VIVEK SINGH B.COM (H) ROLL – 263 SEMESTER - VI RESEARCH GUIDE-PROF.S.SAHA ACCOUNTING & FINANCE DEPARTMENT OF COMMERCE ST.XAVIERS COLLEGE, KOLKATA. 2006 - 2009
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Sometimes words fall short to show gratitude, the same happened with me duri during ng this this proj projec ect. t. The The imme immens nse e help help and and supp suppor ortt rece receiv ived ed from from my institution overwhelmed me during the project. The content and accuracy of this project are the responsibility of the various books used and information available on the net. I am extrem extremely ely grate grateful ful to my facult faculty y guid guide e Dr.S. Dr.S.Sh Shah ah,, Depar Departme tment nt of Commerce, St.Xaviers College, Kolkata who have shared his expertise and knowledge with me and without whom the completion of this project would have been virtually impossible. My sincere sincere gratitude gratitude to all who provide provided d me with the necessary necessary infor informa matio tion n with with valua valuable ble sugge suggesti stion on and and comm comment ents s on bring bringin ing g out out this this report in the best possible way. I also very thankful to my friends who helped me in completion of the project. I am thankful to that power that always inspires me to take right step in the journey of success in my life.
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Sometimes words fall short to show gratitude, the same happened with me duri during ng this this proj projec ect. t. The The imme immens nse e help help and and supp suppor ortt rece receiv ived ed from from my institution overwhelmed me during the project. The content and accuracy of this project are the responsibility of the various books used and information available on the net. I am extrem extremely ely grate grateful ful to my facult faculty y guid guide e Dr.S. Dr.S.Sh Shah ah,, Depar Departme tment nt of Commerce, St.Xaviers College, Kolkata who have shared his expertise and knowledge with me and without whom the completion of this project would have been virtually impossible. My sincere sincere gratitude gratitude to all who provide provided d me with the necessary necessary infor informa matio tion n with with valua valuable ble sugge suggesti stion on and and comm comment ents s on bring bringin ing g out out this this report in the best possible way. I also very thankful to my friends who helped me in completion of the project. I am thankful to that power that always inspires me to take right step in the journey of success in my life.
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The research presented here describes the study of Credit Rating of a firm by Credit Rating Information Information Services of India Ltd. (CRISIL). Credit rating of a firm is a very important issue in the field of finance. The use of credit ratings originated in the U.S. during the 19th-century but they are now spreading arou around nd the globe. globe.
This This paper paper also examine examines s how how the finan financia ciall risk risk of a
company affect credit ratings and to what extent credit ratings directly affect the capital structure decisions of a firm. This research will provide the fundamental understanding of the credit risk analysis process and various aspects of financial statement analysis analysis to help in managing better credit-related issues. This study is not meant to take decisions for the prospective investors and to make make subseq subseque uent nt inve investm stment ents. s. The The resea researc rch h is only only a study study and and not not the the guidelines to make necessary investments.
TABLE OF CONTENTS
CHAPTER I.............................................................................................6 1. INTRODUCTION OF THE STUDY......................................................... ...........6 ........ ...6 1.1 BRIEF IDEA OF THE STUDY.......................... STUDY........................................ ............................ ............................. ............................. .......................6 .........6 1.2 RESEARCH PROBLEMS.................. PROBLEMS................................. ............................. ............................ ............................. .....................................7 ......................7 1.3 LITERATURE REVIEW................ REVIEW............................... ............................. ............................ ............................. ............................. ..........................8 ............8 1.4 OBJECTIVE OF THE STUDY......................... STUDY........................................ ............................. ................................................. ................................... ...8 1.5 METHODOLOGY.............. METHODOLOGY............................ ............................ ............................. ............................. ...................................................8 .....................................8 SCHEME OF WORK ........................... .......................................... ............................. ............................ ............................. ............................. ........................9 ..........9 1.8 LIMITATIONS OF THE STUDY.......................... STUDY........................................ ............................ ............................. ................................ ................. ...9
CHAPTER II............................................................................................9 Page 3 of 37
2. THEORETICAL ASPECTS OF THE STUDY.......................................................10 2.1. Evolution of Credit Ratings...................................................................................... ..10 2.2. Meaning of Credit Ratings.........................................................................................11 2.3. Credit Information.....................................................................................................12
Information commonly used to assess the creditworthiness of a firm includes the following:..................................12 2.4. Five C’s of Credit.......................................................................................................13 2.6 Overview of CRISIL................................................................................................... ..17 2.6.1 CRISIL Ratings .....................................................................................................18 2.6.3 CRISIL Approach...................................................................................................19 2.6.4 CRISIL Rating Process..............................................................................................20 2.6.5.1 Interpretation & Evaluation............................................................................22 2.6.6 CRISIL Rating Scale..............................................................................................22 2.6.7 Long Term Rating Scale.......................................................................................23 2.6.7.1 Investment Grade Ratings.............................................................................23 2.6.7.2 Speculative Grade Ratings.............................................................................23 2.6.8. Short Term Rating Scale......................................................................................24 2.6.10 Time Frame for Credit Rating.............................................................................25 2.6.11 Recommendations to the Investors....................................................................26 2.7 Capital Structure and its Sources.......................................................................... .....26 .........................................................................................................................................26 2.8 Financial Leverage......................................................................................................27
CHAPTER III..........................................................................................28 3. COLLECTION OF DATA & DATA PRESENTATION............................................28 3.1 Primary Data..............................................................................................................28 3.2 Secondary Data..........................................................................................................28 3.3 Data Presentation: Tabulation....................................................................................29 ANNEXURE 1.................................................................................................................29 3.4 Data Analysis & Interpretation....................................................................................31 3.4.1 Effect of Financial Leverage on Credit Rating ......................................................31
CHAPTER VI..........................................................................................33 4. DATA ANALYSIS.........................................................................................33 4.1 By Using Statistical Tools............................................................................................33 4.2 By using computer assistance....................................................................................33
CHAPTER V...........................................................................................34 5. Summary .................................................................................................34 5.1 Findings .....................................................................................................................34 5.2 Final Conclusion..........................................................................................................35 5.3 Areas of Further Research..........................................................................................35 REFERENCE & BIBLIOGRAPHY.........................................................................36
Figure 1...............................................................................................29 Figure 2...............................................................................................30 Figure 3...............................................................................................30
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CHART 1..............................................................................................31
List of Abbreviations 1. SEBI – Securities & Exchange Board of India 2. CRISIL- Credit Rating Information Services of India Ltd. 3. ICRA - Investment Information and Credit Rating Agency of India Limited
4. CARE: - Credit analysis and Research Limited 5. ICSI - Institute of Companies Secretary of India. 6. CR- Credit Ratings 7. FL – Financial Leverage. 8. APP – Approximated figure. 9. F.Y – Financial Year 10.PBIT- Profit Before Interest & Text 11.PBT – Profit Before Tax 12.Contd - continued
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CHAPTER I 1. INTRODUCTION OF THE STUDY 1.1 BRIEF IDEA OF OF THE STUDY Credit Ratings are a symbolic indication of the current opinion regarding the relative capability of a corporate entity to service its debt obligations in time with reference to the instrument being rated. Credit ratings are judgments about firms financial and business prospects. Credit rating is defined ‘as a process by which a statistical service prepares various ratings identified by symbols which are indicators of the investment quality of the credit rated’. The credit may be a debt instrument or equity. In case of debt, ratings are given while in the case of shares grading is done. It is an independent assessment of the creditworthiness of a bond (note or any security of any indebtness) by a credit rating agency. It measures the probability of the timely repayment of principal and interest of a bond. Generally, a higher credit rating would lead to a more favorable effect on the marketability of a bond. The credit rating symbols (long term) are Page 6 of 37
generally assigned with “triple A” as the highest and “triple B” as the lowest in investment grade. Anything below “triple B” is commonly known as a ‘junk bond’. With the help of credit ratings, the lenders can evaluate the potential risk posed by lending money to companies and to mitigate losses due to bad debt. Since, credit rating acts to extend loans from financial institutions, companies will strive to maintain and improve their ratings. Credit rating agencies play a key role in financial markets by helping to reduce the informative asymmetry between lenders, on one side, and borrowers on the other side, about the creditworthiness of a firm. Rating is usually assigned to a specific instrument rather than the company as a whole. In the Indian context, the rating is done at the instance of the issuer, which pays rating fees for this service. If it is unsatisfied with the rating assigned to its proposed instrument, it is at liberty not to disclose the rating given to it.
1.2 RESEARCH PROBLEMS
To present the whole Overview of the Project in a summarized form is quite a difficult task, but in spite of it, sincere efforts has been put to present the whole thing in a brief manner. The debt instrument companies often do not provide the ratings of their creditworthiness obtained from the agencies in the websites. So there arrived a difficulty in analyzing and critically examine the worthiness of the companies to that extent.
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The study more or less comes under the securities market line incorporated with securities laws and compliances issued under the SEBI guidelines. So the workings required expert knowledge in the field of regulatory framework concerning Capital Market of India. Thus due to small time frame the detailed knowledge to that effect was quite impossible. Again there were lack of sufficient articles and journals regarding the research. Despite all the problems it was tried to overcome the same as maximum as it was possible.
1.3 LITERATURE REVIEW The study presented here is brought up with the help of some well known literatures. Some of them were India credit rating is raised by S&P, By Justin Huggler, The State of Credit Rating in India; Ragunathan V Varma & Jayant R. S&P downgrades Tata Motors’ credit rating By Joe Leahy in Mumbai.
1.4 OBJECTIVE OF THE STUDY The objective of this research is to provide the understanding of how credit rating helps the INVESTORS in making the risk and return analysis and thereby helping the company to grow and maintain its success. The study also aims to represent the overall effect of financial leverage of a company on its credit ratings in the market.
1.5 METHODOLOGY The study is accompanied with simple data gathered from various books. The data are very relevant to the study which are lucidly explained with the help of some tables and chart. Since the time frame was small and due to lack of resources available the primary data could not be collected. The study is Page 8 of 37
solely based on secondary data like internet, books, journals, magazines and various articles. In addition to this, quantitative research is used to analyze the data.
SCHEME OF WORK The work is divided into 5 chapters.
1.8 LIMITATIONS OF THE STUDY The procedures and knowledge on credit ratings was limited only to one rating agency, CRISIL. The rating processes, criteria and functioning of other rating agencies like ICRA, CARE and Fitch Ratings India Private Limited were not considered. The research is limited to the secondary data only. Primary data could not be incorporated due to time constraint. Lastly, credit ratings are on the verge of rapid growth worldwide. The rating agencies are looking for fresh ways to drive
growth,
such as
introducing
ratings
for
hospitals,
educational
institutions, builders, state governments and even film projects. So these aspects could not be taken into consideration due to the time limitation and word limitation. Again further research on other case studies could not be carried out due to the time factor.
CHAPTER II Page 9 of 37
2. THEORETICAL ASPECTS OF THE STUDY
2.1. Evolution of Credit Ratings The concept of Credit Rating originated in the United States. The first Credit Ratings were published by John Moody during 1909 in his analysis or rail road investments. This evolved into the rating company, Moody’s Investors Services Inc, a division of Dun and Bradstreet Inc. Moody was followed by Poor’s publishing Company in 1916 and the Standard Statistics Company in 1922, which merged, into Poor to become the largest bond rating concern, Standard and Poor’s corporation, a subsidiary of Mc Graw Hill, Inc. The third is Fitch publishing company of New York, which was established in 1924. The fourth agency is Duff & Phelps of Chicago, which was recognized by Securities and Exchange Commission in 1982. It acquired Crisanti and Maffei Inc. of New York in 1991. These four security rating agencies are the only ones with Securities and Exchange Commission recognition as national bond rating agencies. There are other services that rate securities especially stock, like Value Line Investment Survey. The recognition of rating agency by Securities and Exchange Commission in U.S.A does not constitute approval. Actually, such recognition is not necessary to enter the security rating business. SEC uses the ratings of recognized agencies for evaluation of bong assets of brokers and dealers registered with it. In India there are 4 credit rating agencies. First, Credit Rating Information Services of India Limited (CRISIL) set up by ICICI AND UTI in 1988. Secondly Investment Information and Credit Rating Agency of India limited (ICRA) set up by IFCI in 1991. Thirdly, Credit Analysis and Research Limited (CARE) Page 10 of
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promoted by IDBI in 1993 in association with financial institutions. Fourthly, Duff and Phelps Credit Rating India Private Limited (DCR India) for rating nonbanking financial companies for fixed deposits.
2.2. Meaning of Credit Ratings "Credit rating agency" is a commercial concern engaged in the business of credit rating of any debt obligation or of any project or program requiring finance, whether in the form of debt or otherwise, and includes credit rating of any financial obligation, instrument or security, which has the purpose of providing a potential investor or any other person any information pertaining to the relative safety to timely payment of interest or principal. 1 Credit ratings are judgments about firms financial and business prospects. Credit rating is defined ‘…as a process by which a statistical service prepares various ratings identified by symbols which are indicators of the investment quality of the credit rated’. The credit may be a debt instrument or equity. In case of debt, ratings are given while in the case of shares grading is done. It is an independent assessment of the creditworthiness of a bond (note or any security of any indebtness) by a credit rating agency. It measures the probability of the timely repayment of principal and interest of a bond. Generally, a higher credit rating would lead to a more favorable effect on the marketability of a bond. The credit rating symbols (long term) are generally assigned with “triple A” as the highest and “triple B” as the lowest in investment grade. Anything below “triple B” is commonly known as a ‘junk bond’. CR is the process of assigning standard scores which summarize the probability of the issuer being able to meet its repayment obligations for a particular debt instrument in a timely manner. Credit rating is integral to debt 1
Ministryoffinance,GOI
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markets as it helps market participants to arrive at quick estimates and opinions about various instruments. In this manner it facilitates trading in debt and money market instruments especially in instruments other than Government of India Securities. Credit rating is not a recommendation to buy, hold or sell. Rating is usually assigned to a specific instrument rather than the company as a whole. In the Indian context, the rating is done at the instance of the issuer, which pays rating fees for this service. If it is unsatisfied with the rating assigned to its proposed instrument, it is at liberty not to disclose the rating given to it. There are 4 rating agencies in India. These are as follows: CR is a dynamic concept and all the rating companies are constantly reviewing the companies rated by them with a view to changing (either upgrading or downgrading) the rating. They also have a system whereby they keep ratings for particular companies on "rating watch" in case of major events, which may lead to change in rating in the near future. Ratings are made public through periodic newsletters issued by rating companies, which also elucidate briefly the rationale for particular ratings. In addition, they issue press releases to all major newspapers and wire services about rating events on a regular basis.
2.3. Credit Information Information commonly used to assess the creditworthiness of a firm includes the following:
Credit Reports: Many organizations sell information on the credit
strength of business firms. The best-known and largest firm of this type is Dun & Bradstreet, which provides subscribers with a credit-reference book and credit reports on individual firms.
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Financial
Statements: Financial
statements contain a wealth of
information. A searching analysis of the firm’s financial statements can provide useful insights into the creditworthiness of the firm.
The firm’s payment history: The most obvious way to obtain an
estimate of a firm’s probability on nonpayment is whether it has paid previous bills or not. A study of the promptness of past payments is very useful.
Bank References: The bankers of the firm may be another source of
information. To ensure a higher degree of candour, the firm’s banker may be approached indirectly through the bank granting credit.
2
2.4. Five C’s of Credit A credit rating assesses the creditworthiness of a firm in terms of the “five C’s of credit”.
Character: It refers to the firm’s willingness to honour its obligations. The
credit manager should judge whether the firm will make honest efforts to honour its credit obligation.
Condition: It refers to the prevailing economic and other conditions which
may affect the firm’s ability to pay. Adverse economic conditions can affect the ability or willingness of the firm to pay.
Capacity: It refers to the firm’s ablity to meet credit obligations. The
ability to pay can be judged by assessing the firm’s capital and assets which it may offer as security. Capacity is evaluated by the financial position of the firm.
Capital: It is the financial reserves of the firm. If the firm has problems in
meeting credit obligations from operating cash flow, the focus shifts to its capital.
2
Corporatefinance,WesterfieldRoss&Jaffe
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Collateral: It refers to the security offered by the firm in the form of
pledged assets.3
2.5 Utility of Ratings
2.5.1 INVESTORS PROTECTION
The main purpose of credit rating is to communicate to the investors the relative ranking of the default loss probability for a given fixed income investment, in comparison with other related instruments.4 Investors have always received credit ratings with enthusiasm. But issuers do not share the enthusiasm since they have to share their securities at higher yields if their issue gets inferior rating. Credit rating gives an investor a simple and easy indicator to the credit quality of the debt instrument, the risks and likely returns, thus providing a yardstick against which the risk inherent in an instrument can be measured. An investor uses the rating to assess the risk level and compares the offered rate of return, which is expected rate of return (for the given level of risk) to optimize his risk return trade- off. Ratings also provide a comparative framework, which allows the investor to compare investment opportunities. The advantages of credit rating data for investors are obvious:
Savings in research costs.
Ratings represent the informed opinion of a neutral third party.
Certainty about the financial strength of the issuer.
Identification of the risk involved in the debt instrument.
3 4
FinancialManagement,Pandey.I.M financialManagement,ChandraPrasanna securitieslaws&compliances,ICSI
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Guidance in making an investment decision by being presented with a wide variety of safe choices.
Constant monitoring and surveillance by the agency on the debt instrument leading to effective risk management strategies. 5 Spending too much on credit risk research
diminishes the return on investment. In addition, unlike underwriters and main banks, credit rating agencies are valued for their neutral viewpoint and expertise in credit risk analysis. For these reasons, investors rely heavily on credit rating data. Credit rating also benefits the issuer. If a public offer is contemplated, the financial manager must bear in mind the rating while determining the appropriate leverage. Additional debt may lower the rating from an investment to a speculative grade category, thus rendering the security ineligible for investment by many institutional investors. It may well be that the advantages of debt outweigh the disadvantages of the lower credit rating. Junk bonds, for instance, are a high risk and a high yield (16 to 25% in USA) instruments. Investment may be limited in such instrument to what an investor can afford to lose. Ratings will also affect the pricing of the issue. Actually pricing should reflect the rating. The marketability of a relatively unknown issuer who is competent is enhanced and the role of name recognition in an investment decision is minimized. In actual practice ratings are reflected in prices. There is no difference between the interest rates that are paid on the fixed deposits of two companies even if they are rated differently. Same is true of long dated debentures. But in commercial paper market where banks are major players’ differentials in ratings are reflected in pricing. A reliance CP would be cheaper than of a company, which is not rated well.
5
Legalpundits.com
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Ratings are used by brokers for opinions and as a service for their customers. Insurance companies and mutual funds use them in the purchase of securities even though their own staff prepares investment analysis. Portfolio managers also use them in security management. Banks depend on them for their investment in commercial paper. Individual investors depend on them for their decisions to place fixed deposits. Ratings are bound to assume greater importance with the institutionalization of investors in the form of unit trusts, mutual funds, pension and provident funds. The debt has shown considerable buoyancy in 1996 not only at the wholesale level (institutional investors) but also at retail level in view of poor offerings of equity in the primary market. This has come about largely on account of the availability of ratings on debt instruments, which boosted investor confidence.
2.5.2 SEBI Regulations for Credit Rating Agencies
SEBI issued regulations for credit rating agencies in 1999. These regulations are called as Securities and Exchange board of India. (Credit Rating Agencies) Regulations, 1999.
Only commercial banks, public financial institutions, foreign banks
operating in India, foreign credit rating agencies, and companies with a minimum net worth of Rs 100 crore as per its audited annual accounts for the previous five years are eligible to promote rating agencies in India.
Rating agencies are required to have a minimum net worth of Rs 5
crore.
Rating agencies cannot assess financial instruments of their promoters
who have 10 % stake in them.
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Rating agencies cannot rate a security issued by an entity, which is (a) a
borrower of its promoter. (b) a subsidiary of its promoter. (c) An associate of its promoter, if (i) there is common chairman, directors between credit rating agency and these entities (ii) there are common employees (iii) there are common chairman, directors, and employees on the rating committee.
Rating agencies cannot rate a security issued by its associated or
subsidiary, if the credit rating agency or its rating committee has a chairman, director or employee, who is also a chairman, director or employee of any such entity.
A penalty of suspension of the certificate of registration or a penalty of
cancellation of registration may be imposed on the rating agency if it fails to comply with the condition or contravenes any of the provisions of the Act. 6
2.6 Overview of CRISIL
7
CRISIL is India's leading Ratings, Research, Risk and Policy Advisory Company. At the core of CRISIL are its unimpeachable credibility and unmatched
analytical
rigor.
CRISIL
offers
domestic
and
international
customers a unique combination of local insights and global perspectives, delivering independent information, opinions and solutions that help them make better-informed business decisions and improve the efficiency of markets and market participants and help shape infrastructure policy and projects. 6
www. Sebi.gov.in
7
www.crisilonline.com/images
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CRISIL's majority shareholder is Standard & Poor's, the world's foremost provider of independent credit ratings, indices, risk evaluation, investment research and data. CRISIL's association with Standard & Poor's, a division of The McGraw-Hill Companies, dates back to 1996 when both companies started working together on rating methodologies and joint projects. 8
2.6.1 CRISIL Ratings A CRISIL rating is CRISIL's opinion on the relative degree of risk associated with timely payment of interest and repayment of principal on a specified bank facility. CRISIL assigns rating on the long-term and short-term rating scales. Ratings can be used by banks to determine risk weights for their loan exposures, in keeping with the Reserve Bank of India's (RBI's) April 2007 Guidelines for Implementation of the New Capital Adequacy Framework. The new framework mandates that the amount of capital provided by a bank against any loan and facility will be based on the credit rating assigned to the loan issue by an external rating agency. This means that a loan and a facility with a higher credit will attract a lower risk weight than one with a lower credit rating.
9
2.6.2. Benefits of CRISIL Ratings
For Bank: The new guidelines from RBI create an incentive for banks to
use ratings, by giving significant relief in the capital that banks must hold against their corporate loan exposures. The highest relief of 80 per cent is available for 'AAA' and 'P1+' rated exposures, but there is substantial 8
www.crisil.com/about-crisil.html www.iloveindia.com/finance/encyclopedia/crisil.html
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crisilrating,journal
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relief for exposures that are rated below the highest category as well. For instance, both 'A' category-rated long-term loans and 'P2' category-rated short-term facilities provide 50 per cent relief. Ratings will also be a key input for appropriate pricing of credit risk by banks. For Borrowers: A CRISIL’s rating will help borrowers obtain more precise
risk-based pricing on bank loans. Borrowers may also benefit when the capital savings that the banks enjoy are reflected in loan pricing. In the long run, as many lower rated borrowers obtain ratings, and the market understands the risk associated with such lower ratings, access to markets for lower rated corporate is likely to improve significantly. For the Debt Market: Ratings will help develop a secondary market for
loans, and will provide a uniform scale for analyzing credit risk of bank loans.
10
2.6.3 CRISIL Approach CRISIL’s framework for assessing credit quality covers the four broad areas of business risk, financial risk, management risk and project risk.
o
Business risk analysis covers the business fundamentals of the rated company, the characteristics of the industry in which it operates, its competitive market position in the industry and operational efficiencies.
o
Financial risk analysis includes an assessment of the company’s past financial performance, its future performance and its financial flexibility with particular emphasis on its balance sheet.
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http://www.crisil.com/credit-ratings-risk-assessment/bank-loan-ratings.jsp
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o
An evaluation of the company’s management, its philosophies, strategies and risk appetite is undertaken in assessing management risk.
o
If the company is implementing any large project, the risks associated with the project’s implementation, its funding and marketing risks are also evaluated.
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2.6.4 CRISIL Rating Process CRISIL employs a multi-layered decision making process in assigning a rating. It has structured its rating processes as well as its rating committee to ensure that all assigned ratings are based on the highest standards of independence and analytical rigor. CRISIL strongly believes that the interest of investors is best served if open dialogue is maintained with the issuer. Engaging the issuer in a direct dialogue not only enables it to incorporate non-public information in a rating report, but also makes it forward looking. CRISIL's analysis on each credit is carried out by a team of at least two analysts who interact with the company’s management. The analysis is based on information obtained from the issuer, and on an understanding of the business environment in which the issuer operates and it is carried out within the framework of clearly spelt-out rating criteria. The analysis is then presented to a rating committee comprising members who have the professional competence to meaningfully assess the credit, and have no interest in the entity being rated. The rating committee determines the rating to be assigned.
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11
Journal, ‘Ratings Methodology for Manufacturing Firms ’ book, Corporate Finance by Vishwanath S.R. and the site, http://www.crisil.com/creditratings-risk-assessment/rating-process.htm 12
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2.6.5 DIAGRAMATIC VIEW ON THE PROCESS
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13
www.crisil.com
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2.6.5.1 Interpretation & Evaluation Specific process safeguards that ensure independence from organizational bias include:
∗
Multi-member rating teams
∗
Multi-tier rating process
∗
All
rating
decisions
taken
by
a
rating
committee
comprising
experienced, competent and reputed professionals ∗
Organization-wide internal transparency, with each stage of the rating process for all ratings, including the final rating committee's discussions - being open to all analytical staff in CRISIL's rating division
∗
Rating methodologies and criteria that are clearly spelt out and published, and are consistently applied.
After the rating has been assigned, CRISIL continues to monitor the performance of the issuer, and the economic environment in which the issuer operates. This surveillance ensures that the analysts are aware of current developments, so that they can review sensitive areas and learn about changes in an issuer's plans. All ratings are under continuous surveillance. Moreover, CRISIL has a policy of conducting detailed management meetings with each issuer at least once a year. These meetings essentially focus on developments over the period since the last meeting, and the outlook for the coming year.
2.6.6 CRISIL Rating Scale
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CRISIL ratings are assigned on a scale that is analogous to CRISIL's rating scale for long-term and short-term debt ratings. The scale ranges from 'AAA' to 'D' for a long-term rating (with maturity over 365 days), and from 'P1+' to 'P5' for a short-term rating (maturity of up to 365 days). 14
2.6.7 Long Term Rating Scale
2.6.7.1 Investment Grade Ratings
•
AAA (Triple A) - Highest Safety: Instruments rated ‘AAA’ are judged to
offer the highest degree of safety with regard to timely payment of financial obligations.
•
AA (Double A) - High Safety: Instruments rated 'AA' are judged to offer
a high degree of safety with regard to timely payment of financial obligations. They differ only marginally in safety from `AAA' issues.
•
A - Adequate Safety: Instruments rated 'A' are judged to offer an
adequate degree of safety with regard to timely payment of financial obligations.
•
BBB (Triple B) - Moderate Safety: Instruments rated 'BBB' are judged
to offer a moderate safety with regard to timely payment of financial obligations.
2.6.7.2 Speculative Grade Ratings
14
monthly journal on credit quality – Rating Scan
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•
BB (Double B) - Inadequate Safety: Instruments rated 'BB' are judged
to carry inadequate safety with regard to timely payment of financial obligations. They are less likely to default in the immediate future than other speculative grade instruments.
•
B - High Risk: Instruments rated 'B' are judged to have greater likelihood
of default; while currently financial obligations are met, adverse business or economic conditions would lead to lack of ability or willingness to pay interest or principal.
•
C - Substantial Risk: Instruments rated 'C' are judged to have factors
present that make them vulnerable to default; timely payment of financial obligations is possible only if favorable circumstances continue.
•
D - Default: Instruments rated 'D' are expected to default on scheduled
payment dates. Such instruments are extremely speculative and returns from these may be realized only on reorganization or liquidation. CRISIL may apply '+' (plus) or '-' (minus) signs for ratings from 'AA' to 'C' to reflect comparative standing within the category.
2.6.8. Short Term Rating Scale ∗
P1: This rating indicates that the degree of safety regarding timely
payment on the instrument is very strong. ∗
P2: This rating indicates that the degree of safety regarding timely
payment on the instrument is strong. However, the relative degree of safety is lower than that for instruments rated 'P-1'.
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∗
P3: This rating indicates that the degree of safety regarding timely
payment on the instrument is adequate.
∗
P4: This rating indicates that the degree of safety regarding timely
payment on the instrument is minimal and it is likely to be adversely affected by short-term adversity or less favourable conditions.
∗
P5: This rating indicates that the instrument is expected to be in default
on maturity or is in default. CRISIL may apply "+" (plus) sign for ratings from 'P-1' to 'P-3' to reflect a comparatively higher standing within the category .
2.6.9 Confidentiality of Credit Rating Exercise
CRISIL keeps information obtained for the rating exercise confidential, by enforcing appropriate process safeguards. For instance, all CRISIL employees are required to sign a confidentiality agreement. CRISIL does not disclose confidential information that it has obtained for the purpose of credit rating to anyone (other than to market regulators or law enforcement authorities).
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2.6.10 Time Frame for Credit Rating CRISIL deputes a two-member team to carry out the assignment and the team after having gone through the information submitted by the company, visits their office for meetings in connection with the credit assessment. The meetings take around 1 to 2 days with the involvement of functional, divisional and business heads. On completion of management meetings, the team prepares analytical note on the company that is discussed at the Rating
15
http://www.crisil.com/credit-ratings-risk-assessment/rating-process-confidentiality.htm
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Committee Meeting, and the committee assigns the final rating. Starting from meetings, CRISIL assign a rating in a period of around 2 weeks.
16
2.6.11 Recommendations to the Investors. By and large, the rating is a very good estimate of the actual creditworthiness of the company; however, it is not able to predict extreme situations such as the ones described above, which are unlikely to have been predicted by most investors in any case. Investors should realize that a credit rating is not sacrosanct and that one has to do one’s own due diligence and investigation before investing in any instrument. They should use the rating as a reference and a base point for their own effort. One good way of doing this is examining the behavior of the stock price in case the stock is listed. As a collective, the market is far smarter at predicting problems than any credit rating agency. Witness the sharp erosion in stock prices of companies much before their credit ratings were downgraded. Witness also the fact that foreign currency bonds from Indian issuer’s trade at yields lower than countries which have been rated higher by rating agencies.
2.7 Capital Structure and its Sources Capital structure means the type, composition and proportion of securities to be issued that make up the total capital of the firm. The two principal sources of finance for a business firm are equity and debt. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity financed and 80% debt financed. Credit ratings are a material consideration for managers in making capital structure decisions due to discrete costs (benefits) associated with different ratings levels. 16
sources of the Company, CRISIL
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2.8 Financial Leverage CRISIL’s framework for assessing credit quality covers various analysis like business risk analysis, financial risk analysis and project risk analysis. However, financial risk analysis is considered the most important for credit rating, as it provides insight into how a risky a company is. It is an assessment of the company’s past financial performance and its financial flexibility with particular emphasis on its balance sheet. The financial risk of a company can be measured by calculating its financial leverage. A company more heavily financed by debt poses greater risk. The financial leverage helps in determining the level of fixed financial charge or in other words the extent of debt financing. As the debt financing is relatively a cheaper source of finance, the financial leverage may suggest for more and more use of debt financing, but with every increase in debt financing, the financial risk, the risk of bankruptcy also increases. More over the risk perception in the eyes of the equity shareholders also tends to increase. Analysis of financial leverage is the most important tool in the hands of a finance manager who is engaged in framing the capital structure of the firm. Any firm can easily adopt an all equity capital structure and thus can avoid the financial risk. With financial leverage, the advantage arises from the possibility that funds borrowed at a fixed interest rate can be used for investment opportunities earning a rate of return higher than the interest paid. The opposite effect will apply if the company fails to earn higher returns.
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CHAPTER III 3. COLLECTION OF DATA & DATA PRESENTATION 3.1 Primary Data There is no use primary data’s in the form of interviews, surveys, questionnaires, etc.
3.2 Secondary Data The secondary data has been collected majorly through various books on financial management books and websites. Some of the magazines & journals Page 28 of
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were also brought into use .However there were very few journals & articles available on the study. Necessary steps were taken to incorporate the right data in a summarized form.
3.3 Data Presentation: Tabulation
ANNEXURE 1 Figure 1 CITY BEAUTIFUL TRAVELS Estimate of Revenues, Costs and PBIT
(Rupees in crores) Variable Fixed Cost
Financial
Revenue
Year
(1)
Costs
220.5 252.0 283.5 283.5 283.5
(2) 74.0 98.3 120.6 135.5 151.4
1 2 3 4 5
Total Cost
PBIT
(3)
(4)=(2)+(3
(5)=(1)-(4)
154.0 129.0 112.1 100.9 93.6
) 228.0 227.3 232.7 236.4 245.0
(7.5) 24.7 50.8 47.1 38.5
Figures in bracket shows negative balance 17
17
Source: Pandey, I. M., Bhat, Ramesh, “Cases in Financial Management”, Tata McGraw-Hill Publishing Company Ltd., 2003, Third Edition Reprint, pg-253
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Figure 2 CITY BEAUTIFUL TRAVELS Estimate of Interest tax and PAT
(Rupees in crores) Interest PBT
Financial
PBIT
Tax
PAT
Year
(2)
(3)
(4)=(2)–(3)
(5)
(6)=(4)-(5)
(1) 1
(7.5)
25.8
(33.3)
-
(33.3)
2
24.7
19.2
5.5
-
5.5
3
50.8
12.0
38.8
2.6
36.2
4
47.1
4.8
42.3
10.6
31.7
5
38.5
0.2
38.3
9.6
28.7
Figures in bracket shows negative balance 18
Annexure1 (contd) Figure 3
Financial year 1 2 3 4 5
CITY BEAUTIFUL TRAVELS COMPUTATION OF FINANCIAL LEVERAGE(FL) PBIT PBT FL ESTIMATED CRISIL Ratings SCALE -7.5 -33.3 24.7 5.5 4.49090909 B 1 50.8 38.8 1.30927835 BBB 1 47.1 42.3 1.11347517 AA 7 38.5 38.3 1.00522193 AAA 2
Figures in bracket shows negative balance
Note: Financial leverage = profit before interest & taxation/profit before taxation.
18
Source: Pandey, I. M., Bhat, Ramesh, “Cases in Financial Management”, Tata McGraw-Hill Publishing Company Ltd., 2003, Third Edition Reprint, pg-254
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CHART 1
CITY BEAUTIFUL TARVELS
YEARS FL – FINANCIAL LEVERAGE
3.4 Data Analysis & Interpretation 3.4.1 Effect of Financial Leverage on Credit Rating
Interpretation & Analysis of the Annexure 1 The effect of financial leverage on credit rating has been discussed by interpreting Figure 1, 2, and 3 in Annexure 1.
In the financial year 1, the financial leverage of the company cannot be determined. In that case, the financial stability of the company cannot be judged. Thereby the rating of the company is difficult to estimate.
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However in the year 2, the company has managed to derive revenues out of operational
sales.
The
financial
leverage
of
the
company
is
4.5
(approximated) which is very high compared to other years. Thus the company is not expecting a high rating in the year 2 because the financial risk is high. However, the financial leverage is expected to decrease to 1.31(app) in the financial year 3, because, the company has projected that their net revenue from the sales would rise from 252.0 crores to 283.5 crores in the financial year 4. This will lead to an increase of Rs 26.2 crores in EBIT. Apart from this, the interest payable is also expected to fall from 19.2 crores to 12 crores. Thus the risk of the defaults will decrease and hence the company has projected that their ratings would be upgraded in the F.Y 3. The company’s financial leverage is projected to decrease to 1.11 in the F.Y 4. The EBIT in the same year is expected to decrease from 50.8 crores to 47.1 crores but along with it the fixed charge i.e., the interest burden has slipped from 12.0 crores to 4.8 crores registering decrease in the fixed charges to the extent of 60 percent. On the other hand due to this effect the PBT has risen to the extent of 42.3 percent. The combined effect has lowered down the financial leverage of the 1.3 to 1.1. This is why; it has been projected by the company that they will be able to obtain a higher rating in F.Y 4 in comparison to F.Y 3. Furthermore, in the F.Y 5, the company is expecting that their financial leverage will fall from 1.1 in F.Y 4 to 1.00 (app) F.Y 5. This is because the EBIT & PBT has both declined to the extent of 18.1 percent (app) & 9.5 percent (app) respectively. The company still manages to meet the current year’s financial charge of 0.2 crores. It also indicates that the company is currently having no or very minimal capital from debt financing. This will help the company to further upgrade their ratings in F.Y 5. Therefore, it is evident from table 1 that the company has tried to minimize the capital raised from debt – financing to increase the creditability in the Page 32 of
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market. The significant fall in the financial leverage would enhance the creditworthiness of the company. This will help them to take more loans from the bank at a cheaper rate of interest and the goodwill of the company will also improve. As the F.Y has progressed Chart 1 has recorded a significant downfall in the financial leverage of the company. This has helped the company to enhance its ratings in the market. Again it should be noted that the ratings proposed above to the City Beautiful Travels in all the financial years is based on the assumption that no other factors are present. But in reality CRISIL considers many factors while calculating the ratings to a particular concern. The calculations for financial leverage have been done in fig 3 in Annexure 1.
CHAPTER VI 4. DATA ANALYSIS 4.1 By Using Statistical Tools There were no uses of any statistical tool analysis.
4.2 By using computer assistance The computation of the financial leverage of the company on the basis of different data available has been done through Microsoft Excel. No other computer assistance is used to determine and analyze the values.
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CHAPTER V 5. Summary 5.1 Findings Capital structure decisions are affected by the potential for both an upgrade as well as a downgrade in credit ratings. The rating of a company is inversely related to its financial leverage. The firms, if their ratings are expected to upgrade, can increase its debt capital by extending loans from banks and other financial institutions. However, if the ratings are expected to downgrade, then the debt capital of the firm will be reduced. Therefore it can be said that credit ratings directly affect the equity and debt financing decisions of a firm. Hence, credit ratings are a material consideration for managers in making capital structure decisions.
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5.2 Final Conclusion Ratings are opinions on credit worthiness based on objective and subjective analysis. Rating agencies play an important role in the world markets; they can best serve markets when they operate independently, adopt and enforce internal guidelines to avoid conflicts of interest and protect confidential information received from issuers. Credit rating agencies cannot afford to commit too many mistakes as it the investors who pays the price for their mistakes. Credit rating agencies should be made accountable for any faulty rating by panelizing them or even de-recognizing them, if needed. Since lending money has become more global and diverse, it is difficult for the lenders to determine which companies have a minimum risk of default and assure themselves of the continuous soundness of borrowers after a loan has been extended. The financial intermediaries such as banks turn to credit rating
agencies
to
provide
necessary
information
on
borrower’s
creditworthiness. Credit rating appraises the default risk which is a combination of business risk and financial risk. These agencies help lenders decide how risky it is to lend money to a certain company. In sum, credit ratings can help lenders pierce the fog of asymmetric information that surrounds lending relationships. Equivalently, credit ratings can help borrowers emerge from that same fog.
5.3 Areas of Further Research A CR agency takes into account various factors while grading a particular company. The major ones are cash flow adequacy, operating efficiency, accounting quality, long term earning powers, management evaluation, industry interface and risk and of course financial leverage. However in the paper, the research is carried only on the financial leverage factor. So there is Page 35 of
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a scope of further research on the other factors affecting the creditworthiness of the company.
REFERENCE & BIBLIOGRAPHY careratings.com www.crisil.com sebi.gov.in WWW.Defaultrisk.com www.Moneycontro.com www.Dailytimes.com Hindustantimes.com- corporate news press trust of india articles India credit rating is raised by S&P,By Justin Huggler The State of Credit Rating in Indi, Ragunathan V Varma Jayant R S&P downgrades Tata Motors’ credit rating By Joe Leahy in Mumbai Published: March 25 2009 I.M. PANDEY 9TH EDITION. Pandey, I. M., Bhat, Ramesh, “Cases in Financial Management”, Tata McGraw-Hill Publishing Company Ltd., 2003, Third Edition Reprint, pg-254 ., Bhat, Ramesh, “Cases in Financial Management”, Tata McGraw-Hill Publishing Company Ltd., 2003, Third Edition Reprint, pg-254
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