GCR's Criteria For Rating Corporate Entities

Global Credit Rating Co. (“GCR”) is the leading rating agency in Africa , rating more organisations than any other rating agency operating on the African continent. GCR's expertise in the corporate sector spans across southern, eastern and western Africa and covers a diverse range of corporate entities, which include the industrial, resource, transportation, retail, telecommunications and information technology sectors. Notwithstanding the diverse nature and size of the corporate entities covered, there are fundamental elements that underpin GCR's rating approach.

GCR's rating methodology embraces those methodologies used by international rating agencies, incorporating key principles specific to emerging market entities. GCR's comparative advantage with regards to according ratings in emerging market economies results from its operational presence in all markets in which ratings are accorded, thereby facilitating an accurate evaluation of the relative credit risks within a particular market.

GCR's rating approach employs analytical techniques that incorporate quantitative and qualitative factors. Our ratings reflect an evaluation of the organisation's current financial position, as well as how the financial position may change in the future. In addition, our analysis focuses on a range of administrative, economic and operational factors. GCR examines the ability of the organisation to meet its obligations under reasonable and stressful scenarios. Although this methodology focuses on rating general obligations, it is also relevant to specific debt issues. GCR's objective is to assign ratings that are applicable throughout the various stages of a business cycle.

A brief overview of GCR's rating process is outlined below:

The following guidelines provide a general overview of the quantitative and qualitative factors that GCR considers when analysing a corporate entity.

Fundamental analysis is the basis for ratings assigned by GCR. GCR's opinions are based on a clear understanding of the fundamentals and risks of the rated organisation and the industry (or industries) in which it participates. Whilst the goal of any credit analysis is to determine if and to what extent future cash flows cover interest and principal payments, assigning a credit rating is a dynamic process as each entity possesses unique characteristics and assumes varying levels of risk.

GCR's analytical process focuses on the following key areas:

Focus on the group's operational dynamics begins with a divisional analysis of performance, which is benchmarked against historical trends, industry norms and competitors. Financial data such as turnover growth and profit margins are key in measuring such performance. Within this context, our analysis takes account of industry fundamentals and key determinants of growth, as well as comparative advantages (such as cost profile, product differentiation, degree of product integration). Apart from relative strengths and opportunities, the threats and weaknesses of an entity are also assessed. With a growing number of emerging market corporates participating in global trade, emphasis is also placed on the source of earnings and the company's cost base. This is especially pertinent given the currency volatility of emerging market economies.

The underlying consideration throughout the rating process is the quality and stability of cash flows. In the industry overview, fundamental industry and business risks that could impact on cash flows are identified, and broad rating parameters are set accordingly. For example, highly cyclical industries, where sales (in terms of volume/price) are closely tied to fluctuations in macroeconomic indicators, such as GDP and interest rates, would incur a negative rating bias in the long term. This is due to pronounced deviations in earnings, as these type of corporates are characterised by high operating leverage, arising from their large fixed to variable cost base ratio. Notwithstanding this, there are multiple cyclical businesses whose cycles often offset each other, thereby eliminating the variability in earnings and cash flow exhibited by singular cyclical corporates. The nature and state of the industry is also analysed, as this plays a fundamental role in determining a rating category. For example an industry in decline or a high growth industry may adversely affect a corporation's long term rating. The former may be characterised by waning profitability and weaker cash flows, the latter may require large capital expenditure and R&D expenditure, which may lead to higher gearing levels. In contrast, a corporation operating in a stable industry could enjoy a higher long term rating, owing to the less volatile nature of revenue and cash flow streams.

Our evaluation of industry issues focuses on the following key areas:

Whilst fundamental analysis of the entity forms the cornerstone of our assessment, it is important to stress that GCR does not subscribe to a ‘box' approach. Rather, the approach is to integrate our fundamental and quantitative analysis with a strategically based qualitative analysis. Quantitative analysis involves scrutinising the corporation's financial performance, cash generation and financial position over a five year period.

Before a corporate's results are analysed, due consideration is given to their composition and accounting quality. As the rating process explicitly excludes any type of audit, accounting quality is assessed by examining accounting policies such as:

Financial Performance

GCR assigns great importance to consistency in revenue and cash generation. GCR does not employ a stand alone approach when analysing the corporation's financial data, as cognisance is taken of the climate and circumstances in which the financial results were produced. For example, while a successive drop in operating profit margins may be negatively perceived, it may however, be attributable to management's strategy of penetrating a lower margin segment of the market or increasing market share. Furthermore, in assessing the corporation's financial position, GCR looks for a strong balance sheet, supported by conservatively stated assets.

As mentioned previously, the rating assigned to an entity is primarily based on the extent to which cash flow covers interest and principal payments. Accordingly, of paramount importance is the analysis of the group's cash generation capabilities. Both operating and free cash flow are analysed along the following parameters.

Ratios

GCR analyses the various ratios in relation to the previous year's and the industry in which the corporate operates. Key ratios analysed include:

Cash flow and coverage ratios are deemed key credit protection ratios and are analysed in conjunction with gearing levels and funding structure (as discussed below).

4. Funding Profile

An appraisal of the company's funding profile commences with the quantum and maturity profile of its debt. Particular emphasis is placed on any maturity concentration and the ability of the entity to meet these obligations in the absence of refunding options. The analysis of a corporate's funding composition also examines the currency and interest rate structure (i.e. fixed or floating) associated with its debt exposure.

The unique characteristics of each corporate entity dictates that there are no hard and fast rules with regards to the debt position. Cognisance is taken of the corporate's lifecycle and type of industry in which it operates. For example, a corporation operating in the telecommunications or diversified industrial sectors will generally be capital intensive in nature and have greater funding requirements than a cash retail business, while a credit retail business will have sizeable working capital requirements, which need to be funded. Our analysis also takes into account the need to repair or replace infrastructure that has deteriorated or become obsolete.

Financial flexibility is assessed in terms of the corporation's gearing level (net debt to equity ratio). A more favourable rating is awarded to a company that is financially more flexible than its counterpart (in other words, can incur additional debt with greater ease and less strain on its balance sheet). Given the diverse nature of corporates analysed, GCR does not impose an optimal gearing limit, but rather assesses the entities gearing levels relative to its management's self imposed gearing limits and industry norms. Moreover, GCR looks at the entity's funding structure and while no optimal mix of short term and long term funding is prescribed, importance is placed on the match between assets and liabilities. For example, working capital intensive businesses would predominately make use of short term funding, whereas capital intensive businesses should utilise longer term funding facilities. In addition, GCR assesses the gearing trends within the corporate's respective business cycles. Cognisance is taken of the fact that working capital requirements fluctuate seasonally and hence gearing levels at year end may not accurately reflect the company's risk profile. Finally, GCR assesses the corporation's access to alternate sources of liquidity, such as committed borrowing lines and the ability to tap equity markets.

5. Management

Notwithstanding the fact that all areas of analysis discussed above are a reflection of management's strengths and capabilities, GCR evaluates management's strategies in relation to the entity's overall strengths and the current market environment.

Our specific evaluation of management focuses on a number of key areas. These have been briefly outlined below:

Management structure

GCR analyses the ability of management to adjust to changing conditions in an efficient and effective manner, recognising that flexibility is crucial. The depth of management is also important and the corporate should not be unduly exposed to ‘key man' risk.

Controls

A thorough understanding of management's appetite for risk is gained from a financial, operational, structural and technological point of view.

Credibility and track record

The analysis of this area encompasses the success and impact of past expansionary efforts, as well as the utilisation and management of financing methods. Management's historical success in attaining goals and objectives is also considered.

Strategic vision and business objectives

The overall strategic vision is reviewed, taking cognisance of management's operating, capital expenditure and revenue forecasts within the context of both the internal and external operating environment

Traditionally, the appetite for equity funding by emerging market corporates and ready access to bank lines has negated the need for corporate credit ratings. However, the substantial growth evidenced in demand for corporate ratings in these emerging markets is attributable to the increasing depth of capital markets in emerging economies, following a period of transformation and globalisation of these economies.

While thorough quantitative analysis is important, the qualitative characteristics of our analysis cannot be overemphasized. It is critically important to look “beyond the numbers” to evaluate the intangible strengths and weaknesses of an entity. An important aspect of GCR's analysis is an understanding of the strategic characteristics of an organisation and the quality of management. Ultimately our emphasis is on determining how these strategic aspects will affect the organisation's capacity to generate cash into the future.