How do rating agencies assess your company's credit status? Does good corporate governance help? Chris Legge summarises some key points.

How do rating agencies assess your company's credit status? Does good corporate governance help? Chris Legge summarises some key points.

Giving a company a credit rating means focusing on the stability and predictability of cash flow to service debt obligations. Hence, companies operating in unpredictable, cyclical, volatile conditions are likely to be rated lower down the scale.

However, although industry sector is a key determining factor, it provides a pivot, around which ratings can vary. The best in a weak industry may be a better credit risk than the worst in a good industry.

Generally, industry risk and a company's competitive position within that industry principally dictate the outcome of a rating. To put this in another way, companies' ratings will tend to migrate towards their natural industry and business strengths and weaknesses, no matter how good the finances may look. The variant on this is that the rating of a company (even the best in a good industry), with short term financial problems, very extreme financial leverage or a shock breach of covenant, is likely to be pushed down the scale, weighed by the financial pressure.

Each case is different. The various factors taken into account can work either together, or against one another. Perhaps the most important are: predictability of cash flow; management strategy, and financial policy (management appetite for debt usage). Also taken into account are liquidity, diversity of cash (low sources, regulatory framework and potential for change, and return on assets.

Rather less important are are the dividend history and track record. History is a guide to the past, so it has to be watched, but the emphasis is on the future.

Improving ratings
Standard & Poor's does not advise companies either to improve or weaken a rating, nor how to go about doing so. In our parlance, there is no such thing as a "good" or "bad" rating - it is simply a measure of relative credit quality.

Having said that, we always specify in our published analysis the fundamental reasons for assigning a particular rating. Hence, an issuer can determine the factors which have resulted in a rating, and which may have limited the potential for a higher one.

The easiest answer to improving your rating is to lower debt, probably through equity issuance. This shifts the balance of risk away from lenders towards equity investors. An alternative is to diversify cash flow sources to reduce risk, perhaps by generating cash flow from other products or markets. This is, however, a case where factors can work against one another. An acquisition that improves the diversity of cash flow but is financed with "too much" debt may have a neutral or even negative impact on credit ratings.

A company's corporate governance and its environmental policy are taken into account to the extent that cash flow can be affected - for example, the possibility of supply contracts being awarded which are detrimental to performance of the company. Another example might be where there is a substantial (controlling) shareholder forcing excessive dividend payments, causing cash to leak from the company. Although I said earlier that dividend payments are less important than other factors, nothing is unimportant. It is all just relative.

As with any capital expenditure, we have financial expectations about a company's requirement to meet environmental standards, and what the impact on cash flow maybe. This is not ajudgment of the company's policy but of the financial implications of following a particular path.

Assessing a credit rating is not a straight forward issue.

Processes are very qualitative, and our opinion is a subjective view of credit quality.
Chris Legge is director, corporate ratings, Standard and Poor's, Tel: 020782637471 e-mail:

Emerging markets
Global scoring system

In November 2000, Standard & Poor's launched a new global project, scoring businesses in emerging markets on corporate governance. The new scoring system, which initially focuses on Russia, may be extended in Asia and Latin America later this year.

Corporate governance scores are assigned to

  • ownership issues and affiliated party transactions
  • relations with foreign shareholders
  • overall transparency
  • board procedures


    At the ASEAN Forum of Credit Rating Agencies 2000 Annual Meeting in November 2000, Dr Prasam Trairatvorakul, secretary-general, Secruities & Exchange Commission, Thailand, blamed weak corporate governance in Asian countries as one of the key factors for the region's recent severe economic crisis. He urged agencies to assert their powerful influence in fostering better corporate governance of Asian corporations.

    He said that credit rating agencies can be very influential by taking governance issues into consideration when assigning rating and explaining rationale in rating reports. "Most of corporate governance concepts relate directly to the protection of shareholders. However, creditors of companies that do not have transparency in information disclosure do not have sufficient reliable information for making a proper risk assessment. Corporate governance can, therefore, have strong impact creditors and, hence, is very pertinent to the credit rating business.