Chapter Sixteen

Credit Ratings and Bank Credit Assessment

A CORPORATE CREDIT RATING IS a score given to reflect qualitative and quantitative aspects that assess both business and financial risks of corporate issuers of fixed income debt and their individual debt issues. Many large banks have their own methods of assessing corporate debt from a point of view of lending to these corporates. In this chapter, we summarise both approaches and explore some of the factors that a Treasurer can incorporate during review discussions with these entities.

CREDIT RATINGS

A credit rating is generally a score that indicates an independent agency’s opinion on the degree of credit risk of an issuer of debt, indicating the agency’s assessment of the intention and ability of the issuer to fulfil its debt obligations over a period of time.

Ratings are typically established for short term (generally around a year or lower tenor) or long term, with various types of ratings as given in Figure 16.1.

FIGURE 16.1 Different Corporate Ratings

These can be:

• Issuer ratings. The individual obligor is rated as an organisation.
• Issue ratings. The corporate finance obligation or specific issue is rated for creditworthiness.
• Structured finance obligation ratings. Specific issuances related to a securitised pool of assets or other derivative financing transactions are rated. This process typically is more complicated than that for a simple debt issuance, depending on various factors and market environments.
• Recovery rating. An indicator of the likelihood of recovery of unpaid principal in the event of a default by the issuer is provided by some agencies.

Although credit ratings are global in use, they can be misconstrued in some areas. Table 16.1 shows some of the characteristics of credit ratings and some elements of finance that credit ratings are not.

TABLE 16.1 Credit Ratings Overview

How Credit Ratings Are Used

Credit ratings have use for investors around the world to get a better sense of the issuer’s creditworthiness, as opined by an independent agency. More evolved investors use credit ratings in conjunction with their own assessment methodologies.

Market intermediaries, such as commercial and investment banks, brokers, and other institutions, use credit ratings as indications of counterparty risk while evaluating credit extension to the issuers and while marketing these issues to clients.

Corporations use credit ratings as an indication of creditworthiness of trading partners who could be important cogs in their supply chain and hence to determine the risk to their supplies and/or payments.

For issuers, the credit rating is synonymous with the appetite and the liquidity that the market has for their debt and for its pricing. Generally, the better the rating, the lower will be the cost of borrowing. Two issuers with the same rating in the same industry in the same country could have borrowing costs that could differ slightly from each other owing to differences within the same rating scale that are specific to each company. It is important for the company to determine its optimal credit rating (see the next note) in line with its long-term growth plans and not always gun for an unsustainable but better rating.

Agencies and Compensation Models

There are many credit rating agencies in the world, three of which are Standard & Poor’s (S&P), Moody’s Investors Services (Moody’s), and Fitch. We explore the credit rating process in this book in a generic manner. Readers should refer to each rating agency for specific agency-wise rating fundamentals.

Ratings are generally done either at the behest of the issuer, who pays the agency to undertake the rating activity and issue a rating; or by the agency on its own, which then gets paid by any entity that can purchase the credit rating and report from the agency.

There are numerous pros and cons for each model, with no one school of thought finding overwhelming favour. Some agencies offer to volunteer safeguards, or mitigants, to possible conflicts of interest on either payment model.

Ratings

Each issuer is provided with long-term and short-term ratings for each time horizon. Table 16.2 depicts a sample band of long-term ratings. The ratings are alphabetical or alpha-numeric, starting with AAA (or highest grade) and moving progressively downward, to a D, or default. Relative position within a category is indicated for some categories with a plus sign (higher rating) or a minus sign (lower rating).

TABLE 16.2 Indicative Rating Bands

All the ratings agencies have a similar rating pattern, though their specific methodologies differ to some degree.

Limitations of Issuer Credit Ratings

Ratings have many uses but also quite a few limitations that were highlighted earlier in Table 16.1.

The subjective element in a rating, if present, obviously depends on the analyst’s ability to assess and appreciate the benefits and caveats on the company’s operations. While most agencies try to use uniform methodology through quantitative and objective analytical tools, there tends to be a subjective element that could make a quality and qualitative difference to the eventual rating provided.

CREDIT RATING METHODOLOGY

We explore a simple rating methodology, comprised of the rating process and the factors used to determine the rating in the agency’s model. These ratings, through objective numbers from public sources and discussions with the company as well as estimates, are part of the analysis done by the agency along with subjective inputs. The draft rating is then discussed internally, and the agency’s rating team finally puts out the rating to the public.

Rating Process

A simple rating process is provided in Figure 16.2a. Note: This is only an indicative set of steps, and each agency follows its own process. The review process is a continuous one. If events occur to alter the rating in any way, such as corporate action, business performance, change in regulatory or legal environment, and competitor actions, the agency might choose to advance the review period and issue notifications on review and any change.

FIGURE 16.2 Credit Rating Process (a) and Factors in the Issuer Rating Methodology (b)

Issuer Rating Factors

The components of the various rating and risk factors that could go into the model for rating issuers are provided in Figure 16.2b. The various factors on which the credit rating is based are explained next.

Business Risk

Business risk factors are those business-related aspects that impact the company’s ability to service its debt and fulfil its financial obligations, such as:

• Industry. The rating for each company is determined in the context of its respective industry. Figure 16.3 differentiates the types of industries that could have a high risk of default from the ones that would be perceived to be low risk. Apart from these, factors such cyclicality and seasonality as well as stage in the industry’s life cycle could impact the credit ratings for issuers in that industry.
• Environment. Environment comprises various elements of the firm’s operating environment, such as regulatory, social, demographic, technological, geographical diversification, product maturity, and country related (political, economic, legal, market transparency, and stage of development).
• Competitive landscape. The competitive landscape includes peer group performance, the issuer’s own status in the competitive landscape, and competitor capabilities.
• Capability and business model. The company’s own performance and capability, market presence and influence, diversification, supply chain, and economies of scale are some factors to be considered.

FIGURE 16.3 Dependence on Industry and Business Environment

Governance Risk

Governance risk entails the way the issuer is being managed. Components of this category of risk are:

• Management. The management component includes strategy and quality of management, including operating and business strategy, execution, and background and track record.
• Organisation and corporate structure. This component includes the legal and reporting structure of the issuer, the relationships between the parent and subsidiaries, corporate structure, documentation, associates and partner organisations, and integration.
• Policy. This component encompasses the various policies across the organisation and their ability and scope to cover contingencies and different business, market, operational, and organisational challenges. In many cases, the degree of transparency and clarity depends on the accounting policy adopted, especially for issuers across emerging markets that have not yet transitioned to International Financial Reporting Standards or related standards.
• Governance and execution efficiency. This area is concerned with how the entire governance structure is in place, including role and involvement of the board, reporting structure, and related activities.

Financial Risk

One of the most important cogs in the wheel of rating, financial risk, is considered across these parameters:

• Cash flow and liquidity related. This area remains one of the most critical elements of assessing an entity’s creditworthiness, as it indicates overall financial health and ability to sustain and grow operations, repay debt, and withstand downturns. Liquidity-related aspects have also become critical; they denote the company’s ability to manage all its payment obligations and periods of financial and market stress without a significant impact on its credit quality and dependence on external sources in times of crisis (such as the liquidity squeeze in 2008).
• Profitability and earnings. This area encompasses earnings stability and profitability across key businesses (adjusted for items such as certain kinds of provisions, reserves, write-downs, and one-time charges).
• Capital structure related. The degree of indebtedness and how the issuer funds its operations, and at what cost, become key drivers. In many cases, other key drivers include the liquidity and dependence on external sources of funding. To an extent, the industry’s general capital structure (highly capitalised manufacturing concerns versus thinly capitalised service businesses) is matched with that of the issuers to determine the type of capital structure the industry needs.
• Risk management. This area is concerned with the manner in which the firm deals with its financial risks and how the overall risk has been reduced, including the use of derivative instruments, their treatment, tolerance to risk, and the company’s understanding of their impact and tenor.

In summary, the credit rating process is an involved one. It uses both publicly available data and information provided by the company and its management. The process takes a long time, and the rating agency applies a number of qualitative inputs on top of the indications from the quantitative data. The process has been improving over time, and standards, methodologies, ratings, and efforts are converging.

Rating Changes and Their Impact

Changes to credit ratings can happen and can be caused by generic transitions in the business or by economic changes, weather, regulatory changes, by industry-specific circumstances, or by company-relevant issues.

Investors are cautioned to perform their own analysis prior to making entry, hold, or exit decisions on an investment related to a rated issuer as part of a specific company investment strategy, an industry investment strategy, or a broader strategy. Rating adjustments do play a role in the perception of an issuer or issue in the market, leading to an impact on the issuer’s ability and price of raising fresh capital, and the liquidity and price of the existing debt.

Controversy

The rating process and the role of the agency have been subject to much debate, discussion and controversy in the past. Earlier in the chapter we briefly discussed the possible conflicts of interest in the compensation models. Other areas of contention are the potential “shopping” by issuers who in some cases choose to only use a favourable rating provided by any of the agencies. During the financial events of 2008, highly rated instruments derived from subprime mortgages purchased by many investors were quickly and largely devalued on concerns of default on some of their components, leading to liquidity and valuation issues. This debate is outside the scope of this book.

I recommend prudence in the process of creating ratings and that issuers, investors, and the community all use ratings diligently and as one of the decision criteria.

In Conclusion

Credit ratings as supplied by agencies should be only one of the factors used to determine an entity’s creditworthiness and debt obligations. From the perspective of the corporate Treasurer, determining the optimal credit rating—something that is sustainable in the long term—should be a key priority. Paying a few cents more for debt now is a good investment to retain a similar level of creditworthiness rather than take on an incremental challenge that could prove detrimental in the medium term.

BANK CREDIT ASSESSMENT PROCESS

The bank credit assessment process varies from bank to bank. For purposes of this discussion, we take a sample illustrative bank and run through some of the elements of credit risk assessment by the bank.

Credit Assessment Cycle

The credit assessment cycle typically happens once a year. It also occurs episodically, in case of any sudden event, such as an acquisition or planned one, capital restructuring, litigation, heavy loss, unplanned capital expenditures, or any matter that would cause a shift in the business and financial aspect of the enterprise (see Figure 16.4).

FIGURE 16.4 Credit Assessment Cycle

The credit assessment process involves studying the corporate financial plans and historical performance, and the company’s and the bank’s own inputs on the needs in the coming period (needs assessment). The firm’s financials are then scrutinised, and the expected performance is evaluated from both business and financial standpoints (enterprise appraisal), with a focus being on cash flows. This process provides an indicative estimate of the amount of risk that the bank would be able to take on the group and also an expectation of the documentation, covenants, security, and collateral that would make the bank comfortable with extending credit. Once these have been agreed and executed, the facilities are provided. These can be funded (direct lending for working capital, trade, projects, and other purposes) or nonfunded (guarantees, pre-settlement risk limits for hedges, etc.).

In addition, the bank can offer a number of transactional non–credit related services that can be factored in and pricing and modalities discussed at the time of the assessment, or subsequently.

Enterprise Appraisal

The enterprise appraisal process involves a detailed study of the qualitative and quantitative aspects of a company’s financials and business model. This includes physical inspection of premises, plant, and equipment; detailed discussions with management and operations personnel; independent research and verification from the industry to corroborate management’s views on the company’s products or services; and other activities and information gathering to allow risk managers and bank branch management to decide on the client’s creditworthiness.

Figure 16.5 shows the typical enterprise appraisal components.

FIGURE 16.5 Enterprise Appraisal

One of the key differences between the bank credit assessment and a rating agency’s is that the bank has much deeper access to information and has a relationship with the company’s management; rating agencies, in contrast, have no funding, transactional, or developmental role.

Overall Management

The overall management assessment (see Figure 16.6) assesses the management quality and the company’s business performance. The overall management appraisal of the company takes into account the company’s business and industry-related performance, its standing in the industry, due diligence on its promoters, a thorough “Know-Your-Customer” (KYC) exercise, operations, historical performance, employee quality and turnover, accounting, history across markets and lenders, and overall role of the promoters and principal in management and financial support.

FIGURE 16.6 Overall Management Appraisals

Cash Flows and Profitability

Cash flows form a core part of lending to a firm, and banks usually look at cash flows as the first-way out to service interest and principal on outstanding debt. The cash flow appraisal is comprised of many factors, as shown in Figure 16.7.

FIGURE 16.7 Cash Flows Appraisal

Assessing cash flows includes a detailed evaluation of past and future flows, seasonality and episodic impact, use of working capital, receivables and payables, promoter involvement to provide liquidity, unencumbered cash, and other aspects that could cause a drain on existing flows or future growth. Cash flows are seen as the major source for servicing debt flows (coupon and principal), and strong cash flows through the business would indicate a higher creditworthiness. The bank would be eager to lend money to the enterprise.

Capital and Balance Sheet

The assessment of capital and other elements of the balance sheet (see Figure 16.8) can provide a good window on the financial management of the firm.

FIGURE 16.8 Capital and Balance Sheet Assessment

While short-term liquidity aspects were covered in the cash flows assessment, this part of the assessment focuses on the capitalisation and overall sources of funds and their use, the quality of assets and liabilities, and the sufficiency of capital for short-, medium-, and long-term sustainability and profitability of the company’s operations.

Risk Management

The final aspect of the appraisal, the manner in which the enterprise manages its risk, is also one of the most important aspects. It is on the radar of practically every bank (see Figure 16.9).

FIGURE 16.9 Risk Management Appraisal

Different elements of financial and nonfinancial risk are evaluated, and management awareness, policy, responses, and implementation are factored in to the assessment process.

Putting It All Together

The relationship manager assists the credit risk manager to obtain information and interface with the company’s finance and management teams. In turn, the credit risk manager evaluates the credit and calls on company management, if required, for further qualitative insights into the organisation’s working and expectations on business, cash flow, and profitability.

The entire process is iterative and discussion based. Companies that are trying to get the most out of the credit relationship with banks have to find the right mix among risk, return, and relationship.

IMPORTANT FOCUS AREAS AND DISCUSSION POINTS WITH BANKS DURING CREDIT REVIEWS

During the credit review process, it is important for the Treasurer, as the main contact point with the banks, to ensure transparency and accuracy of financial data, views, expectations, and business performance. Relationships will make a difference in the nature and quality of the dialogue and also the extent to which bankers can understand the firm’s needs, performance, and ability to succeed as well as the difference that credit lines will make to the company’s performance.

Yet too much information can lead to an overload that could cloud the judgment of the risk reviewers or potentially highlight the company’s dependence on the bank and hence allow for higher spreads.

The balanced view can be gained when the right areas are focused on. The next list highlights some good tenets to follow.

• Balanced transparency. Decide what level of transparency will be provided to the reviewers, what degree of detail, and so on.
• Honesty. There is no ambiguity about this: Numbers speak for themselves, but the qualitative responses should be the individual views of the manager and/or the collective view of the firm. They should never be what the reviewer would like to hear.
• Level of aggression on business plans. Often, business projections tend to be weighted to an aggressive side, depending on the chief executive and company culture. It may be prudent to provide two scenarios in case the basic projection is very aggressive.
• Highlighting issues or potential areas of concern. Bankers love clients who know their areas of concern and are forthright about them: It shows control and the ability and confidence to manage. If there was an issue in the past, discussion of it and the fact that the company now has a tighter, more controlled situation would do much more to supplement the bank’s perception of the firm than nondisclosure and a consequent surprise discovery.
• Optimising needs. Some treasurers overbudget credit requirements and do not use the facilities through the year; they simply have an excess requirement for a rainy day. It is important to let the bank know how much is being used for possible contingency and how much is for projected actual use. Every bank has limited capital, and bankers will do more for companies that utilise the bank’s capital wisely.
• Let the banks make their money, but not too much. Banks provide good service and products to most clients, but the ones who squeeze them really hard on every transaction and pinch pennies do not fall into a very high priority category. Hence, the bank’s profit margins may be discussed and learned, but allowing the bank to make some money incentivises it to put more resources behind you.

SUMMARY

We have gone through the credit assessment process, including the credit rating and bank assessment practices. Also discussed were some key aspects of dealing with banks during the credit assessment period.

The principles and concepts of assessing the creditworthiness of the company are uniform between the rating agencies and the banks. The difference lies in the access to information and what weight each piece of information is given in determining the final level of credit quality. Also, the bank is the end user of its own evaluation, while agencies are only service providers to institutions and other companies, without providing financial support themselves.

This concludes Part Three. Next we turn to the third major responsibility of the Treasurer: managing risk.