Question

1.      What are five of the External and five of the Internal factors that credit rating firms take into account in assigning ratings to individual businesses?

Answer 1

Following are the external factors affecting the credit rating of an issuer: -

1. Macroeconomic conditions

Suppose, you are an analyst in USA, analysing a company in Italy. According to the Top-down approach, you first explore the economy of the respective country. Macroeconomic factors mostly involve, Inflation rates, state of the economy, government support, Fiscal and Current account deficits, currency strength and volatility etc.

2. Industry Structure/ Supply in economy

This section usually analyses the supply side sector of the respective industry. Which includes threat of entry, type of market the firm is operating in(Oligopoly, perfect competition, Monopolistic competition etc.).

Then we analyse the power of suppliers, An industry that relies on just a few suppliers tends to be less profitable.

3. Threat of substitutes

What if the current product can easily be substituted by a new product or a new technology, which can hugely impact the operational revenue of the business, thus increasing the credit risk. If there aren’t many substitutes in the market, a company would have a strong pricing power.

4. Power of buyers/Customers

Industry that rely heavily on just a few main customers have a greater credit risk because the negotiating power lies with the buyers.

5.Industry Fundamentals

This section usually analyses the fundamental factors of the industry. If the industry is cyclical or non-cyclical, this is a crucial assessment because industries that are cyclical have more volatile revenues.

Then, what are the growth prospects of the company, industries which have no/little growth opportunities tend to consolidate via mergers/acquisitions.

Also, analysts can get an understanding of an industry fundamentals and performance by researching statistics that are published by and available from a number of different sources.

Some of the internal factors that affect credit rating of a company are:-

1. Company Fundamentals

Competitive position of the company, what is the market share? How it has evolved over time, how is it different from its peers. Then they analyse the track record/operating history, which involves company’s financial performance during different phases of the economy.

2. Management’s Strategy and execution

What is the management’s strategy to grow and compete? How differentiated is it? Analysts can learn about management’s strategy from reading comments discussion and analysis that are included with financial statements.

3.Ratio analysis

There are usually three types of ratio analysis in credit rating. Profitability, leverage and coverage.

Profitability usually involves cash flow measures, EBITDA, FFO,FCF Before dividends, FCF After dividends

Leverage ratios – Debt/capital, Debt/EBITDA, FFO/Debt, FCF After dividends/debt

Coverage ratios involve – EBITDA/Interest expense, EBIT/Interest Expense.

Also, issuer’s liquidity is analysed through cash on the balance sheet, operating cash flow, net working capital etc.

4.Collateral

Collateral or asset values, analysis is typically emphasised more with lower credit quality companies. Credit analysts focus more on probability of default, which is mostly about an issuer’s ability to generate sufficient cash flow to support its debt payment.

Analysts do think about the value and quality of company’s assets, however, these are difficult to observe directly. Factors to consider are nature and amount of intangible assets on balance sheet.

5.Character

The character of a corporate borrower can be difficult to observe. An analyst observes the following things for a company’s character.

An assessment of the soundness of the management’s strategy, management’s track record in executing past strategies, particularly if they led to bankruptcy or restructuring, use of aggressive accounting policies and or tax strategies. Any history of fraud or malfeasance, previous poor treatment of bondholders etc.