Key Financial Indicators that Influence Credit Rating
Key Financial Indicators that Influence Credit Rating
Credit rating exercises undertaken by the banks and external credit rating agencies play a major role in determining a businesses ability to borrow and the cost of borrowing. Typical domains that are factored into a credit rating are industry risk, government policy, market position, operating efficiency, financial risk and management evaluation. Of all the factors that influence a credit rating, financial risk carries the highest weightage in the rating model and influence the credit rating of a business the most. Therefore, it is important for financial managers to understand the factors that influence credit rating and work to continually improve the credit rating of a business, by reducing risk. In this article we look at some of the key financial indicators that influence credit rating the most:
Total Outside Liability to Total Net Worth (TOL/TNW)
TOL/TNW is a measure of a company’s financial leverage calculated by dividing the total liabilities of the company by the total net worth of the business. Total outside liability is the sum of all the liabilities of the business and total net worth is the sum of share capital and surplus reserves of the company. This ratio gives an accurate picture of the businesses reliance on debt. A low TOL/TNW ratio signifies good levels of promoter’s stake in the business, whereas a high TOL/TNW ratio shows low levels of promoter’s stake in the business, which is considered risky. In the rating exercise, businesses with a TOL/TNW of less than 1 score the maximum amount of points while a TOL/TNW ratio of more than 3 is awarded no points. For most businesses, it would be good to have an average TOL/TNW ratio in the range of 1-2.
Current Ratio
Current Ratio is a measure of businesses liquidity calculated by dividing the total current assets of the business by total liabilities. This ratio is a great indicator of a businesses ability to repay its short-term obligations as they become due over the next 12 months. A current ratio of more than 1.5 implies the business has adequate cash flows over the next 12 months to meet the demands, while a current ratio of less than 1 would imply that the business might have cash flow problems. In the rating exercise, businesses with a current ratio of more than 1.5 score the maximum amount of points, while it awards no points for a current ratio of less than 1. For most businesses, it would be good to have a current ratio in the range of >1.35 – 1.20.
Return on Capital Employed (ROCE)
Return on Capital Employed (ROCE) is a measure of a businesses profitability and efficiency of capital employed. ROCE is calculated by dividing profit before depreciation, interest and tax (PBDIT) by total capital employed. Capital employed is total assets minus the total current liabilities. A high ROCE would imply efficient use of the capital employed in the business, whereas a low ROCE would indicate inefficient use of the capital employed by the business. In any case, the ROCE of the company must be higher than its borrowing cost; otherwise, it indicates that the company is degenerating shareholder value. Businesses with a ROCE of more than 20% score the highest in the rating exercise, while businesses with a ROCE of less than 2% score the least. It is good for businesses to have a ROCE in the range of >15% – 5%.
Retained Profit / Total Assets
Retained Profit / Total Assets (RPTA) is a measure of the profitability of a business and used to benchmark the value of cumulative profits retained in the business. Retained profit is the value of net earnings in the company is to reinvest it into its core business. High RPTA implies a business would have a minimum requirement for debt or equity financing, while low RPTA would imply that the business might have to look for debt/equity fund sources to fund its operations. Generally, it awards the RPTA of more than 7.50% with the maximum points in the credit rating models, while an RPTA of less than 1% garners no points. For most businesses, it is ideal to have an RPTA % in the range of > 5% to 3%.
Profit before Depreciation, Interest & Tax / Interest Expense
Profit before depreciation, interest and tax divided (PBDIT) by interest expense (INT), also known as the interest coverage ratio measures the number of times a company can make interest payments on its debt with its earnings. A low PBDIT/INT of less than 1 would imply the business would have trouble honouring its interest payments on time, whereas higher PBDIT/INT of more than 2 is considered comfortable for lenders. PBDIT/INT higher than 8 is given the maximum points and a ratio lower than 1 is given no points in many credit rating models. For most businesses, it is ideal to have a PBDIT/INT which is higher than 2.
Profit after Tax / Net Sales
Profit after Tax (PAT) divided by Net Sales is a profitability measure used to determine a businesses financial performance. PAT/Net Sales is a more stringent profitability measure as it also takes into consideration the tax payments. A PAT/Net Sales of more than 8% shows very good financial performance by the company and gets the highest points in a credit rating exercise, while a PAT/Net Sales of less than 2% highlights poor financial performance and no points are awarded. It is ideal for businesses to have a PAT/Net Sales in the range of >6 – 3%.
Net Cash Accrual / Total Debt
Net cash accrual by total debt is a coverage ratio to determine the ability of a business to cover its total debt with its yearly cash accrual. Net cash accrual is the sum of profit after tax and depreciation minus any dividends. A higher net cash accrual / total debt is preferable, as it provides better coverage for the lenders. In most rating models, company’s with a net cash accrual / total debt of more than 20% get the highest number of points, while companies with a net cash accrual / total debt of less than 4% get no point. It is ideal to have a net cash accrual / total debt ratio in the range of >18% – 8%.
Average Growth in Net Sales
Measuring the average growth in sales of a business over a period is a very good metric to gauging how well the company is doing. Growing businesses have better prospects and lower financial risk when compared to businesses having declining sales. Therefore, rating models assign businesses with a sales growth of more than 15% over the last two quarters the highest amount of points, while businesses penalize with representing declining sales. For most businesses, it is ideal to have sales grown in the range of >15% to >3%.
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