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Frequently asked questions on rating reports

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4 April 2016 12:00 am - 0     - {{hitsCtrl.values.hits}}

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The previous article provided an overview on credit ratings. Today’s article will present a detail description on the subject matter by elaborating on rating reports. It will answer common questions raised by many investors.
 

What is a rating report?
It is a report that is issued by the rating agency upon completion of the ‘forward looking’ analysis (generally a three-year horizon) for an entity (e.g. a financial institution, corporate etc.). The report will give a rationale for the rating, rating drivers, both upward and downward triggers and any constraining factors for the rating. The rating is also compared with peers both internally and externally. 
Needless to say, the rating report will include the ‘rating’ of the entity on the rating scale of AAA to D and will also include an ‘outlook’. Ratings are usually reviewed every year. 
 

What is an outlook?
Rating agencies take certain actions in relation to its ratings. These actions can indicate a change in the credit quality of the rated entity, with a horizon of 12-18 months as a guidance of possibility. In addition, actions regarding ‘outlooks’ or ‘watches’ provide an indication of a potential rating change and indicate the likely direction of the rating. Rating outlooks indicate the direction a rating is likely to move over a one- to two-year period. Rating watches indicate that there is a heightened probability of a rating change and the likely direction of such a change.

  • Rating watch positive- indicating a potential upgrade
  • Rating watch negative- indicating a potential downgrade
  • Positive/negative outlook- does not indicate a rating change is inevitable
  • Stable- consistent with the historical migration experience of ratings over a one- to two-year period
  • Evolving- indicating that ratings may be raised, lowered or affirmed

It is important to note that ratings are not moved up or down for reasons such as super gains or unusual losses. Rather an upgrade could be expected when there is a sustained performance of the company or a downgrade in the event of deterioration of performance over a longer period.
 

What is included in a rating report?
Ideally a rating report should include the following sections:

  • Key rating drivers
  • Rating sensitivities
  • Operating environment
  • Company profile
  • Management and strategy
  • Risk appetite
  • Financial profile
  • Support

What are key rating drivers?
A ‘driver’ is anything that could materially affect the rating. After a thorough scrutiny of the entity being rated, the key factors that drive the rationale for the rating are defined. These key factors are broken down into sections and an explanation of each section and how it impacts the rating is defined. Every entity will have its own unique drivers though a few common drivers are based on the structure of the organisation (such as if they receive support from the parent company), consumption of capital, pressure on asset quality, etc.
 

What are rating sensitivities?
A definition of ‘sensitivity’ is, ‘the magnitude of a financial instrument’s reaction to changes in underlying factors’. ‘Rating sensitivities’ as the term suggests are any criteria that the existing rating would react to (i.e. sensitive to). This means any ‘potential reasons’ for a downgrade or upgrade are indicated as the ‘rating sensitivities’. The rating sensitivities for each entity differ based on each entity’s key rating drivers. If we take the above mentioned common drivers into consideration, the most likely rating sensitivities could be weaker or stronger linkages with the parent company, adequacy of capital levels, weaker or stronger credit 
profiles, etc.
 

What is the operating environment? 
While a macro environment would be the condition that exists in the economy as a whole, operating environment indicates the conditions of a particular industry, sector or even region. Hence, the environment in which the entity operates such as the industry and the sector is considered and the challenges or opportunities arising from the environment are taken into consideration when issuing the rating.


It is important for local analysts to be included in the rating process and rating committee as they are able to share their insight of the operational environment of the rated entity. The business risks faced, how these risks are mitigated in the macro operational environment and the company’s performance are valuable insights that a local analyst would be privy to. Foreign analysts bring insight on the same industry within similar/peer countries.
 

What is company profile?
A company profile is an overview of the company and its business. The company profile would consider the number of years the entity has been in operation and the experience garnered, the shareholding structure of the entity, the diverse businesses of the group if any, the number of branches that are in operation (if it is a financial institution (FI)), any subsidiaries of the rated entity, etc.
 

What is management and strategy?
The board composition and any changes in management are detailed. Changes in management could be due to an entity being bought over by a new party or a change in the board members. The rating agency’s opinion of the management team and the experience it lends may on occasion be included in the rating report. However, it is not a must. The strategy in moving forward would also be deliberated in this section.
On occasion, the management and strategy section could be included in the company profile and the rating report would move on to the next sub section which is ‘risk appetite’.
 

So what is risk appetite?
The definition of ‘risk appetite’ is ‘the level of risk an entity is agreeable to accept in order to attain goals and objectives of the organisation’. The entity’s risk appetite could be anything from ‘risk averse’, ‘minimal’, ‘cautious’ to ‘open to risk’. The rating agency will take into consideration the rated entity’s appetite for risk and state its own view on this appetite. Some factors that could bear upon the rating agency to deem an entity as having a high-risk appetite are its growth in loans, the ratio of non-performing loans (i.e. if it is a FI). Risk mitigatory factors that are put into place by the entity will also be considered when the rating agency is stating its view on the risk appetite of the rated entity.
On occasion the risk appetite could be excluded from the report and the factors considered in the section could be discussed within the next section which is the financial profile of the entity.
 

What is financial profile?
The financial profile will generally cover the following sub sections:

  • Asset quality
  • Earnings and profitability
  • Capitalisation and leverage
  • Funding and liquidity

What is considered in asset quality?
In the case of a FI or non-bank financial institution (NBFI), the assets will be the growth of gross loans, the reduced measure of non-performing loans, reserves maintained for impaired loans, etc. 
 

What are the main points of interest in earnings and profitability?
In this section the rated entity’s profitability metrics and net interest margins (NIMs) are looked at, among others such as the return on assets.
 

What is considered in capitalisation and leverage?
Capitalisation as a definition could refer to stock, long-term debt and /or retained assets. Leverage is defined as the use of financial instruments or borrowed capital to increase returns on an investment.
In this section the reasons why capital can increase or weaken in the rated entity are carefully considered. 
 

What are the main points considered in funding and liquidity?
The basic idea is to identify the main sources of funding for the rated entity. For FIs or NBFIs the ‘loan to customer deposit’ ratios are considered along with ‘customer deposits to total funding’ ratios. The mix of current account, savings account (CASA) is also considered in this section. CASA accounts are prominent in middle and South-East Asian countries as FIs and NBFIs attempt to entice customers to keep their money in banks and other FIs by combining savings and current accounts. Typically the current account portion pays no interest while the savings account portion pays an above average interest.
 

What is support?
If the rated entity is a ‘subsidiary’, the rating agency would make a statement on their assumption of support from the parent company, if the subsidiary is in need of a bailout. Typically the statement on the support from a parent company would wrap up the rating report. On occasion this could be followed by an appendix in which the sections discussed above could be explained in more detail with the use of graphs and charts, etc. The above format/sections defined are generally seen in a rating report of a financial institution/non banking financial institution. For corporate, the flow of the report would differ. A few sections may remain the same but there could be additions or deletions or amalgamations of the above sections in a rating report of a corporate entity. A basic structure of a corporate rating report is detailed below:

  • Key rating drivers
  • Rating sensitivities
  • Liquidity and debt structure
  • Key rating issues

While the first two sections are the same as in a financial institution/non-banking financial institution rating report, the latter sections are described below.
 

What is liquidity and debt structure?
A basic definition of liquidity is the degree to which an asset can be ‘quickly’ bought or sold in the market without affecting the price of the asset. If liquidity position of the company ranks as an important factor in the rationale behind the rating of the corporate entity, the sources of liquidity such as free cash flow and external sources (such as, bonds used by the corporate entity for liquidity purposes) will be discussed in this section in detail.
 

What are key rating issues?
Ideally the rating issues (i.e. the key issues faced by the corporate entity being rated) would be listed in a table as an appendix at the end of the rating report. However, the main issues will be discussed in detail in this section. As is the case with any entity, the issues faced by each corporate entity are unique to the company and/or the industry or sector they operate in. For each rated entity within Sri Lanka a ‘national’ rating
is assigned.
 

What is a ‘national rating’?
In each rating report the rating given is on a ‘national’ scale. For FIs and NBFIs the sovereign rating (i.e. the rating assigned to the country) will also be indicated (Sri Lanka B+, negative outlook). It is important to understand that entities rated as ‘AAA’ in Sri Lanka such as Citibank or Standard Chartered do not exceed the sovereign rating. The national rating scale provides a relative measure of creditworthiness for rated entities only within the country concerned. Under this rating scale, an ‘AAA’ long-term national rating will be assigned to the lowest relative risk within that country (i.e. AAA is mapped to B+, since the sovereign rating 
is B+).
The national rating scale is unique to each country and it ranks the degree of perceived risk relative to the lowest default risk in that same country.
 

How is the rating report made available to investors?
Following the completion of a rating review, all rating actions for new or existing rated entities and issues whether an affirmation, downgrade, or upgrade and including any decisions taken regarding either the rating outlook or watch s tatus should be made available to the rated entity and the public, in the event it is a publicly monitored rating.
Every reasonable effort should be taken to ensure that the time between a rating committee determining a final rating action and the publication of that rating action and related commentary is as short as reasonably possible, to maintain an up to date and current rating report.   The timing of publication reflects the important balance to be maintained between allowing sufficient time for the rated entity to review the rating rationale for factual accuracy and the presence of confidential information and requirements of the users of ratings for timely and objective opinions. Where issuers provide comments on draft commentaries, the rating agency duly evaluates this feedback. However, the review is aimed at the removal of any factual errors or references to non-public information only, the entity being rated is not in a position to sway the judgment or decision taken by the rating agency. The rating agency retains full editorial control over its commentaries and independent views with unbiased input.
A press release is generally issued which will cover the main point of the rating rationale, accessible by the public while a longer rating report is generally available for investors who are subscribers to the rating agency’s website. On occasion the rating agency may at its discretion, release such full rating reports to the public.  
 

How can an investor voice their concerns?
The press release and rating report for each entity would include the name of the primary and secondary analyst dedicated to that particular entity. The analysts’ contact details such as the email address and telephone number would also be included, enabling the investor or public to contact them for any clarifications or to provide feedback. 
(Source: Fitch Ratings)


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Order Gifts and Flowers to Sri Lanka. See Kapruka's top selling online shopping categories such as Toys, Grocery, Kids Toys, Birthday Cakes, Fruits, Chocolates, Clothing and Electronics. Also see Kapruka's unique online services such as Money Remittence,Astrology, Courier/Delivery, Medicine Delivery and over 700 top brands. Also get products from Amazon & Ebay via Kapruka Gloabal Shop into Sri Lanka

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