RATING METHODOLOGY PROFILE FOR CORPORATE ENTITIES
Rating Methodology Profile for Corporate Entities
In arriving at an evaluation of a corporate entity, whether an industrial company, a privately-owned utility, or a company in the service sector, there are three main areas to be considered:
Business Risk Analysis
Financial Risk Analysis
Management / Ownership / Governance and Other Qualitative Factors
BUSINESS RISK ANALYSIS
Business Risk Analysis is segmented into two or three sub sectors - industry characteristics and outlook, competitive position, and, as appropriate, operations analysis.
Industry Characteristics and Outlook
Industry Characteristics and Outlook evaluates the level of risk involved in participating in a particular business or businesses. Factors to consider include but are not limited to demand growth, pricing flexibility, capital intensity, research and development requirements, barriers to entry, and particularly for utilities and corporations involved in sponsoring infrastructure projects, regulatory framework. The degree to which the business is driven and/or affected by local, regional or international business, economic and political conditions must be considered. If appropriate, benefits of diversification will also be evaluated. In general, companies participating in industries with less favorable industry outlooks (i.e. having high industry risk) will require maintenance of more conservative financial profiles/policies to achieve the same rating level as firms operating in industries with more favorable industry outlooks. Relatively favorable industry outlooks should allow stronger industry participants the possibility of producing operating results which have the following features: adequate operating margins, solid returns on assets and on equity, and growing, or at worst, stable cash-flows.
Competitive Position looks at an organization’s competitive strengths and weaknesses relative to its peers. As implied above, unless regulation is a factor that makes such comparisons meaningless, peers may well include firms outside the home market. Specifically, the question analysts must answer is whether the firm’s market position and associated business strategies allow it to favorably differentiate itself from its competitors or, alternatively, limit it to a mediocre performance at best. Size can be an advantage if it translates into economies of scale, purchasing power, or pricing advantages. But this will usually only be the case when industry leaders have relatively sizable market shares. When market share is widely fragmented, the advantages of size will often be diluted. Competing manufacturers can often be differentiated on the basis of manufacturing efficiency, which may or may not have anything to do with size. The age of plant and equipment in use, together with the quality of systems and ocesses, will often be the more telling explanation for differences in performance. Similarly, for companies operating in service industries, performance differentials are most typically associated with the quality and execution of business strategies. Size is a less important consideration. Net operating (or profit) margin
is the universal measure of performance on which firms in the same industry can be compared. It relates earnings before non-operating income/expense, interest expense and taxes to sales revenue. Some caution needs to be exercised in utilizing this measure to compare firms in different industries, due to differing structural characteristics. What is considered a reasonable net operating margin depends very much on the industry. An additional or alternative measure, especially for companies in industries with large fixed assets and/or regular amortization of goodwill and patents, relates earnings before interest expense, taxes, depreciation and amortization (i.e. “EBITDA ”) to sales revenue. Again, what is considered reasonable depends very much on the industry. Industries that allow high Net Operating and EBITDA margins will generally score well on the Industry Characteristics and Outlook risk factor.
For companies operating in several different industries, segment information should be obtained to enable net operating margins to be calculated for each part of the business, thus enabling more meaningful peer comparisons to be made.
The relationship of sales/assets is a measure of capital intensity. Industries with lower capital intensity are not inherently less risky than those with higher capital intensity, but comparing sales/assets ratios within a peer group may indicate differences in relative operating efficiency. Likewise, comparing relative growth rates, measured in terms of both physical volumes and sales levels if obtainable, can help in understanding actual competitive strengths or weaknesses that may be obscured if only headline sales figures are considered. Other industry-specific measures of competitive position, such as sales/square foot for retailers, energy finding costs for oil and gas producers, or load factor for airline companies, should be used whenever possible.
Operations Analysis is a useful additional element of Business Risk analysis in those cases where technical competence is an absolutely critical ingredient of success. Such situations would most prominently include those where human safety is at issue and, therefore, a sudden loss of customer confidence could potentially translate rather quickly into financial disaster. Pharmaceutical and airline companies would be examples of potentially more exposed industries.
FINANCIAL RISK ANALYSIS
Financial Risk Analysis is segmented into four sub sectors - profitability, cash flow generation/debt servicing capacity, capital adequacy, and financial flexibility.
Generally speaking, in the absence of profits or the potential for profits, equity capital will be difficult to come by and debt financing will be costly, if available at all. Alternately, a record of reliable profits, even if they have been cyclical or somewhat volatile, should enable access to funding on commercial terms. Firms that have compiled such records have more flexibility to refund or retire outstanding debts through capital market operations, rather than being dependent on matching internally generated cash flows to debt maturities. Growth either significantly faster or slower than industry counterparts may be a basis for concern and, in any event, should be thoroughly investigated and the reasons understood.
In the Turkish context, it must be recognized that for tax or other reasons the reporting of maximum levels of earnings may not always be a principal corporate objective. However, analysts should seek to understand as fully as possible the basis for and magnitude of any purported earnings reduction actions. In other words, statements by company officials that reported earnings have been ¨managed¨ should not bemerely accepted at face value.
Performance is generally evaluated by relating profits to assets, to permanent capital, and to equity. Return on assets is computed before taxes, and measures the productivity of all assets. Companies rated investment grade on global scale should be able to generate ratios on the order of 5%-7% on average over a business cycle.
Return on permanent capitalis a slightly narrower measure, which relates profits to the “permanent” funding provided by debt and equity cap ital, principally excluding trade financing and other current liabilities. Companies rated investment grade on global scale should typically be able to generate ratios of at least 10% on average over a business cycle. Return on equity is the narrowest of the return computations, and the outcome of the calculation is influenced by the capital structure chosen by the subject company. Companies rated investment grade on global scale should typically be able to generate ratios on the order of 12%-15% on average over a business cycle.
One other ratio used to judge the contribution of profits to the firm’s credit profile is the dividend payout ratio. The dividend pay out ratio considers the portion of earnings paid out as dividends on common stock. Pay outs above the norm for the industry may be a source of concern. In addition, analysts should question the reasons for a high pay out ratio if the firm faces a large capital investment program. What is considered reasonable depends very much on the cash needs of the business. Companies facing high debt service or capital expenditure requirements should typically not be paying out more than 50% of earnings as dividends.
Cash Flow Generation /Debt Servicing Capacity
As cash flow is the principal source of repayment for debt obligations issued by corporations, cash flow generating ability and debt servicing capacity are closely related. Cash flow can either be from operating or from non-operating sources. Operating cash flow is also called funds from operation and is typically defined as pretax profits adjusted for items not involving movement of funds, principally depreciation, amortization and other non-cash items, plus interest. Non-operating cash flows are normally derived from sales of long term assets, which may include property or equipment, parts of or entire business units, or investments in affiliates. Normally these are not considered recurring sources of funds, but it should be recognized that many long-established firms have numerous non-core assets, which could be sold to raise cash. Still, for the analyst to give positive consideration to such assets (which would be incorporated in the Financial Flexibility section of the analysis), companies should be able to demonstrate knowledge of the extent of their holdings and a sense of approximate market values.
Annual cash inflows (sources) from operating and non-operating activities are compared with annual cash outflows (uses), both on historical and projected bases. This is called the Cash Flow Match, and indicates the extent to which the organization has been reliant on external funds in the past and is likely to be so in the future.
Cash outflows considered include capital expenditures, long-term investments, dividends on common and preferred stock, income taxes, interest expense, and working capital changes. This last item may actually be either a use of cash or a source of cash, and is defined as the year-to-year change in current assets minus current liabilities, excluding changes in cash and equivalents and short-term debt. The reason these two items are excluded from consideration in this calculation is that they are products, rather than causes, of operating and non-operating transactions.
A company’s historical record of cash flow surpluses or deficits must be judged in terms of the reasons for the performance. Cash surpluses are of little comfort if they resulted from the company spending inadequate amounts on maintaining the competitiveness of its plant and equipment. Cash deficits are of much greater concern if they stem from high dividend pay outs or working capital changes unrelated to the development of the business than from capital investments in a new or expanded production facility.
Ideally a firm will borrow to finance an expansion or an acquisition, and then will almost immediately be in a position to begin paying off the debt out of cash flow. This does happen, but rarely. Often, firms’ cash flow surpluses or deficits are heavily influenced by business cycles, unplanned working capital changes, and opportunistic transactions. Thus, in gauging the reasonableness of a company’s cash flow forecasts the underlying assumptions must be considered in the context of what the firm has previously accomplished as well as to the outlook for the industry and the overall economy. Only then can their reasonableness be gauged. The analyst can then stress certain aspects of the cash flows to test the effects of the changed assumptions on the overall surplus or deficit. The cash flow surplus needs to be considered in terms of the debt interest and principal it needs to service and to the competitive health of the business if the surplus is, in fact, used to reduce debt rather than reinvested.
Besides the Cash Flow Match, eight other ratios can be used to evaluate cash flow and debt servicing capacity. These include Interest Coverage, Interest and Rent Coverage, EBITDA/Interest, Debt Service Coverage, EBITDA/Total Debt, Free Cash Flow/Debt, Capital Expenditures/Depreciation, and Funds from Operation/Capital Expenditures. The Interest Coverage ratio (earnings before interest expense and taxes/gross interest) measures the number of times operating profit before interest and taxes covers gross interest expense. Gross interest expense is defined as interest before any offset for interest income or for capitalized interest. Variations in results among companies in the same industry can be attributable either to differences in profitability or to levels of interest expense. Interest coverage is a useful measure for drawing credit quality distinctions among companies in all different industries. In general, coverage of three times or so would be the minimum expectation for investment grade consideration.
A supplementary coverage ratio, the Interest and Rent Coverage ratio (earnings before interest expense, rent expense and taxes/ gross interest and rent expense), combines interest expense and rent expense in cases where leasing is a significant method of financing, especially for long-term assets. Coverage of two times or so would be the minimum expected for a strong credit.
The EBITDA/Interest Coverage ratio is a variation on the Interest Coverage ratio. For EBITDA coverage, it is assumed that amounts attributable to depreciation and amortization are available to service interest payments. EBITDA interest coverage is equal to EBITDA (i.e. earnings before interest, taxes and depreciation and amortization)/gross interest expense. Strong credits should typically have coverage of about four times. For companies facing heavy capital expenditure requirements and having limited flexibility to adjust such investments, EBITDA coverage is less relevant that the traditional Interest Coverage ratio.
Interest (or interest and rents) can also be combined with debt amortization requirements and compared with EBITDA (or EBITDAR) to produce a Debt Service Coverage ratio. In general, coverage of at least 1 time would be consistent with an investment grade rating.
The EBITDA/Total Debt ratio compares funds from operation to the overall level of debt outstanding. In theory, the ratio indicates how long it would take for one year’s EBITDA (either that of the past year, the most recent 12 months, or projected years) to repay all short and long-term debt. EBITDA /total debt ratio is equal to earnings before interest and taxes + depreciation and amortization /sum of short-term debt + long-term debt. Strong credits should typically be able to generate a ratio of 20%-30% on average over a business cycle.
For example, a ratio of 25% would suggest that it would take four years for EBITDA to pay off all debt. While such an exercise is, of course, purely theoretical, since EBITDA is committed to many other purposes besides debt repayment, it is nonetheless instructive to see the magnitude of internally generated cash flow a firm could bring to bear against its debt burden if absolutely necessary.
Free Cash Flow to Total Debt (net income from continuing operations + depreciation and amortization +/- deferred taxes +/- other operating cash flows – capital expenditures +/- change in working capital/sum of short-term debt + long-term debt) is also a useful ratio. Strong credits should typically be able to generate a ratio of 10%-15% on average over a business cycle.
Capital Expenditures / Depreciation Depreciation is a way to quickly judge whether a firm is replacing its aging property, plant, and equipment with new facilities. Companies rated investment grade should typically have a ratio of at least 100% on average over a business/investment cycle. A ratio of less than 100% would certainly be a red flag, but it is best to compare this ratio against an industry peer group to develop a proper idea about required spending levels. Ratios well in excess of a peer group also need to be investigated; as one explanation could be that the firm is using longer depreciation lives than its peers. Such a practice would produce artificially inflated profits, and might necessitate an asset write down at some point. FFO/capital expenditures (net income from continuing operations + depreciation and amortization +/-deferred taxes +/- other operating cash flows /capital expenditures) is another way to gauge the extent to which a company is making needed capital investments. What is considered reasonable depends very much on the fixed capital intensity of the industry.
Capitalization and Financial Policies
Under this heading the analyst should assess whether the capital structure and financial practices the company has selected fit with the risks of its business. While on the one hand, very low financial leverage may appeal to a firm’s financial creditors, such a strategy is typically not appropriate or realistic. After all, equity financing is usually more expensive than debt financing, and so a balance between the two forms of financing is reasonable. It should be noted that it is not unusual to find company management that have not thought through their financial policies very thoroughly. Rather, they rely on “rules of thumb”, i.e., what bankers tell them is appropriate, or what they think rating agencies or lenders expect of them.
Several ratios are normally computed to enable the analyst to measure debt leverage. The universal standard leverage measure is Total Debt/Equity, which considers all on-balance sheet debt obligations, including such short-term liabilities as bank overdrafts, relative to equity. Equity includes common and irredeemable preferred shares. Looking at leverage on a prospective basis, promised capital injections from shareholders cannot be assumed unless firm commitments are provided and, more importantly, the analyst can conclude that the promise is supported by an ability to perform on the part of the capital provider. Other forms of capital enhancement, such as warrant or option conversions, cannot be assumed, considering the inherent volatility of stock markets which may prevent the warrants or options from ever getting into the money.
The mix of debt can be evaluated by calculating Short-Term Debt/Equity. While short-term debt does expose a company to refinancing risk, its use within reasonable limits is justified by cost and asset-matching considerations.
Equity values reported on corporate balance sheets are not always comparable. Asset revaluations can increase a firm’s capital to nearly true market values, while another firm’s reported capital can reflect much lower asset valuations. Also, goodwill can sometimes represent a sizable portion of equity. While it is worthwhile making such observations, the acid test of whether revaluations or goodwill have value is the firm’s ability to earn a return on that investment. The return calculations discussed in the Profitability section should be revisited to gauge whether reasonable returns are being earned. If they are not, then asset write- downs (which probably will include write downs of goodwill) will likely occur at some point in the future.
Aside from ratios designed to measure leverage or gearing (multiples of equity represented by debt), there are ratios that measure debt against the entire capital structure of the company. The primary ratio used is total debt/total capital (sum of short-term debt + long-term debt/ sum of short-term debt + long-term debt + preferred stock + total common equity, which will vary dramatically depending on whether company has chosen to step up the basis of its assets. Strong credits will typically have a ratio of 50% or less on average over a business cycle.
Total debt/total capital at market value (sum of short-term debt + long-term debt/ sum of short-term debt + long-term debt + preferred stock + (common shares outstanding x period end common stock price) is applicable only to companies with publicly traded equity securities. If the ratio is lower than the unadjusted total debt/total capital ratio, it suggests that the company should be able to raise new equity if needed. However, if the ratio is higher, it raises some questions about the company’s ability to obtain new equity capital on reasonable terms.
Short-term debt/total capital is short-term debt/sum of short-term debt + long-term debt + preferred stock + total common equity. What is reasonable depends in part on the mix of assets employed in the business. However, high short-term debt usage magnifies rollover risk and, therefore, the degree of short-term debt usage should be related to industry outlook and competitive position assessments.
Evaluation of total liabilities/total capital (total liabilities/sum of short-term debt + long-term debt + preferred stock + total common equity) depends very much on the liabilities profile of the industry and the company.
A firm’s debt amortization schedule needs to be considered as part of the evaluation of financial policies. When looking at the maturity schedule of long-term debt, a smooth pattern is ideal. However, bullet maturities are the norm, and use of sinking funds the exception. Thus, most companies have sharp spikes in their maturity schedules. These amounts often have to be refinanced, with new debt or other forms of external capital. As long as operating results are adequate and the capital markets are hospitable, there should be no problem. But there is always an element of uncertainty, and firms that address these debt spikes well in advance are certainly preferable to those that wait until the last minute.
Liquidity and Financial Flexibility
Financial flexibility principally incorporates the concepts of liquidity and access to alternate financial sources. Potential constraints on financial flexibility, such as legal claims, pension or other employee-related liabilities or potential environmental liabilities, would also be considered in this section.
A number of ratios are used to evaluate a firm’s liquidity. Traditional favorites include the Cash Ratio (cash and equivalents/current liabilities), and the Current Ratio (current assets/current liabilities). However, one should not be overly exuberant when observing a high Cash Ratio as the output depends very much on the liquidity management policy of the company. While a current ratio of > 1.5:1 is desirable, it too depends on the company’s liquidity management policy and the characteristics of its accounts receivables and inventories.
While large amounts of cash and other liquid securities are nice to see on a firm’s balance sheet when debt maturities loom ahead, it doesn’t usually make economic sense for a firm to permanently carry sizable cash balances, since returns on them are low. Large cash balances may arise from seasonal flows as well as from asset sales or financing activities where proceeds haven’t yet been disbursed. This is the main reason why ratios that include debt are usually calculated on a gross rather than a net basis (i.e. reduced by cash and investments).
It is also useful to compile Accounts Receivable Turnover (average accounts receivable/sales x 365/1) and Inventory Turnover (cost of goods sold/average inventory x 365/1) ratios to gauge the level of funds tied up in these activities, and a Payables Turnover ratio (payables/cost of goods sold x 365/1) to see whether the firm is stretching out or speeding up payment to its suppliers. Regarding the accounts receivable turnover, strong credits should typically turn over their trade receivables every 30-60 days while inventory turnover depends very much on the characteristics of the industry. Strong credits should typically turn over their trade payables every 30-60 days.
Important information can be learned by tracking turnover rates both over time and relative to key competitors. Also, in assessing the reasonableness of a firm’s projected Cash Flow Match, analysts should pay attention to whether management has appropriately recognized growth in required working capital along with growth in revenues. Computation of the turnover ratios using the projections provided by management can help to make this assessment.
The availability for potential sale of discrete assets whose marketability and value can be reasonably established may be considered additional liquidity support. Some positive consideration may also be given to unencumbered assets available for pledge to secure further funding. In addition to internally generated liquidity, most companies arrange alternative financing to protect against contingencies and to take advantage of opportunities. These usually take the form of bank facilities of various types. To the extent the firm pays commitment fees or other forms of compensation to the bank for these facilities they may be considered favorably. However, it should be recognized that most bank facilities contain “material adverse change” language, which releases the bank from any obligation to lend if the company experiences a significant business reversal. Trade financing lines do not really provide liquidity against contingencies because their use requires presentation of documents related to a specific transaction. They cannot just be used for general corporate purposes.
Potential legal liabilities, labor and other employee-related liabilities or environmental claims can place a cloud over a company, raising its cost of capital or even precluding its ability to raise capital at economic rates. These are generally disclosed in the notes to financial statements. On legal matters of potential significance, it is appropriate to have a company’s external counsel provide its views on likely outcomes of litigation. Legal actions with potentially serious consequences should always be monitored closely.
MANAGEMENT / OWNERSHIP / GOVERNANCE RISK ANALYSIS
Management evaluation is critical since it is management that decides what businesses to be in, what strategies should be pursued, and how these activities should be financed. Ideally, management’s business goals and financial policy are clear, have been consistently pursued, and are realistic based on the firm’s business risk . As with any ideal, the reality usually falls short or management’s track record is not sufficiently long for any clear-cut conclusions to be drawn. The evaluation of management should emphasize past performance, fulfillment of earlier plans, and strategy for the future. In the Turkish context, many businesses are closely controlled, either by individuals, families, or by holding companies. Thus, there is a close inter-relationship between management and ownership interests.
The following are questions to consider in the assessment of the reasonableness of the company’s strategic direction and plan:
Does management demonstrate an excessive orientation towards short-term results?
Does management consistently blame outside forces for problems and failures?
Has there been management continuity - in terms of strategies and policies - even more so than in terms of the specific individuals?
Is there an effort at contingency planning and building financial flexibility?
How has management responded to past problems - weakly or forcefully?
To answer these questions some historical perspective is helpful. Clearly, a crisis of some sort is an excellent basis to assess management’s thoughtfulness, control systems, and responsiveness. What is critical is to gain an appreciation of how well thought out the company’s development has been. Management that has given considerable thought to the development of its business and its financial policies is less likely to abandon them abruptly.
As suggested earlier, the management evaluation also needs to be conducted with due consideration given to the actual and potential influence of significant shareholders. If the company is privately owned, typically by a family, the analyst needs to assess the extent to which decision-making authority has evolved to a professional management approach. In addition, understanding the structure, responsibilities, and activities of the Board of Directors will be helpful in judging how effective that body is likely to be in precluding or dealing with a crisis. It is also important to determine if there is in place a reasonable ownership succession plan. If possible, it is desirable for the analyst to interview significant or controlling shareholders, either in person or by phone, to assess how they view the relationship between their personal interests and those of the company.
Additional governance issues that are of particular relevance include information disclosure and transparency. To be specific, the quality of a company’s accounting (see further discussion below) and financial reporting practices, including timeliness and transparency, speak volumes about management’s attitudes towards risk and towards dealing fairly with key constituencies including, most importantly for our purposes, creditors. The independence and credibility of the firm’s external auditor is worth considering as well.
Financial statements (and related disclosures) are the primary source of information regarding the financial performance of industrial or privately-owned utility companies. Accordingly, the standards by which the statements are prepared should be understood. The starting point is an understanding of the national accounting standards, as these vary widely, and how they compare with international accounting standards. Recent moves to adopt International Financial Reporting Standards (“IFRS”) in many coun tries as well as an ongoing work to achieve convergence between U.S. GAAP and IFRS, could over time enhance comparability among companies. In different jurisdictions, companies choose among alternative methods of accounting --for example, cost as opposed to fair-value methods. Differences in the choices made by individual companies can make it difficult to compare performance among peers. Individual companies can choose to be aggressive or conservative in their underlying estimates and judgments. The carrying value of assets can be greatly influenced by whether the asset was acquired through internal development or through acquisitions, or whether it previously underwent a leveraged buyout or bankruptcy reorganization. These differences clearly will affect the quantitative measures of financial analysis, and thus require analysts to have a historical perspective to make appropriate assessments and comparisons.
Accounting policies that the analyst needs to understand include, but are not necessarily limited to:
revenue and expense recognition
valuations of cash and investments
valuation and provisioning of receivables
inventory valuation methods
fixed asset valuation and depreciation
valuation of intangible assets, including capitalization of research and development
costs and financial expenses
post-retirement benefit obligations
other liabilities and contingent obligations
derivatives and hedges
accounting for inflation