Before a banker can reach a lending decision or a credit rating agency (CRA) allocate a rating, they will need sufficient information to understand your business. The more you can help them gain that understanding the better the chance that they will come to a fair decision.

So, while this article does not purport to be a comprehensive checklist, it will help you think widely about what needs to be considered when you are asked to explain your business risks and opportunities to credit rating agencies and potential funders.

At the outset, even if just approaching a bank for a loan, look to see if the CRAs rate other companies similar to yours. If you subscribe to one or more ratings agency’s services – Standard & Poor’s, Moody’s, Fitch Ratings – you will have access to reports on individual companies, describing any special factors. From this you can learn whether there are any special factors the analysts see as risks or as strengths. In turn, if there are important factors distinguishing your company from others in the industry, resolve to make them clear.

Also, as the CRAs’ websites (see below for links) show their rating methodologies – and often the ratios they regard as key performance indicators too – it is well worth looking at them.

The easy part is the provision of relevant publicly available information and previous accounts for the company. But even this benefits from some thought being given to the exercise. For example, if particular accounting conventions affect the company’s business, then it makes sense to provide covering explanations and, if need be, pro forma recalculations of the data.

You will also need to provide a lot of unpublished information about the business, strategies, plans and projections, governance and risk management. This can be handed over as part of a presentation to the analysts.

Any credit analysis will depend on the historic track record plus forecasts and projections. For those forecasts to have credibility the analysts will want to build up confidence in the senior management and its overall strategy. For that reason an assessment of management, partly gained from those presentations, is an important part of the process. The directors or managers involved should understand this and be suitably prepared.

That said, it may not always be possible to answer every question instantly in the presentation meeting and it is vital that the management team does not blow its chances at this stage. Giving wrong answers off the cuff can weaken an otherwise excellent impression. There is no shame in promising to get back to the analysts. Credit analysts inevitably look at the world through different eyes from businessmen and the topics on which they raise questions may not always be top of mind for company executives, even the finance director.

In explaining your business, start with the big picture – the macro (whole economy) and meso (industry level) scenarios. The analysts will usually be experienced in reviewing the company’s industry, but it is unwise to assume their knowledge is encyclopaedic, current, correctly selected or relevant to exactly what you do and where you do it.

They need a summary of how the company sees the risk factors affecting its industry, and how they will develop. Look at:

• capital intensiveness;
• maturity (technological and market);
• cyclicality;
• competition;
• barriers to entry;
• substitutes for the industry’s products;
• demand factors;
• under/over capacity;
• growth/decline;
• what is happening to customers and among your wider stakeholders and the supply chain; and
• environmental impact and ‘social responsibility’ issues.

And finally, it may be necessary to deal with separate major product sectors.

A similar run-down on the environment in which the company operates is needed – geographical, social, regulatory and technical/technological.

With the wider picture established, start to deal with the company’s particular situation within the three categories of ‘strategic’, ‘financial’ and ‘operational’ as follows.

Cover the market position of key products, including the ability to differentiate the product and provide competitive advantages, with a review of specific product life-cycle positions and sales/distribution patterns in various geographies.

Discuss relative costs and how sourcing arrangements are advantaged/disadvantaged, the implications of single/multiple sourcing of key components/materials/skills, and the impact of the company’s relative size within its industry.

Explain the business’s access to, or ownership of, necessary intellectual property (‘know-how’ as well as protectable matter). Also point out where the company has any trademark/copyright or regulatory privileges (if it operates in a regulated business) or, in certain markets, whether it operates under price regulation or specific orders of restrictive practices courts or competition authorities.

The principal risks – and opportunities – arising from the story so far must be outlined and related to the industry risk profiles discussed previously. Don’t forget litigation risk. Is any significant process, product or service you use or provide, or any material customer, potentially going to be subject to changed or new regulation? Consider, too, risks from dependence on particular customers and suppliers or particular end users for intermediate products.

All of the above information leads naturally to strategy. Outline the company’s strategic processes, and current strategy and its approach to risk management/risk financing. An important aspect will be the company’s balance sheet and cashflow profile and how it is related to the risk financing task. Cover business continuity plans too.

Show how current strategy relates to past strategies – are strategies the chairman’s current whim (hopefully not), or deeply thought out, tested and measured against the real world and a range of future external developments?

Outline very briefly the management and legal structure of the group, major shareholders and other important stakeholders.

If they are not already clear, outline the main drivers of profitability, with particular emphasis on cashflow.

Provide copies of the company’s business plan. If there are identifiable risks or developments ahead, model their effects and how management will react to deal with these changes. If it is not self-evident, explain the link between the business plan and the strategy.

The business plan and cash flow should be ‘stress tested’ in a variety of scenarios to demonstrate compliance with loan covenants and other limiting factors. Remember that credit analysts focus on how the potential downside risks are controlled and are less interested in outperformance on the upside, which are more the domain of the equity analysts.

A commentary on any divergences between last year’s plan and the new one, and on actual variances, can stand you in good stead with the analyst. It can convey a powerful sense of management competence and continuity. A divergence against prior plans (or budgets) surfacing as a major discussion point at a credit/rating committee without the analyst having heard the company’s view of it can be damaging.

Cashflow is inevitably important. In presenting past and projected financials, ensure that cashflow is highlighted, together with the quantitative aspects of the major cashflow drivers previously identified. In any credit analysis cashflow ratios as well as conventional measures of gearing are crucial. Trends in the ratios will be important. The impact of financial transactions (share issuance, share buy-backs, etc) must be made clear, especially in projections. Equally, highlight and adjust out any flattery of operating cash flows by receipt of exceptional advanced payments or similar distorting items.

Discuss the balance sheet, explaining the overall approach, target duration of debt, as well as dividend policy/objectives. If ‘net debt’ has been affected by unusual items, make that clear. With the experience of the last few years, analysts will pay particular attention to the outlook for liquidity.

CRAs are more interested than ever in the location and form of cash and marketable securities holdings. Are any restricted in any way or for any purpose?

Consider contingent liabilities – those noted in the report and accounts and those not mentioned. Pension and medical benefits and environmental obligations can loom large here. And consider relationships with any ‘off balance sheet’ companies or special purpose vehicles. Highlight any ‘onerous’ contracts.

Set out the company’s ‘strategy for financial mobility’¹:

How aggressive is gearing (however defined); how flexible are capital/major revenue project expenditures; how disposable/re-deployable are assets?

How strong are banking relationships; how fragile are roll-overs of drawn facilities?

What multi-year facilities are un-drawn – and what might make them unavailable for drawing?

How receptive might equity markets or bond markets be (given that in this context some corporate stress is assumed)?

The analyst’s evaluation of the management’s abilities and the suitability of the management structure are important to the eventual rating. Partly derived from the strategic expositions given, the evaluation will also look at the management’s track-record: what does the record show? Set it out for them:

• Has the business been on an improving track or a muddled/declining one (operationally as well as strategically)?
• Has there been delivery of past strategic plans?
• How has the company performed against previous shorter-term plans?
• How has it coped with previous unexpected developments with significant impact for good or ill?

A rating attempts to be forward-looking, so it is impossible to overstress how important it is that the CRAs understand and respect the management’s approach – and bank analysts will have the same interest.

The analysts will also be interested in the company’s enterprise risk management and approach to risk generally.²

It may be useful to take the analyst to see convenient, important or ‘example’ company sites. Seeing the attention to hygiene in a food or electronics factory or the application of unique technologies or the differentiation in use of the company’s products in the real world can give reassurance for which there is no substitute. But be aware that analysts’ time is valuable and do not arrange visits just for the sake of it.

Your lender and CRA will usually review your company performance formally each year. This provides an opportunity for updating them and dealing with worries, and for them to meet and hear from top management again. In the meantime any published information should be provided as it is issued. Major announcements will often be about matters already flagged in strategic plans. Even in such cases, it is sensible to give the credit rating analysts a bit of notice and, if need be, access, so that, where possible, they can, after a rating committee meeting, quickly issue a firm ‘no change’ or a firm change, rather than putting the company on ‘credit watch’ (perhaps with negative-seeming implications).Your lender, on the other hand, will not be making any public reaction so pre-warning is not so critical but maybe a courtesy to demonstrate that their relationship is valued.

Disclosing forecasts to lenders or CRAs is a sensitive commercial matter, so a formal confidentiality agreement is recommended even though each will assure you that they automatically owe a duty of confidentiality. Pre-advising them of a major announcement such as an acquisition or disposal could be disclosure of price sensitive information or inside information. For a listed company³ there are strict rules covering this but disclosure prior to the market disclosure is allowed provided that ‘any person receiving the information owes the issuer a duty of confidentiality, regardless of whether such duty is based on law, regulations, articles of association or contract’⁴ and the guidance further gives the specific examples of permitting disclosure to the issuer’s lenders and credit rating agencies.⁵

Presenting your company in the best light requires extensive preparation and an ongoing commitment to disclosure, but there are benefits. The grant of a loan or assignment of a rating will be the direct outcome. In addition the preparation process, the review of risks and scenarios will give you and your management the indirect benefit of understanding your own business that much better, and of course there is no harm in using feedback from the external analysts as a further source of insight for your company – they should have valuable experience of your industry after all.

1. G Donaldson, ‘Strategy for financial mobility’, Division of Research, Harvard Graduate School of Business Administration, 1969 (available in the Harvard Business School Classics series, ISBN: 9780875841274, 1986).
2. Eg ‘Standard and Poor’s to Apply Enterprise Risk Analysis to Corporate Ratings’, 7 May 2008.
3. The Disclosure and Transparency Rules apply to companies with securities admitted to trading on ‘regulated markets’, which therefore does not include companies traded on AIM which is an exchange regulated market.
4. Financial Services Authority Disclosure and Transparency Rules DTR 2.5.1
5. DTR 2.5.7

Download PDF version:

• Finance & Management Magazine, Issue 192, October 2011

• Standard and Poor’s
• Moody’s
• Fitch Ratings

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