SME Ratings – An Overview

SME Rating Scale

Major Milestones in SME Rating

Rating Process Flow

Rating Methodology – A Brief :

SMERA’s rating methodology consists of identifying and evaluating credit quality drivers of the enterprise being rated and covers both, quantitative and qualitative aspects. Typically, it is a 360 degree assessment of an enterprise as the factors impinging on the credit quality can emerge from any aspect of the enterprise. For the purpose of credit assessment SMERA takes into account the data/ information provided by the entity and those available on public domain such as Watchout Investor etc. SMERA arrives at the credit risk of an enterprise by evaluating four main parameters –

  • Industry Risk
  • Management Risk
  • Financial Risk

In addition, wherever necessary, the ability of the entity to execute and operationalize a project (Brownfield, Greenfield) and the projects impact on the debt repayment capabilities is also assessed.

Risk Assessment :

  1. Industry Risk

    The characteristics of an industry are common and applicable to all the entities operating within that industry. A company/ firm needs to be assessed in the context of the industry it belongs to. Industry evaluation brings out the effect of various factors on the business prospects and the general operating environment. Besides, the analyst takes into account the niche strength and weakness of the entity arising out of the various factors such as linkages with the suppliers and the customers of the entity being rated. The other aspects such as the bargaining power of the entity with its suppliers/ customers, the strategic tie up with them, the relative importance of the entity to the consumer etc. is also taken into account while evaluating the business risk.

    The other areas considered under business risk are relationship with the suppliers and major customers, market competition, regulatory environment (Price controls etc.) as well as entry barriers/ restrictions and the government policies.

    1. Operating Efficiency

      The operating efficiency of the entity is evaluated taking into account the cost trends of raw material and their impacts to analyse if the entity is facing or likely to face pressure on this front. Similarly, the sales trends are also evaluated to understand the market penetration of the entity.

    The business risk thus essentially evaluates the long term sustainability and viability of the operations taking into account the contributory aspects.

  2. Management Risk

    This is the most important aspect of the evaluation. The quality and capability of the management are crucial and has bearing on the performance of an enterprise, as the success of an enterprise solely rest on the capabilities, competencies and resourcefulness of the promotors. This is so because a SME may not have a large organization to take care of various functional aspects of the entity. In a vast majority of the SME’s, the main promotor looks after the important functional areas.

    Management risk assessment focuses on the following aspects:

    • Quality
    • Competence
    • Governance
    • Risk attitude
    • Resourcefulness
    1. Promotor/Management

      The promotor influences the decision making and future course of the company. The analyst during the management discussion and during site visit as the ease may be, understand and evaluate certain aspects about the promotor viz.

      • Promotor’s background and previous business undertaken and the track record
      • Growth plans, risk appetite, style of conducting business (cautious or aggressive)
      • Promotor’s ability and intention of professionalizing management
      • Promotor’s integrity/Value system (adherence to local laws, environmental laws, litigation etc.)
      • Resourcefulness
    2. Management Practice

      The following aspects are evaluated:

      • Soundness of accounting practices
      • Extent of group transactions & their disclosures
      • Presence of planning team
      • Automation of operations and use of technology
  3. Financial Risk

    The Financials of an enterprise is a clear indicator of its performance and SMERA carriers out its analysis based on the financial statements made available by the entity being rated. The focuses on accounting quality, track record of financial performance in the terms of the growth, profitability, liquidity, level of indebtedness, level of reach, outside liabilities, quality of receivables and quality of investments. Aspects such as contingent liabilities, auditor’s qualifications and notes to accounts are studied in detail.

    While a number of ratios are considered important ones are debt/equity, return on capital employed, profitability margin, asset turnover, interest cover, debt service coverage, cash accruals to debt and the size of net worth. The relative importance placed on different ratios would depend on the nature of business.

    The historical financial analyses considered by the analyst are:

    • Trends: sales, profitability (ROCE, operating profit, PAT), debt-equity, debt protection cover (interest coverage ratio; debt service coverage ratio).
    • Operating efficiency: cost as a percentage of sales, productivity per employee etc.
    • Margins: Operating profit margins, PAT margins etc.
    • Liquidity: Current ratio, quick ratio, inventory days, receivable days, payable days, working capital days.
    • Return Measures: Return on net worth, ROCE, Return on assets etc.
    • Solvency: Debt/Equity mix, debt service coverage ratio, interest coverage ratio etc. These factors are compared with the nearest peers to find the relative risk standing.