Topic - Credit Rating

Credit Rating
A credit rating is the quantitative analysis about the performance of creditworthiness of an
individual, business or corporate or product.
It is offered by credit rating agencies that perform in-depth analysis of the credit risks
associated with financial instrument or entity.
It is an assessment of the borrower (be it a group or company) by a registered credit rating
agency that determines whether the borrower will be able to pay the loan back on time, as per
the loan agreement.

Types of Credit Ratings Scales

Credit Ratings are assigned to companies and businesses. It is in the form of various symbols
which represent the creditworthiness of these entities.
The following table illustrates the credit rating symbols offered by Credit rating agencies –

Credit Rating Credit Rating Symbols

Agency
CRISIL Credit Rating Information Services of India Limited calculates the
credit worthiness of companies based on their strengths, market share,
market reputation and board. It also rates companies, banks and
organizations, helping investors make a better decision before investing
in companies’ bonds. Besides India, it is also operational in countries
 including the USA, the UK, Hong Kong, Poland, Argentina and China.
It offers 8 types of credit rating which are as follows:
Maximum Safety - AAA, AA, A – Good Credit Rating
Moderate Safety - BBB, BB – Average Credit Rating
High Risk - B, C, D – Low Credit Rating
CARE
Credit Analysis and Research Limited (CARE) offers a range of credit
rating services in areas like debt, bank loan, corporate governance,
recovery, financial sector and more. Its rating scale includes two
categories – long term debt instruments and short-term debt
ratings. The short-term debt is rated as CARE AAA, CARE AA, CARE
A, CARE BBB, CARE BB, CARE B, CARE C, CARE D. The long-term
debt ratings are CARE A1, CARE A2, CARE A3, CARE A4, and CARE
D.
BRICKWORKS Brickwork Ratings rates using its signature rating scale starting with
“BW” followed by unique rating symbols.
SMERA — AAA – Highest amount of Safety with the Lowest Credit Risk
— AA – Highest amount of Safety with the Super Low Credit Risk
— A – High amount of Safety with Low Credit Risk
— BBB – Moderate amount of Safety with Moderate Credit Risk
— BB – Moderate amount of Risk along with Moderate Risk of Default
— B – High amount of Risk along with High Risk of Default
— C – Very High amount of Risk with Very High Risk of Default
— D – Default or soon Expected to be in Default

Functions of Credit Rating –

Credit rating is an important aspect of investment and study of credit-worthiness of any
individual, business or corporate. It fulfils following functions:
• Analysis of Business
• Evaluation of Risk profile
• Used as marketing tool used for placing company or business in the industry
• To understand operating efficiency of the entity
• To understand financial analysis of the entity
Importance of Credit Rating
A) Importance to Investors –
1. Better Investment Decision - No bank or money lending companies would like to
give money to a risky customer. With credit rating, they get an idea about the
 creditworthiness of a company (that is borrowing the money) and the risk factor
attached with them. By evaluating this, they can make a better investment decision.
Understand the risk profile of the investments/business. Thereby, take a wise and
informed decision

2. Safety Assured: High credit rating means an assurance about the safety of money
and that it will be paid back with interest on time.
B) Importance to Borrowers –
1. Easy loan approval: A borrower with a high credit score rating shows high
creditworthiness and is considered to be a low-risk customer. Lending institutions
are quick to approve the loan application of such borrowers.
2. Competitive Interest rate: When it comes to personal loans, every institution
charges interest on the loan amount. A high CIBIL score or credit score gives the
borrower the leverage to negotiate and avail an online loan with a lower interest
rate.
3. High loan amount: One of the benefits of a good CIBIL score is that the borrower
can avail a loan of a higher amount.
4. Higher the credit rating, higher shall be the potential of individual, business or
corporate to attract investors.
5. It improves their presence across the corporate spectrum.
How do Credit Ratings work?
As we know, credit rating companies offer various ratings which are benchmark parameters
used by investors who seek valuable information regarding various investment or debt
instruments available in India. Higher the credit rating, higher are the chances of attracting
investors for investments. The calculation of credit rating or process of rating an instrument
varies from one agency to another. Each credit rating agency has its own unique way of rating
various entities, but the basic parameters that every credit rating agency considers are financial
statements of the entity, type of lending, borrowing and lending history, repayment history and
debt history of the entity. Thus, every credit rating agency analysis entity on these parameters
and offers credit rating for them.

• Every credit rating agency has its own algorithm to evaluate the credit rating through
major factors such as timely repayment of supplies and dues, cash flow, working capital,
net worth, etc.
• Every month, these credit rating agencies collect credit information from partner banks
and other financial institutions
• Once the request for credit rating has been made, these agencies dig out the information
and prepare a report based on such factors
• Based on that report, they grade every individual or company and give them a credit
rating
 • This rating is used by banks, financial institutions and investors to make a decision of
investing money, buying bonds or giving loan or credit card.
• The better the rating is, more are the chances of getting loan at lower interest rates.

Factors considered while rating a company –

a) Risk profile - It considers present as well as future (projected) financial risk profile
while assessing a company’s credit quality. These parameters give an insight to the
company’s financial health and are factored into the final rating. However, the final
rating assessment entails the interplay of various other factors such as financial
flexibility, business risk, project risk, management risk, as well as support from a
stronger parent, group or the government. In cases where the linkage to a weaker parent
or group puts a strain on the entity's resources, the same is factored in.

MARKET POSITION
A) SCALE OF OPERATIONS - The larger the scale, the greater the benefits of
economies of scale, and the ability to withstand profitability pressures.
It considers benefits of a company’s niche focus areas, for example, engineering
design for a specific industry segment
 Large available employee base provides flexibility to deploy employees across
projects under simultaneous implementation, while leaving sufficient resources to
undertake new contracts on short notice.
B) REVENUE MIX - Vertical segments are defined in terms of client industries such as
manufacturing, insurance, banking, telecom, and travel/tourism. It analyses the
business prospects of key segments in these industries. Presence in diverse segments
lends stability to earnings.
C) GEOGRAPHIC DIVERSITY - The geographic spread of revenue is an important
parameter in analysing a company's business risk. Although geographic diversity mitigates
business risk, the skew is unavoidable. However, if there is a slowdown, geographic
concentration poses risks related to spending in the company's key markets and other
factors such as visa restrictions for software professionals.
D) CLIENT PROFILE - Established relationships with large clients, lead to repeat business
and provide stability to earnings. However, dependence on a single client increases risks as
any setback following loss of the client could be substantial. New client acquisitions and the
quality of such clients are indicators of a company's marketing and delivery capabilities.
E) MERGERS AND ACQUISITION - Many Indian companies are acquiring
companies in the US and other countries to capitalize on existing client relations and
to acquire domain expertise. Successful and speedy integration of the acquired
company is critical for this strategy to yield optimal gains. Further inorganic growth
is a key driver, with companies specializing in artificial intelligence, machine
learning, automation, and analytics being acquired.

OPERATING EFFICIENCY

A) Productivity
B) Employee utilization rates, offshore-onshore employee mix, and contract mix
C) Systems and process
D) Input-Output ratio
E) HR and Knowledge Management

Operating efficiency varies from industry to industry.

FINANCIAL RISK - The analysis of a company’s financial ratios is core to rating

process as these ratios help understand a company’s overall financial risk profile. It
considers some crucial financial parameters while evaluating a company’s credit quality:
A) Capital structure –
A company’s capital structure--commonly referred to as its gearing, leverage, or
debt-to-equity ratio--reflects the extent of borrowed funds in the company’s funding
mix.
The equity component in the capital employed by a company has no fixed
repayment obligations; returns to equity shareholders depend on the profits made
by the company. Debt, on the other hand, carries specified contractual obligations of
interest and principal. These will necessarily have to be honoured, in full, and on
time; irrespective of the volatility witnessed in the business.
 A company’s capital structure is invariably a function of the strategy adopted by its
management.
Although high dependence on borrowed funds (and thus, high gearing) may result
in a higher return on shareholders’ funds. In fact, in situations of weak business
performance, high gearing may weaken profitability, constraining a company’s
ability to repay debt. Gearing, therefore, denotes the extent of financial risk taken by
a company: the larger the quantum of debt, the higher the gearing, and the more
difficult it will be for the company to service its debt obligations.
A credit rating informs investors about the probability of timely servicing of the
rated debt obligation.
Therefore, financial risk in the form of high gearing adversely affects an entity’s
credit rating. The rating also depends on the mix of business and financial risks
borne by the entity. For instance, entities that are highly susceptible to industry
cycles, such as sugar and cement companies cannot afford high gearing. On the other
hand, companies in stable industries may choose to operate with higher debt
without unduly straining their financial position.
Gearing = Adjusted total debt /Adjusted net worth
B) Interest coverage ratio - Interest coverage represents the extent of cushion that a
company has for meeting its interest obligations from surplus generated from its
operations.
The interest coverage ratio, therefore, links a company’s interest and finance charges to
its ability to service them from profits generated from operations.
This ratio is important to the rating process because the rating reflects the entity’s ability
to service its debt obligations in a timely manner.
This implies that the company should generate adequate income for it to be able to meet
its interest obligations, even if business prospects were to turn adverse.
Thus, companies with a higher interest coverage ratio can absorb more adversity, and
are more likely to pay interest on time; therefore, by definition, they are less likely to
default. Interest coverage is a consequence of a company’s profitability, capital structure,
and cost of borrowings. For businesses that have an intrinsically low profit margin, a
high interest burden – either on account of high gearing or high cost of funds, or both –
may adversely affect the interest coverage ratio, and therefore the rating.
Interest coverage ratio = Profit before depreciation, interest, and tax (PBDIT1 )/
Interest and finance charges
Interest and finance charges refer to the total interest payable by the company during
the financial year under assessment; this includes the interest component of lease
liabilities, non-funded capitalized interest , and also preference dividend
C) Debt service coverage - The debt-service coverage ratio (DSCR) indicates a company’s
ability to service its debt obligations, both principal and interest, through earnings
generated from its operations
D) Net worth - A company’s net worth represents shareholders’ funds that do not have
fixed repayment or servicing obligations, and thus provides a cushion against adverse
business conditions
E) Profitability - Profit margin broadly indicates both a company’s competitive position in
an industry, and the industry’s characteristics in terms of the strength of competition,
pricing flexibility, demand-supply scenario, and regulation. A company’s profit
performance is a good indicator of its fundamental health and competitive position.
Profit margin, observed over a period of time, also indicates whether a company can
sustain its present cash accruals. A profitable company exhibits the ability to generate
internal equity capital, attract external capital, and withstand business adversity.
From a rating point of view, the profit after tax (PAT) margin, that is, the ratio of PAT to
operating income is an important profitability ratio.
Although other ratios such as operating profit before depreciation, interest, and tax
(OPBDIT) to operating income, or operating profit before tax (OPBT) to operating
income, are also evaluated, these ratios tend to be influenced by industry-specific
characteristics, and hence, do not lend themselves to comparison across industries. A
high PAT margin offsets, to some extent, the effect of business risk and the
corresponding financial risk. However, when used in evaluating low-value-added
industries such as trading, the PAT margin also tends to have industry-specific
characteristics. This is appropriately factored in while analyzing such industries
PAT margin = Profit after tax / Operating income
F) Return on capital employed - Return on capital employed (RoCE) indicates the returns
generated by a company on the total capital employed in the business. The ratio
comprehensively indicates how well the company is run by its managers and is
unaffected by the extent of its leveraging or by the nature of its industry. A consistently
low RoCE reflects the company’s poor viability over the long term.
RoCE = Profit before interest and tax (PBIT) / [Total debt + Adjusted net worth +
Deferred tax liability]
G) Net cash accruals to total debt ratio - The net cash accruals to total debt (NCATD) ratio
indicates the level of cash accruals from the company’s operations in relation to its total
outstanding debt. Looked at from a different perspective, the inverse of this ratio reflects
the number of years a company will take to repay all its debt obligations at present cash
generation levels. The ratio is computed as follows:
NCATD = [PAT - Dividend + Depreciation] / Adjusted total debt (short and long
term, including off-balance- sheet debt)
H) Current ratio- The current ratio indicates a company’s overall liquidity. It is widely used
by banks in making decisions regarding the sanction of working capital credit to their
clients. The current ratio broadly indicates the matching profiles of short and long-term
assets and liabilities. A healthy current ratio indicates that all long-term assets and a
portion of the short-term assets are funded using long-term liabilities, ensuring adequate
liquidity for the company’s normal operations.
Current ratio = Current assets (including marketable securities)/Current liabilities
(including current portion of long-term debt i.e. CPLTD)
Links to view Credit Rating –

Sonata Software Limited - Rating Rationale (crisil.com)

Infosys Limited - Rating Rationale (crisil.com)

Rating Methodologies - Moody - ..\Downloads\Rating Methodologies - List-of-Rating-

Methodologies - 14Apr22.xlsx