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Chapter 4
THEORETICAL FRAMEWORK OF CREDIT RATING AND
FINANCIAL VARIABLES
4.1 Introduction
The cred~t rat~ngs are partly ass~gned by evaluat~ng the financ~al status
of the firms, seek~ng cred~t ratlng Th~s study trles to evaluate th~s content of
financlal lnformatlon In credit ratlng Initially a theoretical framework has been
drawn to develop a loglcal relat~onshlp between credrt ratlng and financ~al
var~ables Thls evolved log~cal relatlonsh~p could provide a base for exploring
the requlred lnformat~on through any other quantltatlve analysis Thls chapter
highlights the financlal varlables used In the study, and the~r relatlonshlp w~th
the cred~t rating T h ~ s logical relationsh~p IS also comprehensively explained
using graphs These graphs are plotted uslng the med~an value of 600
observations of financ~al variables and the credit ratlng
4.2 Variables Used in this Study
The company's speciflc varlables were chosen ~n accordance w~th
past emp~ncal literature on cred~t rat~ng and financ~al d~stress models The
study also uses new varlables, whlch have not been used ~n any other
studies These new var~ables were used w~th the expectat~on of improving
the predlctlve and dlscrlminatlng power of d~fferent statlstlcal models The
selected varlabies were grouped lnto different financial dimensions based on
the~r components The selected financlal var~ables conta~ned few absolute
varrables (TA and SALES) and the firm's age (AGE) The ~dent~fied 39
financlal var~ables were grouped Into 9 financ~al dimens~ons (table 4 1) The
computational details of the varlables are glven ~n append~x 4
4.3 Financial Variables and Credit Rating
The financ~al performance of a company can be analysed by carefully
examining the balance sheet and Income statement of the company The
Table 4.1
Literature
d, f a, d, e, f, g
a. c, d
d, e, h, 1
a, d, e, I a, c, d, e, f, I, k
a , b , d , e , g , ~ , i , I a, d, e, f, g,l
a, f, k
Variables
PBDITMS PBlTlNS PBITfTA PBlTlCE PBTlNS PBTrrA RPfTA DlVlPAT RPIPAT CASHICL CASH~TA CNCL WClNS WCKA QNCL CASHICA INVTURN INVICA 1 NVITA RECITA DRTURN CRTURN PBlTllNT PBDITANT CPIINT OCFIINT CAPlTL R S n L TBITL BBKB DEBfrB T A SALES AGE
Details of Financial Var~ables Financial
Dimension Prof~tablllty Profitab~l~ty Profitabrl~ty Profitab~lity Profitabtl~ty Profitabil~ty Profitability Profitability Profitab~llty Llquldlty Llquld~ty Llquldlty Llquldlty Llquldlty Llqu~dlty Llquldlty Actlvlty Actlvlty Act~vlty Actlv~ty Actlvlty Act~vlty Debt servlce coverage Debt servlce coverage Debt servlce coverage Debt servlce coverage L~ablllt~es structure L ~ a b ~ l ~ t ~ e s structure L ~ a b ~ l ~ t ~ e s structure L ~ a b ~ l ~ t ~ e s structure L~abilities structure S~ze S ~ z e Firm's age
Table 4.1 continued I I I
Variables
DIE TBITA
CGR NSITA
NS/CA
Financial Dimension I Literature I I
Leverage I I Leverage Leverage
Sales turnover Sales turnover
I a Falkenst~ n, Boral, and Ca* (2000j. b Khandanr, Lozano, and C a m (2001). c Led Mayr (20011 d Chen and Shrmerda (1981). f Crouhy, Galal, and Mark (2001j. g Altman (1968). h E5mrnister (19721, 1 Deakrn (1972), 1 Baever (1966). k Altman. Haldeman, and Narayanan (1977). 1 Wlnakorand Srnllh (1935)
BB Bank G%rowmgs, CAP Capltal, CGR Cap~tal Geanng RaDo, CP Cash Profib, D Debts, DIV Divrdend, E Equibes, INV Inventones, NS Net Sales, PAT Profit Afier Taxes, PBlT Prof# 3efore Interest, and Taxes, PA Qurck Assets, RP Relarned Profits, TA Total Assets, T L Total Liabilibes, CA Current Assets, CE Capital Employed, CL Cumnt Lrabibties, Ci'TURN Credrtors Turnover, DEB Debentures, DRTURN Debtors Tumover, INT lnteresr INWURN Inventones Turnover, OCF Operating Cash Flow PBDIT Profit Before Depmratron, Interest, and Taxes, PBT Profit Before Taxes. REC Recervables. RS Reserves and Surplus, TB Tolai Borrowings, WC Workrng Caprtal
larger quantities of data are made comprehensive and comparisons between
firms made possible uslng financial accounting rat~os The credit analysts In a
rating agency consider many attr~butes of a firm, financial as well as
managerla, and quantitat~ve as well as qual~tative The quantitative analysis
IS mainly tnanctal analysls and IS based on the firm's financial reports The
analysts escertain the financtal health of the firm, determines the sufictency
of earnlnss and cash flows to cover debt obligat~ons The quality of the firrn's
assets anc the ltquidlty position of the firm IS also ascerta~ned
The financ~al vartables are belng lncreaslngly used as simple
measures of complex financ~al relationships and In the predlct~on of cred~t
rat~ng and Rnanclal distress The financial variables were used to uncover the
financial irformatlon content of credit rat~ng, slnce they are the effective tool
for, (I) evauating firm's performance, (ti) sening benchmark or standards of
performarce, (111) htghlighting the areas that need to be improved, and (iv)
enabilng external part~es to assess the credtt worthiness and profitab~l~ty of
the firm Tne financtal lndtcators over the last two and the current year were
compared wlth the credit ratlng Thls comparison IS important for better
understanding of the Importance given to financial performance of firms In
cred~t ratlrg assignments The brief details of the financial dlrnensions and
the relat~cnship between the variables of the dimensions and the credit
ratings are expla~ned In the succeed~ng paragraphs
4.3.1 Profitability
A traditional indicator of success or fallure of any buslness endeavour
has been its ab~llty to add value to its wealth or generate profits The h~gher
profitab~l~ty ralses a firm's equlty value and also lmpi~es a longer way of
revenues The higher profitab~lity lmpl~es greater cush~on to debt holders
Profitab~lity also determines the market percept~ons, wh~ch has a bear~ng on
the suppct of shareholders and other lenders Th~s support can be an
important factor durlng stress The firms w~th lower profitabll~ty would
subsequently default more frequently The profitabll~ty of a firm w~l l have a
dlrect rela3onshlp w~ th cred~t ratlng (h~gher the prof~tab~lity, higher the cred~t
rat~ng) TPe more profitable the firm, the more resources ~t has to pay
debtors, and the lower its propensity to default Hence ~t IS expected, that
company's cred~t worthiness 1s positively related to its profitab~l~ty Profitabil~ty
IS a relative term It IS hard to say what percentage of profit represents a
profitable 5rrn The profit depends on d~fferent factors lhke the pos~tion of the
company and ~ t s products on the competit~ve cycle
A piofitablllty of firm IS convent~onally measured through financ~al
rat~os, ln \rbich the profit 1s measured as a percentage ~n the total assets, net
sales, an j cap~tal employed PBDITINS, PBITINS, PBITKA, PBITICE,
PBTINS, and PBTK are the rat~os which descr~be the profitability of the firm
and avo~d the volatility of earnlngs assoc~ated w~th extraordinary items A
h~gher va ue of these ratios ind~cates greater profitability and a positlve
relatlonsh 3 with cred~t ratlng Slnce a firm's ultlmate existence IS based on
the earnlna power of 11s assets, some of these ratlos appear to be particularly
appropria:a for studies deal~ng with default r~sk and cred~t ratlng
RPTTA, accounts for the proportion of total amount of reinvested
earnlngs andlor losses of a fin over ~ t s ent~re life The age of a firm IS
lmpl~c~tly wns~dered in these rat~os The relatively young firm w~l l probably
show a low RPrrA ratio because it had no time to bu~ld up ~ t s cumulative
profits It also measures the leverage of a firm, those f i n s w ~ t h h~gh retained
earnlngs to total assets, have financed the~r assets through retent~on of
profits and have not ut~lised as much debt The ratlos DlVlPAT and RPIPAT
measure the d~v~dend pollcy of firm These ratios were also used to study the
financial lnformatlon content in credit rating Fig 4 1 presents the graphical
relation between cred~t rat~ng and the med~an value of select profitab~lity
variables Almost all the var~ables show an ~ o s i t ~ e movement
4.3.2 Liquidity
L~qu~dity is an lnd~cation of the firm's abllrty to respond lmrnediately to
sudden cash payments There are many l~quidrty rat~os In common usage,
but at heart they measure similar things The more liqu~d assets a firm has,
the lower ~ t s propensity to default in short term L~quid~ty ratios as a relevance
to this study would measure the firm's abrl~ty to meet fixed cost expenses of
debt outstanding The l~qu~d~ ty pos~tion IS affected by the state of
cornpetltlons, Issuers market posit~on and pol~cles, and relationsh~p with
customers and suppliers The comparison of the liqu~dity d~rnens~on wlth
credit rating helps to identify the corporate pos~tion ~n meet~ng the fixed
expenses on cap~tal borrowings The fund~ng profile with respect to matchlng
of assets-liab~lity tenures also has an important bearing on the l~quid~ty
position
The cornpanes w~th higher current ratios and b~gger holdings of cash
and marketable securit~es tend to have lower default probability, leading to
higher credit ratlng Since the profitabil~ty and liquidity are two terms which
are ~nversely related, a company w~th h~ghes: profitabil~ty having a good
Fig 4.1 continued
Credit Rating and Median Values of Profitabil~ty Var~ables
~ i g 4 1 (e) PETINS
01,.
4 1 0 .
Jll.
F I ~ 4 1 (g) RPKA
OW,
am.
OW.
om-
:
Fe 4 1 (f) PBTKA
L l l .
D I O .
Fg4 1 (h) DNKA
0 51 -
00s.
Fig 4.1 continued
Credit Rating and Median Values of Profitability Variables
rating may not have hlgh liqu~dity Though tt is argued that higher the l~qu~d~ty
better the ratlng, rt is a relatlve term, which could be understood that
reasonable Iiqu~d~ty, better w~ll be the rating The ind~cators of l~quldtty tnc!ude
CASHICL, CASHTTA, CNCL, WClNS, WCmA. QAICL, and CASHlCA Fig
4 2 exh~brts the graphical relatlon between credit ratlng and the med~an value
of select l~qu~d~ ty variables These graphs explan a complex relat~on behveen
credit rat~ng and financ~al var~ables
4.3.3 Acbvity
The act~v~ty rat~os reflect how were the ftrm's assets are bring
managed The actlvlty rat~os are accounting ratios that reflect some aspects
of the firm, that have less straight forward relatlon to cred~t risk than other
var~ables The act~vity ratlos that use inventory In the numerator IS expected
to have a poslttve relat~onship wtth the default probability, as grcwlng
Inventory reveals h~ghest storage costs as well as non-l~qu~dity, lead~ng to a
Fig 4.2 continued
Credit Rating and Median Values of Liquidity Variables
FlS 4 2 (gi CPSHICA
0 1
003
om
D O 1
0 m t!Q 2 2 ' ; E m u o
lower credt rating The debtors' turnover ratlo shows the firm's eficlency In
collect~ng cash from lts credlt sales Some of the actlvlty ratlos Include,
INVTURN, INVICA, INVTTA, RECTTA, DRTURN, and CRTURN Fig 4 3
shows the graphical relatlon between credlt ratlng and the med~an value of
select a c h t y variables These graphs explaln a remote relatlon between
cred~t rating and financial var~ables
4.3.4 Debt Service Coverage
Th~s d~mens~on of a firm IS considered to be a primary Importance to
the debt holders of a firm The level of these ratios reflects the result of
business nsk diverse and the fundlng polic~es Generally, h~gher the level of
coverage, h~gher IS the cred~t ratlng The bus~ness w~th lower level of
coverage can get h~gher rat~ngs ~f the earnlngs are steady (I e , bus~ness w~th
low Industry risk) As the debt lnstrurnents are fixed Income Instruments, the
rat~ng awarded to these Instruments are expected to be pos~t~vely related to
cred~t ratlng
PBDITIINT, PBlTllNT and OCFllNT measure the hrm's abiltty to
service ~ t s debt wlth Internally generated cash flows These ratios helps to
determine whether a business can meet all ~ t s operative needs and have
suffic~ent funds remalnlng to cover Interest requ~rements and d~vldends
Therefore a ratlo below 1 1 lnd~cates that the company must b o ~ o w funds to
meet s0rr.e of its financing obllgatlons Th~s ratlo also serves as an Indicator
of a company's capacity to Inquire add~t~onal debt The ratlo, CPJINT
measures the cash profit as a percentage to Interest to be pard, whlch
othew~se means the cash term earnlngs of the firms to se4le the fixed
expenses (interest) Fig 4 4 presents the graph~cal relatlon between cred~t
rat~ng and the medran value of select debt servlce coverage vanables These
graphs ex;llaln a positive relatlon between credlt ratlng and the financial
vanables
Fig 4.3 continued
Credit Rating and Median Values of Activity Variables - -
F8g 4 3 (e) D R N R N
am
m
om > > < ; z = u o
F q 4 3 i O C R N R N
m
< ~ ' $ ~ D V C
4.3.5 Liabilities Stmcture
The components of the total l~abillt~es of a firm are also considered In
major financlal decls~ons made by the external parties to the firms More the
fixed cost capital (debt) component in the total I ~ a b ~ l ~ t ~ e s , h~qher will be the
probabil~ty of default The credit rat~ngs are expected h~gher for the firms w~th
less borrow~ng Usually the l~ab~li t~es structure IS studled uslng CAPffL,
RSnL, TBnL, BBRB, and DEBnB Fig 4 4 presents the graphical reatlon
between cred~t rating and the med~an value of select i ~ a b ~ l ~ t ~ e s strueure
var~ables These graphs expla~n a posltive relation between cred~t ratlng and
RSTTL, negatlve relation between credit rating and TBTTL, and a complex
relat~on between credit ratlng and other var~ables
4.3.6 Size
The firm's size IS a var~able that is correlated w~th many financlal
statement Inputs The typical proxles for firm slze are ~ t s TA and SALES It IS
Fia 4.4
Credit Rating and Median Values of Debt Service Coverage Variables
b Fg 4 4 (dl CCFIINT
Im
Am
2 m
3 m /!L o m j ~ . ~ ~ 3 u c
Fis 4.5
Credit Rating and Median Values of Liabil~ttes Structure Variables
Ftg 4 5 l c i T a m
0 Y
0 23
I t 0
0 m ;ILL ~ ~ * ~ ~ m u n
Fig 4.5 continued
Credit Rating and Median Values of Liabi l~t ies Structure Variables
expected that b~gger the firm, the more dlverslfied ~ t s assets and there fore ~ t s
default r1s4 IS lower The larger firms may default less frequently than the
smaller firms So a posltive relationship is expected between size and credlt
ratlng Fig 4 6 presents the graphical relatlon between cred~t ratlng and the
medlan value of select slze variables These graphs explan a positlve
relat~on between credlt rat~ng and financial variables
4.3.7 Firm's Age
The age of the firm also determines the value of figures In financial
statements A older firm may have more of reserves than a firm whlch IS very
young The age and track record of the f~ rm IS also considered In major
financ~al cscls~ons by the stake holders But the term 1s complex that a very
old firm w;;h poor perfomlance can have a very worst fundamental leading to
a poor credlt ratlng As thls d~menslon IS not a dlrect financial variable,
u Credit Rating and Med~an Values of S ~ z e Variables
L
FIQ 4 6 la) LOG SALES
1 1 )
> rc
P YI I;-- 0 rn j l c l s O u O
Fg 4 6 lb) LOG TA
110
> m
0 60
0 k 00 ~ 2 * ~ z = u o
relatlon between credlt rat~ng and firm's age are not clearly understood Fig
4 6 presents the graphlcai relat~on between credit ratlng and the medlan
value of firm's age var~able Thls graph explains a complex rela:~on between
cred~t ratlng and age var~able
4.3.8 Leverage
Leverage IS an important measure of the credrt r~sk of a firm slnce rt
measures the firm's abllrty to w~thstand unforseen clrcumstances The Rrms
with hlgh leverage will have high exposure to default rlsk and as propensty to
default Tne cred~t ratlng for the firms wlth h~gh leverage IS expected to be
lower, as the default probab~lrty IS hrgher The buslness rrsk IS a prrme dnver,
while gearlng has a secondary role in determlnlng the overall ratlng
(especrally long term) To ~llustrate, an Issuer who's geailng level IS
Fis 4.7
Credit Rating and Median Values of Firms' Age Variable
Fig 4 7 AGE
xl m
>om
om I!? 2 s < B 3 m u o
favourable but relat~ve buslness fundamental are weak IS unlikely to get a
favourable long-term rating Thls 1s so because gearlng IS considered to be a
"controllable" factor wh~le business factors are relatively dlficult to alter
s~gn~ficantly Usually leverage IS measured using (I) total borrcw~ngs as a
percentage of total assets, and (11) long term debt as a percentage of equity
DIE ratlo shows the extent to whlch a firm is relylng on debt to finance
~ t s Investments and operations, and how well it can manage the debt
obligat~ons, I e , repayment of pr~ncipal and period~c Interest If the company
IS unable to pay its debt, it will be forced lnto bankruptcy On the positive s~de
the use of debt IS beneficial as it prov~des tax benefits to the f~rm, and allows
~t to explolt business opportunltles and grow It also shows the firm's reliance
on external debt for financing The lower the ratlo, more conservative
Fig 4.8
Credit Rating and Median Values of Leverage Variables
Ftg 4 8 (a) DIE
3 ia : I f . 3m
0 n
om 3 : ' ~ s W u 0
FIQ 4 8 (c) CGR
cm
3 " ' f " " "
(probably safer) the company IS How ever ~f a company 1s not uslng debt, ~t
may be foregoing Investment and growth opportunltles Flg 4 8 shows the
graphical relatlon between cred~t ratlng and the med~an value of select
leverage var~ables These graphs expla~n a negat~ve relatlon between credlt
ratlng and financlal varlables
4.3.9 Sales Turnover
The assets turnover reflects the efflclency wlth whlch the available
capltal 1s used A hlgh N S n A and NSlCA ratlos are a pre requlslte to obtaln
hlgh returns wlth relatively low Investment and has a posltlve effect on the
l~qu~drty of the firm, therefore reduclng the default probablllty and
apprehending the credlt ratlng These ratlos show how much sales the firm
IS generating for every rupee of Investment In assets The hlgher the ratio,
the better the firm IS performing Fig 4 9 presents the graph~cal relatlon
between credlt ratlng and the medlan value of select sales turnover varlab!es
These graphs explaln a complex relatlon between credlt ratlng and financlal
Credlt Rating and Median Values of Sales Turnover Var~ables
Fig 4 9 (a) NSIT A
2 s , = = = t i - : -
Ftg 4 9 (b) NSlCA
I m p, 0 m
C b O
0 4 0
0 21
r m 3 $ < : g * " o
4.4 Chapter Summary
The credlt analysts ln a rat~ng agency cons~der many anr~butes of a
firm, financlal as well as managerial, quantitatlve as well as qua~tatlve The
quantitatlve analysls IS malnly financ~al analysis and 1s based on the firm's
financ~al reports The analysts ascertain the financlal health of the firm,
determines the sufficiency of earnings and cash flows to cover debt
obl~gat~ons The quality of the firm's assets and the llquid~ty pos~t~on of the
firm are also ascertained The profitabll~ty of a firm will have a dlrect
relat~onshlp wlth cred~t ratlng The more profitable the firm the more
resources d has to pay debtors, and the lower its propenslty to default Hence
~t IS expected, that company's cred~t worthiness IS posltlvely related to ~ t s
profitabllltj The more Itquid assets a firm has, the lower ~ t s propenslty to
default ~n short term
The actlvlty ratlos are accounting ratlos that reflect some aspects of
the firm that have less straight forward relat~ons to credit r~sk than other
var~ables Generally, h~gher the level of coverage, h~gher 1s the cred~t ratng
The bus~ness w ~ t h lower level of coverage can get hlgher ratlngs ~f the
earnlngs are steady The cred~t rat~ngs are expected h~gher for the firrns w~th
more borrcwing The larger firms may default less frequently than the smaller
firms The age and track record of the firm is also cons~dered in major
financlal decisions by the stake holders The firms w~th h ~ g h leverage will
have h~gh exposure to default r~sk and as propensity to default A hlgh NSfrA
and NSICA rat~os are a pre-requlslte to obta~n high returns wlth relatively low
Investment and has a positlve effect on the l~quldity of the f i n , therefore
reduc~ng the default probab~l~ty and apprehending the credlt ratlng
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