SCOPE OF THE CRITERIA
The criteria describe the methodology TRIS Rating uses to determine a company rating or issuer rating for a corporate entity or a general non-financial company. The criteria are not applicable to project finance companies and special purpose entities. This article supersedes the “Rating Methodology – Corporate,” published by TRIS Rating Co., Ltd. on 31 October 2007.
SUMMARY
The corporate rating framework is built upon two fundamental parts of credit analysis. The first part is the analysis of the business risk of a corporate entity, and the second part is the analysis of financial risk. The result of business risk assessment, “Business Risk Profile”, and financial risk assessment, “Financial Risk Profile”, are then combined to derive an anchor rating.
The business risk analysis starts with an evaluation of the risk of an industry, as it pertains to the entity being rated, followed by an analysis of the competitive position and profitability of the entity. An entity’s competitive position is determined based on its market position, the size and the diversity of the range of products/services offered, and operating efficiency compared with peers in the same industry. For an entity operates outside Thailand, we also take into consideration the economic risk, financial system risk, and regulatory risk in the countries in which an entity operates.
In assessing an entity’s financial risk profile, we focus on financial ratios in relation to cash flow and financial leverage. Generally, we analyze the ratios for the past few years, the current year, and the ratios from a financial forecast covering at least the next two years.
The anchor rating, resulting from combining the business risk profile and the financial risk profile, may be adjusted to reflect other credit considerations that have not been captured in the business risk and financial risk profile assessments. These additional considerations could be issues related to corporate governance, liquidity risk, financial flexibility, diversification, etc.
If the rated entity is a part of a larger business group (the Group), an assessment on the credit rating of the Group may be necessary if the rated entity’s business operations and financial health are assessed to be closely related to the Group. Depending on the result of the Group risk assessment, the issuer rating could be enhanced, if the strength of the Group is greater, or the issuer rating could be capped by the Group rating, if the Group is assessed to have a weaker credit profile than the rated entity itself.
1. BUSINESS RISK PROFILE
The business risk profile assesses the industry risk, competitive position of an entity in comparison with industry peers, the ability of an entity to generate profit, and the stability of profits. The competitive position is mainly derived from market position, the size and the diversity of the range of products/services offered, and operating efficiency.
1.1. Industry Risk Analysis
TRIS Rating categorizes the riskiness of an industry into one of five risk levels: “very low”, “low”, “intermediate”, “high”, and “very high”. The levels are based on the volatilities of revenues and earnings of a company in a specific industry, industry growth trends, and the degree of competition.
• Volatilities of revenues and earnings
The volatilities of revenues and earnings are measured from the peak-to-trough changes in revenues and earnings during periods of crisis. The higher the volatility, the higher the risk level assigned to an industry. Thailand has experienced two major economic crises in the past twenty years: the Asian financial crisis in 1997 and the global financial crisis in 2008. Most industries went through a severe downturn during the 1997 financial crisis. The crisis resulted in the failure of a large number of financial institutions and corporations. The 2008 global financial crisis had a less severe effect on Thai businesses than the 1997 crisis. Financial institutions in Thailand were strengthened following the 1997 financial crisis, which helped lessen the impact of the 2008 crisis.
Our observations over both periods of market turbulence showed us that revenues and earnings are highly volatile in several non-financial industries. For instance, firms in the engineering & construction industry, homebuilders and real estate developers, and cyclical transportation firms e.g., shipping and airlines, are highly volatile. In contrast, industries that have low volatility in revenues and earnings are regulated utilities. Please refer to the attached Industry Risk Classification for the risk levels assigned to each industry.
• Industry growth trends
Industry growth trends tend to follow the stage of industry development: initial, growth, mature, or declining stage. Generally, industry growth is observed by comparing the growth rate of the industry with the growth rate of the economy. However, an entity in a high-growth industry does not always get a good rating since the industry might be in the initial phase of development or the industry might have experienced a temporary, rapid change due to the robust growth of the economy. Under such circumstances, the sustainability of the growth trends will need to be carefully assessed.
Industries that are characterized by consistent and predictable cash flows, such as regulated utilities, real estate for rent, and transportation infrastructure, are regarded as less risky. In contrast, industries with high growth rates but volatile cash flows are leisure and sports (hotels), homebuilders and real estate developers, and engineering and construction (E&C).
• Degree of competition
The intensity of competition depends on several factors, including the number of competitors, the demand-supply situation, the extent of product differentiation in the industry, and the regulatory framework. Firms in some industries, e.g. commodity trading, cement, petrochemicals, or steel, face more intense competition than firms in other industries. Though companies in these industries are large, they have to compete with larger companies in regional or global markets. In addition, their products are often difficult to differentiate. Competition is thus primarily price-based. Price cutting due to excess market supply is common in these industries.
In contrast, industries with large numbers of small competitors, e.g., homebuilders and real estate developers, face intense competition as well but of a different nature. Competition is largely confined to the domestic market. However, the degree of competition is still high due to the large numbers of companies in the industry.
Other industries that are high risk are industries that are vulnerable to threats from substitute products and low switching costs. These firms are thus constrained in their ability to raise product prices due to their low bargaining power.
Businesses such as regulated utilities, operators of mass transit networks, or businesses that require government licenses typically face a comparatively low degree of competition. These industries typically have few competitors due to huge capital investments and the limited number of business licenses granted. Thus, the entry barriers tend to be high while the degree of competition tends to be low.
1.2. Competitive position
Below are the key factors considered in determining the competitive position of an entity:
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• Competitive advantage
An entity receives a good score for this factor if it is able to maintain its market position and outperform industry peers during good and bad market conditions. A proven record of adapting a business strategy is a plus for the competitive assessment of the entity. For example, an entity may have shown that it can respond to changes in market conditions such as changes in demand, consumer preferences, or regulations. We evaluate the strategic positioning and attractiveness of products or services based on several dimensions, e.g., market share, brand equity, ability to command premium prices, as well as the strength and durability of relationships with key customers and/or suppliers.
Market share is a key indicator of market position when comparing an entity to its peers. For instance, a company with a much larger market share (i.e. a market share of at least 20%, with the balance held by many smaller companies) has the upper hand over its peers. A firm with a large market share has greater negotiating power with suppliers and distributors, and a greater ability to set prices. A company may not have any competitive advantage if the whole market has only three or four competitors and none of the competitors holds a dominant market share.
The competitive advantage of a regulated utility, like power producers or water supply operators, depends more on the regulatory advantages the utility has. For instance, most companies in the power sector in Thailand generally have long-term power purchase agreements (PPA) with reliable state-owned enterprises. The competitive advantage of each company depends largely on the structure of the PPA. The PPA is the major factor which determines risk, return, and the cash flow of each company.
• Size and diversity of products/services
Size is often correlated with the degree of competitiveness. Normally, large companies will have a competitive edge in terms of bargaining power, production costs, and distribution channels. However, small size does not always translate into a weaker competitive position. A smaller company might have a competitive advantage over larger companies in terms of product differentiation, serving a niche market, or superior technology. In addition, a small company might have more management flexibility and might be able to foster closer relationships with clients. However, smaller companies normally suffer more during contractions in market size or after the loss of a few major customers.
Depending on the circumstances in a specific industry, diversity in terms of products, price points, geography, and customer base can be a materially favorable factor in relation to an entity’s business risk. We typically look at a few measurements to determine whether an entity is diversified to a degree significantly different from its peers. For instance, we examine the number and locations of cash-generating assets, product mix, and the revenue contributions from different product lines or customer groups. A more diversified company usually receives a better score in this area. In contrast, an entity that relies on one or just a few products or customers may have material business concentration risk.
• Operating efficiency
Operating efficiency measures the company’s ability to maximize revenues and profits by improving the utilization of its assets and minimizing costs via increased efficiency and the reduction of unnecessary expenses. In addition, the company’s cost structure should enable it to withstand economic downturns better than its peers. The company that has fixed costs lower than peers will be more flexible and more able to withstand economic downturns. Generally, operating efficiency is especially important in some industries that are more commoditized and require a minimum scale of operations, such as petrochemicals, petroleum products, cement, and sugar.
Generally, larger companies benefit from economies of scale. However, the ability to control costs might also depend on the production technology employed, the ability to secure raw materials at lower costs, and careful management of inventory. Operating efficiency may not be as important a factor in some industries. For example, in some industries, customers choose products or services based on quality not pricing, such as in the healthcare services, media and entertainment, and restaurant industries.
1.3. Profitability
For the profitability analysis, we focus on both the level and the stability of profit margins of a company relative to peers in the industry. A profitability ratio higher than the industry average may imply a competitive advantage over peers and/or the ability to control costs better than peers. Some companies may use a price-based strategy to gain market share. Thus, revenues may increase but profits may not move in the same direction. A higher profit margin also gives a company more room to adjust prices when needed. A decline in profitability measures may imply either increasing competition due to excess supply or declining demand.
A few key metrics of profitability, such as operating income margin, the EBIT (earnings before interest and tax) margin, the EBITDA (earnings before interest, tax, depreciation, and amortization) margin, and the return on permanent capital, form the basis of our profitability analysis. In addition to the level of profitability, we also focus on the stability of the profit margins. Entities that have stable profit margins are preferred to companies that have higher yet more volatile profit margins.
2) FINANCIAL RISK PROFILE
In assessing an entity’s financial risk profile, we focus on financial ratio analysis in relation to cash flows and financial leverage. Generally, we analyze the ratios for the past few years, the current year, and the ratios from a financial forecast covering at least the next two years. However, if the issuer recently completed a debt restructuring or reorganization, we may ignore the historical financial ratios. In this situation, the historical financial ratios are no longer relevant to the company’s future financial profile.
2.1 Accounting quality and adjustments
Audited and/or reviewed financial statements serve as the primary source of financial information for our financial analysis. We expect an entity’s financial statements to be audited and/or reviewed by an accounting firm on the list of approved auditors put forth by the Securities and Exchange Commission of Thailand (SEC). In cases where the auditor expresses no opinion or has a qualified opinion on some material aspects of an entity’s financial statements, we will take a very conservative view in assigning the rating, or may not be able to assign a rating to the entity at all. The rating will be adversely impacted if the entity cannot provide acceptable reasons for a material qualified opinion since the reliability of the financial statements will be questioned.
We typically base our analysis on consolidated financial statements, rather than company-only financial statements. Consolidated financial statements give a whole picture of the company and its subsidiaries, and ensure the net effects of inter-company transactions are presented. In addition, we typically make some adjustments to the financial ratios in order to better reflect an entity’s financial condition and make possible consistent financial comparisons among the rated peers. All ratios used in the analysis are adjusted ratios, prepared by using the standard adjustments as described in “Financial Ratios and Adjustments” published by TRIS Rating on 5 September 2018.
2.2 Cash flow and leverage
Below are the key financial ratios that we typically use to assess an entity’s financial leverage and cash flow in relation to the outstanding debt obligations.
• Funds from operations (FFO) to debt
• Debt to EBITDA
• EBITDA interest coverage ratio
• Debt to capitalization
3) OTHER CREDIT CONSIDERATIONS
The anchor rating, resulting from combining the business risk profile and the financial profile, may be adjusted by some other credit considerations that have not been captured in the business risk and financial risk profile assessments. These additional credit considerations could be related to management and governance, liquidity profile, financial flexibility, diversification, or other factors (if any).
• Management & Governance
Management plays a crucial role in the success or failure of a company. To evaluate the management team’s capabilities, TRIS Rating focuses on the team’s track record, past successes and failures, vision, credibility, and managerial style in terms of transparency, teamwork, delegation of authority, and a clear succession plan.
Even though the analysis is largely subjective, certain objective measurements are also taken into consideration. We look at the past performance, growth rate, the ability of the management team to cope with past crises, team continuity, and the financial policies of the company. The assessment of management quality is partly justified through interviews with the management team, the audit committee, and the comparisons with industry peers.
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• Liquidity
For the liquidity analysis, we focus mainly on the sufficiency of the sources of funds to cover the uses of funds, especially over the next 12-24 months. For a company that has a significant amount of debt due in any given year, we emphasize the issuer’s ability to refinance the debts and other possible sources of funds. The rating could be negatively impacted should the issuer have a significant amount of short-dated debt relative to liquidity. However, the liquidity profile will be considered in conjunction with the trend in operating performance, relationships with financial institutions, and the issuer’s ability to access the capital market.
• Financial flexibility
Companies that have a portfolio of investments in unconsolidated equity affiliates and/or other non-core assets that can be liquidated during tough times are considered to have more financial flexibility than other companies. These investments should have a market value and could be monetized over an intermediate timeframe. Generally, we do not include these investments in the evaluation of the business and financial risk profiles of the company. In addition, these investments must be considered as nonstrategic investments. The divestments of these securities or assets should not affect the issuer’s existing operations or competitive position. Moreover, the proceeds from the divestment could be used to repay debt and reduce leverage considerably.
• Diversification
A company may have a diverse core business lines under its umbrella. These lines of business may be or may not be related. Generally, the benefits from diversification are low if the lines of business are highly correlated. In order for diversification to be beneficial, it is crucial that the management team is capable of managing more than one business at the same time and the diversification should help reduce the volatility of revenues and earnings. In addition, the undertaking new ventures should not weaken the existing lines of business. In many cases, a company chooses to diversify into unfamiliar or unrelated businesses and later finds itself unable to compete, resulting in the failures of both the existing business and the new businesses. TRIS Rating takes a conservative view when a company enters a new business.
• Others (if any)
Other credit considerations that could lead to a positive or negative assessment include a short operating track record, exposure to litigation risk or contingent liabilities, or an entity in transition after a significant change of business policy or financial structure.
In the last step, the standalone rating will be compared across the entire portfolio of entities rated by TRIS Rating. The standalone rating could be adjusted upward or downward based on the final decision of the rating committee. However, the adjustment, if any, will be by no more than one notch.
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4) GROUP RATING
If the rated entity is a part of a larger business group (the Group), an assessment of the risk profile of the Group may be necessary if the rated entity’s business operation and financial health are closely related to the Group. Depending on the result of the Group risk assessment, the rating could be enhanced, if the strength of the Group is greater. On the other hand, the rating could be capped by the Group rating if the Group has a risk profile weaker than the rated entity itself.
A weak subsidiary of a strong business group may be able to get a rating notched upward from its standalone company rating. The notch upward is awarded if the company meets the criteria that indicate the likelihood of receiving group support in a distress scenario. In contrast, the rating of a strong subsidiary of a weak business group may be capped by the rating of the Group. Please refer to our “Group Rating Methodology”, published on 10 July, 2015 for more details. The criteria include the evaluation of the strategic importance of the subsidiary, revenues or assets contributed by the subsidiary to the whole group, amount invested in the subsidiary, support received from/or provided to other members of the Group during a crisis in the past, or the sharing of brand(s) within the Group.
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