The general methodology adopted by credit rating companies is to analyze various aspects of a business. They are briefly discussed as below:
(i) BUSINESS RISK
Business risk occurs when there is a possibility of a company earning lower profits than anticipated or incurring a loss. Business risk can be segregated into four categories - Strategic
risk, compliance risk, operational risk and reputational risk. We have briefly discussed each one as follows:
(a) Strategic Risk: A successful business always needs a comprehensive and detailed business plan. Everyone knows that a successful business needs a comprehensive, well-thought-out business plan. But it’s also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts in customer demand, increase in the costs of raw materials, or any number of other large-scale changes.
We can take the example of Kodak which was able to develop a digital camera by 1975. But, it considers this innovation as a threat to its core business model, and failed to develop it. However, it
paid the price because when digital camera was ultimately discovered by other companies, it failed to
develop it and left behind. Similar example can be given in case of Nokia when it failed to upgrade its
technology to develop touch screen mobile phones. That delay enables Samsung to become a market leader in touch screen mobile phones.
However, a positive example can be given in the case of Xerox which invented photocopy machine.
When laser printing was developed, Xerox was quick to lap up this opportunity and changes its
business model to develop laser printing. So, it survived the strategic risk and escalated its profits further.
(b) Compliance Risk: Every business needs to comply with rules and regulations. For example with the advent of Companies Act, 2013, and continuous updating of SEBI guidelines, each business
organization has to comply with plethora of rules, regulations and guidelines. Non compliance leads to penalties in the form of fine and imprisonment.
However, when a company ventures into a new business line or a new geographical area, the real
problem then occurs. For example, a company pursuing cement business likely to venture into sugar
business in a different state. But laws applicable to the sugar mills in that state are different. So, that
poses a compliance risk. If the company fails to comply with laws related to a new area or industry or sector, it will pose a serious threat to its survival.
(c) Operational Risk: This type of risk relates to internal risk. It also relates to failure on the part of the company to cope with day to day operational problems. Operational risk relates to ‘people’ as well
as ‘process’. We will take an example to illustrate this. For example, an employee paying out Rs.
1,00,000 from the account of the company instead of Rs. 10,000.
This is a people as well as a process risk. An organization can employ another person to check the work of that person who has mistakenly paid Rs. 1,00,000 or it can install an electronic system that can flag off an unusual amount.
(d) Reputational Risk: Reputational impact mostly follows a decision under business risk. For example closing of project in a country on the ground of viability, (Just like what GM has done in India) creates bad reputation for the company. For example in the above case it is observed that employees are reacting negatively to the decision and feeling insecure.
On the other hand, adding related products down the line adds customer confidence and boost investor’s confidence. For example several Indian banks have embarked on opening e-trading account. This has added to the reputation and market confidence.
(i) FINANCIAL RISK
Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange
rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but
same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately result in financial loss.
Accordingly, the broadly Financial Risk can be divided into following categories.
(a) Counter Party Risk
(b) Political Risk
(c) Interest Rate Risk
(d) Currency Risk
Now, let us discuss each of the above mentioned risks:
(a) Counter Party Risk
This risk occurs due to non honoring of obligations by the counter party which can be failure to deliver the goods for the payment already made or vice-versa or repayment of borrowings and interest etc.
Thus, this risk also covers the credit risk i.e. default by the counter party.
(b) Political Risk
Generally this type of risk is faced by overseas investors, as the adverse action by the government of host country may lead to huge loses. This can be on any of the following forms :
· Confiscation or destruction of overseas properties.
· Rationing of remittance to home country.
· Restriction on conversion of local currency of host country into foreign currency.
· Restriction as borrowings.
· Invalidation of Patents
· Price control of products
(c) Interest Rate Risk
This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk is
more important for banking companies as their balance sheet’s items are more interest sensitive and their base of earning is spread between borrowing and lending rates.
As we know that the interest rates are of two types i.e. fixed and floating. The risk in both of these types
is inherent. If any company has borrowed money at floating rate then with increase in floating rate the
liability under fixed rate shall remain the same. This fixed rate, with falling floating rate the liability of company to pay interest under fixed rate shall comparatively be higher.
(d) Currency Risk
This risk mainly affects the organization dealing with foreign exchange as their cash flows changes with
the movement in the currency exchange rates. This risk can affect the cash flow adversely or favorably.
For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the importer
who has the liability to pay bill in US$. The best case we can quote, Infosys (Exporter) and Indian Oil
Corporation Ltd. (Importer).
(i) MANAGEMENT EVALUATION
In order to evaluate the management of a company, the best way is to see the company’s Management discussion and analysis (MD&A) report which every listed company is compulsory required to provide. In case of unlisted companies also, the credit rating companies can influence the companies to include
MD&A in their Annual Report.
Actually, MD&A is the section of a company's annual report in which management provides a summary
MD&A in their Annual Report.
Actually, MD&A is the section of a company's annual report in which management provides a summary
of the previous year’s operations and how the company performed financially. Management also gives an outline for the next year by highlighting future plans and some brief about the new projects to be launched by the company.
(i) BUSINESS ENVIRONMENT ANALYSIS
A business environment analysis includes examining factors which influence from outside of a business. These business environment factors can range from new laws such as Companies Act, 2013; new trends i.e. the latest trends is to shop online; and new technology, for instance battery cars which in future can be charged on road itself without the even the need to stop the car.
Now, after considering the above mentioned environmental factors, the next step in the business environment analysis will be to determine as to how much impact they will have on the business. After that strategies will be developed to ward off any negative impact that has arisen.
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