Supplier Risk Monitoring

Understanding the Role of Credit Agencies and a Corporate Rating Downgrade

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The three big global rating agencies – Fitch, Standard & Poor’s and Moody’s – control about 96% of the global market. John Knowles Fitch founded the Fitch Publishing Company in 1913. In 1924, Fitch introduced the ‘AAA’ through ‘D’ rating system that has become the basis for ratings throughout the industry. John Moody and Company first published the “Moody’s Manual” in 1900. The manual published basic statistics and general information about stocks and bonds of various industries. In 1909, Moody began publishing “Moody’s Analyses of Railroad Investments”, providing analytical information about securities. Expanding this idea led to the creation of Moody’s Investors Service in 1914. Henry Varnum Poor first published the “History of Railroads and Canals in the United States” in 1860, providing securities analysis and reporting. Standard Statistics which published corporate bond, sovereign debt and municipal bond ratings, merged with Poor’s Publishing in 1941 to form Standard and Poor’s Corporation, which was acquired by The McGraw-Hill Companies, Inc. in 1966.

What Role Does a Rating Agency Play?

The main purpose of credit agencies is to assess the ability of borrowers, either governments or private enterprises, to repay their debt at a given time and then based on an independent assessment, the agencies issue credit ratings. Credit rating agencies rate derivatives, government bonds, company securities etc. Agencies charge a fee to an entity that wants to be rated or someone who wants to leverage the rating or the agency’s analysts’ opinion, for analysis purposes.

Some firms utilize ratings by credit agencies as guidelines when making investment decisions. One would prefer a supplier who is financially stable, since it would mean that the supplier is not struggling to meet their working capital requirements and has sufficient cash to invest in their products, employees, infrastructure, and to deliver competitive services.

Understanding Ratings

Every rating agency has an in-house methodology to calculate its rating. Agencies commonly take in to account both quantitative and qualitative data, and contingency scenarios. These could include current strategies adopted by an organization, macro-environment factors including industry shifts, financials, debt, product diversity, distribution channel, competition, shareholder-rewarding programs, large acquisitions etc., which may have an impact on the entity’s policy decisions.

The rating is based on the likelihood of debt being repaid and average recovery of principal in the event of a payment default. The safest rating is given under letter ‘A’, reflecting the lowest level of credit risk. Rating under letter ‘B’ represents moderate credit risk and as such may possess certain speculative characteristics. Rating under letter ‘C’ or ‘D’ have potential of a default or are in default, with little prospect for recovery of principal or interest. Moody’s for instance appends numerical modifiers 1, 2, and 3 to each generic rating classification from ‘Aa’ through ‘Caa’. Modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; modifier 2 indicates a mid-range ranking; and modifier 3 indicates a ranking in the lower end of that generic rating category.

In addition to the letter grade, a credit rating might also include forward looking statements that describe how a particular rating may change in the next 12-18 months, based on the facts/opinions supplied by the agencies.

Factors Influencing a Downward Change in Rating

  • Deteriorating finances such as greater than expected decline in revenues or the failure to achieve anticipated operating margin improvement, share buybacks/dividends schemes that result in high adjusted total debt to EBITDA ratio, usually accompanied with high debt levels
  • Limited improvement or further deterioration in a company’s cash flows, when debt position is already not favorable
  • High debt equity and low interest coverage ratios
  • Fall in assets quality
  • Business separation, large acquisition (debt-financed) etc.

Interpreting the Rating Downgrade and Its Impact on Companies

  • A downgrade reflects inability to service debt as per schedule or, in some cases, may lead to a default in payment. Ignoring key financial ratios and not initiating action that could strengthen ability to repay debts in time, may lead to downgrades.
  • For an asset-driven organization, a fall in assets quality may lead to higher losses.
  • In case of business separation or units being hived off, the remaining business may be a smaller company with less business diversity and profitability than the current combined business, and be more exposed to industry headwinds.
  • A series of downgrades is a cause for concern and not a single downgrade. If the rating outlook is negative, typically the ratings are likely to be downgraded further. A negative outlook reflects the pressures on the company’s core business, execution challenges, and limited financial flexibility.
  • A ratings downgrade hampers the company’s ability to borrow. Lenders may hesitate loaning to such companies and may not refinance its existing debt. This could, in turn, impact the future growth plans of the company. The cost of borrowing also increases for such companies because investors seek higher returns for the additional risk they are agreeing to undertake.
  • To get funds from investors at more attractive rates, these companies need to improve their operational and financial matrices.

What Can a Company Stakeholder Do?

  • Continue to monitor the recent credit ratings and also future outlook given by the agencies, to gain insights on company’s financial condition and industry performance, which may not be otherwise be publicly accessible.
  • One can leverage the ratings and opinions provided by credit agencies as part of supplier assessment which facilitates their decision to further research and examine the opportunities and risks attached; however, it is also advisable to conduct own research as well. For instance, after doing a peer or industry comparison, if it is found that the negative trend observed at the supplier is not in-line with the peers or industry, chances are that the supplier could face further downgrades.
  • Analyze the explanation provided by the company in response to its rating downgrade. Analyze in the following terms: Will the company be able to honor its promises such as reverse revenue declines and improve margin within the stipulated time frame? If the measures seem unrealistic or if unsure of the company’s capabilities, ask the company how it can factually back its goals or it may be possible that the company has not analyzed its mitigation strategy appropriately.

Conclusion

Credit rating agencies’ critics believe that these agencies lost credibility after the housing crash of 2008, as the critics think that the agencies enabled the housing bubble by not raising flags for securities that contained bad-risk mortgages. Some believe that the issuer-pays model remains an incentive for agencies to go easy on clients. Critics suggest that for uncertain factors like political risks, one should also conduct own analysis, and not rely on the credit rating agencies for insights. Spokespersons for Moody’s and Fitch have cited reports that detail their compliance with post-crisis regulations, including SEC (US Securities and Exchange Commission)-imposed firewalls between credit analysis and sales and marketing designed to reduce potential conflicts of interest. The need of the hour is to regulate these agencies better.

To understand the quality of ratings given by these agencies, it is important to know about the history and evolution of these agencies to get an idea about the methodologies these agencies use. Some users prefer to utilize the information from multiple rating agencies for more authenticity.

Currently, many institutions and individuals continue to rely on credit ratings to make business decisions. Hence, companies strive for improved ratings for brand building. This in turn enables stable and transparent market conditions.

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