By Dr. Vishnu Kanhere
Chartered Accountant
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Risk
A credit rating estimates the credit worthiness of an entity,
be it a corporation, company, individual, public corporation or a
non-governmental organisation or even a country!
Credit rating involves evaluation of the potential borrower’s
credit worthiness in terms of borrowing capacity and the ability to repay,
including the ability to service the debt in terms of repayment of interest and
principale.
Credit rating primarily is of two types. The first is a
personal credit rating or the credit rating of an individual borrower.
Generally, the factors that influence this rating are: the ability of the
individual to repay the loan; the rate of interest; the relative use of credit
vis-à-vis his/her own capital; the saving and investment pattern; the purpose of
the loan; the spending pattern; background credit account enquiries; the
duration of credit history; activity and wealth; the nature and type of debt,
etc.
The other is corporate credit rating which is more of an
indicator to potential investors about the standard and rating of the entity
issuing the debt security.
The credit ratings of corporate entities take into account
the issuers’ credit worthiness, that is, the ability to repay the loan, interest
rate, credit scores depending on track record, profile, history, proposed usage,
capital structure, industry analysis and other factors.
Some of the prominent credit rating agencies abroad and in
India are: S & P (Standards and Poor), Moody’s, and Fitch Ratings
(International); and CRISIL and ICRA (in India), etc.
Generally credit rating agencies for corporate debt offerings
issue ratings like AAA+, AAA, BBB, CCC right down to D, E, F & S, etc. These
indicate ‘rating status’ indicating borrowing strength of the corporate. In the
case of individual borrowers, an assessment is done of the borrower’s ability to
repay. In case of corporates, the rating is at the request of the borrower; and
in case of individual borrowing, the rating is generally done at the instance of
the lender, though normally at the cost of the borrower.
The risk associated with credit rating is that of rating an
entity better than its real standing, resulting in an increased exposure of the
investor/lender. This is probably what led to the Global financial crisis.
Credit rating agencies have been under a cloud and their role
and relevance is being questioned. In India, the credit rating agencies had
failed to downgrade Satyam’s ratings and did so only when the scam was out in
the open — after the event!
The criticism of rating agencies stems from:
1. The nexus that they have with the market, analysts, the
market players and the corporate management.
2. Rating agencies are often wiser after the event.
3. Ratings affect interest rates and borrowing capacity
4. A premature negative rating can trigger corporate
failure.
5. Agencies go more by formulae and lack business acumen.
6. Agencies lack expertise in evaluating ‘green field’
projects.
Services of ‘rating agencies’ are critical in
evaluating risk where
(1) Companies that do not have a credit history or new
companies.
(3) Existing companies are undertaking diversification.
(4) Market risk – where commodities are
involved.
(5) Predicting specific business cycles.
Case study of the Month:
DuPont is a multinational which has a presence in the agro,
nutrition, energy utilities, consumer, government and healthcare sectors,
offering a bouquet of products like flooring materials, lubricants, coatings
like Teflon and a host of other products. Currently it has a net worth of around
7.2 billion US dollars, a long-term debt of 9.5 billion US dollars and a total
debt of 11 billion US dollars.
DuPont up to the 1960’s was known for its financial stability
and low debt to equity ratio and this protected the company from financial
constraints.
Competition increased post 1970, forcing the company to go in
for inorganic growth through acquisitions, and it had to deviate from a zero /
low debt company and start borrowing.
Debt financing resulted in dividend cuts, but with the use of
internal accruals for funding projects, the company managed to maintain a AAA
bond rating.
However, as time passed, the company stopped reducing debt
and went on borrowing, especially for M & A activity.
Increase in debt downgraded the rating to AA. The current
debt rating is lower, being A by Fitch, A2 by Moody’s and A by S & P. The
company is thus faced with a credit rating risk, with the outlook assessment of
all three rating companies being negative.
As a risk management consultant, you are asked for your
inputs and advice in this given situation.
Solution to the Case Study:
The risk manager’s advice is:
(1) Dupont should adopt a conservative capital structure for
the future which will help restore confidence and give the firm greater
financial freedom to fund research projects and diversification and pursue new
projects.
(2) In the interregnum raise the debt equity ratio to 2 to 1
by issue of convertible bonds for a period of 2 to 3 years – conversion at 10%
discount over market price on the date of conversion. This is suggested that the
increased leverage will adversely impact earnings before Tax and also PAT but it
will grant stability in cash flow.
(3) With consolidation and better performance PAT and PE will
increase over a period of 3 years. This is based on the Business plan and profit
projections given by the company and evaluated by the ‘risk manager’.
(4) In the current scenario a better option would be to move
to a higher leveraged position with more debt issued (the company easily can go
up to a debt equity ratio of 2.5 or 3:1. This way it can take advantage of the
tax shield and the revival phase of the economy and manage by issuing much
lesser debt at better rates to finance further activity.
(The case study and solution are not intended to be in the nature of
comments on the functioning or management of the companies but represent one of
the possible approaches selected by the author for demonstrating the concept
and issues of risk management)
