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(Editor's notes:
These criteria have been superseded by the article titled "Criteria
| Corporates | General: 2008 Corporate Criteria: Analytical Methodology,"
published on April 15, 2008)
Introduction
This brochure identifies and briefly
addresses some of the specific factors considered by Taiwan Ratings
Corporation (TRC) in analyzing a corporate credit rating. TRC publishes
its methodology and criteria so that user's of ratings are thoroughly
informed of how ratings are determined.
The corporate rating methodology encompasses
two basic components: business risk analysis and financial risk
analysis. It is critical to understand that the rating analysis
is not limited to an examination of various financial measures.
Proper assessment of debt protection levels requires a broader framework,
involving a thorough review of business fundamentals. A large part
of the rating process is based on subjective analysis and opinion.
This subjectivity allows TRC to fully incorporate a variety of non
statistical issues into its analysis and to input an appropriate
forward looking perspective in ratings.
At times, a rating decision may be
influenced strongly by financial measures including gearing ratios
and interest coverage. At other times, business risk factors may
dominate. To the extent that a firm is strong in one respect and
weak in another, the rating balances the different factors. Viewed
differently, the degree of a firm's business risk sets the parameters
of financial risk it can afford at any rating level.
Business Risk
Each corporate rating analysis begins
with an assessment of the company's environment. To determine the
degree of operating risk facing a company in a given industry or
business, TRC analyses the dynamics of that industry or business.
Factors assessed include industry prospects
for growth, stability, or decline, and the pattern of business cycles.
It is critical to determine vulnerability to technological change,
labour unrest, or the impact of government intervention. Industries
that have long lead times in building production capacity or that
require fixed plant of a specialised nature face heightened risk.
The implications of increasing competition are obviously crucial.
Industry risks can influence heavily
the credit rating of any company or entity in the industry. It would
be hard to imagine TRC assigning 'twAAA' credit ratings to companies
with extensive participation in industries of above-average risk,
regardless of how conservative their financial postures. However,
TRC's methodology emphasises the business position of the company
being rated more than a generic risk profile for the industry in
which it operates.
The many industry and business factors
assessed include:
Growth Potential
- Revenue
determinants;
- Developing,
mature or declining market;
- Degree of
cyclicality; and
- Rate of
technological change.
Competitive Environment
- Nature of
product (commodity or differentiated);
- Competitors;
- Barriers
to entry;
- Import competition;
and
- Regulatory
environment.
Operating Characteristics
- Operating
leverage;
- Capital
intensity;
- Equipment
financing needs;
- Key cost
factors; and
- Research
and development spending requirements.
Company Position
- Overall
market share;
- Cost control;
- Manufacturing
efficiency;
- Production
flexibility;
- Raw material
sourcing;
- Research
and development capabilities; and
- Diversification
Ownership
- Strength
of linkage to parent company including
- financial
- management;
- operational;
- research
and development and technical support;
- whether
the subsidiary is a core group operation; and
- relative
size within the group.
A rating of a subsidiary, or an affiliate
that is controlled by a dominant shareholder, involves an examination
of its parent company's credit quality, which could enhance or detract
from the subsidiary or affiliate's stand-alone rating. If parental
links are weak, the issuer is likely to be rated more on a stand-alone
basis.
Financial Risk and Accounting Quality
Having evaluated the issuer's competitive
position and operating environment, the analysis proceeds to several
financial categories. Financial risk is portrayed largely through
quantitative means, particularly by using financial ratios. Benchmarks
vary greatly by industry, and several analytical adjustments typically
are required to calculate ratios for an individual company.
Analysis of the audited financials
begins with a review of accounting quality. The purpose is to determine
whether ratios and statistics derived from financial statements
can be used accurately to measure a company's performance and position
relative to its peer group. Some of the issues reviewed include
the basis of consolidation, income recognition, depreciation methods,
capitalized interest and off-balance sheet liabilities. To the extent
possible, analytical adjustments are made to better portray reality.
Financial Policies
TRC attaches great importance to management's
philosophies and policies involving financial risk. Specific areas
that are reviewed when assessing a company's financial policies
include.
- Specific
financial targets (return on permanent capital, debt leverage
and cash flow parameters);
- Accounting
policies;
- Willingness
and ability of the company to issue equity or sell assets;
- Dividend
policy; and,
- Parental
linkages and support.
Plans and policies are judged for their
realism. A company's leverage goals, for example, need to be viewed
in the context of its past record and the financial dynamics affecting
the business. If stated policies are not followed, the ratings will
reflect that skepticism unless management has established credibility.
This can become a critical issue when a company is faced with financial
stress or restructuring and TRC must decide on a rating outcome.
Profitability and Earnings Protection
Profit potential is an important determinant
of credit protection. A company that generates higher operating
margins and returns on capital has a greater ability to generate
capital internally and withstand business adversity. Earnings power
ultimately attests to the value of a company's assets. To reflect
more accurately the earnings power of a company, reported profit
figures are sometimes adjusted. Potential areas that are adjusted
include abnormal gains or losses, unremitted equity earnings of
a subsidiary, capitalized interest, and non-recurring profits or
losses on the sale of investments or fixed assets.
The more significant measures of profitability
are:
- Pretax interest
coverage;
- Return on
capital (debt plus equity);
- Operating
margins (operating income as a percentage of sales), and
- Earnings
by business segment.
While absolute levels of ratios are
important, it is equally important to focus on trends and the quality
of the income stream. For example, a company in a highly volatile
industry may require stronger earnings protection than a company
in a more stable industry.
The analysis proceeds from historical
performance to projected profitability. Because a rating is an assessment
of the likelihood of timely payments, the evaluation emphasizes
future performance. However, the rating analysis does not attempt
to forecast performance precisely or to pinpoint economic cycles.
Rather, the forecast analysis considers variability of expected
future performance based on a range of economic and competitive
scenarios.
Capital Structure
As with earnings protection, a company's
asset mix and industry risk are critical determinants of the appropriate
leverage. Assets generating stable cash flow support greater use
of debt financing than those assets exposed to volatile or highly
cyclical markets. Key ratios employed by TRC to capture the degree
of leverage used by a company include:
- Total debt
total debt and equity; and,
- Net debt
to net debt plus equity.
What is considered "debt" or "equity"
for the purpose of ratio calculations is not always so simple. Some
of the more important issues considered include:
- Operating
leases;
- Debt of
joint ventures and unconsolidated subsidiaries;
- Guarantees;
and,
- Asset valuations.
Cash Flow Adequacy
Interest or principal obligations cannot
be serviced out of earnings, which is just an accounting concept.
Payment has to be made in cash. Although there is usually a strong
relationship between cash flow and reported profits, many transactions
and accounting entries affect one and not the other. Analysis of
cash flow patterns can reveal a level of debt-servicing capability
that is either stronger or weaker than might be apparent from reported
earning.
Financial ratios show the relationship
of cash flow to debt and debt service, and also to the company's
business needs. Since there are calls on cash other than repaying
debt, it is important to know the extent to which those requirements
will allow cash to be used for debt service or, alternatively, lead
to a greater need for borrowing.
Some of the specific ratios considered
include:
- Funds from
operations to total debt;
- Funds from
operations plus interest to interest;
- Funds from
operations to capital spending requirements; and,
- Free operating
cash flow to total debt.
Financial Flexibility
The previous assessment of financial factors (profitability, capital
structure and cash flow) are combined to arrive at an overall view
of financial health. In addition, sundry considerations that do
not fit in other categories are examined, including:
- Restrictive
covenants in loan agreements;
- Committed
unused bank lines;
- Cash and
short term investments;
- Proportion
of assets secured;
- Likelihood
of support from parent shareholder; and,
- Saleable
assets.
Sometimes serious legal problems need
to be assessed. When there is a major lawsuit against c company,
suppliers or customers may be reluctant to continue doing business,
and the firm's access to capital may be impaired.
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