A) Business Risk:
Each credit rating analysis begins with an assessment of the company's environment. To determine the degree of operating risk facing a company in a given business, Brickwork analyses the dynamics of business. Factors assessed include the prospects for growth, stability, or decline, and the pattern of business cycles. It is critical to determine vulnerability to technological change, labour unrest, or the impact of government intervention. Industries that have long lead times in building production capacity or that require fixed plant of a specialised nature face heightened risk. The implications of increasing competition are obviously crucial.
B) Industry Risk:
The purpose of industry analysis is to understand the conditions in which a business operates and the changes - cyclical, competitive, and technological - that it is likely to experience. Most industries exhibit some degree of cyclical volatility and some industries are exposed to seasonal variances, too. Such volatility affects the operating performance and financial condition of a company. Technological change and new competitors or substitute products can also affect performance.
Industry risks can influence the credit rating of any company or entity in the industry. Brickwork Ratings assigns lower ratings to companies with extensive participation in industries of above-average risk, regardless of how conservative their financial postures. However, Brickwork's methodology emphasises the business position of the company being rated in addition to a generic risk profile for the industry in which it operates.
C) Management Risk:
The importance of a management - competency and integrity - can not be overstated. The ability of the commercial entity’s managers to guide it, exploit opportunities, develop and execute plans, and react to market changes is extremely important to its financial well being. The unexpected loss of one or two key employees can be detrimental to a company, particularly a small or mid-size firm. Even the most experienced management teams can be challenged by high growth, which is one of the most common reasons for business failure. We consider the risk appetite of the company and as well evaluate its corporate governance principles.
D) Financial Risk:
At Brickwork, we believe that there is no substitute for rigorous analysis of financial statements. The balance sheet, income statement, sources and uses of funds statement, and financial projections provide essential information about the company’s initial and ongoing repayment capacity. Quantitative analysis of revenues, profit margins, income and cash flow, leverage, liquidity, and capitalization should be sufficiently detailed to identify trends and anomalies that may affect borrower performance. Financial risk is portrayed largely through quantitative means, particularly by using financial ratios. Benchmarks vary greatly by industry, and several analytical adjustments typically are required to calculate ratios for an individual company.
Analysis of the audited financials begins with a review of accounting quality. The purpose is to determine whether ratios and statistics derived from financial statements can be used accurately to measure a company's performance and position relative to its peer group. Some of the issues reviewed include the basis of consolidation, income recognition, depreciation methods, capitalized interest and off-balance sheet liabilities. To the extent possible, analytical adjustments are made to better portray reality.
The balance sheet deserves as much attention as the income statement. The balance sheet can provide an early warning of credit problems, for example, if assets degrade or the relative level of assets and liabilities changes. Commercial borrowers generate their revenue, income, and liquidity from their assets, so examiners should analyze the composition of these accounts and how their proportions change. Capitalization and liquidity also warrant careful analysis because they imply a borrower’s ability to withstand an economic slowdown or unplanned events.
Cash Flow
Business cash flow is the operating revenue derived from ordinary business activities less operating costs paid (not simply incurred), plus noncash expenses such as depreciation and amortization. Although the concept is simple, cash flow calculations are often complex. Many businesses calculate cash flow differently because of the nature of their operations and cash conversion cycle.
Changes in “working capital” accounts are reviewed to understand the cash flow implications. Uses of cash flow are scrutinized — debt repayment is not the only use of cash flow. Changes, actual or planned, in capital expenditures must be closely reviewed. A troubled borrower will often cut capital expenditures in order to generate cash for debt service. Although this may provide short-term relief, such reductions can imperil a business’s future. Shortfalls in cash flow or debt service coverage are usually the most obvious indications of a weak credit quality.
Ratio Analysis and Benchmarks
Financial ratios provide vital information about balance sheet and income statement proportions (debt to equity, income to revenues, etc.). Comparing a borrower’s financial ratios with prior periods and industry or peer group norms can identify potential weaknesses. Whenever a ratio deviates significantly from that of its peers, examiners should conduct further analysis to identify the root cause.
Analysis of Projections
While current and historical information is necessary to establish a company’s condition and financial track record, projections estimate expected performance. The Analyst examines how projections vary from historical performance and assess whether the borrower is likely to achieve them. Projections are generally analyzed under multiple scenarios — downside, breakeven, best case, most likely case — and stress-tested periodically. The companies who quickly or repeatedly fall short of their projections lack credibility and factored in rating.
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