Saunders Learning Group, LLC, Andover, KS

Saunders Learning Group, LLC, Andover, KS
Training from Saunders Learning Group

Saunders Learning Group provides a variety
of training programs, workshops and
seminars targeted to the financial services
industry.
Programs are available in a wide range of

topics, and we are specialists in developing
custom programs that are targeted to your
needs.
Contact the founder, Floyd Saunders at

316-680-6482 or at
floyd@floydsaunders.com for more
information.

1
Topics
1. Meaning and Definition

2. Role and Function of Credit Rating Agencies
3. Moody's, Standard & Poor's, Fitch Ratings
4. Rating Methodology
5. Advantages of Credit Rating
6. Disadvantages of Credit Rating
Saunders Learning Group, LLC, Andover, KS Slide 2

Basic Terms

Saunders Learning Group, LLC
Credit Rating
 A credit rating estimates the credit
worthiness of an a financial security, a
corporation, local government or even
a country.
 It is an evaluation made by credit reporting
agency of a risk of buying into a specific
security offering and based on a number
of factors.
 Credit ratings are calculated from financial
history and current assets and liabilities.
 Typically, a credit rating tells a lender or
investor the probability of the subject being
able to meet payment requirements for
interest and principal repayment.

What is A Credit Rating
An opinion on the issuer‟s capacity to meet its financial obligations on a
particular issue in a timely manner, for example long-term bonds:

Distinction Between Credit Rating and Reporting
A Credit Rating Agency (CRA) is a company that is responsible for assessing

the financial strength of a company or government entity. This includes
domestic and foreign companies. The main area that a credit rating agency
focuses on is the ability of the company or government entity to meet the
interest and principle payments on their debts and bonds.
 A credit rating agency is different from a credit reporting agency.
 A credit reporting agency is responsible for compiling financial data that is
necessary for loan decisions.
 A credit rating agency does all the statistical assessments that are involved in
placing a rating on a company or orgaŶizatioŶ͛s credit history..
 A credit rating agency is responsible for providing investors with information
about an orgaŶizatioŶ͛s creditworthiness.

Slide 3
Meaning and Definition
 A Credit Rating issued by a credit rating agency is an assessment of the
credit worthiness of individual financial securities (For example, a bond)
and debt issued by corporations, government issued securities or even a
couŶtry͛s ability to repay debt.
 Credit Ratings are assigned by rating agencies to companies and debt
instruments, are designed to gauge the likelihood that a company will
default on its obligations to creditors. Thus, they give investors a rough
idea of the risk associated with loaning money to the entity being rated.
 Credit ratings are forward-looking opinions about credit risk. It express
the ageŶcy͛s opinion about the ability and willingness of an issuer, such
as a corporation or state or city government, to meet its financial
obligations in full and on time.

Slide 4
Uses of credit ratings
Building
Pricing
Portfolios
Credit
Ratings
Contracts Trading
Regulatory
Requirements
Credit ratings are critical to the activities of securities markets, as they are depended on to create and
manage investment portfolios, the pricing of new securities, trading of securities, financial contracts (and
loans) and for some financial institutions to meet regulatory requirements.
Saunders Learning Group, LLC, Andover, KS 8

Module 1
Role and Function of Credit
Rating Agencies

Saunders Learning Group, LLC Slide 9
Credit Reporting Agencies
Provides investors with unbiased reviews and opinion as the credit risk of
various securities.
Example
 Performs credit and risk analysis to produce ratings.
Activities  Maintains databases of credit and risk information on companies and financial
securities.
 Provides unbiased opinion. An independent credit rating agency provides an
unbiased opinion as to relative capability of a company to service debt obligations.
 Provides quality and dependable information on investment and credit risk which is
more authenticate and reliable.
 Provides information at low cost or no cost to investors.
 Investors rely on the ratings assigned by the ratings agencies while taking
investment decisions.
 Ratings are published in the form of reports and are available easily on the payment
of negligible price or free of charge depending on the arrangements in specific
countries.
Example  A.M. Best; Credit Analysis & Research (CARE), India; Dominion Bond Rating
Service, Canada; Fitch Ratings, U.S. & UK; Investment Information and Credit
Companies Rating Agency (ICRA), India, Moody‟s, S&P. Complete list @:
http://www.defaultrisk.com/rating_agencies.htm

Functions of a Credit Rating Agency
 Provide easy to understand information: Rating agencies gather information,
then analyze information to interpret and summarize complex information in a
simple and readily understood manner.
 Provide basis for investment: An investment rated by a credit rating enjoys higher
confidence from investors. Investors can make an estimate of the risk and return
associated with a particular rated issue while investing money in them.
 Healthy discipline on corporate borrowers: Higher credit rating to any credit

investment makes the financial instrument (bond, mortgage security) more
attractive to investors. Corporations can borrow money more cheaply if they
maintain high credit ratings on their debt.
 Formation of public policy: Once the debt securities are rated professionally, it
would be easier to formulate public policy guidelines as to the eligibility of
securities to be included in different kinds of institutional portfolios.

How Credit Ratings Are Established
Analysis
Adjusted Financial
Statement Data
Rating Committee
Other Company
Package and
Specific Data
Recommendation
Industry / Macro
Economic Data
A credit rating agency collects a variety of data, analyses it and produces a

recommended credit rating, once reviewed, it distributed to potential investors.

IŶdustry ŵethodologies…
Key metrics
Benchmark and rate
Weigh
Indicative Rating
Other qualitative factors
Final rating
The typical methods used by credit rating agencies to compare a individual rating analysis to key
metrics about that company, and benchmark data to weighted values and produce an indicative
rating. This is then reviewed internally to produce a final rating.

Importance of Credit Ratings
Credit ratings establish a link between risk and return. They thus provide a yardstick
against which to measure the risk inherent in any instrument.
An investor uses the ratings to assess the risk level and compares the offered rate of
return with his expected rate of return (for the particular level of risk) to optimize his
risk-return trade-off.
The risk perception of a common investor, in the absence of a credit rating system,
largely depends on his familiarity with the names of company and what they might
know about the company.
It is not feasible for the corporate issuer of a debt instrument to offer every
prospective investor the opportunity to undertake a detailed risk evaluation.
For the typical investor, it would difficult to assess all of the financial information
available to assign their own risk ratings.
Thus the Ŷeed for Đredit ratiŶg iŶ today’s ǁ orld ĐaŶŶot ďe oǀ er eŵphasized.

Module 2
Moody's, Standard & Poor's,
Fitch Ratings

Saunders Learning Group, LLC 15
Nationally Recognized Statistical Rating
Organization
 In 1975, the U.S. Securities Exchange Commission

established the „Nationally Recognized Statistical
Rating Organization‟(NRSRO) designation
 Three of best known rating agencies in the U.S. were
named:
• Moody‟s Investor Services
• Standard and Poor‟s
• Fitch Rating
 In 2003, the SEC approved a fourth NRSRO, Dominion Bond Rating
Services (DBRS) from Canada.

Major Credit Rating Agencies
 The major agencies were either
independent or owned by nonfinancial
companies.
 Moody's, a subsidiary of Dun and
Bradstreet, dominated the market for
commercial credit ratings.
 Standard and Poor's was a subsidiary of
McGraw-Hill, a major publishing company
with a strong business information focus.
 Fitch, initially a publishing company, was
bought by an independent investor group in 1989.
 Credit-rating agencies are often regarded as the gatekeepers of the capital
markets
 because of the impact of their opinions on the structuring and pricing of
financial products.

Rating Scales used by Major Credit Raters
The three largest credit rating agencies each use different scales for their ratings as
shown here:

Value of Credit Ratings
 Credit ratings can also speak to the credit quality of an
individual debt issue, such as a corporate note, a municipal
bond or a mortgage-backed security, and the relative
likelihood that the issue may default.
 The credit rating represents the credit rating agency's
evaluation of qualitative and quantitative information for a
company or government; including non-public information
obtained by the credit rating agencies analysts.
 Each agency applies its own methodology in measuring
creditworthiness and uses a specific rating scale to publish its
ratings opinions.
 A poor credit rating indicates a credit rating agency's opinion
that the company or government has a high risk of defaulting,
based on the agency's analysis of the entity's history and
analysis of long term economic prospects

Factors Involved in Credit Rating
 Credit rating depends on several factors, some of
he
which are tangible/numerical and some of which
are judgmental and intangible. These factors include: s/
 Overall fundamentals and earnings capacity of t
company and volatility of the same. ed
 Overall macro economic and busines
industry environment.
 Liquidity position of the company (as distinguish
from profits).
 Requirement of funds to meet irrevocable commitments.
 Financial flexibility of the company to raise funds from
outside sources to meet temporary financial needs.
 Guarantee/support from financially strong external bodies.
 Level of existing leverage (borrowings) and financial risk.

Slide 18
S&P Credit Rating Process
This is an example of a rating
process:
1. The issuer of a financial product
requests a rating
2. The rating agency does an initial
evaluation
3. This may include meetings with
an issuer͛s management team
4. The financial product is reviewed
5. The analysis is reviewed by a
rating committee
6. Once a rating is assigned the
issuer is notified
7. Ratings are then distributed to
the public
8. Rating agencies then monitor the
issuers and reports adjustments.

RatiŶg data flow…
Company Reports
XYZ Company
Adjusted Financial
Statement Data
Rating Methodologies Adjustment Worksheets

Nature of Credit Rating
 Rating is based on information: A rating is not based entirely on published
information and the success of a rating agency depends, on its ability to access
privileged information.
 Cooperation from the issuers as well as their willingness to share even confidential information are
important pre-requisites.
 The rating agency must keep information of confidential nature possessed during the rating process, a
secret.
 Many factors affect rating: A rating is given by taking into account the 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 specialized financial and credit analysts.
 Rating agencies also ensure that the rating process is free from any possible clash of interest.
 Rating by more than one agency: In a well developed capital market, debt issues are
often rated by more than one agency.
 And it is only natural that ratings given by two or more agencies differ from each other e.g., a debt issue,
may be rated ͚AA+͛ by one agency and ͚AA͛ or ͚AA-͛ by another.
 It would be unusual if one agency assigns a rating of AA while another gives a ͚BBB͛.

Module 3
Rating Methodology

Rating Methodology
 The methodology for creating a rating involves an analysis of all the factors
affecting the creditworthiness of an issuer company: business, financial and
industry characteristics, operational efficiency, management quality, competitive
position of the issuer and commitment to new projects etc.
• A detailed analysis of the past financial statements is made to assess the
performance and to estimate the future earnings.
• The coŵpaŶy͛s ability to service the debt obligations over the tenure of the
instrument being rated is also evaluated.
• In fact, it is the relative comfort level of the issuer to service obligations that
determine the rating.
 A rating analysis includes the following factors:
1. Business Risk Analysis
2. Financial Analysis
3. Management Evaluation
4. Geographical Analysis
5. Regulatory and Competitive Environment
6. Fundamental Analysis

Business Risk Analysis
Business risk analysis aims at analyzing the industry risk, market position of the company,
operating efficiency and legal position of the company.
 Industry risk: The rating agencies evaluates the industry risk by taking into consideration
various factors like strength of the industry prospect, nature and basis of competition,
demand and supply position, structure of industry, pattern of business cycle etc.
 Industries compete with each other on the basis of price, product quality, distribution
capabilities etc.
 Industries with stable growth in demand and flexibility in the timing of capital outlays
are in a stronger position and therefore enjoy better credit rating.
 Market position of the company: Rating agencies evaluate the market standing of a
company taking into account:
i. Percentage of market share ii. Marketing infrastructure
iii. Competitive advantages iv. Selling and distribution channel
v. Diversity of products vi. Customers base
vii. Research and development projects viii. Quality Improvement programs
undertaken to identify obsolete products

Business Risk Analysis - continued
 Operating efficiency: Favorable locational advantages, management and labor
relationships, cost structure, availability of raw-material, labor, compliance to
pollution control programs, level of capital employed and technological
advantages etc. affect the operating efficiency of every issuer company and hence
the credit rating.
 Legal position: Legal position of a debt instrument is assessed by letter of offer
containing terms of issue, trustees and their responsibilities, mode of payment of
interest and principal in time, provision for protection against fraud etc.
 Size of business: The size of business of a company is a relevant factor in the
rating decision.
 Smaller companies are more prone to risk due to business cycle changes as compared
to larger companies.
 Smaller companies operations are limited in terms of product, geographical area and
number of customers.
 Whereas large companies enjoy the benefits of diversification owing to wide range of
products, customers spread over larger geographical area.
 Business analysis covers all the important factors related to the business
operations over an issuer company under credit assessment.

Rating Methodology
 Financial Analysis: Financial analysis is used to determine the financial strength of the
issuer company through quantitative means such as:
 ratio analysis
 cash flow analysis
 study of the existing capital structure.
 Both past and current performance is evaluated to comment the future performance of a
company This includes an analysis of four important factors namely:
 Accounting quality: As credit rating agencies rely on the audited financial statements,
the analysis of statements begins with the study of accounting quality.
 This includes: qualification of auditors, overstatement/understatement of profits, methods
adopted for recognizing income, valuation of stock and charging depreciation on fixed assets
are studied.
 Earnings potential/profitability: Profits indicate coŵpaŶy͛s ability to meet its fixed
interest obligation in time.
 A business with stable earnings can withstand any adverse conditions and also generate
capital resources internally.
 Profitability ratios like operating profit and net profit ratios to sales are calculated and
compared with last 5 years figures or compared with the similar other companies carrying on
same business.
 As a rating is a forward-looking exercise, more emphasis is laid on the future rather than
the past earning capacity of the issuer.

Cash Flow and Financial Analysis
 Cash flow analysis: Cash flow analysis is undertaken in relation to debt and
fixed and working capital requirements of the company.
 Indicates the usage of cash for different purposes and the extent of cash available
for meeting fixed interest obligations.
 Cash flows analysis facilitates credit rating of a company as it better indicates the
issuer͛s debt servicing capability compared to reported earnings.
 Financial flexibility: Existing Capital structure of a company is studied to find:
 The debt/equity ratio, alternative means of financing used to raise funds, ability to
raise funds, asset deployment potential etc.
 The future debt claims on the issuer͛s as well as the issuer͛s ability to raise capital is
determined in order to find issuer͛s financial flexibility.
 Management Evaluation: Any coŵpaŶy͛s performance is significantly affected
by:
 Management goals, plans and strategies
 Capacity to overcome unfavorable conditions
 staff͛s own experience and skills, planning and control system etc.
 Rating of a debt instrument requires evaluation of the management strengths
and weaknesses.

Additional Analysis
 Geographical Analysis: Geographical analysis is undertaken to determine
the locational advantages enjoyed by the issuer company.
 An issuer company having its business spread over large geographical area
enjoys the benefits of diversification and hence gets better credit rating.
 A company located in backward area may enjoy subsidies from government
thus enjoying the benefit of lower cost of operation.
 Thus geographical analysis is undertaken to determine the locational
advantages enjoyed by the issuer company.
 Regulatory and Competitive Environment: Credit rating agencies evaluate
structure and regulatory framework of the financial system in which it
works.
 While assigning the rating symbols, CRAs evaluate the impact of
regulation/deregulation on the issuer company.
 Fundamental Analysis: Fundamental analysis includes an analysis of
liquidity management, profitability and financial position, interest and tax
rates sensitivity of the company.

Rating scale
Investment Aaa Minimal credit risk

Grade
Aa(1-3)
A(1–3) Watch list =

under review
Baa(1-3)
Ba(1-3)
B(1-3)
Caa(1-3) Outlook =
likely direction
High Ca
Yield
C
In default,
little prospect of recovery
Rating Categories
 Ratings are constructed to represent the risk of default; that
is, a high (low) rating implies a low (high) probability of
default.
 Default refers to any event that results in the issuer‟s
breaching its financial contract.
 Large companies with strong and stable cash flows are likely to
be rated higher than small companies with more volatile cash
flows.
 Investment grade refers to the safest levels of financial
securities.
 Investment-grade securities have historically exhibited
relatively low rates of default.
 Speculative grade, or noninvestment grade, refers to the
riskier securities.
 Debt rated BB (Ba for Moody‟s) or below is noninvestment
grade, and is sometimes referred to as “high yield” or “junk.”
 Default rates among these classes of securities are
comparatively high.
 Within the major rating categories (AA, A, etc.), credit
ratings are often modified to show relative standing within
a category.
 Moody‟s uses numbers 1, 2, and 3, while S&P and Fitch use
plus ;+ͿaŶd ŵiŶus ;−ͿsigŶs.

 Monitoring the already rated issues: Rating agencies monitor all outstanding debt
issues rated by them as part of their investor service. Rating agencies may put issues
under a credit watch and upgrade or downgrade the ratings as per the
circumstances after intensive interaction with the issuers.
 Publication of ratings: Once a rating is accepted it is 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.
 Right of Appeal: Where an issuer is not satisfied with the rating assigned, a review
may be requested. Unless the rating agency had over looked critical information at
the first stage chances of the rating being changed on appeal are rare.
 Rating is for instrument and not the issuer company: A rating is done for a
particular issue and not for a company or the Issuer.
 It is quite possible that two instruments issued by the same company carry different
ratings, if maturities are substantially different or one of the instruments is backed by
additional credit reinforcements like guarantees.
 In many cases, short-term obligations, like commercial paper (CP) carry the highest rating
even as the risk profile changes for longer maturities.

 Rating not applicable to equity shares: A credit rating is an opinion on the issuers
capacity to service debt. For equity shares there is no debt servicing obligation, so
credit rating does not apply to equity shares.
 Credit vs. financial analysis: Credit rating is much broader concept than financial
analysis. One important factor which needs consideration is that the rating is
normally done at the request of and with the active co-operation of the issuer.
 The rating agency has access to unpublished information and the discussions with the senior
management of issuers give meaningful insights into corporate plans and strategies.
 Necessary adjustments are made to the published accounts for the purpose of analysis. Rating is
carried out by specialized professionals who are highly qualified and experienced. The final rating is
assigned keeping in view the number of factors.
 Time taken in rating process: The rating process is a fairly detailed exercise.
 It involves analysis of published financial information, visits to the issuers offices and
works, intensive discussion with the senior executives of issuers, auditors, bankers, and
creditors etc.
 All this takes time, a rating agency may take 6 to 8 weeks or more to arrive at a decision.

Module 4
Advantages and Disadvantages
of Ratings

Benefits of Ratings
For Investors
 Market access (gate keeping)  Due diligence efficiency
 Expands breadth of market  Multiple independent perspectives
 Widens distribution  Facilitates comparisons
 Improves liquidity  Tool in portfolio management
 Improves pricing  Enhances secondary market liquidity
 Helps management with  Relatively stable over time
independent, outside perspective on  Basis for performance benchmarks
company
 Helps management monitor
counterparty risk

Advantages of Credit Rating
Benefits to Investors Benefits the Company

 Safety of investments.  Easier to raise funding
 Recognition of risk and  Reduced cost of borrowing
returns.  Reduce cost of public issues
 Freedom of investment  Ratings can build up image
decisions.
 Ratings facilitates growth
 Wider choice of investments  Recognition to unknown
 Dependable credibility of companies
issuer
 Easy understanding of
investment proposals
Benefits to Intermediaries
For brokers ratings make it easier to persuade clients to select an investment proposal of
investment in highly rated instruments.

Disadvantages of Credit Rating
Credit rating suffers from the following limitations:

 Non-disclosure of significant information
 Static study
 Rating is no certificate of soundness
 Rating may be biased
 Rating under unfavorable conditions
 Difference in rating grades
 Improper Disclosure May Happen
 Impact of Changing Environment
 Problems for New Companies
 Downgrading by Rating Agency

Questions

Thank You !

Saunders Learning Group, LLC
About the Author/Presenter
 Floyd Saunders has worked on Wall Street
with both Bank of America and JPMorgan,
where is was a vice president in global
financial systems. He has worked across the
industry in retail, commercial, and
investment banking.
 He has taught courses in Money and Banking
and extensively for the American Institute of
Banking and various colleges.
 As a consultant, he developed and taught a
wide range of banking and investing courses.
 He authored three programs for the American
Bankers Association: Banking on Mutual
Funds and Annuities, Introduction to
Securities Markets and Investing in Securities.
 He is the author of ͞FiguriŶg Out Wall Street͟
aŶd his Ŷeǆtďook is ͞FaŵilǇFiŶaŶĐial Freedoŵ ͟
a ďook oŶ persoŶal ŵoŶeǇmanagement.

Reference Material
Figuring Out Wall Street Consumer‟s Guide To

Financial Markets
By Floyd Saunders
Publisher: Saunders Learning Group
ISBN: 978-0-9824019-0-3
Available from Amazon:

http://www.amazon.com/Figuring-Out-Wall-Street-
Consumers/dp/0982401906
and many other online book stores.
Book summary: Figuring Out Wall Street, is the
concise guide to help everyone understand how what to do
now to restore our financial systems. Written in an easy to
understand manner, even the most complex financial
concepts are easy to digest. This book provides help to
monitor investments with a review of investment products,
financial regulators and economic indicators. Learn how the
stock market exchanges work and the world of investment
banking, hedge funds, venture capital and private equity.
Every chapter includes action plans for investing.

Saunders Learning Group, LLC, Andover, KS

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Saunders Learning Group, LLC, Andover, KS

Training from Saunders Learning Group

Programs are available in a wide range of

Contact the founder, Floyd Saunders at