How reliable are companies’ credit ratings?

Krishna Kant  of BS points to an internal study which looks at rating agencies of some 250 odd companies.

The ratings are same for companies which appear to be different on fin ratios:

What is a financially safe company? Is it one that is nearly debt-free and earns over 20 per cent returns on capital employed (RoCE) in its business; or one with a debt-to-equity ratio of around one and of around 10 per cent? Or is it a company with the leverage ratio of more than three and RoCE in a low single digit? If in India are to be believed, all three are equally safe with little or no chance of default on their debt.

Shree Cement, Indian Hotels, Cox & Kings, Century Textile and Reliance Infrastructure are all rated ‘AA’ for their domestic debt issues, despite contrasting financial ratios.

Shree Cement is nearly debt-free, has a RoCE of over 20 per cent and enough operating profit to cover six years of interest payment. By comparison, Indian Hotels has a net debt-to-equity ratio of 2.1 times, reported losses last financial year and its operating profit was just 1.9 times its interest expenses. Cement, textile and paper maker Century Textile’s leverage ratio was 3.6 times in 2013-14, it earned just 5.1 per cent on its capital and its operating profit was just enough to cover a year of interest payment. Ditto for travel and tour operator Cox & Kings, which was struggling with a leverage ratio of three times at the end of March this year. The financial ratios of Anil Ambani group’s Reliance Infrastructure are somewhere in the middle, but the company still enjoys similar ratings.

The ratings seem to hide more than they reveal. Bhushan Steel was a A- company till its crisis surfaced:

Analysts say the widening gap between a company’s financial ratio and its credit rating raises questions over the accuracy of credit ratings in the country. “Credit ratings often give false sense of comfort to lenders,” says an analyst who does not wish to be named.

The case with Bhushan Steel was similar. The firm, despite being one the most indebted in its sector and its market capitalisation being a fraction of its total debt, was rated A- (adequate safety and low risk of default) until a few weeks ago. For over a year now, Bhushan Steel’s stock price has been falling despite a rally in steel stocks which indicates market scepticism about the firm’s finances. However, rating agencies took action only last week and downgraded it by four notches in one swoop to BBB-, a sub-investment grade category.

Critics blame this on competition among rating agencies. “Many companies virtually do rating shopping in India,” says a senior official with a domestic rating agency, asking not to be named.

But rating agencies refute this. They say they follow a transparent rating matrix and there is a Chinese wall between the analytical team, which assigns ratings, and the business development team. “Financial ratios are only one of the many metrics used to rate a company. We also take into account factors like management quality, the company’s track record, its industry position, degree of support from the parent or promoter group and the project analysis,” says Arun Kumar, head of rating at CARE Ratings.

This means two companies with contrasting balance sheets could end up getting similar ratings, as one could score higher on other factors. “A company with higher market share or belonging to a large and reputed business group could be rated higher, despite its poor financial ratios,” says Kumar.

This standard comparison of companies is like comparing apples with oranges. Firms differ across industries. One should be looking at different firms in one kind of industry to draw comparisons. If things remain weird even then, there are issues.

Having said that, nothing in finance/economics is sacrosanct. Everything is sentiment based which changes really quickly. The trouble is we deem certain organisations/theories as God-like and just believe in them. . Just like Mutual Funds say” Read the prospectus before you invest as markets are risky” etc etc. Ratings agencies should add: “Believe these ratings at your own peril” or some other more fancily worded statement.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: