UNIVERSITY OF MUMBAI

A PROJECT ON
CREDIT RATING
AGENCIES
Bachelor of Commerce
Banking & Insurance
Semester V
Submitted In Partial Fulfillment of the Requirements
For the Award of Degree of
Bachelor of Commerce- Banking & Insurance
By
Rishikesh Korhale
ROLL NO: I.13.30
Project Guide
Mrs .Lata Lokhande
SIES (Nerul) College of Arts, Science & Commerce
Plot 1-E, Sector-V, Nerul
Navi Mumbai- 400706
(2015-2016)

CERTIFICATE
This is to certify that Miss. Rishikesh Korhale has satisfactorily carried out
the project work on the topic CREDIT RATING AGENCIES under the
guidance of Mrs. Lata Lokhande, in partial fulfillment of Bachelor of
Banking and Insurance Semester V as per the curriculum laid down by the
University of Mumbai, during the academic year 2015 - 2016.
Project Guide
Mrs. Lata Lokhande

Course Co-ordinator
Mrs.Bhumika More

Principal
Dr

.Rita.Basu

Internal Examiner

External Examiner

DECLARATION
I, Rishikesh Korhale, a student of SIES College of Arts, Science
& Commerce T.Y.BI, hereby declare that I have completed the
project on the topic Credit Rating Agencies for the academic
year 2015-2016, under the kind guidance of Prof. Lata Lokhande
as a partial fulfillment of the course curriculum in the third year
Bachelor Of Banking and Insurance, Semester V. The information
submitted herein is true and original to the best of my knowledge.

Rishikesh Korhale
I.13.30

ACKNOWLEDGEMENT

Completing a task is never one persons effort. It is often the result of

in valuable contribution of number of individuals in shaping success
& achieving it. It gives me pleasure to present this project on Credit
Rating Agencies.
I am gratefully acknowledging the valuable efforts, suggestions &
clarifications provided by many for making this project practical.
I am grateful to SIES College of Arts, Science and Commerce for
giving me an opportunity to pursue B.Com B/I. I wish to thank my
project guide Mrs.Lata Lokhande who has been a perpetual source of
inspiration and offered valuable suggestions to improve my
knowledge.
I am indebted to my Coordinator Mrs. Bhumika More, for abundant
guidance, support and encouragement throughout my project.
Last but not the least I would like to extend my gratitude towards all
those people who have been associated with this project directly and
indirectly for their valuable time and inputs.

INDEX

SR

TITLE

PAGE

NO.
1

Introduction to credit rating

1.1

Definition of credit rating

5-6

1.2

Origin of credit rating

7-8

1.3

Determinants of credit rating

9-11

1.4

Utility of credit rating

11-15

1.5

Growth of credit rating

16-18

1.6

Types of credit rating

18-20

1.7

Kinds of instruments rated

20-25

1.8

Rating symbols

26-30

SEBI credit rating agencies

31-47

Registration of credit rating agency

48-50

Steps in credit rating process

51-52

3.1

Time frame process

53-59

3.2

Fundamental principles of credit rating

60

3.3

Mechanism in credit rating

61

3.4

Accounting ratios

2
2.1
3

NO.

Major players

SME

Limitations and codes of ethics

Conclusion
Bibliography

EXECUTIVE SUMMARY

Credit rating is slowly being recognized in India as a significant measure

towards investor protection and self check for the corporate enterprises of their
financial and operational strength. Credit rating provide s indicative guidance to
the prospective investor

in the fixed income

securities or fixed deposit

programs on the degree of risk involved in the timely repayment of principal

and interest . A rated company is placed higher in the estimation of the investor
than a an unrated company irrespective of better financial standing of the
latter or the reputation attached as a familiar group company of a big business
houses. This makes a transition in the corporate culture in this country. So far,
the finding show that company are shy enough to opt for credit rating unless it
is made mandatory under the government directives.

With the commencement of CRISIL (1998) and ICRA in (1991) about 400
companies have under compulsion or voluntary gone for the rating for different
debt instrument or fixed deposit programs issued by them.

It is the need of an hour to create a deeper understanding of the rating process,

procedure, practices & information requirements particularly in the minds of the
persons managing the corporate enterprises. A lot of efforts are needed to
educate the people in general and the corporate executive in particular on the
systems, methodology and practices followed by them in rating the credit
instrument and debt obligations.

Chapter 1
INTRODUCTION TO CREDIT RATING

The Ratings industry in India has been built up to its present position over a
period of fifteen years. Over the years, credit ratings have evolved into a 90crore market, with four agencies providing rating services, and significant pull
from investors for the product. The ratings business in India has seen three
phases. During the first of these phases, as described above, there was no
experience of credit ratings, and virtually no awareness, on the part of investors
and issuers.
The second phase saw the advent of regulatory support for credit
ratings, with the introduction and Increasing rigor of regulations covering
primarily the markets for public issue of debt and for fixed deposits. Aimed at
protecting smaller investors, these measures also amounted to regulatory
recognition of the role of credit ratings and the quality of the effort put in till
then, in estimating credit quality. With these measures, credit ratings rapidly
passed out of the arcane realm of high finance, and into the lexicon of the
individual market participant. This phase also saw the arrival of competition, in
the form of other domestic agencies entering the market.
Recent years have seen a third phase of the markets development
with public issues of debt reducing in volume; the focus has shifted to the
market for private placements. Almost all the privately placed debt issued in the
Indian market is rated, even though this is not a regulatory requirement. This
shift is entirely driven by investors in these securities, who typically tend to be
highly sophisticated financial sector entities. We are looking therefore at a
qualitative maturing of the market, where a rating is required not as a
compliance issue or a mandatory requirement, but as an opinion on credit
quality demanded by discerning buyers.
Going forward, following trends are expdifferent types of mouse
More intensive use of ratings by investors.
7

- Increasing sophistication in use of ratings.

These two trends will result in credit ratings not being used only as a
go- no-go input, as is currently often the case. We expect the major use of
credit ratings to be in the pricing of debt instruments. The correlation of yields
and ratings, already strong, will deepen as the bond market evolves further.
Measures increasing the sophistication of the market, such as the introduction
of credit derivatives, will add a further dimension to the use of ratings.
Credit rating is also known as SECURITY RATING in India. It is
mandatory for the issuance of debt instruments, debentures, commercial paper
issued by corporate and public deposits of all NBFCs (Non Banking Financial
Companies).

Chapter 1.1
DEFINITION OF CREDIT RATING

Credit ratings are judgments about firms financial and

business prospects. Credit rating is defined as a process by which a
statistical service prepares various ratings identified by symbols which are
indicators of the investment quality of the credit rated. The credit may be a debt
instrument or equity. In case of debt, ratings are given while in the case of
shares grading is done.
It is an independent assessment of the creditworthiness of
a bond (note or any security of any indebt ness) by a credit rating agency. It
measures the probability of the timely repayment of principal and interest of a
bond. Generally, a higher credit rating would lead to a more favorable effect on
the marketability of a bond. The credit rating symbols (long term) are generally
assigned with triple A as the highest and triple B as the lowest in investment
grade. Anything below triple B is commonly known as a junk bond.

Credit rating is the process of assigning standard scores

which summarize the probability of the issuer being able to meet its repayment
obligations for a particular debt instrument in a timely manner. Credit rating is
integral to debt markets as it helps market participants to arrive at quick
estimates and opinions about various instruments. In this manner it facilitates
trading in debt and money market instruments especially in instruments other
than Government of India Securities. Credit rating is not a recommendation to
buy, hold or sell.
Rating is usually assigned to a specific instrument rather than
the company as a whole. In the Indian context, the rating is done at the
instance of the issuer, which pays rating fees for this service. If it is unsatisfied
with the rating assigned to its proposed instrument, it is at liberty not to disclose
the rating given to it. There are 4 rating agencies in India. These are as follows:

Credit rating is a dynamic concept and all the rating

companies are constantly reviewing the companies rated by them with a view
to changing (either upgrading or downgrading) the rating. They also have a
system whereby they keep ratings for particular companies on "rating watch" in
case of major events, which may lead to change in rating in the near future.
Ratings are made public through periodic newsletters issued by rating
companies, which also elucidate briefly the rationale for particular ratings. In
addition, they issue press releases to all major newspapers and wire services
about rating events on a regular basis.

Indian credit rating agencies define credit rating as follows:

According to CARE: Credit ratings is essentially, the opinion of the rating

agency on the relative ability and willingness of the issuer of a debt instrument
to meet the debt service obligation as and when they arise.

According to CRISL: Credit rating is an unbiased, objective and independent

opinion to an issuers capacity to meet financial obligation, it is the current
opinion as to the relative safety of timely payment of interest and principal on a
particular debt instruments. Thus, rating applies to a particular debt obligation
of the company and is not a rating for the company as a whole

According to ICRA: credit rating is a simple and easy to understand symbolic

indicator of the opinion of the credit rating agency about the risk involved in a
borrowing program of an issuer with reverence to the capability of the issuer to
repay the debt as per terms of issues. This is neither a general purpose

10

evaluation of the company nor the recommendation to buy, hold or sell a debt
instrument.

Thus, precisely, rating is a measure of credit risks and is only element in the
investment decision making.
Credit rating does not indicate market risks or predict prices or yield of credits
instrument. It evaluates only a specific instrument and indicates risk associated
with such instrument only. It is general purpose evaluation of the issuer
business or operations.

Chapter 1.2
ORIGIN OF CREDIT RATINGS

11

The concept of Credit Rating originated in the United

States. The first Credit Ratings were published by John Moody during 1909 in
his analysis or rail road investments. This evolved into the rating company,
Moodys Investors Services Inc, a division of Dun and Bradstreet Inc.
Moody was followed by Poors publishing Company in
1916 and the Standard Statistics Company in 1922, which merged, into Poor to
become the largest bond rating concern, Standard and Poors corporation, a
subsidiary of Mc Graw Hill, Inc. The third is Fitch publishing company of New
York, which was established in 1924. The fourth agency is Duff & Phelps of
Chicago, which was recognized by Securities and Exchange Commission in
1982. It acquired Crisanti and Maffei Inc. of New York in 1991. These four
security raring agencies are the only ones with Securities and Exchange
Commission recognition as national bond rating agencies. There are other
services that rate securities especially stock, like Value Line Investment Survey.
The recognition of rating agency by Securities and Exchange
Commission in U.S.A does not constitute approval. Actually, such recognition is
not necessary to enter the security rating business. SEC uses the ratings of
recognized agencies for evaluation of bong assets of brokers and dealers
registered with it.
In India there are 5 credit rating agencies. First, Credit
Rating Information Services Of India Limited (CRISIL) set up by ICICI AND UTI
in 1988. Secondly Investment Information and Credit Rating Agency of India
limited (ICRA) set up by IFCI in 1991. Thirdly, Credit Analysis and Research
Limited (CARE) promoted by IDBI in 1993 in association with financial
institutions. Fourthly, Duff and Phelps Credit Rating India Private Limited (DCR
India) for rating non-banking financial companies for fixed deposits.

12

Chapter 1.3
DETERMINANTS OF CREDIT RATINGS

13

Credit rating is a symbolic indicator of the current opinion

of a rating agency of the willingness and relative of an issuer debt instrument to
pay interest and repay principal as per the terms of the contract. A rating
agency assigns quality ratings that measures the default risk of a security and
sells rating to their subscribers. The default risks primarily determined by the
amount of work available to the issuer relative to the amount of funds to be paid
to the security holders. The ability to pay is evaluated by financial ratios. Ratio
analysis is done to analyze the present and future earning power of the
company issuing the security. Ratio analysis of the issuers financial statements
yields insights about the strength and weaknesses of the company. The credit
rating agencies have written guidelines about what values particular ratios
should have in order to earn each different quality ratings.
Credit rating appraises the default risk which is a combination
of business risk and financial risk.

Business Risk: Business risk relates to the market position of the company,
operating efficiency and management quality. The key factor taken into
consideration are: the nature of the industry the company is in, the demandsupply position, cyclical/ seasonal factors and government policies vis--vis the
industry; and the competition its facing within the industry.
Market Position: The market share the company enjoys, it is competitive
advantages and selling and distribution arrangements.
Operating Efficiency: Locational advantages, labor relationships, cost
structure, technological and

manufacturing efficiency as compared to its

competitors.
Legal Position: Terms of prospectus, systems for timely payment, and for
protection against fraud.
14

Financial Risk: Financial risk is a function of the profitability, debt leverage

flexibility and adequate cash flow. The assessment of financial risk is done on
the basis of:
a) Financial analysis, including accounting quality: accuracy of statement of
profit, auditors comments, valuation and depreciation policies.
b) Earnings protection: Sources of future earning growth, profitability ratios and
earnings in relation to fixed income charges.
c) Adequacy of cash flow: Sustainability of cash flows and working capital
management.
d) Financial flexibility: Ability to raise funds.
Management: An evaluation of the management, which is qualitative in nature
and imparts certain amount of subjective element, is done on the basis of track
record of the management; planning and control system, depth of managerial
talent, succession plans. Evaluation of capacity to meet adverse situations,
goals, philosophy and strategies.
Environment: An analysis of environment covering regulatory and operating
environment, national economic outlook, pending litigation and unpaid taxes
are also attempted.
Rating thus is not based on a predetermined formula which specifies
the relevant variables and as well as weights attached to each one of them.
Further the emphasis on different aspects varies from agency to agency.
Broadly the rating agencies assures itself that there is good congruence
between assets and liabilities of a company and downgrades the rating if the
quality of the assets depreciates.
The rating agencies employ qualified professionals to ensure
consistency and reliability. The agencies also ensure the integrity of rating by
insulating rating from conflicts of interest.

15

The rating agencies employ nearly identical symbols. They

examine the above factors before assigning a grade. The symbols are A, B, C
and D and each symbol is graded with associated risk by adding two or one of
the same symbol, like AAA, AA and A; BBB, BB and b; and so on

Chapter 1.4
UTILITY OF RATINGS

16

Investors have always received credit ratings with enthusiasm. But

issuers do not share the enthusiasm since they have to share their securities at
higher yields if their issue gets inferior rating.
Credit rating gives an investor a simple and easy indicator to the credit
quality of the debt instrument, the risks and likely returns, thus providing a
yardstick against which the risk inherent in an instrument can be measured. An
investor uses the rating to assess the risk level and compares the offered rate
of return, which is expected rate of return (for the given level of risk) to optimize
his risk return trade- off. Ratings also provide a comparative framework, which
allows the investor to compare investment opportunities.
Credit rating also benefits the issuer. If a public offer is contemplated, the
financial manager must bear in mind the rating while determining the
appropriate leverage. Additional debt may lower the rating from an investment
to a speculative grade category, thus rendering the security ineligible for
investment by many institutional investors. It may well be that the advantages
of debt outweigh the disadvantages of the lower credit rating.
Junk bonds, for instance, are a high risk and a high yield (16 to 25% in
USA) instruments. Investment may be limited in such instrument to what an
investor can afford to loose.
Ratings will also effect the pricing of the issue. Actually pricing should
reflect the rating. The marketability of a relatively unknown issuer who is
competent is enhanced and the role of name recognition in an investment
decision is minimized.

In actual practice ratings are reflected in prices. There is no

difference between the interest rates that are paid on the fixed deposits of two
companies even if they are rated differently. Same is true of long dated
17

debentures. But in commercial paper market where banks are major players
differentials in ratings are reflected in pricing. A reliance CP would be cheaper
than of a company, which is not rated well.
Ratings are used by brokers for opinions and as a service for
their customers. Insurance companies and mutual funds use them in the
purchase of securities even though their own staff prepares investment
analysis. Portfolio managers also use them in security management. Banks
depend on them for their investment in commercial paper. Individual investors
depend on them for their decisions to place fixed deposits. Ratings are bound
to assume greater importance with the institutionalization of investors in the
form of unit trusts, mutual funds, pension and provident funds. The debt has
shown considerable buoyancy in 1996 not only at the wholesale level
(institutional investors) but also at retail level in view of poor offerings of equity
in the primary market. This has come about largely on account of the
availability of ratings on debt instruments, which boosted investor confidence.

Chapter 1.5
THE GROWTH OF CREDIT RATING INDUSTRY IN INDIA

18

The prominent rating agencies in India are: i)

CRISIL: - Credit Rating Information Services of India Limited.

ii)

ICRA: - Investment Information and Credit Rating Agency of India

Limited.
iii)

CARE: - Credit analysis and Research Limited.

iv)

Fitch Ratings India Private Limited.

Fitch Rating India Limited was formally known as DCR India- Duff and

Phelps Credit Rating Co. USA and DCR India merged to form a new entity
called Fitch India. Fitch India is a 100% subsidiary of Fitch IBCA, and is the
only wholly owned foreign operator in India. Fitch is the only international rating
agency with a presence on the ground in India.
The Indian credit rating industry is next to US in terms of number of
ratings issued and in the number of agencies. Between the four rating agencies
in India, over 5,000 ratings have been issued for around 1,400 issuers. CRISIL
is the market leader in credit rating agency with a 65% market share.
The regulators support played an important role in the development of the
credit rating industry. In 1992, for the first time, the Reserve Bank introduced
the requirement of rating for commercial papers. SEBI followed up by
introducing mandatory ratings of bonds. The other growth drivers of the credit
rating industry were declining interest rates, a shift towards market borrowings
from bank loans and a steep increase in the state government borrowings
through special purpose vehicles. Besides these factors the growth in the
private placement market of debt increased business volume in the credit rating
industry. For private placements, rating is not mandatory but mutual funds and
banks ask for a rating. In 1997, the penetration of rating, that is, the number of
rated issues, out of the total number of issues was 35%. In the year 2002, it
was 97%.

This means that the credit rating industry has transited from a
19

regulatory driven market to an investor driven market in the growing debt

markets. Between fiscal 1997 and 2001, rated debt volumes increased from Rs.
13,743 crore to Rs. 52,746 crore, which is 84% of the total issuance.

Chapter 1.6
TYPES OF CREDIT RATINGS

20

Two type of credit rating has been noticed :

1) Traditional debt rating (TDR)
2) Private placement rating (PPR)

Traditional debt ratings (TDR): Traditional debt ratings are a symbolic

prediction about the debt security probability resulting in a default in timely
payment of interest and principal. In other words, traditional debt rating reflects
the current opinion of a credit rating agency of the relative capability and
willingness of an issuer of a debt instrument to service the debt obligation as
per the term of contract .Traditional debt rating is specific to specific to to a
debt instrument in term of credit risk associated with such

instrument

.Traditional debt rating enable an investor to establish a link between risk and
return and provide a symbolic yardstick to identify the risk level associated with
the instrument and the return it offers to match with his preferences with
expectations
Private placement rating (PPR): Privately rating is newly introduced credit
rating system finding in the literature generated by standard & poor on credit
rating , private placement rating is not much different to traditional debt rating
but it goes one step ahead to traditional debt rating ,ie. Apart from evaluating a
risk of default in timely payment it also evaluates the likelihood of loss to an
investor in the vent of default according on the investment .

Never the less, either or both of the two types of rating can be used for new
issues of debt securities or structured obligations.

21

Chapter 1.7
KINDS OF INSTRUMENT RATED

22

Followings are the bodys or organization which can be rated :

1) Manufacturing Companies
2) Banks
3) Non Banking Financial Institution
4) Financial Institutions
5) Housing Finance Companies
6) Municipal Bodies
7) Companies In Infrastructure Sector

To keep the pace with the changing credit requirements of new instruments the
rating agencies have been upgrading the technology and bringing in analytical
innovation. The instrument being rated by such agencies include:
1) Mortgage & Asset Backed Securities
2)

Letter Of Credit Backed Bonds, Commercial Paper and Structure Finance

For Global Market;

3) Project Finance
4) Municipal and Corporate Bond Insurance;
5) Bonds and Money Market Funds;
6) Syndicated Banks Loans:

In Indian context
With reference to India the rating agencies have been rating the following
types of debts & debt obligations:
1) Debenture Bonds
23

2) Fixed Deposits
3) Commercial Paper
4) Structured Obligations
5) other ratings :
a) Utilities Rating
b) State Government Ratings
c) Asset Backed Securieties
d) Mutual Funds Rating
e) Equity Grading/Assessment
f) Bank Lines Of Credit
g) Others

DUAL RATINGS s
Dual Rating would mean rating opinion on one or more instrument s from two
different rating agencies. Such dual rating leaves several question unanswered
in the minds of the investor ,viz. firstly, which of the two CRAS rating opinion
relied upon ;secondly ,why the difference in two rating should occur when both
follow alike methodology, and thirdly, if such difference is unavoidable why
should not the rating s be rendered unreliable etc

Chapter 1.8
RATING SYMBOLS

24

Rating agencies use symbols such as AAA, AA, BBB, B, C, D,

to convey the safety grade to the investor. Ratings are classified into three
grades: High investment grades, investment grades and speculative grades. In
all ratings is classified into 14 or 15 categories. Signs + or - are used to
show the certainty of timely payment. The suffix + or may be used to indicate
the comparative position of the instrument within the group covered by the
symbol. Thus FAA- lies one notch above FA+. To provide finer gradations,
rating industry attach + or to their ratings. The rating symbols for different
instruments of the same company need not necessarily be the same.
High Investment Grades AAA: - Triple A denotes highest safety in terms of
timely payment of interest and principal. The issuer is fundamentally strong and
any adverse changes are not going to affect it.
AA: - Double A denotes high safety in terms of timely payment of interest and
principal. The issuer differs in safety from AAA issue only marginally.
Investment Grades A : - denotes adequate safety in terms of timely payment
of interest and principal. Changes in circumstances can adversely affect such
issues.
BB: - Triple B denotes moderate safety in terms of timely payment of
interest and principal speculative grades.

Speculative Grades

BB: - Double B denotes inadequate safety terms of

timely payment of interest and principal. Uncertain changes can lead to

inadequate financial capacity to make timely payments in the immediate future.

25

B: - denotes high risk. Adverse changes could lead to inability or

unwillingness to pay timely

payment.

C: - denotes substantial risk. Issue rated is vulnerable to default.

D: - denoted default in terms of timely payment of interest and principal.
These symbols are just a current opinion of an agency and they are not
recommendations to invest or not to invest. The rating assigned applies to a
particular instrument of the company and is not a general evaluation of the
company.
Rating Fees: -In the credit rating business, the users of rating service, such as
investors, financial intermediaries and other end- users, do not pay for it. The
issuer of the financial instrument pays fees to the credit rating industry and this
is the major source of revenue to the rating agency. Today issuers fees
constitute 95% of the total revenues of the rating agencies. In India rating
agencies charge 0.1 % of the instrument size as rating fees. They also charge
an annual surveillance fees at a rate of 0.03% to monitor the instrument during
his life.

Chapter 2
SEBI REGULATIONS FOR CREDIT RATING AGENCIES

26

SEBI issued regulations for credit rating agencies in 1999. These

regulations are called as Securities and Exchange board of India. (Credit
Rating Agencies) Regulations, 1999.
Only commercial banks, public financial institutions, foreign banks
operating in India, foreign credit rating agencies, and companies with a
minimum net worth of Rs 100 crore as per its audited annual accounts for the
previous five years are eligible to promote rating agencies in India.
1) Rating agencies are required to have a minimum net worth of Rs 5 crore.
2) Rating agencies cannot assess financial instruments of their promoters who
have 10 % stake in them.
3) Rating agencies cannot rate a security issued by an entity, which is (a) a
borrower of its promoter. (b) a subsidiary of its promoter. (c) an associate of
its promoter, if (i) there are common chairman, directors between credit
rating agency and these entities (ii) there are common employees (iii) there
are common chairman, directors, employees on the rating committee.
4) Rating agencies cannot rate a security issued by its associated or
subsidiary, if the credit rating agency or its rating committee has a chairman,
director or employee, who is also a chairman, director or employee of any
such entity.
5) A penalty of suspension of the certificate of registration or a penalty of
cancellation of registration may be imposed on the rating agency if it fails to
comply with the condition or contravenes any of the provisions of the Act.

Chapter 2.1
REGISTRATION OF CREDIT RATING AGENCIES

27

1) Grant of Certificate
i)

Any person proposing to commence any activity as a credit

rating agency on or after the date of commencement of these regulations shall

make an application to the Board for the grant of a certificate of registration for
the purpose.
ii) A non- refundable application fee shall accompany an application for the
grant of a certificate.
2) Promoter of Credit Rating Agency
The Board shall not consider an application under unless a person
belonging to any of the following categories promotes the applicant:
a)

A Public Financial Institution.

b)

A Scheduled Commercial Bank.

c)

A Foreign Bank operating in India.

d)

A foreign credit rating agency having at least five years experience in

rating securities.

e)

Any company or a body corporate, having continuous net worth of

minimum rupees of one hundred crores for the previous five years prior to
filling of the application with the board for the grant of certificate under these
regulations.

3) Eligibility Criteria
The Board shall not consider an application for the grant of a
certificate unless the applicant satisfies the following condition: 28

a) The applicant is set up and registered as a company under the Companies

Act, 1956;
b) The applicant has, in its memorandum of Association, specified rating
activity as one of its main objects;
c) The applicant has a minimum net worth of rupees five crores.
d) The applicant has adequate infrastructure, to enable it to provide rating
service.
e) The applicant and the promoters of the applicant have professional
competence, financial soundness and general reputation of fairness and
integrity in business transactions, to the satisfaction of the Board.
f) Neither the applicant, nor its promoter, nor any director of the applicant or its
promoter, s involved in any legal proceeding connected with the securities
market, which may have an adverse effect on the interest of the investors;
g) Neither the applicant, nor its promoters, nor any director, or its promoter has
at any time in the past been convicted of any offence involving moral
turpitude or any economic offence.
h) The applicant has, in its employment, persons having adequate professional
and other relevant experience to the satisfaction of the Board.
i) The applicant in all other respects is a fit and a proper person for the grant
of a certificate.
j) The grant of certificate to the applicant is in the interest of the investors and
the securities market.

4) Application to Conform to the Requirements

The Board shall reject any application for a certificate, which is not
complete in all aspects or does not confirm to the requirements of regulation or
29

instructions. Providing that, before rejecting any such application, the applicant
shall be given an opportunity to remove. Within thirty days of the date of receipt
of relevant communication, from the Board such objections as may be indicated
by the Board.
Provided further, that the Board may, on sufficient reason being
shown, extend the time for removal of objections by such further time, not
exceeding thirty days, as the Board may consider fit to enable the applicant to
remove such objections.

5) Furnishing of Information, Clarification and Personal Representation

i)

The Board may require the applicant to furnish such further information
or clarification, as the Board may consider necessary, for the purpose
of processing of the application.
ii) The Board, if it so desires, may ask the applicant or its authorized

representative to appear

before the Board, for personal representation in

connection with the grant of a certificate.

6) Grant of certificate
i) The Board. On being satisfied that the applicant is eligible for the grant of a
certificate of registration, shall grant a certificate.
ii) The grant of certificate of registration shall be subject to the payment
of the registration fee specified.
7) Conditions of Certificate and Validity Period
The certificate shall be granted subject to the following conditions,
namely;
30

a) The credit rating agency shall comply with the provisions of the Act, the
regulations made there under and the guidelines, directives, circulars and
instructions issued by the Board from time to time on the subject of credit
rating.
b) Where any information furnished to the Board by a credit rating agency:
i)

is found to be false or misleading in any material particular; or

ii) has undergone change subsequently to its furnishing at the time of the
application for the certificate; the credit rating agency shall forthwith inform
the Board in writing;
c) The period of validity of the certificate of registration shall be three years.
8) Renewal of certificate
A credit rating agency, if it desires renewal of the certificate granted to
it, shall make to the Board an application for the renewal of the certificate or
registration within 3 months before expiry of the period of the validity of the
certificate.
The application for the renewal shall be accompanied by a renewal fee.

Chapter 3
STEPS IN CREDIT RATING PROCESS

31

Rating may differ with respect to different instrument of same organization . Also
different rating assigned to different instrument of two different organizations
does not indicate the superiority or inferiority of the organizations . the steps
involved in credit rating activity are given below :
PROCESS FLOW CHART OF CREDIT RATING

MANDATE
INITIAL STAGE
ASSIGN RATING TEAM
RECEVE INITIAL INFORMATION,
CONDUCT BAIC RESEARCH
MEETING & VISIT
FACTS FINDING &
ANALYSIS
ANALYSIS & PREPARTION OF REPORT
STAGE
PREVIEW MEETING
RATING
FINALISA
TION
CLARIFI
STAGE

RATING MEETNG

ASIGN RATING
COMMUNICATE THE RATING & RATIONALE
ACCEPTNCE
32

FRESH INPUT

REQUEST FOR
REVIEW
NON ACCEPTANCE

SURVEILLANCE

The entire rating process is normally completed in three stage in practical

scenario1) Primary Or Initial Stages.
2) Facts Finding & Analysis Stage.
3) Rating Finalization Stage.
1) The rating process begins at the request of the company.
2) The tem consisting of professionally qualified

analyst well versed with the

workings of the industry in which the company operates, first visits the
company plants and inspect the operations first hand .
3) Meeting with different levels of management follow culminating with the
meeting with chief executive officer.
4)

Generally, middle & top level management meeting cover the field of
operations , finance , marketing , project, etc.

5) In completion of the assignment , the tem interacts with the back up tem that
has separately collected the additional industry information and prepares a
report
6) The report is then placed before n internal committee consisting of senior
executives of credit rating agency who themselves have hands on experience
in rating assignments.

33

7) The internal committee then has an open discussion with the tem member
and amongst themselves arrives at rating.
8)

To avoid any type ort of bias, the ratings proposed are placed before an
external

committee consisting of eminent people unconnected with credit

rating agency .
9) The external committee then takes the final decision which is communicated
to the company .
10)The company may volunteer ny further information at this point which could
effect the ratings, it is passed ion to the external committee again for
affirmation/change.
11) The company has the option to request the agency for review of the rating.

Chapter 3.1
TIME FRAME FOR RATING PROCESS

34

From Time to Time frame

Initial request

Meeting with management

4-6 weeks
Meeting with management

Initial rating indication

4-

6weeks
Initial rating indication

Publication of rating
Time depends
Upon

completion

of formalities

Chapter 3.2
FUNDAMNETAL PRINCIPLE OF RATING & GRADING

35

The basic requirement in risk grading is that it should reflect a clear and fine
distinction between credit grades covering default risks and safe risks in the
short run. While there is no ideal number of grades covering default raks in the
short run . while there uis no ideal number of grades that would facilitate
achieving this objective, it is expected that more granularity may serve the
following purpose :

1) Objective analysis of portfolio risks.

2) Appropriate pricing of various risks grade borrowers, with a focus on low
risk borrower in term of lower pricing
3) Allocation of risk capital for high risk graded exposures
4) Achieving accuracy and consistency.
According to the RBI, there should be an ideal balance (in numbers) between
acceptable credit risk and unacceptable credit risk in a grading system. It is
suggested that:
1) A rating scale may consisit of 8 9 levels.
2) Of the above, the first levels may represent acceptable credit risks
3) The remaining four levels may represent unacceptable credit risks.

Chapter 3.3
MECHANISIM OF CREDIT RATING

36

The quantitative & qualitative factors in the case of whole sale exposure and
four type factors in the case of retail sector needed to be accorded weight or
scores. The aggregate outcome will reflect the rating /grade of an exposure
against a benchmark. Hence the mechanism must lay down the following:
1) For wholesale exposure :
The marks for each parameter , with a randge of marks for various ranges of a
parameter have to be fixed .
If the growth in the last completed year compared with the previous year is :
20% & above

4 marks

15% to less than 20%

3 marks

5% to less than 15%

2 marks

0% to less than 5%

1 marks

Negative growth:

0 marks

For qualitative factors, also, there can be suitable scoring based on excellent
(maximum marks) and the lowest one non satisfactory (zero marks) may be
fixed.
2) Aggregate marks for all the applicable parameters for each category may
then be mapped into various grades taking the maximum marks as 100,
as shown below.
3) Wherever a particular parameter is not applicable for an exposure , it
may be ignored and the aggregate marks be readjusted / graded
accordingly

37

Sl.

Total score for an

Grade

Implication of

No.

exposure

accorded

grade accorded

86-100

AA+

Excellent safety

71-85

AA

Very good safety

61-70

Good safety

51-60

BB+

Ordinary safety

41-50

BB

Less ordinary

36-35

safety
Low safety

31-35

Unsafe safety

0-30

Loss category

For retail exposure (consumer lending):

1) As with the wholesale exposure, maximum marks for each parameter
can be fixed. for example, age, months, income etc.
2) Similarly, aggregate marks for each parameter can be determined the
overall grading of the account. While there may be eight grades in
wholesale exposure because of the risk related issue in pricing involved,
in the case of retail exposure, four/five grades are considered sufficient.

3) The scoring /grading system in various banks / financial institution may

vary substantially depending on inter alia, risk perceptions, thrust area
and other allied factors.

Chapter 3.4
ACCOUNTING RATIOS FOR RISK EVALUTION

38

A ratio conveys a quantitative interrelationship between two attribute/variable

for eventual comparison against the bench mar and for trend analysis. in
business , accounting ratios facilitate

meaningful and purpose oriented

decision ma,ing . Its utility I determined according to the purpose for which the
ratio is computed.
From the age of credit risk valuation , accounting ratios plays significant role
for a lending/investment banks, since the overall computation of type credit
rating of their account /exposure I aided/ supported by ratio analysis also.
Hence, not , not only is it necessary to identify the relevant ratios depending
upon the purpose, quantum, tenure of exposure etc but also in marketable
securities ( rated by approved external rating agency ) , one may focus more on
current ratio/net profit/sales ratio than an long-term solvency ratios.

Internationally, there are no prescribed accounting ratios for risk evaluation. In

India, too, the banking regulatory authorities have left such matter to the the
judgments and discretion of the banks/financial institution to go by established
financial practices and frame an accounting ratio policy that is relevant to the
purpose of its credit risk evaluation .

RATIOS FOR CREDIT EVALUATION

For identification criteria for example, items of current asset , current

liabilities, etc-one is to be guided by standard accounting practices
39

1) short term solvency angle :

a) Current ratio: Current asset

Current liabilities
Minimum expected level: 1.3:1

For financing working capital requirement based on the turnover method

for small & medium enterprise (sme) and others, the mininmum
expected level may be 1.10:1.
b) Acid test ratios: Quick assets
Quick liabilities
Minimum expected level : 1:1
For SMEs the minimum expected level may be 0.8:1
c) Cash ratio: Cash +Bank Balance+Marketable Securities
Current liabilities
Minimum expected level: 0.5:1
For SME the minimum may be lower
2) Long term solvency angle:
d) Debt eqity ratio : Total external liabilities
40

Equity (owned funds)

Maximum allowable level: 2:1

e) Debt servicing coverage ratio:

Earning available for debt service
One year debt installment payment + interest thereon

Earning includes:

Net Profit :

****

(+) depreciation on fixed asset ,

**

(-) loss on the sale of fixed assets

**

Interest on debt for one year

**
****

Minimum expected level: 1.5:1

For the priority sector. SME etc, the minimum may be allowed at 1:30:1
3) Profitability angle:
41

a) Operating profit ratio :

Profit before deduction of depreciation ,tax & finance
charges
Sales/income
the expected level will depend upon the nature of the industry/business,
operational area, size of the unit, the duration of the business being carried on,
trend analysis and other relevant factors. However, a good unit is likely to show
at least a margin of 25-30 %
b) Return on capital employed ratio (ROCE) :
Operating profit
Owned funds+long term loan
funds
The expected level will depend upon the nature of the industry /business,
operational area, size of the unit, the duration of the business being carried on,
trend analysis and other relevant factors, however, a good unit is likely to show
at least a margin of 15-20%

c) Interest coverage ratio :

Operating profit
Interest liability

42

Subjected to the factor as stated above:

d) Profit asset ratio :
Operating profit
Total tangible asset

Subjected to the factor as stated

e) Indirect overhead ratios
finance charges+ depreciation + selling and administrative cost
Sales/income
The maximum allowable unit as stated above , however , it might be 10-15% .
From the asset movement angle
a) Inventory holding *300 days**
sales

b) Trade debtors*300 days**

(Preferably average outstanding in a year )
Sales/income
43

c) Trade creditors*300 days**

(preferably average outstanding in a year )

Credit purchase of current assets
(preferably average level in a year)
** computation based on 300 days in a year is advisable in Indian context
keeping in the view the usual 52 weekly offs, national holidays,etc
The expected level varies from case to case as stated above , however
,generally , the maximum level in terms of days may be between 90 and 120 .
From the stress angle:
(the Basel committee states : stress testing has been adopted as a generic
term describing various technique used by banks to gauge their potential
vulnerability to exceptional , but plausible, events.)

Stress tested cash flow

Debt payment +preference dividend+interest

For this purpose, cash flow would include only operating cash flow (ignoring
investing cash flow @ financing cash flow). As a point of the stress testing
scale, a reduction of a certain percentage in incomes/sales with the
simultaneous increase in the expenses (for example. Direct costs etc ) may
44

result in charge ( reduction) in cash flow . There is no minimum or maximum.

The stress percentage depends upon the industry, operating envoirment and
also the overall business envoirment at the time of analysis.
The above cluster is only indicative of the ratios that a commercial
bank/financial institution may find usefull from the credit risks evaluation angle.
There, may be other important ratios as well, such as :
1) Finished Good Holding
2) Cash Flow Interest Coverage
3) Capital Gearing Ratio
4) Proprietary Ratio.

PRACTICAL IMPLICATION OF ACCOUNTING RATIO IN CREDIT RISKS

EVALUATION

45

Accounting ratios are usually computed on the year end position of asset ,
liabilities, profit/loss account competent ( over a position of generally 12
months) as reflected in the financial statements . This is based on a going
concern concept approach. However , one limitation here is that the static
view of the asset liability at the end of the year may not reflect the true and
correct position .the alternative is to collect the figures from the party concerned
say , on a monthly basis( or as frequently as may be possible) and average the
same on a 12 months basis . This may then, for credit risks evaluation process,
be a more effective and dynamic tool . Irrespective of whether a bank financial
institution follows the year end or average method of computation, the
implication from the credit risks evaluation angle will depend upon:
Adopting an appropriate credit rating system with generally a large number of
grades , where one of the inputs would be accounting ratios.
The bank/financial institution will have to decide as a matter of corporate
finance policy the nature of the accounting ratio to be used for credit risk
evaluation/( for example , there may be different focus in assessing working
capital for loans for fixed asset or for non funded facilities/investment in
securities, etc.
Specific weight has to be allocated for accounting ratios (from the credit rating
angle).
Say,20 out of the total of 100 points for the entire credit rating structure .
The benchmarking for each ratio should be consistent with the bank/financial
institutions corporate finance policy.
The maximum weight age for each component of the ratio should be fixedsay.4 out of 20 points (20 being the total for all accounting ratios put together)

46

Ratios conforming to the benchmark should be awarded the highest points

.those below the benchmark should be ranked with the varying points. Down to
even zero.
Total marks awarded for all adopted ratios should then be carried forward to the
overall credit rating structure so as to arrive at final grade for each account
/exposure.
In sum, accounting ratios is inseparable arm of the credit risks evaluation and
its actual implication will depends upon the purpose, quantum and tenure of the
exposure on a case by case basi

Chapter 4

47

MAJOR PLAYER IN CREDIT RATING & THEIR RESEARCH

METHODOLOGY

CRISIL
INTRODUCTION:

The rating industry in India was ushered in 1988 with the setting
up of Credit Rating and Information Services of India Limited (CRISIL) followed
by three more, the latest entirely devoted to rating NBFCs. The industry is
sustained by mandatory requirement for rating debt instruments. Crisil was set
up by ICICI and UTI in 1988.
Standard and Poor rating service (S&P) has formed a strategic
alliance in 1996 with CRISIL for providing analytical and business development
co-operation. S&P will share with CRISIL its advanced rating methodologies
and analytical criteria and assist on other aspects of credit rating agency
operations. CRISIL would in turn offer business development assistance in
India and insight into local debt market and issuers.
The purchase by S&P of 6 lakhs shares in 1997 of CRISIL from
Asian development Bank to acquire a stake of 9.6 % in CRISIL is a logical
culmination of the strategic alliance into earlier. Asian Development Bank

48

invested in 1988 in CRISIL as an effort to play a catalystic role in its

establishment.

CRISIL RTAING METHODLOGY:

The rating methodology followed by CRISIL involves an analysis of the

following factors: i) BUSINESS ANALYSIS
a) Industry risk, including analysis of the structure of the structure, the
demand-supply position, a study of the success factors, the nature and
basis of competition, the impact of government policies, cyclicity and
seasonality of the industry.
b) Market position of the company within the industry including market
shares, product and customer diversity, competitive advantages, selling
and distribution arrangements.

c) Operating efficiency of the company like locational advantages, labour

relationships, technology, manufacturing efficiency as compared to
competitors.
d) Legal position including the terms of the prospectus, trustees and their
responsibilities as systems for timely payments.
ii) FINANCIAL ANALYSIS

49

a) Accounting quality like any overstatement or understatement of profits,

auditors qualification in their reports, methods of valuation of inventory,
depreciation policy.
b) Earnings protection in terms of future earning growth for the company and
future profitability.
c) Adequacy of cash flows to meet debt servicing requirements in addition to
fixed and working capital needs. An opinion would be formed on the
sustainability of the cash flows in the future and working capital
management of the company.
d) Financial flexibility including the companies ability to source funds from
other sources like group companies, ability to defer capital expenditure
and alternative financing plans in times of stress.
iii) MANAGEMENT EVALUATION
a) The quality and ability of the management would be judged on the basis
of past track record, their goals , philosophies and strategies their ability
to overcome difficult situations, etc. In addition to ability to repay, an
assessment would be made of the managements willingness to pay debt.
This would involve an opinion of the integrity of the management.
Iv) FUNDAMENTAL ANALYSIS
a) Capital adequacy, that is the true net worth as compared to the volume of
business and risk profile of assets.
b) Asset quality including the companies credit risk management, systems
for monitoring credit, exposure to individual borrowers and management
of problem credits.

50

c) Liquidity management, Capital structure, term matching of assets and

liabilities and policies on liquid assets in relation to financial commitments
would be some of the areas examined.
d) Profitability and financial position in terms of past historical profits, the
spread on funds deployed and accretion to reserves.
e) Exposure to interest rate changes and tax law changes.

51

RATING PROCESS

CRISIL's rating process and rating committee are designed to

ensure that all assigned ratings are based on the highest standards of
independence and analytical rigor.
The rating committee comprises members who have the
professional competence to meaningfully assess the credit analysis that
underlies the rating, and have no interest in the entity being rated. A team of
analysts carries out the credit analysis . Each team has at least two members.
CRISIL's analysis is based on issuer meetings and an understanding of the
business environment. The analysis is carried out within the framework of
clearly spelt-out rating criteria.

Rating Process
Management Meeting
Rating Committee and assignment of rating
Confidentiality
Advice to Issuer
Publication
Surveillance and Annual Review
CRISIL ensures confidentiality of the information obtained for the rating
exercise by putting in place appropriate process safeguards. All CRISIL
employees are required to sign a confidentiality agreement. CRISIL does not
disclose confidential information that it has obtained for the purpose of credit
rating to anyone (other than market regulators or law enforcement authorities, if
required).

52

A detailed flow chart of CRISIL's rating process is as under :

53

CRISIL RATING SYMBOLS

Long Term Rating Scale:
1) High Investment Grades
AAA

Debentures rated `AAA' are judged to offer highest

(Triple A) Highest

safety of timely payment of interest and principal.

Safety

Though the circumstances providing this degree of

safety are likely to change, such changes as can be
envisaged are most unlikely to affect adversely the
fundamentally strong position of such issues.

AA
(Double A) High

Debentures rated 'AA' are judged to offer high safety of

Safety

timely payment of interest and principal. They differ in

safety from `AAA' issues only marginally.

2) Investment Grades
Debentures rated `A' are judged to offer adequate safety
of timely payment of interest and principal; however,
A

changes in circumstances can adversely affect such

Adequate Safety
BBB

issues more than those in the higher rated categories.

(Triple

B)

Moderate Safety

Debentures rated `BBB' are judged to offer sufficient

safety of timely payment of interest and principal for the
present; however, changing circumstances are more
likely to lead to a weakened capacity to pay interest and
repay principal than for debentures in higher rated
categories.

3) Speculative Grades

54

Debentures rated `BB' are judged to carry inadequate

BB
(Double

safety of timely payment of interest and principal; while

B)

they are less susceptible to default than other

Inadequate

speculative grade debentures in the immediate future,

Safety

the uncertainties that the issuer faces could lead to

inadequate capacity to make timely interest and
principal payments.

B
High Risk

Debentures rated `B' are judged to have greater

susceptibility to default; while currently interest and
principal payments are met, adverse business or
economic conditions would lead to lack of ability or
willingness to pay interest or principal

Substanti C Substantial Risk

Debentures rated `C' are judged to have factors present

that make them vulnerable to default; timely payment of
interest and principal is possible only if favourable
circumstances continue.

D In Default

Debentures rated `D' are in default and in arrears of

interest or principal payments or are expected to default
on maturity. Such debentures are extremely speculative
and returns from these debentures may be realized only
on reorganisation or liquidation.

As mentioned above CRISIL have ratings for the following:

1) Fixed Deposit Rating (Start From FAAA To FD)
2) Short Term Instruments Rating (Start From P-1 To P-5)
55

3) Structured Obligations Rating ( Strat From AAA To D(So) )

4) Non Credit Risk Rating Scale ( Start From AAA To Dr)
5) Real Estate Developers/Projects Rating (Start From DA1 To DA5)
6) Rating Scales For Real Estate Projects ( Start From PA1 To PA5)

LIMITATIONS OF CRISIL RATINGS

A Credit Rating from CRISIL is NOT

56

1) A general-purpose credit or performance evaluation of the rated entity:

CRISIL Credit Ratings are always issue-specific

2) A recommendation to invest in, or not to invest in, any shares, debentures or

other

instruments

issued by the rated entity, or derivatives thereof.

3) An opinion on associate, affiliate or group companies of the rated entity, or

on promoters, directors or officers of the rated entity
4) A statutory or non-statutory audit of the rated entity
5) An indication of compliance or otherwise with legal or statutory requirements

CARE
Credit Analysis & Research Ltd. (CARE), incorporated in April
1993, is a credit rating, information and advisory services company promoted
57

by Industrial Development Bank of India (IDBI), Canara Bank, Unit Trust of

India (UTI) and other leading banks and financial services companies. In all
CARE has 14 shareholders.
CARE assigned its first rating in November 1993, and upto
March 31, 2005, had completed 2875 rating assignments for an aggregate
value of about Rs 4438 billion. CARE's ratings are recognised by the
Government of India and all regulatory authorities including the Reserve Bank
of India (RBI), and thurities and Exchange Board of India (SEBI). CARE has
been granted registration by SEBI under the Securities & Exchange Board of
India (Credit Rating Agencies) Regulations,1999.
The rating coverage has extended beyond industrial
companies, to include public utilities, financial institutions, infrastructure
projects, special purpose vehicles, state governments and municipal bodies.
CARE's clients include some of the largest private sector manufacturing and
financial services companies as well financial institutions of India. CARE is well
equipped to rate all types of debt instruments like Commercial Paper, Fixed
Deposit, Bonds, Debentures and Structured Obligations.
CARE's Information and Advisory services group prepares
credit reports on specific requests from banks or business partners, conducts
sector studies and provides advisory services in the areas of financial
restructuring, valuation and credit appraisal systems. CARE was retained by
the Disinvestment Commission, Government of India, for assistance in equity
valuation of a number of state owned companies and for suggesting divestment
strategies for these companies.

CREDIT RATING : RATING METHODOLOGY

58

CARE undertakes rating exercise based on information provided

by the company, in-house database and data from other sources that CARE
considers reliable. CARE does not undertake unsolicited ratings. The primary
focus of the rating exercise is to assess future cash generation capability and
their adequacy to meet debt obligations in adverse conditions. The analysis
therefore attempts to determine the long-term fundamentals and the
probabilities of change in these fundamentals, which could affect the creditworthiness of the borrower. The analytical framework of CARE's rating
methodology is divided into two interdependent segments. The first deals with
the operational characteristics and the second with the financial characteristics.
Besides

quantitative

factors,

qualitative

aspects

like

assessment

of

management capabilities play a very important role in arriving at the rating for
an instrument. The relative importance of qualitative and quantitative
components of the analysis vary with the type of issuer. Rating determination is
a matter of experienced and holistic judgement, based on the relevant
quantitative and qualitative factors affecting the credit quality of the issuer.
Key parameters considered in the rating exercise for industrial companies
include the following :
Economy and Industry Risks
CARE's rating analysis begins by assessing the characteristics of the
industry/industries in which the borrower operates. Some important factors are:
1) Effect of economic cycles on the industry.
2) Business cycles in the industry and their severity.
3) Tariff structure, threat from imports, price competitiveness of the domestic
industry, and pace of technological change.

59

4)

Basis of competition and key success factors.

5) Structure of the industry; entry and exit barriers.

6)

Environmental and political factors.

Business Risks
Against the backdrop of the issuer's industry, CARE then assesses the issuer's
strengths and weaknesses vis-a-vis its competitors. Factors considered
include:
1)

Size of the company and market share.

2)

Locational advantages and disadvantages.

3)

Supply of raw materials and marketing arrangements.

4)

Bargaining power of the issuer's suppliers and customers

5)

Diversification of income sources.

6)

Technology.

Financial Risk
1)

Financial management philosophy and track record (capital structure,

profitability, liquidity position, financial flexibility and cash flow adequacy).

2)

Financial projections (with particular emphasis on achievability of sales

targets, the components of cash flow and ability to meet debt obligations as and
when they fall due).
60

3)

Free cash flows and their sensitivity to various economic, industrial and

business risks over the term of the instrument.

4)

Inter-firm comparison of the financial structure and profitability margins.

5)

Accounting policies and practices.

Management Assessment
1)

Background and history of the issuer.

2)

Corporate strategy and philosophy.

3)

Quality of management and management capabilities under stress.

4)

Organizational

structure,

personnel

policies including

succession

planning .
Instrument Terms
Rating may vary according to such factors as:
1)

Maturity of instrument.

2)

Nature of security - secured or unsecured, senior or subordinated,

covenants and other provisions that may reduce the amount of recovery in case
of default.
3)

Repayment terms - moratorium period, repayment in instalments or

bullet repayment etc.

61

4)

Coupon rates - floating, fixed, zero coupon etc.

5)

Options - conversion into equity, put and call options etc.

6)

Credit Reinforcements through guarantees or the backing of financial

assets
.

The criteria discussed above are specific to industrial companies.

Credit rating methodology for banks, financial institutions and non-banking
finance companies, in addition to some factors discussed above, focuses on
the CRAMEL model:

Capital adequacy

Resource raising ability

Asset quality

Management quality

Earnings quality

Liquidity

CREDIT RATING : RATING SYMBOLS AND DEFINITION

62

CARE'S RATING DEFINITION

A. Long Term & Medium Term Instruments

63

Definition

Symbols

Instruments carrying this rating are considered to be of

CARE
CARE

AAA the best quality, carrying negligible investment risk.

AAA Debt service payments are protected by stable cash

(FD)/(CD)/(SO)/

flows

with

good

margin.

While

the

underlying

(CPS)/(RPS)

assumptions may change, such changes as can be

visualized are most unlikely to impair the strong
position of such instruments.
Instruments carrying this rating are judged to be of
high quality by all standards. They are also classified

CARE

AA

CARE

AA

(FD)/(CD)/(SO)/
(CPS)/(RPS)

as high investment grade. They are rated lower than

CARE AAA securities because of somewhat lower
margins of protection. Changes in assumptions may
have a greater impact or the long-term risks may be
somewhat larger. Overall, the difference with CARE
AAA rated securities is marginal.
Instruments with this rating are considered upper

CARE

CARE

(FD)/(CD)/(SO)/
(CPS)/(RPS)

medium grade instruments and have many favorable

investment attributes. Safety for principal and interest
are considered adequate. Assumptions that do not
materialise may have a greater impact as compared to
the instruments rated higher.
Such instruments are considered to be of investment

CARE

BBB

CARE

BBB

(FD)/(CD)/(SO)/
(CPS)/(RPS)

grade. They indicate sufficient safety for payment of

interest and principal, at the time of rating. However,
adverse changes in assumptions are more likely to
weaken the debt servicing capability compared to the
higher rated instruments.

64

CARE

BB

CARE

BB

(FD)/(CD)/(SO)/
CARE

CARE

(FD)/(CD)/(SO)/
(CPS)/(RPS)

Such instruments are considered to be speculative,

with inadequate protection for interest and principal
payments.
Instruments with such rating are generally classified
susceptible to default. While interest and principal
payments are being met, adverse changes in business
conditions are likely to lead to default.

CARE

CARE

(FD)/(CD)/(SO)/

Such instruments carry high investment risk with

likelihood of default in the payment of interest and
principal.

(CPS)/(RPS)
CARE

CARE

(FD)/(CD)/(SO)/

Such instruments are of the lowest category. They are

either in default or are likely to be in default soon.

(CPS)/(RPS)
FD
CD
SO
CPS
RPS

Fixed

Deposit

Certificate

of

Structured

Deposit
Obligations

Convertible

Preference

Shares

Redeemable Preference Shares

B. Short Term Instruments

Symbols

Definition

PR 1
Instruments would have superior capacity for repayment
of short-term promissory obligations. Issuers of such
instruments will normally be characterized by leading
market positions in established industries, high rates of

65

return on funds employed etc.

Instruments would have strong capacity for repayment of
PR 2

short- term promissory obligations. Issuers would have

most of the characteristics as for those with PR-1
instruments but to a lesser degree.
Instruments have an adequate capacity for repayment of
short- term promissory obligations. The effect of industry

PR 3

characteristics and market composition may be more

pronounced. Variability in earnings and profitability may
result in changes in the level of debt protection.
Instruments have minimal degree of safety regarding

PR 4

timely payment of short-term promissory obligations and

the safety is likely to be adversely affected by short-term
adversity or less favorable conditions.

PR 5

The instrument is in default or is likely to be in default on

maturity.

C. Credit Analysis Rating

Symbols

Definition
Excellent debt management capability. Such companies

CARE 1

will normally be characterized as leaders in the respective

industries.

66

Very good debt management capability. Such companies

would be regarded as close to those rated CARE-1, but

CARE 2

with

lower

capability

to

withstand

changes

in

assumptions.
Good capability for debt management. Such companies
are considered medium grade; assumptions that do not

CARE 3

materialize may impair debt management capability in

future.
Barely satisfactory capability for debt management. The
capacity to meet obligations is likely to be adversely

CARE 4

affected by short- term adversity or less favorable

conditions.
Poor capability for debt management. Such companies
CARE 5

are in default or are likely to default in meeting their debt

obligations.

D. Long Term Loans

Definition

Symbols
CARE
(L)

AAA
Loans carrying this rating are considered to be of the best
quality, carrying negligible investment risk. Debt service
payments are protected by stable cash flows with good

67

margin. While the underlying assumptions may change,

such changes as can be visualised are most unlikely to
impair the strong position of such loans.
Loans carrying this rating are judged to be of high quality
by all standards. They are also classified as high
investment grade. They are rated lower than CARE AAA
CARE AA (L)

loans because of somewhat lower margins of protection.

Changes in assumptions may have a greater impact or
the long-term risks may be somewhat larger. Overall, the
difference with CARE AAA rated loans is marginal.
Loans with this rating are considered upper medium
grade and have many favourable investment attributes.

CARE A (L)

Safety for principal and interest are considered adequate.

Assumptions that do not materialise may have a greater
impact as compared to the loans rated higher.
Such loans are considered to be of investment grade.

CARE
(L)

BBB They indicate sufficient safety for payment of interest and

principal, at the time of rating. However, adverse changes
in assumptions are more likely to weaken the debt
servicing capability compared to the higher rated loans.

CARE BB (L) Such loans are considered to be speculative, with

inadequate protection for interest and principal payments.
Loans with such rating are generally classified susceptible
CARE B (L)

to default. While interest and principal payments are being

met, adverse changes in business conditions are likely to
lead to default.

CARE C (L)
Such loans carry high investment risk with likelihood of

68

default in the payment of interest and principal.

CARE D (L)

Such loans are of the lowest category. They are either in

default or are likely to be in default soon.

E. Short Term Loans

Symbols
PL 1

Definition
Superior capacity for repayment of interest and principal
on the loan.

69

Strong capacity for repayment of interest and principal on

PL 2

the loan. They are rated lower than PL-1 because of

somewhat lower margins of protection. Changes in
assumptions may have a greater impact.
Adequate capacity for repayment of interest and principal
on the loan. Variability in earnings and profitability may

PL 3

result in significant changes in the level of debt servicing

capability. The effect of industry characteristics may be
more pronounced.
Minimal degree of safety regarding timely payment of

PL 4

interest & principal and the safety is likely to be adversely

affected by short-term adversity or less favourable
conditions.

PL 5

The loan is in default or is likely to be in default on

maturity.

As instruments characteristics/loan characteristics or debt management capability

could cover a wide range of possible attributes whereas rating is expressed only
in limited number of symbols, CARE assigns '+' or '-' signs to be shown after the
assigned rating (wherever necessary) to indicate the relative position within the
band covered by the rating symbol.

F : Performance Rating of Parallel Marketers

These ratings are on a scale of 1 to 4 as notified by Govt. of India.
1-Good

2-Satisfactory

3-Low Risk

4-High Risk

G : Collective Investment Schemes

70

Symbols

Definition

Schemes carrying this rating are considered to be very strong,

CARE 1 (CIS)

with high likelihood of achieving their objectives and meeting the

obligations to investors.
Schemes carrying this rating are considered to be strong, with

CARE 2 (CIS)

adequate likelihood of achieving their objectives and meeting the

obligations to investors. They are rated lower than CARE 1 (CIS)
rated schemes because of relativesly higher risk.
Such schemes are considered to have adequate strengths for

CARE 3 (CIS)

achieving their objectives and meeting the obligations to

investors. They are considered to be investment grade.
Schemes carrying this rating are considered to have inadequate

CARE 4 (CIS)

capability to achieve their objectives and meet the obligations to

investors. They are considered to be speculative grade.
Such schemes are considered weak and are unlikely to achieve

CARE 5 (CIS)

their objectives and meet their obligations to investors. They

have either failed or are likely to do so in the near future.

CREDIT RATING : RATING PROCESS

71

The rating process takes about three to four weeks, depending on the
complexity of the assignment and the flow of information from the client. Rating
decisions are made by the Rating Committee.
Client

Care

Requests for rating

1. Assigns rating team

Submits

information

and

detailed

2.

The

team

analyses

the

schedules

information.

Interacts with the team, responds to

3. The team interacts with clients,

queries

undertakes site visits, and analyses

raised

and

provides

any

additional data necessary for the

data submitted by the client

analysis
4.

Internal

committee

previews

analysis.
5. RATING COMMITTEE awards
rating to client
6. Notification in press
7. Periodic Surveillance

Accepts rating * , **

* : Client may ask for a review of the rating assigned and furnish additional
information

for

the

purpose.

** : Client has option not to accept the final rating in which case, CARE will not
publish the rating or monitor it.

Chapter 5
NEW CONCEPT AND OVERVIEW OF INDIAN CREDIT RATING
AGENCY (SMEs )

72

SMERA

SMERA is the country's first rating agency that focuses primarily on the Indian
SME segment. SMERA's primary objective is to provide ratings that are
comprehensive, transparent and reliable. This would facilitate greater and
easier flow of credit from the banking sector to SMEs.
SME Rating Agency of India Limited (SMERA) is a joint initiative by SIDBI
(www.sidbi.in), Dun & Bradstreet Information Services India Private Limited
(D&B) (www.dnb.co.in), Credit Information Bureau (India) Limited (CIBIL)
(www.cibil.com)

MEANING :
1)

SMERA Rating is an independent third-party comprehensive

assessment of the overall condition of the SME,
conducted by SME Rating Agency of India Limited

2)

It takes into account the financial condition and several qualitative

factors that have bearing on credit
worthiness of the SME

3)

SMERA Rating consists of 2 parts,a Composite Appraisal/Condition

indicator and a size indicator

4)

SMERA Rating categorises SMEs based on size, so as to enable fair

evaluation of each SME amongst its peers

5)

An SME unit having SMERA Rating would enhance its market standing
amongst trading partners and prospective customers

73

SMERA FEATURES :
SMERA is the only rating agency dedicated to SMEs and its rating model takes
into consideration financial and non-financial factors for assigning rating to a
SME unit. SMERA ratings will also factor-in payment score obtained from CIBIL
indicating the payment track record of the SME unit being rated. Dun &
Bradstreets expertise on rating SME units is also an important factor that
distinguishes SMERA rating from any other ratings
ELIGIBILITY OF SMEs
All types of SMEs including manufacturing, service sector, trading etc can
approach SMERA directly or through the banks for a rating from SMERA.
However, NBFCs/finance companies/Nidhis/chit funds etc., are not rated by
SMERA.
TIME VALIDITY OF RATING
The rating certificate issued by SMERA is based on the latest financial
statement available, the site visit report and management interview carried out
as on a recent date. Thus, the validity of SMERA rating of an SME unit is as on
a given date and based on the assumption of a going concern.

SMERA RATING METHODOLOGY & RATING SCALE

74

LIMITATIONS OF CREDIT RATING - RATING DOWNGRADES

Rating agencies all across the world have often been

accused of not being able to predict future problems. In part, the problem lies in

75

the rating process itself, which relies heavily on past numerical data and
standard ratios with relatively lower usage of judgment and understanding of
the underlying business or the country economics. Data does not always
capture all aspects of the situation especially in the complex financial world of
today. An excellent example of the meaningless over reliance on numbers is
the poor country rating given to India. Major rating agencies site one of the
reasons for this as the low ratio Indias exports to foreign currency
indebtedness. This completely ignores two issues firstly, India gets a very
high quantum of foreign currency earnings through remittances from Indians
working abroad and also services exports in the form of software exports which
are not counted as "merchandise" exports. These two flows along with other
"invisible" earnings accounted for almost US$11bn in FY 99. Secondly, since
India has tight control on foreign currency transactions, there is very little error
possible in the foreign currency borrowing figure. As against this, for a country
like Korea, the figure for foreign currency borrowing increased by US$50bn
after the exchange crisis began. This was on account of hidden forward
liabilities through swaps and other derivative products.
In general, Indian rating agencies have lost some amount of
their credibility in the last two years due to their inability to predict defaults in
many companies, which they had rated quite highly. Sometimes, some of the
agencies had an investment grade rating in place when the company in
question had already defaulted to some of the fixed deposit holders. Further,
rating agencies resorted to mass downgrading of 50-100 companies as a
reaction to public criticism, which further eroded their credibility. The major
reasons for these downgrades are as follows :

1) Biased raiting and misrepresentation:

In the absence of quality ratings , credit rating is a curse for capital market
industry. To avoid biased rating ,the expert in rating agency ,carrying out detaild
analysisi of the company , should have no links
76

with the company or the

persons intersete din the company so that they can make their report impartial
and judicious recommendation for rating committee.

2) Static study :
Rating is done on the present and the past historical data of the company and
this is only a sttsic study . prediction of the company health through rating is
momentary and anything can happen after assignment of rating sybols to the
company .dependence for the future result on the rating,therefore defeat the
vary purpose of the risk indicative of the rating.
3) Concealment of material information :
Rating company might conceal material information from the investigating team
of the credit rating company, in such cases quality of rating suffer and renders
the rating reliable.
4) Rating is no guarantee for soundness of the company :
Rating is done for a particular instrument to assess the credit risk but it should
not be considered as a certificate for matching quality of the company or its
management.
5)

Human bias :

Finding of the investigation team at times may suffer from with the human bias
for unavoidable personal weakness of the staff and might effect the rating .
6)

Down grade:

77

Once the company has been rated and if it is not able to maintain its working
result

and performance ,credit rating agency

would review the grade or

downgrade the rating resulting into impairing the image of the company .
7)

Validity of rating

Validity of the rating ends with the maturity of a debt instrument and its no
longer subsequently benefits the issuer company becsuse the rating is valid
for the life time of the debt instrument being rated .

8)

Difference in rating of two agencies:

Rating done by two different credit rating agencies for the same instrument of
the same issuer

company in many cases

would not be identical. Such

difference is likely to occur because of the because of the value judgment

differences on qualitative aspect of the analysis in two different rating agencies
whereas quantitative analysis might be the same and identical .

Limitations cont
Corporate earnings fell very sharply due to persistent recessionary conditions
prevailing in the economy. Many of the corporate are in commodity sectors
where fluctuations in selling prices of products can be very sharp - leading to
78

complete erosion of profitability. This problem was compounded by the Asian

crisis, which led to increased competition from cheap imports in many product
categories.
Rating agencies substantially overestimated financial
flexibility of corporate especially from traditional corporate houses. Much of the
financial flexibility was implicit on raising money from new issues from the
capital market, which has been impossible in the last 3 years.
In the case of finance companies, widespread defaults like CRB and tightening
of regulations made it virtually impossible for them to raise money in any form.
These finance companies had been in the habit of investing in longer term,
illiquid assets by borrowing shorter term fixed deposits. When the flow of credit
stopped, they faced liquidity problems. These were further compounded by
defaults by some of the companies to which they had on lent money.
The experience is no different from the international scenario
where reputed and highly experienced rating agencies like Standard & Poor
(S&P) and Moodys were unable to predict the Asian crisis and had to face the
embarrassment of seeing the credit rating of South Korea as a country go from
A+ to BB+ in a short span of 3 months.
By and large, the rating is a very good estimate of the actual creditworthiness of
the company; however, it is not able to predict extreme situations such as the
ones described above, which are unlikely to have been predicted by most
investors in any case. Investors should realize that a credit rating is not
sacrosanct and that one has to do ones own due diligence and investigation
before investing in any instrument. They should use the rating as a reference
and a base point for their own effort.
One good way of doing this is examining the behavior of
the stock price in case the stock is listed. As a collective, the market is far
smarter at predicting problems than any credit rating agency. Witness the sharp
erosion in stock prices of companies much before their credit ratings were
downgraded. Witness also the fact that foreign currency bonds from Indian
issuers trade at yields lower than countries which have been rated higher by
rating agencies.
79

Chapter 6
Code of Ethics
to be followed by Rating Agencies

80

Member Credit Rating Agencies shall put in place systems and procedures to
ensure the following :
1) The proceedings of a credit rating board / rating committee, are kept
confidential at all times, and not revealed to any external parties or
agencies. If any records of the proceedings are made, credit rating
agencies must take steps to keep such records properly safeguarded,
except where required to be disclosed by the provisions of laws or
regulations.
2) When the credit rating board decides on a rating, it shall be announced
as a joint decision and the individual votes shall be kept confidential,
even if recorded. This requirement of confidentiality shall apply to rating
board members for their own votes as well.

Member Credit Rating Agencies shall put in place systems and procedures to
ensure the following :
1) When and after a credit rating board / rating committee member or credit
rating agency employee terminates his/her employment or work
association with the rating agency, the requirement of confidentiality with
respect to the information received during the period of work association
shall continue as information held in trust.
2) A credit rating board / rating committee member does not take undue
material advantage of any confidential information received through his
or her participation in a credit rating process. Persons involved in the
ratings process should also be made vigilant to prevent abuse of prior
knowledge of ratings changes.

81

FREQUENTLY ASKED QUESTIONS

1) What is credit rating?

82

Credit rating is, essentially, the opinion of the rating agency on the relative
ability and willingness of the issuer of a debt instrument to meet the debt
service obligations as and when they arise.
2) Why do rating agencies use symbols like AAA, AA, rather than give marks or
descriptive credit opinion?
The great advantage of rating symbols is their simplicity, which facilitates
universal understanding. Rating companies also publish explanations for their
symbols used as well as the rationale for the ratings assigned by them, to
facilitate deeper understanding.
3) Why is credit rating necessary at all?
Credit rating is an opinion expressed by an independent professional
organisation, after making a detailed study of all relevant factors. Such an
opinion will be of great assistance to investors in making investment decisions.
It also helps the issuers of debt instruments to price their issues correctly and to
reach out to new investors. Regulators like Reserve Bank of India (RBI) and
Securities & Exchange Board of India (SEBI) often use credit rating to
determine eligibility criteria for some instruments. For example, the RBI has
stipulated a minimum credit rating by an approved agency for issue of
Commerce Paper. In general, credit rating is expected to improve quality
consciousness in the market and establish, over a period of time, a more
meaningful relationship between the quality of debt and the yield from it. Credit
Rating is also a valuable input in establishing business relationships of various
types.
4) Does credit rating constitute an advice to the investors to buy?
It does not. The reason is that some factors, which are of significance to an
investor in arriving at an investment decision, are not taken into account by
83

rating agencies. These include reasonableness of the issue price or the coupon
rate, secondary market liquidity and pre-payment risk. Further, different
investors have different views regarding the level of risk to be taken and rating
agencies can only express their views on the relative risk.
5) What kind of responsibility or accountability will attach to a rating agency if
an investor, who makes his investment decision on the basis of its rating, incurs
a loss on the investment?
A credit rating is a professional opinion given after studying all available
information at a particular point of time. Nevertheless, such opinions may prove
wrong in the context of subsequent events. Further, there is no privity of
contract between an investor and a rating agency and the investor is free to
accept or reject the opinion of the agency. Nevertheless, rating is essentially an
investor service and a rating agency is expected to maintain the highest
possible level of analytical competence and integrity. In the long run, the
credibility of a rating agency has to be built, brick by brick, on the quality of its
services.
6) Do rating companies undertake unsolicited ratings?
Not in India, at least not yet. There is however, a good case for undertaking
unsolicited ratings. It will be relevant to mention here that any rating based
entirely on published information has serious limitations and the success of a
rating agency will depend, to a great extent, on its ability to access privileged
information. Co-operation from the issuers as well as their willingness to share
even confidential information are important pre-requisites. On its part, the rating
agency has a great responsibility to ensure confidentiality of the sensitive
information that comes into its possession during the rating process.
7) How reliable and consistent is the rating process? How do rating agencies
eliminate the subjective element in rating?
84

To answer the second question first, it is neither possible nor even desirable, to
totally eliminate the subjective element. Rating does not come out of a predetermined mathematical formula, which fixes the relevant variables as well as
the weights attached to each one of them. Rating agencies do a great amount
of number crunching, but the final outcome also takes into account factors like
quality of management, corporate strategy, economic outlook and international
environment. To ensure consistency and reliability, a number of qualified
professionals are involved in the rating process. The Rating Committee, which
assigns the final rating, consists of professionals with impeccable credentials.
Rating agencies also ensure that the rating process is insulated from any
possible conflicts of interest.
8) Is it customary to have the same issue rated by more than one rating
agency? Do the ratings for the same instrument vary from agency to agency?
The answer to both the questions is yes. In the well-developed capital markets,
debt issues are, more often than not, rated by more than one agency. And, it is
only natural that the opinions given by two or more agencies will vary, in some
cases. But it will be very unusual if such differences are very wide. For
example, a debt issue may be rated DOUBLE A PLUS by one agency and
DOUBLE A or DOUBLE A MINUS by another. It will indeed be unusual if one
agency assigns a rating of DOUBLE A while another gives a TRIPLE B.

9) Why do rating agencies monitor the issues already rated?

A rating is an opinion given on the basis of information available at a particular

point of time. As time goes by, many things change, affecting the debt servicing
85

capabilities of the issuer, one way or the other. It is, therefore, essential that as
a part of their investor service, rating agencies monitor all outstanding debt
issues rated by them. In the context of emerging developments, the rating
agencies often put issues under creditwatch and upgrade or downgrade the
ratings as and when necessary. Normally, such action is taken after intensive
interaction with the issuers.

10) Are all ratings published?

In India, ratings are undertaken only at the request of the issuers and only
those ratings, which are accepted by the issuers, are published. But there is a
view that the rating agencies should publish all ratings, even those found
unacceptable by the issuers. This is a matter for further discussion, so that a
generally acceptable industry practice emerges. Once a rating is accepted, it
will be published and subsequent changes emerging out of the monitoring by
the agency will be published even if such changes are not found acceptable by
the issuers.

CONCLUSION
A credit rating is a useful tool not only for the investor, but also for the entities

86

looking for investors. An investment grade rating can put a security, company or
country on the global radar, attracting foreign money and boosting a nation's
economy. Indeed, for emerging market economies, the credit rating is key to
showing their worthiness of money from foreign investors, And because the
credit rating acts to facilitate investments, many countries and companies will
strive to maintain and improve their ratings, hence ensuring a stable political
environment and a more transparent .
They can best serve markets when they operate independently, adopt and
enforce internal guidelines to avoid conflicts of interest and protect confidential
information received from issuers. Credit rating agencies cannot afford to
commit too many mistakes as it the investors who pays the price for their
mistakes. Credit rating agencies should be made accountable for any faulty
rating by panelizing them or even de-recognizing them, if needed.

BIBLOGRAPHY

WEBSITES

87

1) www.crisil.com
2) www.icra.com
3) www.careratings.com

NEWS PAPER1) ECOMICTIMES

2) BUSINESS STANDARD

88