Introduction

A very large number of SMEs are in the manufacturing sector, operating with very low to  state-of-the-art  technology, with their revenue levels ranging from tiny operations (ranging between Rs. 10 lakhs to more than Rs. 500 crore.) SMERA follows a well-structured approach and methodology in assessing the credit risk profile of entities in the manufacturing sector/subsectors of the SMEs. This criteria is not specific to any particular industry, but broad based and applicable to the SME manufacturing units as a whole,. This document presents the process to evaluate the qualitative and quantitative credit quality drivers of the enterprise being rated. Based on the nature of the enterprise and other factors such as scale, revenue levels, market coverage, and prevailing circumstances, the weightage and application   of parameters and factors would differ from enterprise to enterprise.

Applicability and limitations of this Criteria

The criteria presuppose availability of financial data from the entities being rated. However, the vast majority of the SMSs are usually very small in size and are managed by the promoters. They normally do not have a second line of management or qualified CAs. While they may maintain books of accounts for their own purposes, a structured set of accounting statements may not be available with them. However, in spite of the limitations, they understand the businesses and manage them profitably. Such of these SMEs may not have any bank borrowings but often resort to unsecured loans from relatives and friends as well as loans against property. So is the case with many of the Start Ups in the SMEs Thus, it may not be possible to apply the criteria contained in this document to determine the credit risk profile of these SMEs. However, it is noteworthy that the management discussions with the SMEs do throw sufficient information on the businesses, and various other data such as cost of raw material, selling price, competition, current business scenario and future business plans, including resources position of the promoters, to come to an informed assessment of the credit risk profile of the concerned entity.

The risks to be evaluated to determine the rating:

1. Business Risk ((Industry, Market position and Operating Efficiency)
2. Management risk
3. Financial Risk (Historical Financials, Accounting Policies and ability to raise resources)
4. Overall rating

Business Risk

Industry Risk

Every manufacturing entity belongs to a particular industry (say, textiles, chemicals, plastics etc.,). The characteristics of the industry such as ease of establishment, availability and procurement of raw materials, are common and applicable to all the entities operating in that industry. Similarly, the operating environment is also nearly the same for all the entities operating in the industry. The industry risk analysis is a very important factor in the credit profile of an entity.

Industry risk evaluation assesses the various factors in the industry and the general operating environment. Following are the major aspects that are considered:

Macro-economic Risk

• The economic conditions of a country/ state and the performance of the economy/state have a direct bearing on the performance and prospects of the industry. The growth rate of economy, foreign exchange movements, imports and exports, interest rate risk and commodity risk are the important factors that directly influence the industry and its profitability.
• Growth rate of Economy; The analyst needs to assess the demand for a product or service based on its utility to the consumer, and the growth in the disposable income and spending patterns.
• Foreign Exchange Risk: An industry depends on exports and imports for sales of goods and raw materials for manufacture. Therefore, foreign exchange rate movements and exposures have an impact on the profit margins and eventually the credit profile of an enterprise. Though hedging mechanisms are available, the complexity, cost and ease of the process need- to be understood.
• Interest-Rate Risk: the movement of interest rates in the economy has a direct impact on the ability of an entity to borrow to increase its production. Similarly, they impact consumer spending patterns positively or negatively depending on the interest rate movements. It is well recognized that an increase in interest rates not only reduces profitability but also the cost of debt funded expansion/new projects. A careful study of the existing interest rate movements and the future possibilities would enable the analyst to assess the interest rate risk.

Demand, Supply and Pricing

The demand, supply and pricing determine the profitability of an enterprise. This assessment considers the following­:

• Current Demand Supply Gap:

  An analysis of the past as well as current price trends indicates whether a product is in excess supply, short supply or in an equilibrium situation. While assessing the demand supply gap, the analysts also need- to factor in the availability of substitutes, future capacities planned, product innovation and – process improvements. The growth of end user industries is also an important indicator of – future demand.

• Factors influencing Demand:

  The analyst must consider the following while forecasting the demand for a product.

  The product, its utility to the consumer, and the spending pattern of the consumers.

  Substitutes:

  Availability of many equivalent products/ substitutes makes switchover from a product easy and impacts demand.

  End Users:

  The demand for a product is also determined by the need from the end users. Therefore, the growth of the end users is an important factor, that impacts the demand.

• Life Cycle of a product
• also plays a role in demand forecasting – nascent, growth, mature or declining life cycle of the product
• Product Usage: Whether a product has a single, or multiple applications also influences the demand.
• Imports and Exports:
• The position and dimensions of imports and exports, such as pricing, quality, lead time, minimum order quantity etc, need to be assessed while estimating. One also has to assess the impact of cheaper imports not only on the demand of the product but also on the profitability of the enterprise as cheaper imports are a perceptible threat to the industry’s prospects.

Market

The key points to be considered are:

• The number of players, competition, entry barriers, organized/unorganized/ fragmented players
• Market entry barriers, Capital expenditure for creation of capacity, licensing,
• Extent of competition

Regulatory Environment

The following have an impact on the demand and are to be taken into account.

• Duty structure (ie, import, export, countervailing, anti-dumping etc)
• Fiscal incentives to certain sectors (tax holidays, setting up of special economic zones, increasing credit flow through policy prescriptions)
• Price controls
• Distribution controls
• Regulatory guidelines regarding establishment of certain industries, pollution control
• Stability of regulations

Industry Profitability

While assessing the industry risk, it is also necessary to forecast the future profitability of the industry. Various factors and scenarios contribute to and influence the future profitability. Some of the critical aspects in this regard are

• Whether the existing situation regarding demand /supply gap will continue in the future and will improve or worsen?
• Whether the current cost structure of production will continue/improve/worsen?
• Are there any trend breakers?
• Whether there has been any technological advancement in the production process and whether the company has undertaken any process/technological improvements to economise the production cost?

Market Position

Market position analysis considers the revenue side risks. The following factors are analyzed in detail.

1. Product diversification and ability to withstand shocks.
2. Diversification of revenue streams by geography, customer and product.
3. Market penetration efforts and pricing power-ancillaries and tier 1 and tier 2 suppliers with assured offtake.

Operating Efficiency

Every enterprise desires to improve its profitability by employing the best means and methods at its command. The operating efficiency is the ratio of the inputs into the operating system/process to the output from the operating system/process, both measured in financial terms. This ratio provides an indication of the overall efficiency of the performance of the manufacturing entity.

The various factors to be considered while arriving at operating efficiency are:

1. Interfirm comparison:

   Comparison of break-even point of the entity with units in the peer group—a lower break-even percentage indicates a higher level of profitability. The computation of consumption of each of the various inputs, such as raw materials, other additives, power, and fuel, and wages and salaries as a percentage to the cost of production/sales are worked out. The debtor days, inventory days and creditor days are also worked out. Similarly, the profitability and debt equity ratio are also computed. The parameters of the unit obtained through the above working are compared with entities in the peer group. This comparison will provide an useful analysis of the performance of the entity being rated vis-à-vis its peers on parameters such as efficiency of operation, working capital management, profitability, and the standing of the entity with reference to its peers. Operational strength of the entity such as long-term sourcing contracts of raw materials, long term sales contract with end users and logistical arrangements also needs to be looked into.

2. Technology improvements:

   While assessing the future profitability of an enterprise, it is necessary to consider the technical and process improvements taking place in the industry being rated and its peers. Procurement strategy, inventory management, philosophy of the management to upgrade the technology, capital expenditure towards forward integration/backward integration also plays a role in determining cost structure and profitability

3. Sustainability of the entity:

   While assessing the sustainability of an entity, SMERA considers compliance with local laws, litigation cases, and meeting with pollution control requirements as well as statutory requirements. The number of years of existence of the entity in the business and the growth/profitability achieved also play a role in determining the sustainability of the unit.

Management Risk

Most of the SMEs are in the non-corporate form and may/ may not have a defined second line of management. This is a very important aspect of the evaluation. The quality of management has a crucial bearing on the performance of an enterprise. The assessment focuses on management quality, competence, governance and risk attitude. The risk framework for assessing the same has been laid down below:

Promoters

The promoters decide the line of business, other matters relating to operations including selection of manpower, machinery and the policies and procedures. The current business strategy, future growth plans is also decided by the promoters. Promoters influence management action, decision making and future course of the company. The promoter’s long term and short-term vision and plans influence the growth and profitability of the enterprise.

Against the above background, it is necessary to understand the following:

• Promoter’s background and previous experience and exposure to the chosen line of business
• Previous business ventures undertaken and the performance of those enterprises
• Role and responsibility of the promoters in the decision-making process, their depth of knowledge/ expertise and commitment to the entity, succession plan, intention to professionalize management
• Growth plans, risk appetite, style of conducting business (conservative or aggressive)
• Promoter’s ability, intention and extent of dilution of stake and gearing philosophy; and
• The cohesiveness of the partners/management, dissensions among partners, business partition.

Leadership Capability

In assessing leadership of an enterprise, it is necessary to focus on four factors such as competence, foresight, stability and risk orientation. In addition, the following factors are considered:

1. Track record and consistency in performance
2. Managing the organization during times of uncertainty
3. Presenting opportunities for the executives to emerge as leaders
4. Leadership style
5. Communication skills and team building
6. Labour relationship and turnover of top management
7. Ambitious expansion, unrelated diversification and track record of performance
8. Short-term and long-term strategy for growth

Management integrity and value system:

 The key risk parameters to be considered include:

1. Adherence to local laws and environmental norms.
2. Instances of default on statutory obligations (wilful or otherwise).
3. Banking conduct, repayment record, data submission
4. Adverse news about the company, reputation of management.
5. Criminal proceedings, if any, against one or more of the promoters and raids, if any, conducted on the organization.
6. History of litigation.

Strategy, Track record and Future strategic moves:

It is necessary to understand – how a company has evolved itself over a period of time to its current level. It is also pertinent to assess – how it has responded to the market forces and shareholders. This analysis includes management’s strategic moves, undertaking capital projects, takeovers and technology absorption. This historical context helps to understand the future plans of the management. Promoting group firms/entities in allied industries could also be looked into in the case of SMEs.

Management processes and governance practices:

The key factors to be considered include:

1. Adequacy and quality of disclosures.
2. Market feedback and management responses.
3. Unexplained group/parent transaction.
4. Soundness of accounting practices.
5. Frequent change of auditors and accounting policies.
6. Employee remuneration and motivational levels.

Financial Risks/Ratios:

The financial position and working results of an enterprise portrays its performance. The financial analysis focuses on track record of the financial performance in terms of growth, profitability, break even, value addition, liquidity, level of indebtedness, level of overall outside liabilities, quality of receivables, quality of investments, cash flow adequacy and short term and long-term solvency. Aspects such as contingent liabilities, auditor’s qualifications, accounting quality, notes to accounts and reputation of the auditors are also considered.

The important financial ratios analysed are debt/equity, return on capital employed, net profit margin, debt to equity ratio, interest coverage, debt service coverage, cash accruals to debt and working capital management. The relative importance placed on different ratios would depend on the nature of business.

These ratios are compared with peers and bench marked for different ratings.

Financial Flexibility:

Financial flexibility represents the ability of an enterprise to generate additional funds from various sources if need arises. The track record in raising funds from the banks, NBFCs and other sources is analysed. The relationship with the bank/s is important. Availability of liquid investments, marketable securities and assets would also impart financial flexibility to an enterprise.

Auditors’ comments and notes to account:

While considering the audited figures, the analyst should factor in the following and suitably recast the figures, if need be:

1. Auditors’ comments and qualification;
2. Changes in depreciation, write-off and reserve policy;
3. Consistency of policies/methods;
4. Quality of financial disclosures;
5. Contingent liabilities; and
6. Unprovided depreciation, revaluation reserves, intangible assets and reworking of net worth if need be.

Historical Financial Analysis:

Historical financial analysis should cover the previous 3 years and the factors considered in the analysis are:

1. Sales, profitability (ROCE, operating profit, PAT), debt-equity, debt protection cover (interest coverage ratio, debt service coverage ratio) and the trends;
2. Operating efficiency – cost as a percentage of sales, productivity per employee, break even analysis.
3. Margins: Operating profit margins, PAT margins etc;
4. Liquidity: Current ratio, inventory days, receivable days, payable days, quantum and possible impact on cost of purchases, working capital days, quality of receivables and debtor’s ageing;
5. Return ratios: Return on net worth, ROCE, Return on assets etc;
6. Solvency: Debt equity mix, debt service coverage ratio, interest coverage ratio

These factors are compared with the nearest peers to find the relative standing of the entity.

Resource Mobilization Ability

Resource mobilization ability of the promoters and the firm reflects the reflects the ability to access easy and cost-effective finance to fulfill obligations under normal and stressed conditions. The following factors need to be considered.

• Ability of the promoters to raise funds from their own sources
• Ability to raise short/ long term resources from banks/ NBFCs /other lenders/ friends and relatives/ group companies
• Unencumbered liquid assets

The services sector is a major contributor to the Indian economy. It comprises of the following:

1. Educational sector: educational institutions, coaching classes, and such other types of entities
2. Health Sector: hospitals, nursing homes, pathological and diagnostic centres
3. Hospitality sector: hotels, restaurants, fast food centres
4. IT sector: IT and IT enabled services
5. Transportation sector: fleet operators, road transport, bus services, taxis, and aggregator services
6. Advertising, legal, and other consultancy services
7. Manpower supply services, facility management services, and
8. Other services

It is important to note that the services of an entity are consumed as and when they are rendered. In other words, the services cannot be produced and stored as inventory. Further most of the entities in the services sector, excepting hotels, hospitals and educational institutions and the like, do not need much fixed assets and their investments in fixed assets are minimal. Their requirement of funds is more for meeting operational expenses, debtors and other current assets

The major risks that need to be evaluated in case of service sector entities, while assessing the credit risk profile, include Industry /Business risk, Financial risk and Management risk.

Industry/Business Risk

Following are the major risk factors that need to be analysed while evaluating the Business risk of a services sector entity

1. Restrictions/ ease in setting up the entity such as entry barriers, Govt. regulations to be complied with, the ease with which the entity can be set up and such issues need to be assessed.
2. Capital outlay required:  For example, Hotels, Hospitals, Educational institutions need a higher level of capital outlay for setting them up as compared to establishing an advertising company, manpower supply services or IT and IT enabled services.
3. Availability and cost of manpower required for managing and carrying out is another factor that needs to be analysed. For instance, the cost of manpower for a hospital is likely to be more than that of a school
4. Regulatory framework guidelines and its compliance both for establishment and running of the concerned service entity, price controls and fiscal incentives, if any
5. Cyclicity of business and stability of revenues for example the revenue from schools is more stable than that of hotels and restaurants that are dependent on business and tourism. It is pertinent to note that the entity that is independent of the business cycle for the stability of its revenues therefore carries lower credit risk compared to others.
6. Gestation period: The entities in the services sector usually have a high gestation period which should be factored in the analysis.
7. Revenue streams/Allied services A service industry having a greater number of allied services, for example, a nursing home having diagnostic/pathological facilities, will have better stability of revenues and therefore profitability.
8. Human Resources The success of an entity engaged in providing services depends on – customer satisfaction. The quality and timely service, response to customer complaints and their resolution is directly related to the manpower resources of the entity, their skill- sets and their willingness to provide the requisite responses/ services.
   SMERA analyses factors such as cost per employee, revenue per employee, profit  per employee and peer comparison while evaluating the efficiency and productivity of a service-entity.
9. Operating costs Due to various factors such as competition in the business, revenue fluctuations, etc., it is necessary for a service entity to keep control of its costs so that profitability is maintained, more particularly on the fixed costs for a certain level of service.

Financial Risk

In the case of service industries such as hotels, hospitals, and educational institutions involving high capital investments, the financial risks are similar to those of manufacturing companies and the risks are to be assessed accordingly. However, in the case other service sector entities such as consultancy services, manpower supply services, facility management services, etc., the financial risk assessment needs to consider the following:

Liquidity

This is an important aspect to ensure timely payment of wages, salaries, and other operational expenditures and facilitate smooth operations of the entity.

Delayed payments non-payment, etc. by the customers due to faulty services, write-offs, etc., and its impact on profitability.

Credit/Debtors risk the debtor days, trends, and peer comparison are to be considered, and the risk and impact on profitability need to be assessed.

Accounting quality  and disclosures.

Management risk  The following areas are to be considered in the assessment of management risk   

1. Past track record of the entity
2. Expansion/diversification plans executed and their impact on the business and profitability
3. Banking conduct and the willingness of the banker to continue or extend additional facilities, if need be.
4. Compliance with local regulations and laws
5. Litigations with customers and suppliers
6. Resource raising capacity and ability to manage challenges.

Introduction

Trading entities/companies buy goods and commodities including consumer durables and non-durables from the producers/ manufactures and OEMs, mostly in bulk quantities and sell them to retailers/ consumers/ others. The trade may be from B to B and or B to C. The trading firms may size and sort the goods based on quality, grade, functions and repack them in appropriate quantities for sale. However, the value addition by the trading outfits is very minimal.

Applicability and limitations of this Criteria

The industry, which is an important link between producers and consumers, comprised a large number of family-owned businesses in non-corporate forms of various sizes and operated in the small towns to the metros previously. The size of their business was not very large. However, over the last one or two decades, organized retailing and trading have come into the market in almost all areas of trading in different formats, including specialty stores. The volumes of sales, of organized retail trade, that have PAN India presence, are large, and they employ sophisticated systems for the various operations such as vendor selection, supply chain management, inventory management, and strategy for sale and stock clearance.

The risks to be evaluated to determine the rating:

1. Fluctuations in the commodity prices
2. Foreign currency fluctuations
3. Inherently low margins of the industry due to no / minimal value additions
4. Low entry barriers
5. The fiercely competitive environment. SMERA’s credit risk assessment is based on the entity’s sustainability /scale of operations, supplier and customer risks, value addition (in terms of logistics, branding, retailing among others), exposure to forex fluctuation and extent of mitigation, inventory holding policy and volatility in the prices of commodities being traded.

While evaluating the trading company, SMERA takes into consideration Business Risk, Management Risk and Financial Risk.

Business Risk Analysis

The following factors are analyzed in assessing the business risk of a trading entity

• Procurement/Supplier/Vendor Risk
• Debtor/customer Risk
• Size of Business and Sustainability
• Inventory Risk
• Forex Risk
• Level of Value Addition
• Regulatory Risk

Procurement/Supplier/Vendor Risk

The performance of a trading entity depends, to a very large extent, on the reliability and continuity of availability of goods/commodities at the right time, quantity and quality at competitive prices. Given this background, it is necessary to assess the profile of the supplier/producer, reliability/ability to supply goods as per the terms contracted, length of relationship with them, tie-ups and such related factors. As every business has a cycle of ups and downs, it is necessary to assess the possible business tolerance that could be expected from the suppliers during the times of stress/challenges that may arise in trading business. Supplier concentration is another area that needs to be looked into. Dependence on one/two large suppliers could provide certain advantages in terms of price and other terms, but increases concentration risks and may lead to supply bottlenecks. On the other hand, a large number of suppliers will mitigate the supplier concentration risk but at the same time may lead to limited bargaining power. The analyst therefore needs to take a considered view on the suppliers’ risk considering the above factors.

Customer/Debtor Risk

Depending on the nature of business, competition, and trade practices, the number of customers and the extent of debtors ( the amount blocked in the form of debtors ) vary. This risk of debtors, i.e. counterparty risk, arises when there is a delay in payment by the debtors in part or full. Resultantly, the cash flows get affected, leading to liquidity stretching in addition to the impact on profitability. Thus, assessment of the counter credit risk profile of the debtor is an important aspect to be considered in debtor risk. In addition to analyzing the credit policy of the trading entity, trends of debtor days, debtors written off in earlier years, and the trends, strengths, and weaknesses of the debtors need to be assessed. The collection procedure and methods, such as open/free trade credit, those backed by postdated cheques, letters of credit, or bills of exchange, need to be assessed.

Size of Business and Sustainability

Sustainability is necessary to ensure that a business continues on an ongoing basis. Various factors influence sustainability, the most important being the size of business operations. Size, both in terms of volume and revenue, imparts the necessary strength to a trading entity to withstand the challenges and shocks that arise due to the business cycle and the state of the economy. Large volumes of business facilitate economies of scale of operations. Besides, with an increase in volume of trade, the bargaining power of the entities to purchase goods at a remunerative price and terms improves profitability. Size also facilitates diversification of business through products and geographies. With the increase in size, the trading entities adopt modern methods/practices in inventory and supply chain management, which eventually leads to cost control in procurement and storage. These factors play an important role in assessing the impact of the size of the business and risks arising therefrom.

Inventory risk

Notwithstanding the size, the performance of all trading companies and their credit risk is influenced by inventory risk. The following are the factors that need to be assessed while evaluating the inventory risk:

Inventory Levels

The level of inventory holding of a trading company depends on the business model adopted by it. For instance, in the case of back-to-back order-based trade, the holding period of the inventory and therefore the level of risk are lower. However, in the case of a fixed-priced order, with deferred deliveries, the risk is higher. In the case of entities engaged in the trading of a large variety of products such as consumer goods, fashion fabrics, etc., the levels of inventory and the risks are high. The factors that need to be considered in assessing the inventory risks include, inventory holding cost and its impact on profit, storage, damage and the associated impact, and the price fluctuations in the commodities or goods that may occur during the duration of storage and their impact.

Goods/ commodity prices and their fluctuations

Price movements of the goods also contribute to the inventory risk. The type of commodity/ goods such as fashion jewellery, ready-made garments, influences the level of price risk. Similarly stocking/ buying of goods in expectation of anticipated price movements also contributes to inventory risk. The change in customer preferences, disposal of old/ non-moving inventory and discounts offered are the other factors that need to be considered while assessing the risk arising out of fluctuations in the price of inventory holding.

It is also necessary to factor in the ability of the trading entity to pass on the price increase of the goods to the customer through suitable price variation clause so that the risk arising out of price increase and impact on profit is mitigated.

Forex Risk

The trading entities that import goods and sell them in the domestic market and those that procure goods domestically and export them are impacted by the fluctuations in the exchange rates. Many of such entities resort to hedging to guard against currency fluctuations. The analysts have to evaluate the effectiveness, cost and complexity of such hedging mechanism to determine the forex risk.

Regulatory Risk

The trading entities that import goods and sell them in the domestic market and those that procure goods domestically and export them are impacted by the fluctuations in the exchange rates. Many of such entities resort to hedging to guard against currency fluctuations. The analysts have to evaluate the effectiveness, cost and complexity of such hedging mechanism to determine the forex risk.

Financial Risk  

The fund requirements of a trading entity are largely short term in nature, mainly to fund its inventory and debtor requirements. This is met by short term fund and non fund based facilities such as letters of credit from banks as well as owned funds. Following are the important factors that are taken into consideration in assessing the financial risk analysis of a trading entity.

• Liquidity – Inventory days, Debtor days, Creditor days, Current ratio, Quick ratio
• Sales-Cash/credit sales, Sales returns, Damages/ discounts/ rejections, write offs
• Profitability-Gross profit, operating profit and net profit margins
• Debt coverage ratio, Interest coverage ratio, DER, total outside liabilities to networth
• Return on assets and Return on networth
• Trend analysis of the above factors
• Peer comparison
• Quality of the financial statements, accounting policies and their changes

Management Risk Analysis

Management is the key to planning, execution and control of the various aspects of an organisation which influences its continuity and profitability. Therefore, management risk evaluation is a key factor in the credit rating process. Following are the areas that should be analysed in assessment of management risk:

• Previous track record of growth in sales and profitability.
• Diversification of the business through different geographies, products and value-added services.
• Vision of the future and technological improvements planned/ implemented.
• Relationship with the suppliers and customers.
• Opinion of the bankers about the entity /management, its conduct and their willingness to consider additional facilities.
• Credit policy and its stability.
• Resourcefulness of the promoters and their ability to manage challenges, competition and the environmental and economic changes taking place in the industry and economy.