Credit ratings

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What Does Credit Rating Mean? An assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities. Credit is important since individuals and corporations with poor credit will have difficulty finding financing, and will most likely have to pay more due to the risk of default. A credit rating is a simple number which many lenders use to determine whether or not they will give a loan or line of credit to an individual. One's credit rating is impacted by a number of factors, some of which are controllable, others of which are not. An assessment of a particular issuer's creditworthiness which results in a rating being assigned. Ratings range from AAA (very high) to D (in default). Several companies study issuers and make ratings decisions, including Moody's and Standard & Poor's. The credit rating agencies in India mainly include ICRA and CRISIL apart from these, there is ONICRA and many others. ICRA was formerly referred to the Investment Information and Credit Rating Agency of India Limited. Their main function is to grade the different sector and companies in terms of performance and offer solutions for up gradation. Functions of Credit rating agencies in India: The credit rating agencies in India offer varied services like mutual consulting services, which comprises of operation up gradation, risk management. The have special sections to carry on research and development work of

the industries. They provide training to the employees and executives of the companies for better management. They examine the risk involved in a new project, chalk out plans to fight with the problem successfully and thus ameliorate the percentage of risk to a great extent. For this they carry on thorough research into the respective industry. They have started offering services to the mutual fund sector through the application of fund utilization services. The major industries currently graded by the credit rating agencies include agriculture, health care industry, infrastructure, and maritime industry. Guidelines for Credit rating agencies in India: The Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 offers various guidelines with regard to the registration and functioning of the credit rating agencies in India. The registration procedure includes application for the establishment of a credit rating agency, matching the eligibility criteria and providing all the details required. They have to undergo the strict examination procedure with regard to the details furnished by them. They are required to prepare internal procedures, abidance with circulars. They are offered guidelines regarding the credit rating procedure, by the Act. The credit rating agencies are provided with compliance officers. They are required to show their accounting records. CRISIL: CRISIL was set up in the year 1987 in order to rate the firms and then entered into the field of assessment service for the banks. Highly skilled members manage the agency. Ms. Roopa Kudva who acts as the Managing Director and Chief Executive Officer of the company heads it.

The company has set up large number of committees to look after dispersal of various services offered by the company for example, investor grievance committee, investment committee, rating committee, allotment committee, compensation committee and so on. The head office of the company is located at Mumbai and it has established offices outside India also. ICRA: ICRA was established in the year 1991 by the collaboration of financial institutions, investment companies, and banks. The company has formed the ICRA group together with its subsidiaries. The company is headed by Mr. Piyush G. Mankad and offers products like short-term debt schemes, Issue-specific long-term rating and offers fund based as well as non-fund based facilities to its clients. Rating Criteria/Methodology Credit rating exercise is based on
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information provided by the company In-house database and data from other sources that the credit rating agencies considers reliability. It does not undertake unsolicited ratings. The primary focus of the rating exercise is to assess future cash generation capability and their adequacy to meet debt obligations in adverse conditions. The analysis attempts to determine the long-term fundamentals and the probabilities of change in these fundamentals, which could affect the credit-worthiness of the borrower. The analytical framework of rating methodology is divided into two interdependent segments. The first deals with the operational characteristics and the second with the financial characteristics. Besides quantitative factors, qualitative aspects like assessment of management capabilities play a very important role in arriving at the



rating for an instrument. The relative importance of qualitative and quantitative components of the analysis vary with the type of issuer. Rating determination is a matter of experienced and holistic judgement, based on the relevant quantitative and qualitative factors affecting the credit quality of the issuer.

WHAT RATINGS DO NOT MEASURE It is important to emphasise the limitations of credit ratings. They are not recommendations to invest. They do not take into account many aspects which influence an investment decision. They do not, for example, evaluate the reasonableness of the issue price, possibilities for capital gains or take into account the liquidity in the secondary market. Ratings also do not take into account the risk of prepayment by issuer. Although these are often related to the credit risk, the rating essentially is an opinion on the relative quality of the credit risk. A credit score is a 3 digit number that tells a creditor how creditworthy you are and how likely it is that you'll repay the credit once it is extended to you. These scores affect the interest rates you receive on mortgages, auto loans, credit cards, etc. In addition, when you go for an insurance policy or apply for a job, the insurer or employer may look at your credit scores. Even when you're looking to rent, your landlord would prefer it if you have a good credit/FICO score. What is FICO score? A FICO score is calculated on the basis of the FICO Scoring Model developed by the Fair Isaac Corporation. In most cases, when people talk about their credit scores, their FICO credit score is what they mean. Consumers can access different versions of the FICO score at the 2 bureaus - Equifax and TransUnion. These scores are known as the Beacon score and Empirica score.

Consumer FICO scores calculated by Experian are sold to lenders only and consumers can't access them. However, consumers can find their credit scores (based on Experian data) online at Experian. They can even request a free credit report from Experian, just like from other bureaus.

What is a good credit score? Usually FICO credit scores range from 300 to 850. The higher your score is, the lower the risk to the creditor is when offering you a loan. A FICO score equal to or above 700 is considered a good credit score which will qualify you for some of the best deals at affordable rates.

What is a credit score chart? A score chart helps you get an idea of credit score ratings based on the credit scores you have. The credit score chart is given below:
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730+ - Excellent 700 - 729 - Good 670 - 699 - Needs a closer look 585 - 699 - Higher risk Below 585 - Limited credit history

Can you get a free credit score? Under the Fair Credit Reporting Act (FCRA), anyone is entitled to a free copy of their credit report once a year from each of the bureaus; but free credit scores are not available. You'll have to place an order with the bureaus and pay a fee (set by the Federal Trade Commission) if you'd like to get your credit score.

What is the Credit Scoring system?

It's a system where the credit bureaus figure out your scores based on the information that is available from your credit report. The bureaus use a statistical program to compare the loan repayment history of consumers with similar profiles. Then they award points for each item that helps find the consumers who can easily pay down a debt. The total number of points adds up to your credit score.

Why do credit scores or FICO scores vary? The major credit bureaus - Equifax, and Trans Union follow the FICO scoring model (developed by Fair Issac Corporation) to calculate a FICO score. But scores differ because they use minor variations in the FICO Scoring Model as well as assign different points to each item on your credit report. Not all lenders/creditors and collection agencies will report your credit information to the same credit bureau. Therefore, the credit score you get from one bureau may differ from what you receive from another. In addition, your credit scores changes from time to time based on your credit transactions. So, make sure that your creditors update the bureaus with your latest credit details.

Do credit score ratings differ? Credit ratings may vary from one lender/creditor to another depending upon the items (such as late payments on revolving accounts, mortgages, credit card balances,) they consider after reviewing your credit report. For instance, an auto loan provider may leave out an item that a mortgage lender would consider while providing credit score ratings.

Is Mortgage Credit score similar to the regular score?

Mortgage lenders consider the median score - the one that comes in between the maximum and minimum scores you receive from the bureaus. But often lenders may not use the median score in order to evaluate your creditworthiness because the credit report you pull from the bureau is based on the Consumer Model, where your lender may prefer to calculate the score using a different scoring system - the Mortgage Model. The information used for both Models may be the same but the importance given to each tradeline account may vary. The Mortgage Model gives more emphasis to the tradelines that can affect your mortgage loan. Thus, your chances of getting a mortgage at a favorable interest rate may depend more upon your mortgage credit scores instead of your regular score.

Are there alternatives to FICO scores? Apart from the FICO Scores, there are Alternative scores developed for consumers with poor credit. The Alternative scores are based on your payment history, outstanding loan balances, the type of credit accounts you have, and other factors. As lenders pull your credit report from different bureaus, every lender will probably show different scores. Therefore, you won't get the same offers from different lenders. To avoid these discrepancies, the Vantage score has been introduced. A Vantage score ranges from 501 to 990 and is calculated the same way by each bureau thus giving you the same credit score, provided similar information is reported to each bureau With the increase in the number of consumers who find themselves delinquent on their bills, lending standards have gotten tighter. Therefore, qualifying for a loan has become harder, especially if you don't have a good credit report or score. Especially when it comes to getting a mortgage, even those that are not supposed to be score driven

require you to have a minimum 580 credit score. So, it's important to protect your credit standing and maintain a good score. Credit rating process for manufacturing companies begins with a review of the Economy/Industry in which the company operates along with an assessment of the business risk factors specific to the company.This is followed by an assessment of the financial risk factors and quality of management of the company. The degree of financial risk exposure of the company within the overall context of the business risk together with the evaluation of the company management forms the basis for arriving at the rating level. 1. Economy and Industry risk analysis Analysis of industry risk focuses on the prospects of the industry and the competitive factors affecting the industry. The Economic/industry environment is assessed to determine the degree of operating risk faced by the company in a given business. Investment plans of the major players in the industry, demand supply factors, price trends, changes in technology, international/domestic competitive factors in the industry, entry barriers, capital intensity, business cycles etc. are key ingredients of industry risk. CREDIT also takes into account economy wide factors which have a bearing on the industry under consideration. The strategic nature of the industry in the prevailing policy environment, regulatory oversight governing industries etc are also analysed. 2. Business risk analysis Against the backdrop of economy and industry risk, It assesses the company¶s position within the industry. Some of the key parameters used to assess business risk are: 2.1 Diversification For companies that operate in several industries, each major business segment is analysed separately. The contribution of each business

segment to the company¶s overall profitability is assessed. While diversification results in better sustainability in cash flows, It also analyses the suitability and adequacy of management structure in such scenarios and forward and backward linkages present. 2.2 Seasonality and Cyclicality Some industries are cyclical in nature with their performance varying through the economic cycle. Moreover, certain industries are seen to exhibit seasonality. It ratings aim to be stable across seasons and economic cycles and are arrived at after deliberating on the long term fundamentals. Rating Methodology for Manufacturing Companies 2.3 Size Small size presents a significant hurdle in getting higher ratings commensurate with a company¶s financials. Presence in selected market segments, limited access to funds leading to lack of financial flexibility etc., result in lower protection of margins when faced with adverse developments in business areas. Large firms, on the other hand, have higher susteinance power, even during troubled times. 2.4 Cost structure The cost factors and efficiency parameters of existing operations are assessed with respect to expenditure levels required to maintain its existing operating efficiencies as well as to improve its efficiency parameters in a competitive scenario. Nature of technology may also influence the cost structure. 2.5 Market share A company¶s current market share and the trends in market share in the past are important indicators of the competitive strengths of the company. A sustained leadership position leads to ability to generate cash over the long term. A market leader generally has financial resources to meet competitive pricing challenges.

2.6 Marketing and distribution arrangements Depending on the nature of the product, it analyses the depth and importance of the marketing and distribution of the company. For example, companies in FMCG sector require an extensive marketing and distribution network and it attaches high importance to the same when analyzing companies in those industries.

3. Financial risk analysis Financial risk analysis involves evaluation of past and expected future financial performance with emphasis on assessment of adequacy of cash flows towards debt servicing. CREDIT¶s analysis is mainly based on audited accounts of the company although unaudited accounts are noted. A review of accounting quality and adherence to prudential accounting norms are examined for measuring the company¶s performance. Accounting policies relating to depreciation, inventory valuation, income recognition, valuation of investments, provisioning/ write off etc. are given special attention. Prudent disclosures of material events affecting the company are reviewed. Impact of the auditor¶s qualifications and comments are quantified and analytical adjustments are made to the accounts, if they are material. The rating team meets the auditor to understand his comfort level with the accounting records, systems and policies of the company and his assessment of the management of the company. In the process, the rating group also forms an opinion on the quality of the auditor and his firms¶ reputation in the market. Off-balance sheet items are factored into the financial analysis and adjustments made to the accounts, wherever necessary. Change of accounting policy in a particular year which results in improved reported performance is analysed more closely. CREDIT ANALYSIS & RESEARCH LIMITED

3.1 Financial ratios Financial ratios are used to make a holistic assessment of financial performance of the company, as also to see the company¶s performance w.r.t its peers within the industry. (i) Growth Ratios Trends in the growth rates of a company vis-à-vis the industry reflect the company¶s ability to sustain its market share, profitability and operating efficiency. In this regard, focus is drawn to growth in income, PBILDT, PAT and assets. (ii) Profitability Ratios Capacity of a company to earn profits determines the protection available to the company. Profitability reflects the final result of business operations. Important measures of profitability are PBILDT, Operating and PAT margins, ROCE and RONW. Profitability ratios are not regarded in isolation but are seen in comparison with those of the competitors and the industry segments in which the company operates. (iii) Leverage and Coverage Ratios Financial leverage refers to the use of debt finance. While leverage ratios help in assessing the risk arising from the use of debt capital, coverage ratios show the relationship between debt servicing commitments and the cash flow sources available for meeting these obligations. CREDIT uses ratios like Debt / Equity Ratio, Overall gearing ratio, Interest Coverage, Net cash accruals / Debt and Debt Service Coverage Ratio to measure the degree of leverage used vis-à-vis level of coverage available with the company. (iv) Turnover Ratios Turnover ratios, also referred to as activity ratios or asset management ratios,

measure how efficiently the assets are employed by the firm. These ratios are based on the relationship between the level of activity, represented by sales or cost of goods sold, and level of various assets, including inventories and fixed assets. (v) Liquidity Ratios Liquidity ratios such as current ratio, quick ratio etc. are broad indicators of liquidity level and are important ratios for rating short term instruments. Cash flow statements are also important for liquidity analysis. 3.2 Cash flows Interest and principal obligations are required to be met by cash and hence only a thorough analysis of cash flow statements would reveal the level of debt servicing capability of a company. Cash flow analysis forms an important part of credit rating decisions. Availability of internally generated cash for servicing debt is the most comforting factor for rating decisions as compared to dependence on external sources of cash to cover temporary shortfalls. Cash flow adequacy is viewed by the capability of a company to finance normal capital expenditure, as well as its ability to manage capital expenditure programmes as per envisaged plans apart from meeting debt servicing requirements. 3.3 Financial flexibility Financial flexibility refers to alternative sources of liquidity available to the company as and when required. Company¶s contingency plans under various stress scenarios are considered and examined. Ability to access capital markets and other sources of funds whenever a company faces financial crunch is reviewed. Existence of liquid investments, access to lines of credits from strong group concerns to tide over stress situations, ability to sell assets quickly, defer capex etc. are favourably considered.

3.4 Validation of projections and sensitivity analysis The projected performance of the company over the life of the instrument is critically examined and assumptions underlying the projections are validated. The critical parameters affecting the industry and the anticipated performance of the industry are identified. Each critical parameter is then stress tested to arrive at the performance of the company in a stress situation. Debt service coverage for each of the scenarios would indicate the capability of the company to service its debt, under each scenario. 4. Management Evaluation Management evaluation is one of the most important factors supporting a company¶s credit standing. An assessment of the management¶s plan in comparison to those of their industry peers can provide important insights into the company¶s ability to sustain its business. Capability of the management to perform under stress provides an added level of comfort. Meetings with the top management of the company are an essential part of CREDIT¶s rating process. 4.1 Track record The track record of the management team is a good indicator for evaluating the performance of the management. Management¶s response to key issues/events in the past like liquidity problems, competitive pressures, new project implementation, expansions and diversifications, etc. are assessed. 4.2 Corporate Strategy The company¶s business plans, mission, policies and future strategies in relation to the general industry scenario are assessed. An important factor in management evaluation is assessment of the management¶s ability to look into the future and its strategies and policies to tackle emerging challenges.

4.3 Performance of group companies Interests and capabilities of the group companies belonging to the same management give important insights into the management¶s capabilities and performance in general. 4.4 Organisational structure Assessment of the organizational structure would indicate the adequacy of the same in relation to the size of the company and also give an insight on the levels of authority and extent of its delegation to lower levels in the organization. The extent to which the current organisational structure is attuned to management strategy is assessed Creditfully. 4.5 Control systems Adequacy of the internal control systems to the size of business is closely examined. Existence of proper accounting records and control systems adds credence to the accounting numbers. Management information systems commensurate with the size and nature of business enables the management to stay tuned to the current business environment and take judicious decisions. 4.6 Personnel policies Personnel policies laid down by the company would critically determine its ability to attract and retain human resources. Incidence of labour strikes/unrest, attrition rates etc., are seen in perspective of nature of business and relative importance of humancapital. The rating process is ultimately an assessment of the fundamentals and the probabilities of change in the fundamentals. Rating determination is a matter of experienced and holistic judgement, based on the relevant quantitative and qualitative factors affecting the credit quality of the issuer.

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