CRISIL Ratings Research Approach To Financial Ratios 2013

Topics: Finance, Generally Accepted Accounting Principles, Credit rating Pages: 12 (3256 words) Published: July 10, 2015
CRISIL’s Approach to Financial Ratios
Executive Summary
The analysis of a company’s financial ratios is core to CRISIL’s rating process as these ratios help understand a company’s overall financial risk profile. CRISIL considers eight crucial financial parameters while evaluating a company’s credit quality: capital structure, interest coverage ratio, debt service coverage, net worth, profitability, return on capital employed, net cash accruals to total debt ratio, and current ratio. CRISIL considers present as well as future (projected) financial risk profile while assessing a company’s credit quality. These parameters give an insight to the company’s financial health and are factored into the final rating. However, the final rating assessment entails the interplay of various other factors such as financial flexibility, business, project, and management risks.

Scope and Objective
This article focuses on the key ratios that CRISIL uses in its rating process for manufacturing companies. These same ratios are also used, with minor variations if necessary, in analysing trading companies, logistics providers, construction companies, and a majority of service sector companies. The article aims to explain CRISIL’s approach to financial ratios and the formulae employed in computing them. This is beneficial to users of CRISIL Ratings, including investors in corporate debt. Credit rating is not determined solely on the basis of financial ratios. Among other factors that play a key role in determining credit ratings are industry risk evaluations, operating efficiency, market position, management risk evaluation, financial flexibility, project risks, and support from a strong parent. The financial ratios indicated here are used as inputs in rating financial risk, which, in turn is factored into the overall assessment of a company’s credit quality.

CRISIL’s Approach to Financial Ratios

Chart 1: Use of Financial Risk Analysis in Rating Decisions
Accounting
Quality

Business
Risk

Existing Financial
Position

Future Financial
Position

Financial
Risk

Cash Flow
Adequacy and
Financial Flexibility

Parent/Group/
Govt. support

Standalone
credit
risk

Overall Credit
Rating

Management
Risk

Project
Risk

The relative importance of the ratios may vary on a case-specific basis. CRISIL does not adopt an arithmetic approach in using these ratios while assessing financial risk; instead, CRISIL makes a subjective assessment of the importance of the ratios for each credit. A detailed discussion on each of the eight parameters is presented below:

Capital Structure
A company’s capital structure--commonly referred to as gearing, leverage, or debt-to-equity ratio-reflects the extent of borrowed funds in the company’s funding mix. The equity component in the capital employed by a company has no fixed repayment obligations; returns to equity shareholders depend on the profits made by the company. Debt, on the other hand, carries specified contractual obligations of interest and principal. These will necessarily have to be honoured, in full and on time, irrespective of the volatility witnessed in the business.

A company’s capital structure is invariably a function of the strategy adopted by its management. Although high dependence on borrowed funds (and thus, high gearing) may result in a higher return on shareholders’ funds, it translates into high fixed costs in terms of the interest burden, which may adversely affect the company’s financial position. In fact, in situations of weak business performance, high gearing may weaken profitability, constraining a company’s ability to repay debt. Gearing, therefore, denotes the extent of financial risk taken by a company: the larger the quantum of debt, the higher the gearing, and the more difficult it will be for the company to service its debt obligations. A credit rating informs investors about the probability of timely servicing of the rated debt...
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