CREDIT RATING METHODOLOGIES
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 But it’s also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot keep pace with the latest trends.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.
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