Credit Rating Process

Process of Credit Rating

Credit rating process is the process in which a credit rating agency (preferably third party) takes details of a bond, stock, security or a company and analyses it so as to rate them so that everyone else can use those ratings to use them as investments.

In other words, it is an assessment of the borrower’s ability to repay his or her financial obligations and the creditworthiness of an individual, organization, etc. can be evaluated by taking various factors into due consideration that represents the willingness and capability of a borrower to timely discharge his/her financial commitment.

Explanation

There are only two ways in which any company would fund its business – equity or debt. The equity portion of the capital structure could be derived broadly from three sources: Promoters investing in the business, Company’s internal cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more accruing over the years to equity, or IPO (Initial Public Offering)/FPO (Follow-on-public offering) for which a company taps different financial markets.

Out of the three, only the last step of the equity source i.e., IPO/FPO, requires the attention of large banks and broker houses, who capture the equity valuation of the company and drive the process. On the other hand, any form of debt issuance demands validation from a credit rating process. Of course, debt is cheaper than equity, companies quite frequently and on an ongoing basis, issue debt (and repay the same eventually), which means the credit rating process of a company plays a major role in its debt raising capacity.

Why Companies Opt for Credit Rating?

Let us assume that Teva Pharmaceuticals Industries Ltd (or “Teva”), an Israel based world’s leading generics pharma company plans to set up a manufacturing unit in the US to manufacture its drugs for the US market. To fund this capital expenditure, suppose Teva plans to issue a bond in the US market or a bank loan from Morgan Stanley. Of course, the creditors would like to evaluate Teva’s ability to repay its debt (also called as the creditworthiness of the company). In such a scenario, Teva may ask a credit rating agency, say Moody’s, to assign them a credit rating, so as to enable them to raise debt. A non-rated company (bringing in fear of the unknown for the creditors) would, on the other hand, face issues in raising debt compared to a company rated by an external credit rating agency. The credit rating of a company helps the creditors to price the debt instrument for the company with reference to the amount of credit risk that the creditors would be taking.

Below is one of the samples of Moody’s rating assigned to Teva

credit-rating-process-moodys-teva

source: Moody’s

Significance of Credit Rating

Now let us understand what the credit rating signifies.

A credit rating determines the probability of the company paying back its financial indebtedness within the stipulated time. The ratings could be assigned to a particular company, or could also be issue specific.

Below is the chart illustrating the credit rating scale from the global credit rating agencies – S&P, Moody’s, and Fitch. To be noted that Indian rating agencies ICRA, Crisil, and India rating and research are Indian subsidiaries of Moody’s, S&P, and Fitch, respectively. The long term ratings are usually assigned to a company, while the short term ratings are essentially for specific loans or debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more.

credit-rating-significance-and-process

Credit Rating Process: Teva’s Example

Coming back to Teva, who approached Moody’s to assess its credit rating. With the receipt of this request, Moody’s assigns a credit rating (typically through a couple of weeks long process) to Teva. Let us think about some of the factors that Moody’s would look at for assigning a credit rating to Teva.

Moody’s industry expert analysts would perform the credit rating process, a detailed analysis of Teva broadly based on the following factors:

  1. Business Profile
  2. Operating Segment and Industry Standing
  3. Business RiskBusiness RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.read more
  4. Historical Performance Analysis
  5. Scale and margins compared to its peers:
  6. Revenue and margin drivers in the past, and their sustainability:
  7. Cash flow generation capability:
  8. Balance sheet analysisBalance Sheet AnalysisBalance sheet analysis interprets the company's assets, liabilities and owner's capital in a certain period. It provides an accurate picture of the organization's financial health and position to the investors, shareholders and institutions.read more and liquidity profile:
  9. Financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more and peer analysis:
Credit Rating Process

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For eg:
Source: Credit Rating Process (wallstreetmojo.com)

#1 – Business profile

The very first thing that the analyst would do is to understand Teva’s business profile, its competition, core products, number of employees, facilities, clients, etc.

#2 – Operating segments and industry standing

  • Teva operates in two broad segments comprising: 1) a portfolio of generic drugs (i.e., copycats of drugs of which patents have already expired), as well as a 2,) modest product pipeline of originator drugs (which have live patents).
  • Moody’s would analyze each of its operating segments and their respective market positions. Teva has a strong generics product pipeline, which derives most of its revenues from the US and Europe, and has leading positions in these developed markets, which are already encouraging the growth of generics.
  • The Obamacare act in the US, which increases the insurance coverage of the US citizens, would really like to focus on reducing their healthcare costs, while the European markets would aim to reduce healthcare costs too (owing to the ongoing difficult macroeconomic conditions) by increasing usage of generics.
  • Hence, we believe that overall, Moody’s would view Teva’s generics segment quite favorably.
  • On the other hand, the branded segment is subject to competition from generics (post the patent expiries of its drugs). In fact, Teva’s sclerosis (a disease pertaining to hardening of tissues) therapy drug Copaxone, which represents ~20% of its revenues, is facing the same risk!
  • Copaxone’s one version of the drug has already expired, which means that cheaper generic drugs of the same brand could be launched in the markets, thus impacting Copaxone’s market position significantly.

#3 – Business risks

  • Moody’s would look at each of its product segments and also see the kind of future portfolio (characterized by the type of their R&D expenses) that Teva plans to launch in order to cover the loss in sales from the expiring drugs in the branded portfolio.
  • Further, Moody’s pharma industry expert would analyze all the industry-specific factors such as litigations in which Teva is involved and their materiality in terms of probable financial impact, and regulatory risks in terms of US FDA inspections of its facilities (to be noted that US FDA demands the highest quality of manufacturing practices for the pharma companies selling their products in the US).
  • Additionally, concentration risks related to a particular product (where difficulties in one product could impact the company financially), a particular supplier (where a supply issue could impact its sales), and particular geography (where geopolitical issues could arise) would need to be analyzed separately on a company and industry-specific basis.

#4 – Historical financial performance

In this, an analyst would go about analyzing the historical performance of the company—calculating Margins, Cash Cycles, growth rates of revenue, Balance Sheet Strength, etc.

#5 – Scale and margins compared to its peers:

#6 – Revenue and margin drivers in the past, and their sustainability:

  • As mentioned earlier, Copaxone’s patent expiry would significantly drive the revenues and margins down for the company in the coming years, and Moody’s would need to analyze how the company’s future product pipeline would cover the loss.
  • However, we note that Moody’s would nevertheless derive comfort from its leading position in the generics segment.

#7 – Cash flow generation capability:

#8 – Balance sheet analysisBalance Sheet AnalysisBalance sheet analysis interprets the company's assets, liabilities and owner's capital in a certain period. It provides an accurate picture of the organization's financial health and position to the investors, shareholders and institutions.read more and liquidity profile:

#9 – Financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more and peer analysis:

Credit Rating of Teva

Moody would assess the credit rating process, its profile, and, subsequently, the ratings of Teva with respect to different weights assigned to different parameters, as described above (both financial and business). Of course, if the need arises, Moody’s could also visit Teva’s manufacturing facilities and meet with the management to perform its due diligence (to evaluate Teva’s actual commercial potential). For issue-specific ratings, Moody’s would also analyze the quality of collateral provided by the Company for a particular instrument.

We note that the rating that Moody’s came up with Teva’s inherent profile was A3 as of Apr 2015.

However, we note that Moody’s downgraded Teva by one notch to Baa1 in Jul 2015 and another notch to Baa2 in Jul 2016.

Let us see what drove Moody’s to downgrade Teva by two notches within a year.

Conflict of Interest Between Rating Agencies and Companies

You may wonder if there exists a conflict of interest between rating agencies and the companies paying them for the ratings.

It may seem so, given that Teva is actually a source of revenue from Moody’s. After all, rating agencies actually earn only from companies which they so closely and critically evaluate!

However, for a rating agency, their credibility is of utmost importance.

If Moody’s would not have downgraded Teva based on the significant increase in debt post the acquisition of the generics business of Allergan, it would have lost the trust from the creditors and would not have valued Moody’s opinion going forward.

Once the credit rating agencies are subscribed to by the companies, they need to periodically monitor the company’s ratings based on new developments in the company (like seen in the above case with Teva’s announcement of acquisition), as well as any updates related to the industry (in Teva’s case pharma), regulatory changes, and peers.

Conclusion

In conclusion, creditors rely heavily on the credit rating agencies for lending at a particular price for the risk-reward ratioRisk-reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process.read more. Hence, the rating agencies need to ensure fairness of opinion, a hawk-eyed approach for probable developments in the future, as well as unbiased credit ratings for a company they are evaluating. In various cases of corporate lending, the banks themselves conduct credit analysisCredit AnalysisCredit analysis is the process of drawing conclusions about an entity's creditworthiness based on available data (both quantitative and qualitative) and making recommendations about perceived needs and risks. Credit analysis also involves identifying, assessing, and mitigating risks associated with an entity's failure to meet financial commitments.read more, as they may not want to rely on external credit agencies and rather form their own view on the credit of a company. However, as seen in the recent cases of increasing NPAs (non-performing assetsNon-performing AssetsNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days.read more) coming to light in India, banks need to be all the more cautious while lending to corporate.

Reader Interactions

Comments

  1. Govind Kumar says

    Can U post any related stuff regarding Asset backed securities and its valuation

    • Dheeraj Vaidya says

      Hi Govind, please checkout this article . However, valuations is not covered here.

      thanks,
      Dheeraj

  2. Gautam Mohan says

    Thanks Dheeraj. Good piece on the credit rating process. Keep this going………

  3. Alex says

    so good to learn.

    Thanks for sharing

  4. S.Sridhar says

    Very good and informative article.Like to receive more such articles.

  5. Kalpesh Chouhan says

    Great Article…Provide good Insight about How the credit rating Agencies grades and there importance in eyes of creditors.

  6. khushhal gupta says

    Good case study to understand how the credit rating assigned to company.

  7. samuel mbuthia says

    A very informative article.
    Kindly is it possible to prepare a sample model for credit rating analysis?
    It could be of great help.

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