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This summary of Capital Intelligence's (CI) corporate rating methodology describes the analytical criteria important in assigning corporate ratings to commercial and industrial companies and groups. It details the most important areas of analysis that are germane to the understanding of a corporate's overall creditworthiness and therefore the assignment by CI of an appropriate rating.
CI's assessment of corporate creditworthiness is based upon a thorough evaluation of financial risk, business risk and country risk.
1. Financial Risk - CI assesses a corporate's financial strengths and weaknesses by analysing various quantitative indicators extrapolated from a company's financial reports. Within this fundamental analysis, CI focuses on three areas: (1) cash flow coverage of debt service and other fixed costs; (2) earnings and profitability in relation to overall capitalisation, shareholder's investment and assets deployed; and (3) the relationship between the company's equity base and its assets, in the form of leverage. The cash flow aspects are of particular importance for CI's credit analysis and are given the most weight.
Ultimately, a company will have to service its debt with cash. Thus, although CI's financial analysis begins by reviewing a company's earnings power, it is cash flow generation that forms the foundation for all credit rating analysis and for determining a company's credit rating. As a general rule, the larger the company's cushion of cash and liquid assets over its fixed servicing requirements, the more likely it will be able to meet its debt obligations, even during downturns, and therefore warrant a higher credit rating.
The quality of the cash flow, both from an historical and forecasted point of view, is a function of how the sources of cash within the company maintain a viable balance between each other and the sustainability of those sources over time. A strong generation of cash from normal operations is important. If it is not sufficient to meet all its claims on cash and to meet its debt service requirements, then the company will need to be able to access new capital, additional cash from new debt issuances or dispose of assets to meet those obligations. In general, a company that comes to rely on extraordinary income to meet its servicing requirements exhibits less financial strength than one with a steady and predictable cash flow from operations.
Although financial analysis relies upon historical data, CI uses that data as a foundation to assess the likelihood of timely debt service in the future. Earnings are a starting point for that analysis. CI analyses historical profits and profit potential to determine whether operating margins and return on the company's capital are strong enough to generate increases in equity capital, both internally generated and from external sources. The more successful at this, the more likely the company will be able to withstand downturns. The relationship between earnings and its fixed charges is evaluated to assess the company's capacity to meet its annual financing costs.
One of the most important considerations in determining a company's financial flexibility is whether it generates sufficient liquidity to meet its debt obligations in a timely manner. The first source of that liquidity is from its cash generation capacity and secondly, from external sources. Both primary liquidity from internally generated cash and back-up liquidity from short term funding sources are dependent on the company's earning power.
The relationship between equity capital and debt is one indicator of financial strength, but high leverage in itself is not a reason to assign a low rating. The composition of the company's assets determines at what level leverage begins to assume higher risk. Assets with stable cash flow and yielding commensurate debt service coverage, as well as high market and liquidity values, can, in some cases, justify higher debt levels.
2. Business Risk - The second series of factors which are important in CI's analysis of corporate creditworthiness centre on company-specific business risks as identified through a review of industry characteristics and an evaluation of management in terms of organisation and corporate governance issues. These areas of analysis typically fall under the generic term of "qualitative" analysis, as opposed to the "quantitative" which focuses on a review of a company's financial accounts and reports, and involves the use of ratio analysis for, among other things, peer comparisons.
Business risk analysis addresses the qualitative aspects of corporate credit rating methodology. In emerging markets, qualitative aspects are often as important, and sometimes more so, than quantitative analysis. The often lack of credible, transparent and historical financial data coming from emerging market corporates places a heavy weight on the qualitative skills of the analyst. Areas of importance for understanding a company's business risk include assessing the industry's prospects for growth, its stability and the pattern of its business cycle, vulnerability to technological change, labour issues and costs, the presence of regulatory interference and the links that may exist between the industry and the state.
The industry's prospects for growth encompass an assessment of not only potential demand, but also whether the industry's market has the capacity to maintain margins while taking advantage of that growth prospect. The requirements for capital outlays to keep up with the growth are also considered, both in terms of timing and intensity. Generally, industries demonstrating favourable characteristics in these lines tend to find themselves at the lower end of the risk scale. The characteristics of the industry and a company's performance at all points in its business cycle are assessed in order to determine the severity and likely timing of the peaks and troughs. Also to be taken into account is the profile of the infrastructure available in terms of its capacity to meet the demands of the company's current and future operations. The overall cost structure, product mix, market share, and geographical diversification are analysed to determine whether competitive prospects are at a level commensurate with a successful business plan.
CI also considers corporate governance and management capacity. The company's plans, policies and management philosophy are reviewed for credibility, while its organisational structure is assessed to determine whether it is efficiently administered. Critical to any consideration of governance is the issue of transparency and accountability in financial policy and reporting. A careful analysis of these issues is undertaken to assess whether company practices are at a sufficiently high level.
3. Country Risk - The political and economic environment in emerging markets tend to be less stable, by definition, than in more developed markets. In addition, the scale of any change may be far greater, resulting in the potential for disruption or impairment of a company's operations to be that much more dramatic. Because of this, CI places heavy emphasis on understanding the underlying country risk factors that may affect a corporate's performance and prospects.
CI's assessment of country risk focuses on three areas: macroeconomic volatility; business environment risk; and operating environment risk.
Macroeconomic Volatility - Factors considered under this area include inflationary trends, exchange rate stability and the depth and diversity of the economy. The prospects for growth are carefully assessed, as an economy suffering through extended recessionary periods erodes the underlying strength of those companies reliant on sales within that economy and reduces the predictability of future cash flows available for debt service.
Business Environment - Country risk is further assessed through a thorough analysis of the business environment wherein the corporate operates. Areas of particular focus include identifying the level of accessibility available for a company to meet its needs for imported raw materials. This goes beyond problems generated from currency risk described above and addresses issues as wide-ranging as availability of relevant permits and the presence of adequate domestic infrastructure, such as port facilities, distribution and communication systems, to facilitate the movement of goods to and from the company's production plants.
The political environment is of particular importance. Lack of political stability brings with it uncertainty as to future legislation which might impact a company's operations, or unrest which could disrupt all or part of a company's chain of production or distribution. Corruption at the political level adds direct and indirect costs and in some cases can restrict foreign companies from actively participating in the local economy, whether as investors, suppliers or buyers. Those political issues, to the extent present, create additional risk that our analysts incorporate into the overall analysis.
The absence of a strong and diversified financial sector can be a major restraint on a company's financial health. The availability of local credit and a stable banking environment is an important consideration. A shallow local capital market can expose a company to unreasonable interest costs and, during times of economic stress, can witness "flights to quality" which exacerbate an already illiquid market.
Operating Environment - The third and final area of analysis focuses on operating risk in the context of operating in a particular sovereign jurisdiction. CI looks at the degree of government involvement in local ownership structures, the degree of regulatory interference, fiscal policies and practices in place, as well as, the structure and transparency of the legal system in question. National fiscal policies can have varied effects on a company's operations and the presence or elimination of fiscal subsidies or incentives is carefully reviewed as to their impact on a company's profits and cash flows.