. While lower the ratios are better (in case of ii) to (v), as aforesaid, optimum holding of each current asset ultimately gets reflected into a high level of turnover vis-a-vis working capital. While average collection period is a popular and common measure for ascertaining the efficiency of the entity in receivable management, Infomerics feels it important to ascertain the overall inventory management pattern. The higher average finished goods holding period shows loss of market/decline in market share due to various reasons including competition, obsolescence, major technical innovation, etc., besides the general industry pattern. The average raw material holding period indicates how efficiently the inventory of raw material is managed. Sometime the entity feels it prudent to source the raw material (imported, indigenous or both) in bulk to optimise the transportation cost and/or to ensure that the critical raw material is always in stock. Average creditors period indicate how the suppliers payments are managed and this may, at times, be strategically high to gain the benefit of superior bargaining power. The operating cycle is used as a measure to evaluate the length of the entire value chain.
Following are some of the common major adjustments made to Financial Statements while calculating &/or interpreting various financial ratios:
It is the prerogative of a company due to business or other considerations as to how it will carry out its business operations. It may prefer to carry out its business as a single legal entity or through various separate entities. These separate entities may be subsidiary companies, associate companies and/or joint ventures. In India, companies have resorted to complex structures while entering into new markets, new geographical territories and so on. Many acquisitions have taken place through special purpose vehicles as well. In case the main company carries out its operations through various separate entities, the mode of operation and the business synergy may be varied. These entities may be in the same line of business as the parent or few of them may be in the similar line of business with strong/limited operational synergy or without any synergy. This paper contains the modality & approach of Infomerics in evaluating an entity’s financial profile, after taking due cognisance of the aforesaid factors.
There are instances where a company prefers to isolate its cash flows from those of the new venture and does ring fencing. In such cases stand-alone financials carry more weightage than consolidated financials.
The evaluation of consolidated financials assumes strong significance where there are inter-group transactions or strong operational linkages since the consolidated financials present an overall financial position of the parent and all its group companies as a single economic entity. Infomerics also considers the potential business synergy and the expected fund flows within the group. So what Infomerics considers important is the underlying business & operational linkages which may not always be substantiated through the percentage of equity holding. Needless to make a mention here that the Consolidated financials portrays a meaningful picture of the overall operation & financials such as profitability, debt level & debt mix, resource pattern and asset base of the group. Therefore, in the evaluation process, depending on the significance, approach followed may be that of rating the parent/other group entities as a single economic unit with all subsidiaries, associates and JVs being its various departments.
Infomerics believes that the necessity or willingness of one group entity to extend support to another is triggered by the business linkage. In a situation where the parent company has a significant equity holding in a group company, but there is no business linkage, the necessity of consolidation is inferred from the possibility & extent of cash flow transactions.
The relationship between the parent entity and the group company is evaluated mainly on the basis of the extent and likelihood of support from the parent/stronger group entity to other group companies. This evaluation depends on many factors like the strategic & economic importance of the group company in the group, the extent of shareholding of the parent in the group company, the nature of management control in the group company by the parent, parent’s track record in extending support to the group company, the possibility of using the cash flow of one by the other and the common logo and/or group name indicating strong bondage.
Thus if there are common promoters and there is high business, financial and managerial integration of the operations between various entities in the group, a consolidated view may be taken. In the absence of the same, the rating of subsidiaries and other group entities may be notched up for the possible support from the stronger parent or group entity.
In evaluating the credit worthiness of a company/entity, the direct and/or tacit support of the group it belongs to or of the parent company assumes significance. While carrying out the credit rating exercise, Infomerics tries to derive comfort from such support, which may be likely, after considering many factors including the demonstrated support in the past. Actually this support goes a long way for the subsidiary/associate/joint venture company in meeting its debt obligation in times of stress. This is more so only when the parent company and/or the group has stronger financials and net cash flow availability.
In case of group support, Infomerics considers large groups with operations in many segments and have complicated shareholding structure. Such groups leverage their brand reputation in raising resources. Most companies in the group may be listed and each will have a professional management and an independent board. But the promoters exercise control over companies in the group, retaining a sizeable stake. In this context, it is important to identify the companies comprising the group. The overall credit profile of the group is evaluated considering the fundamental strength, business model, industry sensitivity and the managerial quality of the major entities of the group.
Infomerics’ attempt is aimed at exploring the possibilities of notching up the credit rating of the subsidiary/associate/joint venture company based on the aforesaid support. Besides the demonstrated support extended by the parent/group in the past, as highlighted above, the other factors considered by Infomerics are moral obligation of the parent/group, stature & standing of the parent/group, strategic position of the company in the group / to the parent company, the commercial benefits to the parent and/or to the group at large due to such association.
Let us discuss below the aforesaid factors in seriatim:
(i) Demonstrated support extended by the parent/group in the past to the company being rated
The support by the parent company and/or by the group may be continuous or situation specific. The parent/group extends support operationally or financially or managerial and on sustained basis or sporadically, as and when the need arises. Operational support may be by way of forward integration, backward integration, marketing support, technology support or infrastructure sharing. Financial support can be by way of infusing equity, extending loans/advances on softer terms, using group or parent’s strength in raising money and/or extending corporate guarantee for raising money. Managerial support may be in the form of sharing services in the areas of corporate finance, legal, representation of eminent people of the parent’s Board in the company being rated. Infomerics also tries to view as to whether this support is on regular basis or in case of eventualities. Prima facie, the operational support is generally on sustained basis; while the financial support may be regular in nature or situation specific.
(ii) Moral obligation of the parent/group
In India, there are groups or companies which are so reputed and have established credentials over decades that association of their name with a company even tacitly imparts high level of comforts to all the counter-parties, including the lender community. While this speaks well for the parent/group, circumstantially it casts a significant obligation on the parent/group to ensure that their images are not adversely impacted due to any deficiency on the part of the subsidiary/associate/joint venture company. This is more so in case of honouring financial obligations such as, vendors payment, payment of statutory liabilities, employee payment and debt servicing, besides all sorts of contractual non-financial obligations. Extent of management control and shared name also reflect the moral obligation of the parent company/group.
(iii) Stature & standing of the group/parent
While the support of the group and/or parent company assumes considerable significance in assessing the creditworthiness of the subsidiary/associate/joint venture company, the weightage on such support also depends on the stature & standing of the group/parent. More precisely, all parent companies/groups cannot command the similar level of acceptability from the market. A listed company or a company accessing capital market frequently has a more obligation to extend support to its group companies.
(iv) Strategic position of the company being rated
A large group has many companies in its portfolio and those may be involved diversified activities. Each company in the group is differently placed in terms of its nature of operations, business model, individual financial strength, scenario & outlook of the industry in which the company operates and past track record. All these determine the strategic position/importance of such company in the group / to the parent company and hence, the support flows accordingly. For captive finance companies, the extent of parent’s business being funded by the captive finance company reflects the level of strategic importance. More candidly, all companies in the same group may not get similar level of support from the group/parent.
(v) Commercial/economic benefits to the parent and/or to the group for a particular subsidiary/associate/joint venture company
While the commercial benefits accruing to the parent and/or to the group for a particular company also determines the strategic position of the latter, this factor also plays a significant role in imparting parent/group support. Apart from other factors, if the parent/group feels that extending support to a particular subsidiary/associate/joint venture company is a matter of high level of financial gain in the ensuing years, then the former tries to protect such objective in a reasonable manner. Further, the propensity of the parent company to support a profitable group company in times of stress is generally more, as compared to a loss making entity, to protect decline in economic value of its investment. Extent of parent holding, both current & future, also indicates parent’s level of commitment.
From Infomerics’ perspective, the parent/group support is relevant for credit rating of debt programme of the subsidiary/associate/joint venture company if there is a case of notching up of such credit rating. Infomerics believes that such notching up may be possible only when the parent’s credit rating is stronger than the standalone rating of the subsidiary/associate/joint venture company or when the overall standing of the group is explicitly/implicitly much superior than that of the company being rated. But this notching-up approach is a two-way traffic in the sense that when the credit rating of subsidiary/associate is notched up due to parent support, there is a likely impact on parent company’s credit quality for extending such support. This notching up is not certain and depends on a case to case basis as in case of a independent special purpose vehicles (SPVs), parent company/group support from parent may be limited in meeting debt obligations and hence, is the impact on credit rating. Further, the notching-up approach is applied only when there is no corporate guarantee from the parent. If the debt instrument of a company being rated is unconditionally and irrevocably guaranteed by the parent, and backed by a ring fenced payment mechanism, the rating of the guaranteed instrument is equated with the parent’s rating and rating so assigned carries a suffix ‘SO’ (Structured Obligation).
The ultimate rating of the subsidiary/associate/joint venture company depends upon three factors such as, the standalone rating of the company being rated, the rating of the parent company and to what extent the notch-up is feasible. While the standalone rating is an assessment of the company being rated without factoring parent company support, the parent company rating is after factoring the support being extended by the parent to the company being rated. The extent of notch-up shall depend on five factors mentioned above with the premises as to whether the linkage between the subsidiary/associate company are strong, moderate or weak. In case of strong linkage, the rating of the subsidiary/associate company is made equal to that of the parent. If it is weak, no notching up is done. If the linkage is moderate, then the rating of the subsidiary becomes somewhere between the rating of the subsidiary/associate company and the rating of parent company. However, if support is expected from a number of companies in the group, then it would be difficult to identify a single company for the purpose of measuring support. This causes uncertainty regarding the extent and timeliness of support. Hence, the notch-up gets restricted in such cases.
In case of a joint venture where two or more sponsors have equal shareholding, Infomerics factors the credit worthiness of the sponsor if it provides a written undertaking to provide distress support in servicing the entire/substantial portion of the debt obligation of the joint venture company.
RATING METHODOLOGY FOR GOVERNMENT SUPPORT
The stand-alone rating of government owned entities (GOEs) may be altered by Infomerics based on the extent and probability of support that the government can provide to them. GOEs are generally classified into four categories based on their role and the wider implications that their probable default can have on the government.
Importance in Government policy
Infomerics assesses the importance of a particular GOE in broad policy ambit of the Government. It is assessed through the following factors:
Default and its fallout
The potential fallout of default by a GOE is assessed through the following factors:
Based on the above criteria, Infomerics classifies GOEs into four different categories:
Default Recognition & Post-Default Curing Period
ProposedDefinition of Default
Fund-basedfacilities & Facilities with pre-defined repayment schedule
Adelay of 1 day even of 1 rupee (of principal or interest) from thescheduled repayment date.
WorkingCapital Term Loan
WorkingCapital Demand Loan (WCDL)
Certificateof Deposits (CD)/Fixed Deposits (FD)
PackingCredit (pre-shipment credit)
Overdue/unpaidfor more than 30 days.
Continuouslyoverdrawn for more than 30 days.
BillPurchase/Bill discounting/Foreign bill discounting/Negotiation(BP/BD/FBP/FBDN)
Overdue/unpaidfor more than 30 days.
Fund-basedfacilities & No Pre Defined Repayment Schedule
Continuouslyoverdrawn for more than 30 days.
Continuouslyoverdrawn for more than 30 days.
Letterof credit (LC)
Overduefor more than 30 days from the day of devolvement
Amountremaining unpaid from 30 days from invocation of the facility
Whenrated instrument is rescheduled:
Non-servicingof the debt (principal as well as interest) as per the existingrepayment terms in anticipation of a favourable response from thebanks of accepting their restructuring application/ proposal shallbe considered as a default.
90Days for Default to Speculative Grade and 365 days for Default toInvestment Grade.
Forbank loan ratings, default recognition shall be in line with the RBIguidelines.
Criteria – Complexity Level of Rated Instruments/Facilities
The level of complexity of a debt instrument and/or a debt facility plays a very pivotal role for the various associated parties like, investor/lender, market intermediary and regulatory bodies. It is important for the investor/lender to rightly understand & evaluate the terms & conditions and covenants of each debt instrument/facility, more particularly for innovative ones before deciding on any financial exposure, given the series of developments taken place in the financial market. It may not necessarily be perceived that a debt instrument and/or a debt facility with relatively more complexities has more credit risks; however, all associated parties need to know the level of complexities to take the appropriate call. It may so happen that a simple type of debt instrument/facility may have higher credit risk vis-a- vis the complex one. Keeping the aforesaid in view, Infomerics has classified debt instrument/facility based on complexity to facilitate the investor/lender to take the most informed decision. Infomerics believes that this classification will help the intermediaries to identify the right investor, based on level of complexity. This will also enable all the concerned regulatory bodies to guide the major investors in debt instruments (like insurance companies, provident funds, pension funds, etc.).
For this classification, Infomerics has considered four parameters such as, Premature Redemption, Number of Parties Involved in the Transaction, Certainty of Return and Familiarity of Financial Market with the Debt Instrument/Facility. The aforesaid parameters are elaborated below:
(i) Premature Redemption
Usual debt instruments generally do not have any options and hence, there is no reinvestment risk. But certain bonds/debentures, being in the deep discounting nature, have multiple put/call options. Investors for such instruments should be aware of the same so that they should be prepared for the event of issuer exercising the call option and the consequential reinvestment risk.
(ii) Number of Counterparties Involved in the Transaction
Number of counter- parties involved in a transaction is very important as that has a bearing in understanding/evaluating debt instrument/facility. If the debt instrument/facility is guaranteed, then there is a need to understand the implication of creditworthiness of the guarantor as well, besides the issuer/borrower. The guarantor may be one or more and the nature of guarantee may be full or partial and may be conditional/unconditional.
(iii) Certainty of Return
In case of debt instrument/facility carrying fixed interest rate, there is adequate certainty of receiving the interest on due date. This is so in case of fixed deposits, vanilla type of debentures and fixed rate of loans. However, in case of floating rate paper/debt facility, scenario is different. The rate becomes floating when it is linked to some benchmark rate. Hence, the investor/lender should be fully conversant with the nature of interest rate.
(iv) Familiarity of Financial Market with the Debt Instrument/Facility
The financial market needs to be familiar with the debt instrument per se. Certain debt instruments like non-convertible debentures, fixed deposits, commercial paper are, by and large, known to the market. However, with the gradual developments taken place in the market over the years, there are many sophisticated instruments have come in. Those are Pass Through Certificate (PTC), Perpetual Bond, etc. It is therefore necessary for the investors to
become familiar with the pros and cons of such debt instruments.
Based on the above parameters, to the extent applicable, debt instruments/facilities have been classified in three categories: (a) Simple, (ii) Complex and (iii) Highly Complex.
(a) Debt instruments/facilities are classified as Simple when the same carries a fixed rate of interest, there is a pre-specified tenure, there is one counterparty and there is no prepayment risk. Generally, the market is quite conversant with this type of instrument/facility.
(b) Debt instruments/facilities are classified as Complex when the same carries a floating rate of interest, there is a prepayment risk, tenure may be pre-specified but subject to conditions and the number of counterparties may be more than one. The market may be conversant with this type of debt instrument/facility to a limited extent.
(c) Debt instruments/facilities are classified as Highly Complex when the same carries a floating rate of interest, the maturity profile is varied, there is a prepayment risk and the number of counterparties is more than one. Market is generally not conversant with this type of instrument.
Benefits of Classification
For investor/lender – The aforesaid classification is likely to help the investor/lender to understand the nature of instrument/facility and the level of complexities of the structure.
For Intermediaries - This classification is expected to enable the intermediaries to identify the right investor & target accordingly, based on the level of complexity.
For Regulatory Bodies - This classification may help all the concerned regulatory bodies to prescribe investment criteria for the major investors (like insurance companies, provident funds, pension funds, etc.).