In India, trading businesses have traditionally been dominated by a wide number of small unorganised players, largely in the form of family run businesses. Barring a few sectors such as oil & gas and energy, most of the trading business segments are extremely fragmented. However, the participation of organised players has been increasing gradually with relaxation in Government’s trade and investment policies. Some of the organised players have strong parentage, including large global players, that has recognized India as an important emerging market and its positioning in the global commodity trade. Besides having benefits of diversification, such players benefit from the strong risk management practices, deep understanding of global commodity markets and ability to withstand inherent business risk, given the considerable parentage support.
INDUSTRY SCENARIO (FOR MAJOR INDUSTRIES, IF THE ENTITY IS IN MULTIPLE PRODUCTS)
Each of these key determinants are explained below for the issuers, investors and other key market participants to understand the approach adopted by Infomerics in assessing various risks associated with the entities in the Industry. This methodology does not include an exhaustive treatment of all factors that are reflected in ratings, but enables to understand the rating considerations that are most important.
In line with the rating methodology for most of the other corporate sectors, assessment of a trading company’s scale, market position and business diversification play an equally important in reflecting a company’s competitive strength in the markets it serves, its bargaining power with suppliers and customers. The line of business the company is engaged in and whether the company is in multiple products – that also assumes considerable significance. In India, trading has traditionally been a fragmented business.
In India, most of the trading businesses have traditionally been managed by family run businesses. Such business outfits, though have vast experience in their fields, but generally lack strong market position and even diversification. Such business traits may however vary from business to business. For instance, the share of organized segment in trading of agricultural commodities, especially rice has attained a reasonable share of the market over the years, while some of the businesses especially metal trading etc. continue to remain highly fragmented. With significant export opportunities, many of the players have gradually attained meaningful scale and market position in agricultural commodity trading and have also explored both backward & forward integration measures to strengthen their business profiles.
Nevertheless, given the unorganized and fragmented nature of trading business in India, the importance of scale and market position may command different weighting across sectors and qualitative factors such as experience of the promoters and their understanding of the business may be acknowledged while assessing the business risk. Some of the key parameters analysed include:-
Companies that score highly on the above parameters are often able to source products at competitive prices, spend less on logistics and provide quicker delivery of products. As a result, companies with larger market share are able to generate higher margins over time by exploiting any regional discrepancies in price and short-term imbalances in supply and demand.
Apart from enjoying strong market position and diversification, trading businesses also strengthen their business profile by vertically integrated their operations. While backward integration measures prima facie add strength to a company’s business model, the extent of investments required in backward integration and the ability of a company gain critical importance in an attempt to transform a business model. As a result, certain businesses by their very nature have limited vertical integration opportunities. Thus, the approach will depend on the sector the business belongs to and follows a comprehensive benchmarking evaluation with peer group, while assigning ratings.
One of the key risks which trading companies face is the market risk arising out of volatility in commodity prices which may be influenced by trends in international commodity prices, demand-supply dynamics and macro-economic trends. Exposure to a commodity is either taken through physical possession or through financial derivatives and the risk may be hedged through back-to-back transactions or through counter purchase agreements on local/global exchanges. In assessing market risk, the evaluation is done on the company’s trading and hedging strategies, management’s track record in the business, volatility in earnings from its core business segments and longevity of the company’s operations in each of its major market segments. In addition, the extent of market risk in a business is also influenced by inventory holding period.
After market risk, the other prominent challenge that trading companies face is the potential change in regulations related to commodity trading. In India, the regulatory environment is fairly stringent, restricting free trade, sourcing, warehousing and even pricing of essential commodities. In an attempt to strike a balance between the welfare of the agricultural community and ensuring supplies at competitive rates, the Government also engages directly in sourcing and pricing (by setting minimum support prices) of essential commodities. Besides, the Government also implements restrictions in imports/exports from time-to-time depending upon the prevailing market conditions. Import duties are often altered to align with the interest of the local industries. Such risk expose companies engaged in trading of essential commodities to regulatory risk further emphasizing the importance of diversification. Given these considerations, detailed analysis of the regulatory framework is carried out and appropriate adjustments are made to the analytical framework for trading companies.
Involvement of multiple counterparties in trading transactions also exposes a company to credit risk, and necessities a comprehensive credit risk management system for identifying, assessing and monitoring credit risk with respect to their customers and suppliers. Credit risk can be mitigated through managing counterparty exposure through risk weighted limits and customized credit terms determined. Additional risk mitigants may include third party guarantees, collateral agreements, margin deposits and trade insurance measures. The implementation of such measures in a tightly monitored environment is favourably considered.
The trading companies are exposed to multiple other risks across the supply chain, including but not limited to, risk of loss or damage during storage or transit, foreign exchange risk or events of political risks. In addition, political risk insurance provides cover for events such as war, export restrictions, seizure or blockage of funds, prohibition of transfers in foreign currency, among others. The evaluation is based upon the importance given by a company to these risks and is reflected by its insurance and forex policies.
In trading business, the accounting quality assumes high significance as most of the players in this segment are from unorganised sector. Given that, it is necessary to assess the typical financial parameters like growth in revenue & profit level, profitability & trend, capital structure & leverage, liquidity position & adequacy of cash flow with reference to debt servicing and meeting other financial obligations. In assessing a company’s credit profile, analysis is made on the financial leverage on both unadjusted and adjusted basis. The two material adjustments applicable to the calculation of adjusted ratios include a) impact of operating leases (related to warehouse leases, vessel chartering etc.) and loans from promoters/group companies.
These companies are generally working capital intensive, given the nature of operations, and hence, how they manage the working capital plays a very dominant role for the purpose of assessing the liquidity position. In India, trading firms generally rely on banking system to meet their working capital requirements and have limited access to capital markets. Given the stringent lending norms, access to bank funding at times becomes a time consuming process, especially for start-up or fast-growing companies, resulting in liquidity issues or even delays in timely servicing of debt obligations. Further, as the importance given to financial planning & financial management is not very formalised, it is necessary to critically assess the financial prudence of the management. It is observed that most of trading businesses in India being family run tend to rely on promoter funding (usually in the form of loans) in addition to bank borrowings. As part of working capital management, companies also discount receivables. In most cases, such trade receivable financing is not recognized on a company’s balance sheet. Thus, such financing arrangements are considered as part of debt.
Given the critical importance of liquidity in this industry, we consider management’s approach and track record on proactively maintaining sufficient excess liquidity to absorb any reasonable increase in commodity prices or other events that could stress liquidity.
All debt ratings necessarily incorporate an assessment of the quality of the issuer’s management, as well as the strength and weaknesses arising from an issuer being part of a conglomerate or large group. In case, the issuer is among the stronger entities within the group, its past track record and future plans in supporting other group companies are analyzed. Resourcefulness of promoters also plays a key role in assessing the creditworthiness of the entity. Usually, a detailed discussion is held with the management to understand the business objectives, plans and strategies, besides the outlook on the issuer’s industry. Some of the other points assessed are:-
Apart from quality and experience of management, assessment of corporate governance, quality of financial reporting and information disclosures are given considerable weightage while assigning ratings. The assessment of these factors can be highly subjective and variable over time. Ratings may include additional factors that are difficult to quantify or that only have a meaningful effect in differentiating credit quality in some cases.
Depending on the entity’s participation, whether in single product or multiple products, the major industries are evaluated in terms of characteristics like whether fragmented or being managed by few players and the key factors in terms superiority or limitations. It is also evaluated as to whether the particular industry is domestic oriented or it has linkage with the global market, in which event the demand-supply situation and its implications in the overseas front impact the particular industry. Infomerics also evaluates the performance of the industry in terms of growth, profitability & trend, price volatility and so on. Infomerics also tries to assess the outlook of the industry in the near-term and the long-term depending on the nature of debt instrument/borrowing facility being rated.