Rating Methodology: Evaluating The Issuer

Rating Methodology:
Evaluating the Issuer

■ STANDARD & POOR’S
Industrials and Utilities

Standard & Poor’s uses a format that divides analysis of industry characteristics and how a
the analytical task into several categories, pro- firm is positioned to succeed in that environ-
viding a framework that ensures all salient ment establish the financial benchmarks used
issues are considered (see box). For corporates, in the quantitative part of the analysis (See
the first several categories are oriented to fun- Ratio Guidelines on pages 56-58).
damental business analysis; the remainder
relate to financial analysis. As further analyti- CORPORATE CREDIT ANALYSIS FACTORS
cal discipline, each category is scored in the
course of the ratings process, and there are Business Risk
also scores for the overall business risk profile Industry Characteristics
and the overall financial risk profile. Competitive Position
(Analytical groups choose various ways to (e.g.) Marketing
express these scores: Some use letter symbols, (e.g.) Technology
while others prefer to use numerical scoring
(e.g.) Efficiency
systems. For example, utilities scoring is from
1 to 10—with 1 representing the best. (e.g.) Regulation
Companies with a strong business profile— Management
typically, transmission/distribution utilities— Financial Risk
are scored 1 through 4; those facing greater Financial Characteristics
competitive threats—such as power genera- Financial Policy
tors—would wind up with an overall business
Profitability
profile score of 7 to 10.)
There are no formulae for combining scores Capital Structure
to arrive at a rating conclusion. Bear in mind Cash Flow Protection
that ratings represent an art as much as a sci- Financial Flexibility
ence. A rating is, in the end, an opinion. Indeed,
it is critical to understand that the rating process
is not limited to the examination of various Industry risk
financial measures. Proper assessment of debt Each rating analysis begins with an assess-
protection levels requires a broader framework, ment of the company’s environment. To deter-
involving a thorough review of business funda- mine the degree of operating risk facing a par-
mentals, including judgments about the compa- ticipant in a given business, Standard & Poor’s
ny’s competitive position and evaluation of analyzes the dynamics of that business. This
management and its strategies. Clearly, such analysis focuses on the strength of industry
judgments are highly subjective; indeed, subjec- prospects, as well as the competitive factors
tivity is at the heart of every rating. affecting that industry.
At times, a rating decision may be influenced The many factors assessed include industry
strongly by financial measures. At other times, prospects for growth, stability, or decline, and
business risk factors may dominate. If a firm is the pattern of business cycles (see Cyclicality,
strong in one respect and weak in another, the page 41). It is critical to determine vulnerabili-
rating will balance the different factors. ty to technological change, labor unrest, or
Viewed differently, the degree of a firm’s busi- regulatory interference. Industries that have
ness risk sets the expectations for the financial long lead times or that require a fixed plant of
risk it can afford at any rating level. The a specialized nature face heightened risk. The
RATING METHODOLOGY ■ Corporate Ratings Criteria 17

implications of increasing competition are and in still others, such as cement, competition
obviously crucial. Standard & Poor’s knowl- is strictly regional.
edge of investment plans of the major players The basis for competition determines which
in any industry offers a unique vantage point factors are analyzed for a given company. The
from which to assess competitive prospects. accompanying charts highlight factors that are
While any particular profile category can be considered critical for airlines and electricity
the overriding rating consideration, the industry companies and the specific considerations that
risk assessment goes a long way toward setting determine a company’s position in each.
the upper limit on the rating to which any par- For any particular company, one or more
ticipant in the industry can aspire. Specifically, it factors can hold special significance, even if
would be hard to imagine assigning ‘AA’ and that factor is not common to the industry. For
‘AAA’ debt ratings or ‘A-1+’ commercial paper example, the fact that a company has only one
ratings to companies with extensive participa- major production facility should certainly be
tion in industries of above-average risk, regard- regarded as an area of vulnerability. Similarly,
less of how conservative their financial posture. reliance on one product creates risk, even if the
Examples of these industries are integrated steel product is highly successful. For example, one
makers, tire and rubber companies, home- major pharmaceutical company has reaped a
builders, and most of the mining sector. financial bonanza from just two medications.
Conversely, some industries are regarded The firm’s debt is reasonably highly rated,
favorably. They are distinguished by such traits given its exceptional profits and cash flow—
as steady demand growth, ability to maintain but it would be viewed still more favorably
margins without impairing future prospects, were it not for the dependence on only two
flexibility in the timing of capital outlays, and drugs (which are, after all, subject to competi-
moderate capital intensity. Industries possess- tion and patent expiration).
ing one or more of these attributes include
manufacturers of branded consumer products, Diversification factors
drug firms, and publishing and broadcasting. When a company participates in more than
Again, high marks in this category do not one business, each segment is separately ana-
translate into high ratings for all industry par- lyzed. A composite is formed from these build-
ticipants, but the cushion of strong industry ing blocks, weighting each element according
fundamentals provides helpful support. to its importance to the overall organization.
The industry risk assessment also sets the The potential benefits of diversification, which
stage for analyzing specific company risk fac- may not be apparent from the additive
tors and establishing the priority of these fac- approach, are then considered.
tors in the overall evaluation. For example, if Obviously, the truly diversified company
an industry is determined to be highly compet- will not have a single business segment that is
itive, careful assessment of a firm’s market dominant. One major automobile company
position is stressed. If the industry has large received much attention for diversifying into
capital requirements, examination of cash flow aerospace and computer processing. But it
adequacy assumes major importance. never became a diversified firm, since its suc-
cess was still determined substantially by one
Keys to success line of business.
As part of the industry analysis, key rating Limited credit will be given if the various lines
factors are identified: the keys to success and of business react similarly to economic cycles. For
areas of vulnerability. A company’s rating is example, diversification from nickel into copper
affected crucially by its ability to achieve suc- cannot be expected to stabilize performance; sim-
cess and avoid pitfalls in its business. ilar risk factors are associated with both metals.
The nature of competition is, obviously, Most critical is a company’s ability to man-
different for different industries. Competition age diverse operations. Skills and practices
can be based on price, quality of product, needed to run a business differ greatly among
distribution capabilities, image, product differ- industries, not to mention the challenge posed
entiation, service, or some other factor. by participation in several different industries.
Competition may be on a national basis, as is For example, a number of old-line industrial
the case with major appliances. In other indus- firms rushed to diversify into financial ser-
tries, such as chemicals, competition is global, vices, only to find themselves saddled with
18 RATING METHODOLOGY ■ Corporate Ratings Criteria

unfamiliar businesses they had difficulty important considerations. Large firms have
managing. substantial staying power, even if their busi-
Some firms have adopted a portfolio nesses are troubled. Their constituencies—
approach to their diverse holdings. The busi- including large numbers of employees—can
ness of buying and selling businesses is differ- influence their fates. Banks’ exposure to these
ent from running operations and is analyzed firms may be quite extensive, creating a reluc-
differently. The ever-changing character of the tance to abandon them. Moreover, such firms
company’s assets typically is viewed as a nega- often have accumulated a lot of peripheral
tive. On the other hand, there is often an off- assets that can be sold. In contrast, the promise
setting advantage: greater flexibility in raising of small firms can fade very quickly and their
funds if each line of business is a discrete unit minuscule equity bases will offer scant protec-
that can be sold off. tion, especially given the high debt burden
some companies deliberately assume.
Size considerations Fast growth is often subject to poor execu-
Standard & Poor’s has no minimum size cri- tion, even if the idea is well conceived. There
terion for any given rating level. However, size is also the risk of overambitiousness.
usually provides a measure of diversification Moreover, some firms tend to continue high-
and often affects competitive issues. risk financial policies as they aggressively pur-
Obviously, the need to have a broad product sue ever greater objectives, limiting any cred-
line or a national marketing structure is a fac- it-quality improvement. There is little evi-
tor in many businesses and would be a rating dence to suggest that growth companies ini-
consideration. In this sense, sheer mass is not tially receiving speculative-grade ratings have
important; demonstrable market advantage is. particular upgrade potential. Many more
Small companies also can possess the competi- defaulted over time than achieved investment
tive benefits of dominant market positions, grade. Oil exploration, retail, and high tech-
although that is not common. nology firms have been especially vulnerable,
Market share analysis often provides impor- even though their great potential was touted
tant insights. However, large shares are not at the time they first came to market.
always synonymous with competitive advan-
tage or industry dominance. For instance, if an Management evaluation
industry has a number of large but compara- Management is assessed for its role in deter-
ble-size participants, none may have a particu- mining operational success and also for its risk
lar advantage or disadvantage. Conversely, if tolerance. The first aspect is incorporated in
an industry is highly fragmented, even the the competitive position analysis; the second is
large firms may lack pricing leadership poten- weighed as a financial policy factor.
tial. The textile industry is an example. Subjective judgments help determine each
Still, small companies are, almost by defini- aspect of management evaluation. Opinions
tion, more concentrated in terms of product, formed during the meetings with senior man-
number of customers, or geography. In effect, agement are as important as management’s
they lack some elements of diversification that track record. While a track record may seem to
can benefit larger firms. To the extent that offer a more objective basis for evaluation, it
markets and regional economies change, a often is difficult to determine how results
broader scope of business affords protection. should be attributed to management’s skills.
This consideration is balanced against the per- The analyst must decide to what extent they
formance and prospects of a given business. In are the result of good management, devoid of
addition, lack of financial flexibility is usually management influence, or achieved despite
an important negative factor in the case of very management!
small firms. Adverse developments that would Plans and policies have to be judged for their
simply be a setback for firms with greater realism. How they are implemented deter-
resources could spell the end for companies mines the view of management consistency
with limited access to funds. and credibility. Stated policies often are not
There is a controversial notion that small, followed, and the ratings will reflect skepti-
growth companies represent a better credit risk cism unless management has established credi-
than older, declining companies. While this is bility. Credibility can become a critical issue
intuitively appealing to some, it ignores some when a company is faced with stress or

RATING FACTORS FOR ELECTRIC UTILITIES

Transmission and Distribution Companies Generation Companies
Regulation Regulation
• The nature of the rate-making structure, • Status of restructuring, e.g., posture
e.g., performance-based vs. cost-of-service toward recovery of stranded costs
• Authorized return on equity • Nature of regulatory scheme, e.g., price
• Timely and consistent rate treatment establishment through power exchange or
• Status of restructuring, e.g., residual economic dispatch vs. bilateral contracts
obligation to provide power, which • Uncertainty concerning FERC’s evolving
entails the purchase of electricity for rules for regional transmission organiza-
resale tions, independent system operators, and
• FERC’s evolving rules for regional trans- for-profit transcos, including indepen-
mission of organizations, independent dence and equal access
system operators, and for-profit transcos Markets
• Incentives to maintain existing delivery • Customer mix and diversity
assets and invest in new assets • Generating capacity vs. demand
• Nature of distributor support that retains • Economic growth prospects
the status of provider of last resort Operations
Markets • Nature of generation, i.e., peaking, inter-
• Economic and demographic characteris- mediate, or baseload
tics, including size and growth rates, • Production inputs, including fuel costs,
customer mix, industrial concentrations, fuel diversity, and labor
and cyclical volatility • Level of physical and financial hedging
• Location sophistication
Operations • Nature of supply contracts
• Cost, reliability, and quality of service • Efficiency measures, such as plant capaci-
(usually measured against various bench- ty and availability factors and heat rates
marks) • Technology of plants
• Capacity utilization • Asset concentration within portfolio of
• Projected capital improvements generating units
• Nature of diversified business operations, • Construction risk
if any • Possibility of environmental legislation
Competitiveness • Diversity of fuel sources and types
• Alternative fuel sources, such as gas and • Marketing prowess
self-generation • Access to transmission
• Location of new generation Competitiveness
• Potential for bypass • Relative costs of production, both total
• Rate Structure and variable
• Threat from new, low-cost entrants
• Alternatives to electricity, such as natural
gas, technological innovations, and
remote site applications, including fuel
cells and microturbines
• Plants’ importance to transmission and
voltage support

RATING FACTORS FOR AIRLINES

Market Share Unit revenues, measured by passenger rev-
Share of industry traffic, measured by revenue per available seat mile (yield times
enue passenger miles or revenue ton load factor)
miles for airlines with significant freight Effectiveness of revenue management—
operations maximizing revenues by managing trade-
Share of industry capacity, measured by off between pricing and utilization
available seat miles or available ton miles Service reputation; ranking in measures of
Trend of overall market share customer satisfaction
Membership in global alliance: strength of Nonpassenger revenues: freight, sale of
partners and benefits for airline being frequent flyer miles, services provided to
rated, regulatory environment for other airlines
alliance cooperation (e.g. “antitrust Cost Control
immunity”), extent of and potential for Operating cost per available seat mile
cooperation within alliance Adjusted for average trip length
Position in Specific Markets Adjusted for use of operating leases
Geographic position of airline’s hubs for and differing depreciation accounting
handling major traffic flows; position of Labor
competing hubs of other airlines Labor cost per available seat mile
Share of enplanements and flights at hubs Structure of labor contracts; existence
Share at major origination and destination and nature of any “B-scales” (lower
markets; economic and demographic pay scales for recent hires)
growth prospects of those markets Flexibility of work rules; effect on
Strength of competition at hubs and in productivity
major markets served “Scope clauses” in pilot contracts;
Barriers to entry/infrastructure constraints limits on outsourcing
Gates Status of union contracts and negoti-
Terminal space and other ground tions; possibility of strikes
facilities Labor relations and morale
Air traffic control; takeoff and landing Fuel costs and impact of potential fuel price
slot restrictions hikes, given fuel efficiency of fleet and
Position in international markets nature of routes flown; fuel price hedging
Growth prospects of markets Commissions, marketing, and other operating
Treaty and regulatory barriers to entry expenses; extent of “electronic distribution”
Strength of competition Aircraft Fleet
Revenue Generation Number and type of aircraft in relation to
Utilization of capacity, measured by “load current and projected needs
factor” (revenue passenger miles divided Status of fleet modernization program
by available seat miles) Average age fleet; age weighted by
Pricing seats
Yield (passenger revenues divided by Fleet “commonality” (standardization)
revenue passenger miles) Fuel efficiency of fleet
Yield adjusted for average trip length Aircraft orders and options for future
(Airlines with shorter average trips deliveries
tend to have higher yields.) Ability under pilot contracts to operate
regional jets, through airline or its
regional partners

restructuring and the analyst must decide or utility companies. The rating process is very
whether to rely on management to carry out much one of comparisons, so it is important to
plans for restoring creditworthiness. have a common frame of reference.
Accounting issues to be reviewed include:
Organizational considerations • Consolidation basis. U.S. GAAP now
Standard & Poor’s evaluation is sensitive to requires consolidation of even nonhomoge-
potential organizational problems. These neous operations. For analytical purposes, it is
include situations where: critical to separate these and evaluate each
• There is significant organizational reliance type of business in its own right;
on an individual, especially one who may be • Income recognition. For example, percent-
close to retirement; age of completion vs. completed contract in
• The finance function and finance consid- the construction industry;
erations do not receive high organizational • Depreciation methods and asset lives;
recognition; • Inventory pricing methods;
• The transition from entrepreneurial or family- • Impact of purchase accounting and treat-
bound to professional management has yet ment of goodwill;
to be accomplished; • Employee benefits (see discussion on page 105);
• A relatively large number of changes occur and
within a short period; • Various off-balance-sheet liabilities, from
• The relationship between organizational leases and project finance to defeasance and
structure and management strategy is receivable sales.
unclear; To the extent possible, analytical adjust-
• Shareholders impose constraints on man- ments are made to better portray reality.
agement prerogatives. Although it is not always possible to complete-
ly recast a company’s financial statements, it is
Measuring performance and risk useful to have some notion of the extent per-
Having evaluated the issuer’s competitive formance or assets are overstated or understat-
position and operating environment, the ed. At the very least, the choice of accounting
analysis proceeds to several financial cate- alternatives can be characterized as generally
gories. To reiterate: the company’s business- conservative or liberal.
risk profile determines the level of financial
risk appropriate for any rating category. Financial policy
Financial risk is portrayed largely through Standard & Poor’s attaches great impor-
quantitative means, particularly by using tance to management’s philosophies and poli-
financial ratios (guidelines and medians for cies involving financial risk. A surprising num-
key ratios for U.S. companies are found on ber of companies have not given this question
pages 54 and 57). Benchmarks vary greatly by serious thought, much less reached strong con-
industry, and several analytical adjustments clusions. For many others, debt leverage (cal-
typically are required to calculate ratios for an culated without any adjustment to reported
individual company. Cross-border compar- figures) is the only focal point of such policy
isons require additional care, given the differ- considerations. More sophisticated business
ences in accounting conventions and local managers have thoughtful policies that recog-
financial systems (see discussion on interna- nize cash-flow parameters and the interplay
tional rating issues starting on page 30). between business and financial risk.
Many firms that have set goals do not have
Accounting quality the wherewithal, discipline, or management
Ratings rely on audited data, and the rating commitment to achieve these objectives. A
process does not entail auditing a company’s company’s leverage goals, for example, need to
financial records. Analysis of the audited finan- be viewed in the context of its past record and
cials begins with a review of accounting quali- the financial dynamics affecting the business. If
ty. The purpose is to determine whether ratios management states, as many do, that its goal is
and statistics derived from financial statements to operate with 35% debt-to-capital, Standard
can be used accurately to measure a company’s & Poor’s factors that into its analysis only to
performance and position relative to both its the extent it appears plausible. For example, if
peer group and the larger universe of industrial a company has aggressive spending plans, that

35% goal would carry little weight, unless • Pretax preinterest return on capital;
management has committed to a specific pro- • Operating income as a percentage of sales;
gram of asset sales, equity sales, or other and
actions that in a given time period would pro- • Earnings on business segment assets.
duce the desired results. While the absolute levels of ratios are impor-
Standard & Poor’s does not encourage com- tant, it is equally important to focus on trends
panies to manage themselves with an eye and compare these ratios with those of com-
toward a specific rating. The more appropriate petitors. Various industries follow different
approach is to operate for the good of the busi- cycles and have different earnings characteris-
ness as management sees it, and let the rating tics. Therefore, what may be considered favor-
follow. Certainly, prudence and credit quality able for one business may be relatively poor for
should be among the most important consider- another. For example, the drug industry usual-
ations, but financial policy should be consis- ly generates high operating margins and high
tent with the needs of the business rather than returns on capital. Defense contractors gener-
an arbitrary constraint. ate low operating margins, but high returns on
If opportunities are foregone merely to avoid capital. The pipeline industry has high operat-
financial risk, the firm is making poor strategic ing margins and low returns on capital.
decisions. In fact, it may be sacrificing long- Comparisons with a company’s peers influence
term credit quality for the facade of low risk in Standard & Poor’s perception of a firm’s com-
the near term. One financial article described a petitive strengths and pricing flexibility.
company that curtailed spending expressly “to The analysis proceeds from historical perfor-
become an ‘A’-rated company.” As a result, mance to projected profitability. Because a rat-
“...the company’s business responded poorly ing is an assessment of the likelihood of timely
to an increase in market demand. Needless to payments in the future, the evaluation empha-
say, the sought-after ‘A’ rating continued to sizes future performance. However, the rating
elude the company.” analysis does not attempt to forecast perfor-
In any event, pursuit of the highest rating mance precisely or to pinpoint economic cycles.
attainable is not necessarily in the company’s Rather, the forecast analysis considers variabil-
best interests. ‘AAA’ may be the highest rating, ity of expected future performance based on a
but that does not suggest that it is the “best” range of economic and competitive scenarios.
rating. Typically, a company with virtually no Particularly important today are manage-
financial risk is not optimal as far as meeting ment’s plans for achieving earnings growth.
the needs of its various constituencies. An Can existing businesses provide satisfactory
underleveraged firm is not minimizing its cost growth, especially in a low-inflation environ-
of capital, thereby depriving its owners of ment, and to what extent are acquisitions or
potentially greater value for their investment. divestitures necessary to achieve corporate
In this light, a corporate objective of having its goals? At first glance, a mature, cash-generat-
debt rated ‘AAA’ or ‘AA’ is at times suspect. ing company offers a great deal of bondholder
Whatever a company’s financial track record, protection, but Standard & Poor’s assumes a
an analyst must be skeptical if corporate goals corporation’s central focus is to augment share-
are implicitly irrational. A firm’s “conservative holder value over the long run. In this context,
financial philosophy” must be consistent with a lack of indicated earnings growth potential is
the firm’s overall goals and needs. considered a weakness. By itself this may hin-
der a company’s ability to attract financial and
Profitability and coverage human resources. Moreover, limited internal
Profit potential is a critical determinant of earnings growth opportunities may lead man-
credit protection. A company that generates agement to pursue growth externally, implying
higher operating margins and returns on capi- greater business and financial risks.
tal has a greater ability to generate equity cap- Earnings are also viewed in relation to a
ital internally, attract capital externally, and company’s burden of fixed charges. Otherwise-
withstand business adversity. Earnings power strong performance can be affected detrimen-
ultimately attests to the value of the firm’s tally by aggressive debt financing, and the
assets as well. opposite also is true. The two primary fixed-
The more significant measures of profitabil- charge coverage ratios are:
ity are:

• Earnings before interest and taxes (EBIT) What is considered “debt” and “equity” for
coverage of interest; and the purpose of ratio calculation is not always
• Earnings before interest and taxes and rent so simple. In the case of hybrid securities, the
(EBITR) coverage of interest plus total rents. analysis is based on their features—not the
If preferred stock is outstanding and materi- accounting or the nomenclature (see discussion
al, coverage ratios are calculated both includ- of “equity credit” on page 89). Pension and
ing and excluding preferred dividends, to retiree health obligations are similar to debt in
reflect the company’s discretion over paying many respects. Their treatment is explained on
the dividend when under stress. Similarly, if page 105.
interest payments can be deferred (as in zero Indeed, not all subtleties and complexities
coupon debt, income bonds, or intercompany lend themselves to ratio analysis. Original
debt supporting subsidiary preferred stock) issue discount debt, such as zero coupon debt,
other adjustments to the calculation help cap- is included at the accreted value. However,
ture the firm’s flexibility in making payments. since there is no sinking fund provision, the
To reflect more accurately the ongoing earn- debt increases with time—creating a moving
ings power of the firm, reported profit figures target. (The need, eventually, to refinance this
are adjusted. These adjustments remove the growing amount represents another risk.) In
effect of the case of convertible debt, it is somewhat
• LIFO liquidations, presumptuous to predict whether and when
• Foreign-exchange gains and losses, conversion will occur, making it difficult to
• Litigation reserves, reflect the real risk profile in ratio form.
• Writedowns and other nonrecurring or extra- A company’s asset mix is a critical determi-
ordinary gains and losses, and nant of the appropriate leverage for a given
• Unremitted equity earnings of a subsidiary. level of risk. Assets with stable cash flow or
Similarly, there are numerous analytical market values justify greater use of debt
adjustments to the interest amounts. Interest financing than those with clouded marketabil-
that has been capitalized is added back. An ity. For example, grain or tobacco inventory
interest component is computed for debt- would be viewed positively, compared with
equivalents such as operating leases and receiv- apparel or electronics inventory; transporta-
able sales. Amounts may be subtracted to rec- tion equipment is viewed more favorably than
ognize the impact of borrowings in hyperinfla- other equipment, given its suitability for use by
tionary environments or borrowings to sup- other companies.
port cash investments as part of a tax arbitrage Accordingly, if a firm operates different busi-
strategy. And interest associated with finance nesses, Standard & Poor’s believes it is critical
operations is segregated in accordance with the to analyze each type of business and asset class
methodology spelled out on page 103. in its own right. While FASB and IAS now
require consolidation of nonhomogenous busi-
Capital structure/leverage ness units, Standard & Poor’s analyzes each
and asset protection separately. This is the basis for Standard &
Ratios employed by Standard & Poor’s to Poor’s methodology for analyzing captive
capture the degree of leverage used by a com- finance companies (see page 102). Similarly, if
pany include: a company holds significant amounts of excess
• Total debt/total debt + equity; cash or investments, ratios may be calculated
• Total debt + off-balance-sheet liabilities/total on a “net debt” basis. This approach is used in
debt + off-balance-sheet liabilities + equity; and the case of cash-rich pharmaceutical firms that
• Total debt/total debt + market value of enjoy tax arbitrage opportunities with respect
equity. to these cash holdings.
Traditional measures focusing on long-term
debt have lost much of their significance, since Asset valuation
companies rely increasingly on short-term bor- Knowing the true values to assign a company’s
rowings. It is now commonplace to find per- assets is key to the analysis. Leverage as report-
manent layers of short-term debt, which ed in the financial statements is meaningless if
finance not only seasonal working capital but assets are materially undervalued or overvalued
also an ongoing portion of the asset base. relative to book value. Standard & Poor’s con-
siders the profitability of an asset as an appro-

priate basis for determining its economic value. • Receivables that have been factored, trans-
Market values of a company’s assets or ferred, or securitized; and
independent asset appraisals can offer addition- • Contingent liabilities, such as potential legal
al insights. However, there are shortcomings in judgments or lawsuit settlements.
these methods of valuation (just as there are with Various methodologies are used to deter-
historical cost accounting) that prevent reliance mine the proper adjustment value for each off-
on any single measure. Similarly, ratios using the balance-sheet item. In some cases, the adjust-
market value of a company’s equity in calcula- ment is straightforward. For example, the
tions of leverage are given limited weight as ana- amount of guaranteed debt can simply be
lytical tools. The stock market emphasizes added to the guarantor’s liabilities. Other
growth prospects and has a short time horizon; adjustments are more complex or less precise.
it is influenced by changes in alternative invest- Nonrecourse debt of a joint venture may be
ment opportunities and can be very volatile. A attributed to the parent companies, especially if
company’s ability to service its debt is not affect- they have a strategic tie to the operation. The
ed directly by such factors. analysis may burden one parent with a dispro-
The analytical challenge of which values to portionate amount of the debt if that parent has
use is especially evident in the case of merged the greater strategic interest or operating con-
and acquired companies. Accounting stan- trol or its ability to service the joint-venture debt
dards allow the acquired company’s assets and is greater. Other considerations that affect a
equity to be written up to reflect the acquisi- company’s willingness to walk away from such
tion price, but the revalued assets have the debt—and other nonrecourse debt—include
same earning power as before; they cannot shared banking relationships and common
support more debt just because a different country location. In some instances the debt
number is used to record their value! Right may be so large in relation to the owner’s invest-
after the transaction, the analysis can take ment that the incentives to support the debt are
these factors into account, but down the road minimized. In virtually all cases, though, the
the picture becomes muddied. Standard & parent would likely invest additional amounts
Poor’s attempts to normalize for purchase before deciding to abandon the venture.
accounting, but the ability to relate to pre- Accordingly, adjustments would be made to
acquisition financial statements and to make reflect the owner’s current and projected invest-
comparisons with peer companies is limited. ment, even if the venture’s debt were not added
Presence of a material goodwill account to the parent’s balance sheet. (See page 98.)
indicates the impact of acquisitions and pur- In the case of contingencies, estimates are
chase accounting on a firm’s equity base. developed. Insurance coverage is estimated,
Intangible assets are no less “valuable” than and a present value is calculated if the pay-
tangible ones. But comparisons are still dis- ments will stretch over many years. The result-
torted, since other companies cannot record ing amount is viewed as a corporate liability
their own valuable business intangibles, those from an analytical perspective.
that have been developed instead of acquired. The sale or securitization of accounts
This alone requires some analytical adjustment receivable represents a form of off-balance-
when measuring leverage. In addition, analysts sheet financing. If used to supplant other
are entitled to be more skeptical about earning debt, the impact on credit quality is neutral.
prospects that rely on turnaround strategies or (There can be some incremental benefit to the
“synergistic” mergers. extent that the company has expanded access
to capital, and this financing may be lower in
Off-balance-sheet financing cost. However, there may also be an offset in
Off-balance-sheet items factored into the the higher cost of unsecured financing.) For
leverage analysis include the following: ratio calculations, Standard & Poor’s adds
• Operating leases; back the amount of receivables and a like
• Debt of joint ventures and unconsolidated amount of debt. This eliminates the distort-
subsidiaries; ing, cosmetic effect of utilizing an off-bal-
• Guarantees; ance-sheet technique and allows better com-
• Take-or-pay contracts and obligations under parison with other firms that have chosen
throughput and deficiency agreements; other avenues of financing. Similarly, if a firm

uses proceeds from receivables sales to invest Redeemable preferred stock issues may also
in riskier assets—and not to reduce other be refinanced with debt once an issuer
debt—the adjustment will reveal an increase becomes a taxpayer. Preferreds that can be
in financial risk. exchanged for debt at the company’s option
The debt-equivalent value of operating leas- also may be viewed as debt in anticipation of
es is determined by calculating the present the exchange. However, the analysis would
value of minimum operating lease obligations also take into account any offsetting positives
as reported in the annual report’s footnotes. associated with the change in tax status. Often
The lease amount beyond five years is assumed the trigger prompting an exchange or redemp-
to mature at a rate approximating the mini- tion would be improved profitability. Then,
mum payment due in year five. the added debt in the capital structure would
The variety of lease types may require the not necessarily imply lower credit quality. The
analyst to obtain additional information or implications are different for many issuers that
use estimates to evaluate lease obligations. do not pay taxes for various other reasons,
This is needed whenever lease terms are short- including availability of tax-loss carry-for-
er than the assets’ expected economic lives. wards or foreign tax credits. For them, a
For example, retailers report only the first change in taxpaying status is not associated
period of a lease written with an initial period with better profitability, while the incentive to
and several renewal options over a long term. turn the preferred into debt is identical.
Another limitation develops when a portion of In the same vein, sinking fund preferreds are
the lease payment is contingent, e.g., a per- less equity-like. The sinking fund requirements
centage of sales, as is often the case in the themselves are of a fixed, debt-like nature.
retailing industry. Moreover, they are usually met through debt
(Traditionally, operating leases were recog- issuance, which results in the sinking fund pre-
nized by the “factor method”: annual lease ferred being just the precursor of debt. It
expense is multiplied by a factor that reflects would be misleading to view sinking fund pre-
the average life of the company’s leased assets. ferreds, particularly that portion coming due
This method is an attempt to capitalize the in the near to intermediate term, as equity,
asset, rather than just the use of the asset for only to have each payment convert to debt on
the lease period. However, the method can the sinking fund payment date. Accordingly,
overstate the asset to be capitalized by failing Standard & Poor’s views at least the portion of
to recognize asset use over the course of the the issuer’s sinking fund preferreds due within
lease. It also is too arbitrary to be realistic.) the next five years as debt.
Preferred stock Cash flow adequacy

Preferred stocks can qualify for treatment as Interest or principal payments cannot be ser-
equity or be viewed as debt—or something viced out of earnings, which is just an account-
between debt and equity—depending on their ing concept; payment has to be made with
features and the circumstances. The degree of cash. Although there is usually a strong rela-
equity credit for various preferreds is discussed tionship between cash flow and profitability,
on page 95. Preferred stocks that have a matu- many transactions and accounting entries
rity receive diminishing equity credit as they affect one and not the other. Analysis of cash
progress toward maturity. flow patterns can reveal a level of debt-servic-
A preferred that the analyst believes will be ing capability that is either stronger or weaker
eventually refinanced with debt is viewed as a than might be apparent from earnings.
debt-equivalent, not equity, all along. Auction Cash flow analysis is the single most criti-
preferreds, for example, are “perpetual” on cal aspect of all credit rating decisions. It
the surface. However, they often represent takes on added importance for speculative-
merely a temporary debt alternative for com- grade issuers. While companies with invest-
panies that are not current taxpayers—until ment-grade ratings generally have ready
they once again can benefit from tax access to external cash to cover temporary
deductibility of interest expense. Moreover, the shortfalls, junk-bond issuers lack this degree
holders of these preferreds would pressure for of flexibility and have fewer alternatives to
a redemption in the event of a failed auction or internally generated cash for servicing debt.
even a rating downgrade.

Cash flow ratios Where long-term viability is more assured

Ratios show the relationship of cash flow to (i.e., higher in the rating spectrum) there can be
debt and debt service, and also to the firm’s greater emphasis on the level of funds from
needs. Since there are calls on cash other than operations and its relation to total debt burden.
repaying debt, it is important to know the These measures clearly differentiate between
extent to which those requirements will allow levels of protection over time. Focusing on debt
cash to be used for debt service or, alternative- service coverage and free cash flow becomes
ly, lead to greater need for borrowing. more critical in the analysis of a weaker com-
Some of the specific ratios considered are: pany. Speculative-grade issuers typically face
• Funds from operations/total debt (adjusted near-term vulnerabilities, which are better mea-
for off-balance-sheet liabilities); sured by free cash flow ratios.
• EBITDA/interest; Interpretation of these ratios is not always
• Free operating cash flow + interest/interest; simple; higher values can sometimes indicate
• Free operating cash flow + interest/interest problems rather than strength. A company
+ annual principal repayment obligation serving a low-growth or declining market may
(debt service coverage); exhibit relatively strong free cash flow, owing
• Total debt/discretionary cash flow (debt to minimal fixed and working capital needs.
payback period); Growth companies, in comparison, often
• Funds from operations/capital spending exhibit thin or even negative free cash flow
requirements, and because investment is needed to support
• Capital expenditures/capital maintenance. growth. For the low-growth company, credit
MEASURING CASH FLOW

Discussions about cash flow often suffer external financing and changes in the compa-
from lack of uniform definition of terms. The ny’s own cash balance. In the example, XYZ
table illustrates Standard & Poor’s terminology Inc. experienced a $35.7 million cash shortfall
with respect to specific cash flow concepts. At in year one, which had to be met with a com-
the top is the item from the funds flow state- bination of additional borrowings and a draw-
ment usually labeled “funds from operations” down of its own cash.
(FFO) or “working capital from operations.”
This quantity is net income adjusted for depre- Cash flow summary: XYZ Corp.
ciation and other noncash debits and credits
factored into it. Back out the changes in work- Year Year
(Mil. $) one two
ing capital investment to arrive at “operating
Funds from operations (FFO) 18.58 22.34
cash flow.” Dec. (inc.) in noncash current assets (33.12) 1.05
Next, capital expenditures and cash Inc. (dec.) in nondebt current liabilities 15.07 (12.61)
dividends are subtracted out to arrive at “free Operating cash flow 0.52 10.78
operating cash flow” and “discretionary cash (Capital expenditures) (11.06) (9.74)
flow,” respectively. Finally, cost of acquisitions Free operating cash flow (10.53) 1.04
(Cash dividends) (4.45) (5.14)
is subtracted from the running total, proceeds
Discretionary cash flow (14.98) (4.09)
from asset disposals added, and other miscel- (Acquisitions) (21.00) 0.00
laneous sources and uses of cash netted Asset disposals 0.73 0.23
together. “Prefinancing cash flow” is the end Net other sources (uses) of cash (0.44) (0.09)
result of these computations, which represents Prefinancing cash flow (35.70) (3.95)
the extent to which company cash flow from
Inc. (dec.) in short-term debt 23.00 0.00
all internal sources has been sufficient to
Inc. (dec.) in long-term debt 6.12 13.02
cover all internal needs. Net sale (repurchase) of equity 0.32 (7.07)
The bottom part of the table reconciles Dec. (inc.) in cash and securities 6.25 (2.00)
prefinancing cash flow to various categories of 35.70 3.95

analysis weighs the positives of strong current but that are known to be acquisition-minded.
cash flow against the danger that this high Their choice of acquisition as an avenue for
level of protection might not be sustainable. growth means that this activity must also be
For the high-growth company, the problem is anticipated in the credit analysis.
just the opposite: weighing the negatives of a Management’s stated acquisition goals and
current cash deficit against prospects of past takeover bids, including those that were
enhanced protection once current investment not consummated, provide a basis for judging
begins yielding cash benefits. There is no sim- prospects for future acquisitions.
ple correlation between creditworthiness and
the level of current cash flow. Financial flexibility
The previous assessment of financial factors
The need for capital (profitability, capital structure, cash flow) are
Analysis of cash flow in relation to capital combined to arrive at an overall view of finan-
requirements begins with an examination of a cial health. In addition, sundry considerations
company’s capital needs, including both work- that do not fit in other categories are exam-
ing and fixed capital. While this analysis is per- ined, including serious legal problems, lack of
formed for all debt issuers, it is critically insurance coverage, or restrictive covenants in
important for fixed capital-intensive firms and loan agreements that place the firm at the
growth companies. Companies seeking work- mercy of its bankers.
ing capital often are able to finance a signifi- An analytical task covered at this point is the
cant portion of current assets through trade evaluation of a company’s options under
credit. However, rapidly growing companies stress. The potential impact of various contin-
typically experience a build-up in receivables gencies is considered, along with a firm’s con-
and inventories that cannot be financed inter- tingency plans. Access to various capital mar-
nally or through trade credit. kets, affiliations with other entities, and ability
Improved working-capital management to sell assets are important factors.
techniques have greatly reduced the investment Flexibility can be jeopardized when a firm is
that might otherwise have been required. This overly reliant on bank borrowings or commer-
makes it difficult to base expectations on cial paper. Reliance on commercial paper with-
extrapolating recent trends. In any event, out adequate backup facilities is a big negative.
improved turnover experience would not be a An unusually short maturity schedule for long-
reason to project continuation of such a trend term debt and limited-life preferred stock also
to yet better levels. is a negative. Access to various capital markets
Because Standard & Poor’s evaluates com- can then become an important factor. In gen-
panies as ongoing enterprises, the analysis eral, a company’s experience with different
assumes that firms will provide funds continu- financial instruments and capital markets gives
ally to maintain capital investments as mod- management alternatives if conditions in a par-
ern, efficient assets. Cash flow adequacy is ticular financial market suddenly sour.
viewed from the standpoint of a company’s Company size and its financing needs can play
ability to finance capital-maintenance require- a role in whether it can raise funds in the pub-
ments internally, as well as its ability to finance lic debt markets. Similarly, a firm’s role in the
capital additions. It is difficult to quantify the national economy—and this is particularly
requirements for capital maintenance unless true outside the U.S.—can enhance its access to
data are provided by the company. bank and public funds.
An important dimension of cash flow Access to the common stock market may be
adequacy is the extent of a company’s flexibil- primarily a question of management’s willing-
ity to alter the timing of its capital require- ness to accept dilution of earnings per share,
ments. Expansions are typically discretionary. rather than a question of whether funds are
However, large plants with long lead times available. (However, in some countries,
usually involve, somewhere along the way, a including Japan and Germany, equity markets
commitment to complete the project. may not be so accessible.) When a new com-
There are companies with cash flow mon stock offering is projected as part of a
adequate to the needs of the existing business, company’s financing plan, Standard & Poor’s

tries to measure management’s commitment to cial implications. A large pension burden can
this plan, and its sensitivity to changes in hinder a company’s ability to sell assets,
share price. because potential buyers will be reluctant to
As going concerns, companies should not be assume the liability, or to close excess, ineffi-
expected to repay debt by liquidating opera- cient, and costly manufacturing facilities,
tions. Clearly, there is little benefit in selling which might require the immediate recognition
natural resource properties or manufacturing of future pension obligations and result in a
facilities if these must be replaced in a few charge to equity.
years. Nonetheless, a company’s ability to gen- When there is a major lawsuit against the
erate cash through asset disposals enhances its firm, suppliers or customers may be reluctant
financial flexibility. to continue doing business, and the company’s
Pension obligations, environmental liabili- access to capital may also be impaired, at least
ties, and serious legal problems restrict flexi- temporarily.
bility, apart from the obligations’ direct finan-

The Global Perspective

A global rating scale imposes a consistent, as retailing, are viewed differently than those
common discipline on all cross-border analy- which are exposed to global market forces,
sis, while still allowing the assessment of an such as semiconductors or energy. Other
issuer in its local context. Standard & Poor’s industries, such as automobiles, face a combi-
weighs the diverse national considerations, but nation of global and regional market consider-
expresses its ratings on a single scale so that ations. Industry risk varies from region to
debtholders can compare issues of equivalent region.
credit quality. In reviewing companies in export-oriented
International corporate ratings are conduct- countries, emphasis is placed on a firm’s abili-
ed by teams that combine knowledge of the ty to withstand local currency appreciation
country of domicile with industry expertise. and the country’s sentiments toward trade pro-
The analysis of corporates around the globe all tectionism. Japanese manufacturers, for exam-
follow the same rating methodology (described ple, were challenged in the mid-1980s and
in the previous section): Industry risk and the again in the mid-1990s by the strong appreci-
company’s competitive position are evaluated ation of the yen relative to the dollar. Labor
in conjunction with the firm’s financial profile conditions can also differ internationally.
and policies. This fundamental analysis is per- Where labor costs are high, an industrial com-
formed with an appreciation of relevant indus- pany’s cost structure can impair its interna-
try and financial characteristics of a specific tional competitive position. Differing social
country or region. If the regional environment attitudes and legal restrictions regarding labor
poses additional risks to corporates operating make headcount reductions or other forms of
there, that too is incorporated in the analysis. industrial rationalization more difficult in
(The section starting on page 34 elaborates on certain countries.
country economic and political factors that The role of regulation and legislation, actual
pertain in emerging markets.) and potential, must also be considered. In
The analysis is conducted based on the Europe, a growing number of industries are
issuer’s financial statements prepared in accor- experiencing challenges to traditional arrange-
dance with the prevailing local standard—as ments stemming from new directives from the
long as these meet international standards and European Economic Commission.
are audited by a reputable firm. In some
emerging markets it is critical to resolve in Financial risk
advance what level of disclosure will be avail- Key aspects of financial risk assessed by
able—at the time of the rating and on an ongo- Standard & Poor’s include earnings protec-
ing basis (to allow appropriate surveillance.) tion, cash flow adequacy, asset quality, use of
debt leverage, and financial flexibility. It is a
Business risk challenge to interpret and compare financial
Business risk analysis entails the assessment measures that are derived from differing
of an issuer’s economic, operational, and com- accounting practices. For example, some sys-
petitive environment. The analysis of corpo- tems use historical cost and others use current,
rates of differing nationalities calls for an or inflated, cost to value assets.
appreciation of this environment for an issuer’s The analyst begins by assessing company
specific geographical and industrial mix. performance based on its own accounting
Demand and supply factors, both domestic framework. Adjustments are made to enable
and worldwide, are assessed. Industries where comparisons. Standard & Poor’s does not
competition takes place on a local basis, such translate a company’s financial accounts to a

U.S. GAAP framework (nor does it ask com- both a company’s reported equity base and its
panies to do so.) By understanding the features depreciation expense. There is no easy way to
of each accounting system, analysts seek out compare companies that revalue their assets
differences that materially affect the way a with those that do not. Rather, Standard &
company operating under any reporting sys- Poor’s recognizes that, for all companies,
tem compares with that of its international reported asset values often differ from market
peer group. values. In discussions with management,
Endeavoring to adjust measurements of Standard & Poor’s analysts endeavor to gain
international companies to common denomi- an appreciation of the realizable values of a
nators, the analysis focuses on “real” stocks company’s assets under reasonably
and flows, namely, levels of debt, cash, and conservative assumptions.
cash flow. There is less emphasis on abstract
measures, such as shareholders’ equity and Net debt
reported earnings. Although earnings and net In many countries, notably in Japan and
worth have important economic meaning if Europe, local practice is to maintain a high
measured consistently and responsibly, this level of debt while holding a large portfolio of
meaning is often blurred in a cross-border con- cash and marketable securities. Many compa-
text. For example, differing depreciation or nies manage their finances on a net debt basis.
asset revaluation policies can result in signifi- In these situations, Standard & Poor’s focuses
cant distortions. In addition, profitability on net interest coverage, cash flow to net debt,
norms differ on an international basis. A com- and net debt to capital. When a company con-
pany generating relatively low returns on per- sistently demonstrates such excess liquidity,
manent capital in a country with low interest interest income may be offset against interest
rates perhaps should be viewed more favorably expense in looking at overall financial expens-
than a similar company reporting higher es. Net debt leverage is similarly calculated by
returns in a higher interest rate environment. netting out excess liquidity from short-term
Financial parameters that are increasingly borrowings. Each situation is analyzed on a
viewed as relevant and reliable are coverage of case-by-case basis, subject to additional infor-
fixed financial charges by cash flow and oper- mation regarding a company’s liquidity posi-
ating cash flow relative to total debt. The tra- tion, normal working cash needs, nature of
ditional measure of debt to capital is no longer short-term borrowings, and funding philoso-
weighted as heavily. In any event, ratios of cor- phy. Funds earmarked for future use, such as
porates outside the U.S. are not directly com- an acquisition or a capital project, are not
parable with median statistics published for netted out.
U.S. industrials. In some countries it is not uncommon for
industrial companies to establish their treasury
Balance-sheet distortion operations as a profit center. In Japan, for
Treatment of goodwill offers an example of example, the term “zaiteku financing” refers
balance-sheet distortion. In some countries, to the practice of generating profits through
companies write off goodwill at the outset of arbitrage and other financial-market transac-
an acquisition, whereas companies in other tions. If financial position-taking comprises a
parts of the world do not. U.K. companies material part of a company’s aggregate earn-
tended to write off goodwill, that is, until ings, Standard & Poor’s segregates those earn-
recent changes in their accounting procedures. ings to assess the profitability of the core busi-
The result is that U.K. companies tend to have ness. Standard & Poor’s may also view with
capital structures that look weaker and earn- skepticism the ability to realize such profits on
ings that look better than those of competitors a sustained basis and may treat them like non-
from countries that capitalize goodwill and recurring gains.
amortize it over time. To adjust, the analyst
may add back goodwill to shareholders’ funds Earnings differences
and make a qualitative or quantitative adjust- Shareholder pressures and accounting stan-
ment for goodwill amortization in analyzing a dards in certain countries—such as the U.S.—
U.K. company. can result in companies seeking to maximize
Asset valuation practices also differ from profits on a quarter-to-quarter or short-term
country to country, resulting in differences in basis. In other regions—aided by local tax reg-

ulation—it is normal practice to take provi- Nevertheless, state ownership can bolster a
sions against earnings in good times to provide company’s credit profile through implicit sup-
a cushion against downturns, resulting in a port. Government support can take the form of
long run “smoothing” of reported profits. facilitated access to external sources of capital
Given local accounting standards, it is not rare or, in extreme cases, direct financial infusions.
to see a Swiss or German company vaguely The link between government and industry
report “other income” or “other expenses,” differs from country to country and, even
which are largely provisions or provision within a country, from firm to firm. The analy-
reversals, as the largest line items in a profit sis begins by considering the state’s historical
and loss account. In meetings with manage- relationship with industry, including the degree
ment, Standard & Poor’s discusses provision- to which governmental financial aid has been
ing and depreciation practices to see to what used to support state-owned firms in the past.
extent a company employs noncash charges to However, it is important to anticipate potential
reduce or bolster earnings. Credit analysis changes in historical arrangements. For exam-
focuses on operating performance and cash ple, Economic Commission competition has
flow, not financial reports distorted by the potential to inhibit the ability of member
accounting techniques. states to grant economic support freely to
industries operating in competitive sectors. In
Contingent liabilities many countries, the trend of late has been
Consideration of contingent liabilities also toward forcing government-owned entities to
varies internationally. Off-balance-sheet oblig- operate in a more self-sufficient manner—
ations can often be significant and subject to dubbed “corporatization”—and withdrawing
differing methods of calculation. For example, state support.
the practice of factoring receivables with The analyst considers the strategic impor-
recourse back to the company is common in tance of the firm to the country of domicile.
Japan. While some accounting systems treat Certain state-owned firms provide a vital ser-
this practice as a form of debt financing, vice or technology, often in fields relating to
Japanese companies simply report it as a defense, energy, telecommunications, or elec-
contingency. tronics. Such firms may be perceived to serve
Pensions are handled very differently in dif- national interests more than firms engaged in
ferent countries. For example, U.S. firms more basic industries. Also considered is a
explicitly reflect the pension asset/liability on firm’s economic importance—in terms of
their balance sheet, while German firms do not. employment, foreign-exchange generation,
Standard & Poor’s adds in any pension obliga- and local investment. Standard & Poor’s
tion when calculating ratios for German firms, meets with officials of sovereign governments
to incorporate a consistent view of these liabil- to ascertain their view of a firm’s strategic
ities. Other forms of contingent liabilities, such importance and potential sovereign support
as implicit financial support to nonconsolidat- for that issuer.
ed affiliated companies or projects, are also Analysis of an issuer on a stand-alone basis
common, and are factored into the analysis. allows the rating to reflect both the likelihood
of the issuer needing to seek external state sup-
Other national and regional factors port and the likelihood of receiving such sup-
Many international corporate issuers benefit port. Wherever a rating is notably higher than
from their status within the country or region it would have been on a stand-alone basis,
of domicile. This is particularly true for corpo- strong implicit ties to the sovereign state have
rates with significant state ownership. Other been confirmed in meetings with government
local factors that might affect an issuer’s finan- officials.
cial flexibility include access to local banks and
capital markets. Local ownership blocks
Concentration of ownership, resulting in
State ownership companies with cross shareholdings or com-
Without a guarantee or other form of formal mon parents, exists in several countries. Japan
support arrangement, a state-owned corporate and Korea, for example, have numerous indus-
issuer does not intrinsically carry the same level trial groupings that combine companies across
of credit risk as its sovereign owner. several industrial sectors. In Canada, Sweden,

Latin America, and Southeast Asia large net- issuers in a relatively small country are often in
works of family holdings are found. a favorable position to attract financing from
There are both positive and negative impli- that country’s banking system. Access to ready
cations of group affiliation. In many cases, a bank financing may be enhanced by cross
company may benefit from operating relation- shareholdings between a bank and an industri-
ships or greater access to financing. al firm or the development over time of a spe-
Conversely, a company’s group affiliation cial relationship with one or more banks. At
could bring responsibility for providing sup- the same time, certain issuers benefit from
port to weaker group companies. Standard & recognition and status within local capital
Poor’s assesses whether constraints on group markets. While access to public debt and equi-
influence, such as an external minority interest ty cannot be assumed, particularly in times of
position, justify rating an issuer on a stand- financial stress, prominence within local mar-
alone basis. If not, the analysis attempts to kets broadens a firm’s financial options. One
incorporate the economic and financial trends way to determine how well a company might
in the issuer’s affiliate group as well. compete for capital is by comparing its perfor-
mance to local peers in terms of local account-
Access to local sources of capital ing and financial norms.
An issuer’s standing within its home finan-
cial community is also considered. Large
LOCAL CURRENCY CREDIT RATING: FOREIGN CURRENCY CREDIT RATING:
A current opinion of an obligor’s overall A current opinion of an obligor’s overall

capacity to generate sufficient local currency capacity to met its foreign-currency-denomi-
resources to meet its financial obligations nated financial obligations. It may take the
(both foreign and local currency), absent the form of either an issuer or an issue credit
risk of direct sovereign intervention that may rating. As in the case of local currency credit
constrain payment of foreign currency debt. ratings, a foreign currency credit opinion on
Local currency credit ratings are provided on Standard & Poor’s global scale is based on the
Standard & Poor’s global scale or on separate obligor’s individual credit characteristics,
domestic scales, and they may take the form including the influence of country or economic
of either issuer or specific issue credit ratings. risk factors. However, unlike local currency rat-
Country or economic risk considerations per- ings, a foreign currency credit rating includes
tain to the impact of government policies on transfer and other risks related to sovereign
the obligor’s business and financial environ- actions that may directly affect access to the
ment, including factors such as the exchange foreign exchange needed for timely servicing
rate, interest rates, inflation, labor market con- of the rated obligation.
ditions, taxation, regulation, and infrastructure. Transfer and other direct sovereign risks
However, the opinion does not address trans- addressed in such ratings include the likeli-
fer and other risks related to direct sovereign hood of foreign-exchange controls and the
intervention to prevent the timely servicing of imposition of other restrictions on the repay-
cross-border obligations. ment of foreign debt.

Country Risk:
Emerging Markets
Standard & Poor’s rating criteria has always country environment add up to a lower rating
emphasized an appreciation of relevant local than the government’s—the most creditworthy
characteristics. In emerging markets, country entity in that country!)
risk takes on added importance. Outlined (Separately, there is the risk of direct govern-
below are examples of various country-specif- ment intervention—which is particularly ger-
ic factors, which pertain to every aspect of cor- mane to foreign currency ratings. That is dis-
porate analysis. cussed on page 37.)
The degree of concern to attribute to local
economic/political risk factors is a function of
the likelihood of their occurring. Sovereign rat- Business risk factors
ings provide much insight into the perceived Macroeconomic volatility. Does the coun-
likelihood of these risks coming into play. try’s economic track record suggest high
To acheive a local currency corporate rating volatility in the macroenvironment? This may
higher than the sovereign foreign currency rat- compound the constraint on credit quality typ-
ing would mean that the corporate can service ically associated with cyclical industries, since
its debts (not just survive as an ongoing con- they become even more cyclical, and may
cern) even under a scenario so severe—in terms experience stronger “booms” and “busts.”
of inflation, currency devaluation, and fiscal Access to imported raw materials. Is the
crisis—that it causes the government to default company heavily dependent on imported sup-
on its foreign currency debt. And to be higher- plies, and could the company’s operations
rated than the sovereign local currency rating therefore be interrupted if foreign-exchange
means that the corporate can continue to ser- controls are imposed by the sovereign?
vice its debt even under a scenario so severe— Exchange-rate risk. Is the exchange rate sub-
in terms of financial crisis, banking system col- ject to significant volatility, which could com-
lapse, political unrest, or even anarchy—that it press margins relative to global peers and/or
causes the government to default on its local affect demand for products?
currency debt. Government regulation. Is there a risk of the
History shows us that some companies government “changing the rules of the game,”
indeed have managed to honor their obliga- through import/export restrictions, direct
tions even under such stressful circumstances. intervention in service quality or levels,
But these instances are clearly the exception to redefining boundaries of competition such as
the rule, as all companies are extensively affect- service areas, altering existing barriers to entry,
ed by country factors. Nonetheless, companies changing subsidies, or changing antitrust legis-
that mitigate these specific risks can be rated lation? For extractive industries, what is the
higher than the sovereign, since their risk of risk of government contract renegotiation or
default may be lower. Even for such companies, nationalization? Are environmental regula-
there would normally be a limit on how far tions expected to tighten significantly; are local
above the sovereign the corporate rating lobbying groups gaining political clout in this
could go, considering how difficult it is to divine respect?
in advance how things will play out in crises. Taxes/royalties/duties. Does the company or
And the further away a country is from default its key investments enjoy tax subsidies or royal-
the more speculative such an undertaking ty arrangements that have renegotiation risk at
would be. (In the typical case, the com- the federal or regional level? Does the govern-
bination of ordinary corporate risks with the ment have a history of micro-managing the cur-
potential for problems associated with a risky

rent account balance through changing taxes or statements, which may not be required by local
duties on imports/exports/foreign borrowings? regulatory/accounting standards, can hinder
Legal issues. What is the transparency of the the analyst’s ability to assess overall cash flow
legal system? Does the type of legal system generation and debt service coverage. Lack of
(common vs. civil vs. Islamic) create differ- segment information may make it difficult to
ences in contract risks or treatment of creditor analyze properly profitability trends or project
rights, particularly with regard to collateral performance. Changes in overall accounting
and workout/bankruptcy situations? presentation, for example eliminating inflation
Labor issues. What is the potential for accounting without requiring restatement of
strikes? Is there inflexibility of regulations prior years, makes trend comparisons mean-
which may make firing workers an unrealistic ingless or difficult. Obtaining timely financial
or expensive option? statement reporting may be an issue.
Infrastructure problems. Are there potential Foreign-exchange risks. Does the company
bottlenecks, poor transport, high-cost/ineffi- hedge foreign-exchange risks, to the extent it is
cient port services? Is there a need to supply within its control to do so? Does the company
own electricity or other basic services/infra- show a propensity to speculate with financial
structure? arbitrage opportunities? (For example, does
Changing tariff barriers/trade blocs/ the company borrow in U.S. dollars to invest
subsidies. Are domestic companies protected in high interest rate local currency instruments,
by tariffs or other industry subsidies that are exposing itself to devaluation risk?)
likely to drop as governments liberalize their Family/group ownership issues. If the issuer
external trade regulations? Has/will the coun- is part of a conglomerate or family-controlled
try join a local trade bloc, which could imme- group of companies, is the company’s financial
diately drop tariffs on imports from members? policy dictated by the group, and are there
Corruption issues. Is corruption an issue in potential weaknesses at other group compa-
terms of raising the cost of business or creating nies that could negatively affect the issuer?
uncertainty about maintaining a “level playing Conversely, strong group ownership and sup-
field” for business? port can enhance creditworthiness.
Terrorism. Are there risks of attacks on the Profitability/cash flow:
companies facilities, kidnapping of key Potential price controls. These are particu-
employees? How has the company mitigated larly a threat for basic local goods or services,
these risks? such as telephone/electric services, or gasoline
Industry structure/operating environment. sales. At times of spiraling inflation (a risk cap-
Industry characteristics may be favorable or tured in the sovereign foreign currency rating),
unfavorable relative to global peers. For governments often try to assuage consumers
example, the cement industry in Mexico by controlling prices on highly visible goods or
is highly concentrated among two or three services, and under severe stress may freeze all
large players, versus a fiercely competitive prices in an effort to control inflation.
and fragmented U.S. market. Growth prospects Inflation/currency fluctuation risk. Where
for consumer products or new technologies and existing or potential high/accelerating infla-
services can offer tremendous opportunities, by tion is an issue, does the company have the
tracking expected population growth or increas- pricing flexibility, systems, and know-how to
ing per capita incomes, which may be offset by keep revenues increasing in-line with or ahead
other risks. For example, demand for cellular of costs? Will import prices of supplies be
telephones in many emerging markets that are affected by devaluation? How well matched,
underserved is exploding, yet there are still limi- by currency, are revenues and costs? Does a
tations due to relatively low per capita incomes mismatch expose the company to devaluation
and changing regulations, which may allow new or, for exporters, currency appreciation risk,
forms of competition. which can lead to sustained reductions in
profitability?
Financial risk factors Restricted access to subsidiary cash flow. Is
Financial policy: access to cash flows of foreign subsidiaries
Disclosure/local accounting standards constrained by potential transfer/convertibility
issues. Does the company provide consolidated risk?
financial statements? The lack of consolidated

Capital structure/financial flexibility:

Inflation accounting. Does local accounting stress, the local banking system would be suf-
tend to overstate fixed asset values, which fering illiquidity due to high capital flight. A
leads to understated or noncomparable lever- weak or poorly regulated local banking system
age ratios? As a consequence of overstated can introduce additional volatility. Moreover,
fixed asset values, high depreciation charges Latin American-based companies typically do
may lead to relatively understated earnings. not have access to committed credit lines.
Devaluation risk. Does the currency of debt Debt maturity structure. For emerging mar-
obligations expose the company to devalua- ket issuers, concentration in short-term debt,
tion risk? How well matched by currency are whether dollar- or local-currency denominat-
revenues versus debt? Companies with local ed, exposes the company to critical rollover
currency revenue stream and dollar- risk.
denominated debt see their earnings power Local dividend payout requirements. Do
severely hurt relative to debt service when the the requirements make dividends more like a
government devalues the currency. While fixed cost? In Chile, public companies must
local inflation eventually may allow comp- pay out a minimum 30% of net income as div-
anies to raise prices enough to compensate, idends, while Brazil has a 25% minimum
this process generally takes time, as weak local requirement. On the other hand, this explicit
market conditions or price controls limit price link of payments to profits gives companies
flexibility. more flexibility to lower dividends when prof-
Access to capital. This is often a key con- its decrease.
straint for emerging market issuers, which Liquidity restrictions. Is the company’s liq-
broadly penalizes their credit quality relative uid asset position held in local government
to those of firms in developed markets. Even bonds, local banks, or local equities, and will
the strongest emerging market private-sector the issuer have access to these assets at times of
issuers have had difficulties accessing local or stress on the sovereign. For example, local
international capital markets during periods of bank deposit freezes accompanied the sovereign
stress. Thin domestic capital markets stress scenarios in Ecuador in 1998/1999
prevent companies from accessing local mar- and in Argentina in 2002.
kets at reasonable rates as well; at times of

Sovereign Risk
Sovereign credit risk is always a key consid- From 1975-1995, Standard & Poor’s has
eration in the assessment of the credit standing documented 69 cases of sovereign default on
of banks and corporates. Sovereign risk comes either bond or bank debt. Of those defaulting
into play because the unique, wide-ranging countries where there was significant private-
powers and resources of a national govern- sector external debt outstanding at the time,
ment affect the financial and operating envi- private-sector borrowers defaulted in 68% of
ronments of entities under its jurisdiction. Past the cases.
experience has shown time and again that The key elements to consider are:
defaults by otherwise creditworthy borrowers • The economic, business, and social envi-
can stem directly from a sovereign default. ronments that influence both the sovereign’s
In the case of foreign currency debt, the sov- own rating and those of issuers domiciled
ereign has first claim on available foreign there. (Refer to previous section.)
exchange, and it controls the ability of any res- • The ways in which a sovereign can direct-
ident to obtain funds to repay creditors. To ly or indirectly intervene to affect the ability
service debt denominated in local currency, the of an entity to meet its offshore debt obliga-
sovereign can exercise its powers to tax, to tions, even if that entity has sufficient funds
control the domestic financial system, and on hand to meet that obligation.
even to issue local currency in potentially
unlimited amounts. Given these considera- Actions by the sovereign
tions, the credit ratings of nonsovereign bor- Sovereign governments in many countries
rowers most often are at, or below, the ratings act to constrain an issuer’s ability to meet off-
of the relevant sovereign. shore debt obligations in a timely manner.
While “sovereign ceiling” is an inappropriate While higher-rated sovereigns are not expected
term, Standard & Poor’s always assesses the to interfere with the issuer’s ability to use avail-
impact of sovereign risk on the creditworthiness able funds to meet such offshore obligations,
of each issuer and how it may affect the ability the chances of some form of intervention
of that issuer to fulfill its obligations according increase significantly for entities domiciled in
to the terms of a particular debt instrument. This lower-rated nations.
is done in a more flexible manner than the term At a time of local economic stress, when for-
“ceiling” suggests, by looking at the issuer’s own eign exchange is viewed as an increasingly
position and ability to meet its obligations in scarce and valuable commodity, the likelihood
general, as well as the particular features of a of direct constraint, intervention, or interference
specific obligation that might affect its timely with access to foreign exchange can be high. For
payment. For example, geographic diversifica- this reason alone, it is unlikely that most issuers’
tion or support by an external parent tends to ability to meet offshore debt obligations in a
add to the overall creditworthiness of a borrow- timely manner can be viewed as more probable
er and to lessen its exposure to sovereign action. than their sovereign’s own likelihood of meeting
Also, borrowers may add features to specific their offshore debt obligations.
debt issues, such as external guarantees, or they Even when the issuer has sufficient funds to
may structure them in particular ways, such as meet its offshore debt obligations, the sover-
asset-backed transactions, that enhance the like- eign may absolutely prohibit, or otherwise
lihood of payment. Nevertheless, for most inter- constrain, the issuer from meeting those oblig-
national debt issuers, the sovereign risk factor ations in a timely manner. Such constraint can
remains an extremely important consideration in take many forms. During 2002, for example,
the assignment of overall creditworthiness. the Argentinean government rationed

the availability of foreign exchange to private- ized marketing authority, or the posting of a
sector entities to the point that some of these significant bond prior to the export of goods
entities defaulted on foreign currency debt to assure immediate repatriation of
obligations, despite many of these same firms proceeds;
having sufficient funds to meet these obliga- • Implementing restrictions on inward and
tions in a timely manner if access to foreign outward capital movements;
exchange had been possible. • Refusing to clear a transfer of funds from
However, sovereign governments do not one entity to another;
necessarily treat all types of debt obligations • Revoking permission to use funds to repay
equally. In the past, even in situations where debt obligations;
the sovereign itself was in default on some of • Mandating a moratorium on interest and
its debt, permission has been granted for cer- principal payments, or required rescheduling
tain obligations to be met on a timely basis. or restructuring of debt; and
Trade credits are often distinguished from cap- • “Nationalizing” the debt of an issuer and
ital market instruments. In several instances in making it subject to the same repayment
the 1980s, bond debt issued by private Latin terms or debt restructuring as that of the
American entities continued to be serviced sovereign.
even while bank loans were being rescheduled, The past record of a particular sovereign can
although at that time bond debt was relatively indicate the potential for imposition of con-
low. With bond debt increasing as a propor- trols in the future. Some sovereigns have dis-
tion of the total, future situations could be played much more restraint in applying con-
quite different. Standard & Poor’s expects that trols to private capital movements than others,
sovereigns will continue to discriminate among and such a positive track record is incorporat-
the wide range of issues in the future, permit- ed into the assessment of both the sovereign
ting some to proceed while constraining oth- itself and entities domiciled in that country. In
ers. Therefore, each obligation must be ana- addition, different types of obligations may
lyzed on its own merits in the rating process have been treated differently. However, a good
and the likely government action with respect track record is not, in and of itself, definitive
to that type of obligation addressed. proof that the sovereign would not impose
A sovereign government under severe eco- controls of some type at some point in the
nomic or financial pressure seeking to retain future in a period of severe economic stress.
valued foreign currency reserves in the country, Conditions change and governments change.
and which may not be able to meet, or already One key element in this evaluation is
has not met, its timely obligations on offshore whether, and to what degree, a particular
debt, could impose many constraints on other transaction fits within the national priorities.
governmental or private-sector borrowers, For example, when a government is actively
including: encouraging exports, a transaction specifically
• Setting limits on the absolute availability tied to export promotion might be favored and
to foreign exchange; remain exempt from restrictions even while
• Maintaining dual or multiple exchange other transactions, which do not fulfill such
rates for different types of transactions; national objectives, are constrained. In addi-
• Making it illegal to maintain offshore or tion, when specific permission for a transac-
foreign currency bank accounts; tion has been granted, a sovereign might be
• Requiring the repatriation of all funds held more reluctant to withdraw such permission,
abroad, or the immediate repatriation of or may “grandfather” that particular transac-
proceeds from exports and conversion to tion, while future transactions are constrained
local currency; or prohibited. It is therefore possible that some
• Seizing physical or financial assets if for- debt issues of a particular borrower are not
eign-exchange regulations are breached; highly subject to sovereign interference, while
• Requiring that all exports (of the goods in others issued by the same entity are.
question) be conducted through a central-

Government ownership and Governing law

regulation The law governing a specific debt issue, as
Many of the entities issuing debt that are well as other legal factors, may be relevant in
domiciled in low-rated countries are partially, evaluating whether a sovereign could affect
or completely, government owned. If foreign- timely payment on a debt obligation. However,
exchange controls are imposed, it is unlikely Standard & Poor’s exercises caution in placing
that government-owned institutions would be weight on the legal factor. When sovereign
permitted or would choose to circumvent gov- powers are involved, issues such as conflicts of
ernment controls. law, waivers, and permission to hold and use
The same holds true for entities that are funds held outside the country of domicile are
highly regulated by the government, even with- confused at best and would likely be tested and
out a direct ownership tie. This includes most resolved by the courts only after, rather than
financial institutions and regulated utilities. prior to, a default.
Thus, it is unlikely that a government-owned
entity, or one that is highly regulated, could be Special cases
viewed as more creditworthy than the sover- In some instances, an issuer is technically
eign itself in terms of meeting foreign currency domiciled in a particular country for tax or
obligations. reasons other than business undertaken within
that country. For example, issuers domiciled in
Duration of controls certain specified financial centers, such as the
When controls or restrictions are imposed, Cayman Islands, are viewed as independent of
their duration cannot be predicted. In some that financial center’s sovereign risk. No sub-
instances, controls have lasted for only a few stantial business is undertaken within that
weeks or months, and in some others, they jurisdiction; no substantive assets are main-
have been applied selectively. In still other tained in that jurisdiction; and the issuer could
cases, they have been much longer-lasting and change its location quickly and without risk to
all-encompassing. A rating cannot be based on the debtholder should the sovereign impose
a guess as to the duration or comprehensive- any form of controls or onerous taxes.
ness of controls, and analysis cannot determine Multilateral lending institutions, such as the
that controls would be in place for a specific International Bank for Reconstruction and
(short) period of time. Accordingly, liquidity Development (World Bank), the International
and parental support which would only tem- Finance Corporation (IFC), and the
porarily serve to meet debt service are not suf- Interamerican Development Bank (IADB),
ficient to justify a higher rating in themselves. enjoy preferred creditor status. By virtue of the
A reserve fund of one year’s payments or borrowing country’s membership in the lend-
even longer cannot be assumed sufficient to ing organization and as a condition of eligibil-
overcome the impact of controls. Reserve funds ity to receive loans, the country assures that it
may be used for some transactions—to cover will not impose any currency restriction or
the temporary interruption of supply for an other impairment to the repayment of such
export receivables deal, for example—but not loans. In some cases, the treaty establishing the
to deal with the potential imposition of cur- organization also specifies such special treat-
rency controls or similar actions that may pre- ment of loans by member nations. Often these
vent the payment on debt. loans, while made to other, nonsovereign enti-

ties, are also guaranteed by the borrowing while other borrowings from banks or other
country, and the lending institution has a poli- lenders have fallen into default. One analytical
cy that no further loans will be granted to bor- element is assessing the creditworthiness of
rowers in that country if any loans are in these loans in the proportion of a country’s
default. total external indebtedness made up of this
These factors give the borrowing country type of obligation. The larger the proportion,
strong incentives to maintain timely loan the more difficult it may be for the country to
repayment. The result has been an excellent meet these in a timely manner and preserve
repayment record for such obligations even their special status.

Factoring Cyclicality
into Corporate Ratings
Standard & Poor’s credit ratings are meant to ratings to a company enjoying peak prosperity
be forward-looking; that is, their time horizon if that performance level is expected to be only
extends as far as is analytically foreseeable. temporary. Similarly, there is no need to lower
Accordingly, the anticipated ups and downs of ratings to reflect poor performance as long as
business cycles—whether industry-specific or one can reliably anticipate that better times are
related to the general economy—should be fac- just around the corner.
tored into the credit rating all along. This The rating profile of the chemical industry
approach is in keeping with Standard & Poor’s offers a good illustration of Standard & Poor’s
belief that the value of its rating products is long-term approach. Ratings for the major
greatest when its ratings focus on the long term, industry participants have been highly stable
and do not fluctuate with near-term perfor- over a 12-year period, which has included two
mance. Ratings should never be a mere snapshot full industry cycles.
of the present situation. There are two models However, rating through the cycle is often
for how cyclicality is incorporated in credit rat- the incorrect model. One reason is that rating
ings. Sometimes, ratings are held constant through the cycle requires an ability to predict
throughout the cycle. Alternatively, the rating the cyclical pattern—and this is usually diffi-
does vary—but within a relatively narrow band. cult to do. If indeed there is such a thing as a
“normal” cycle, it is rare. The phases of the
Cyclicality and business risk latest cycle will probably be longer or shorter,
Cyclicality is, of course, a negative that is steeper or less severe, than just repetitions of
incorporated in the assessment of a firm’s busi- earlier cycles. Management’s determination to
ness risk. The degree of business risk, in turn, learn from previous cycles itself implies that
becomes the basis for establishing ratio stan- “things will be different this time.” Interaction
dards for a given company for a given rating of cycles from different parts of the globe, and
category. (The ratio guidelines that Standard & the convergence of secular and cyclical forces
Poor’s publishes are expressed as a matrix, so further complicate things.
that the degree of business risk is explicitly rec- Moreover, even predictable cycles can affect
ognized.) The analysis then focuses on a firm’s individual firms so as to have a lasting impact
ability to meet these levels, on average, over a on credit quality. For example, a firm may
full business cycle, and the extent to which it accumulate enough cash in the upturn to miti-
may deviate and for how long. gate the risks of the next downturn. (The Big
The ideal is to rate “through the cycle” (see Three automobile manufacturers have been
chart 1). There is no point in assigning high able—during the most recent cyclical
Chart 1
upswing—to accumulate huge cash hoards
that should exceed cash outflows anticipated
in future recessions.) Conversely, a firm’s busi-
ness can be so impaired during a downturn
AA Corporate Standard & Poor's
that its competitive position may be perma-
performance Rating
nently altered. In the extreme, a company will
A
not survive a cyclical downturn to participate
in the upturn!
BBB
Accordingly, ratings may well be adjusted
with the phases of a cycle. Normally, however,
the range of the ratings would not fully mirror
Time
the amplitude of the company’s cyclical highs

or lows, given the expectation that a cyclical that the characteristics of future cycles are
pattern will persist. The expectation of change readily foreseeable. The very term “cycle”
from the current performance level—for better seems to imply regularity. In actuality, this is
or worse—would temper any rating action, seldom the case.
even absent a totally clear picture of the cycli- Cyclicality encompasses several different
cal pattern. In most cases, then, the typical phenomena that can affect a company’s per-
relationship of ratings and cycles might look formance. General business cycles, marked by
more like chart 2. fluctuations in overall economic activity and
demand, are only one type. Demand-driven
Chart 2
cycles may be specific to a particular industry.
For example, product-replacement cycles lead
to volatile swings in demand for semiconduc-
AA Corporate Standard & Poor's tors. Other types of cycles arise from varia-
performance Rating
tions in supply, as seen in the pattern of capac-
A ity expansion and retrenchment that is charac-
teristic of the chemicals, forest products, and
BBB metals sectors. In some cases, natural phenom-
ena are the driving forces behind swings in
supply. For example, variations in weather
Time
conditions result in periods of shortage or sur-
plus in agricultural commodities.
The ratings of the forest products industry The confluence of different types of cycles is
reflect such a pattern. not unusual. For example, a general cyclical
Sensitivity to cyclical factors—and ratings upturn could coincide with an industry’s con-
stability—also varies considerably along the struction cycle that has been spurred by new
rating spectrum. The creditworthiness of non- technology. The interrelationship of different
investment-grade firms is, almost by definition, national economies is an additional complicat-
more volatile. Moreover, the lowest credit rating factor.
ing categories often connote the imminence of All these cycles can vary considerably in
default. As the credit quality of a company is their duration, magnitude, and dynamics. For
increasingly marginal, the nature and timing of example, the unprecedented eight years of
near-term changes in market conditions could uninterrupted, robust economic expansion in
mean the difference between survival and fail- the U.S. that followed the 1982 trough was
ure. A cyclical downturn may involve the threat totally unforeseen. On the other hand, there
of default before the opportunity to participate was no basis to assume in advance that the
in the upturn that may follow. Accordingly, downturn that followed would be so severe,
cyclical fluctuations will usually lead directly to albeit relatively brief. Indeed, at any given
rating changes—possibly even several rating point, it is difficult to know the stage in the
changes in a relatively short period. Conversely, cycle of the general economy, or a given indus-
a cyclical upturn may give companies a trial sector. A “plateau” following a period of
breather that may warrant a modest upgrade or demand growth might indicate that the peak
two from those very low levels. has been reached—or it could represent a
In contrast, companies viewed as having pause before the resumption of growth.
strong fundamentals—that is, those enjoying Even general downturns vary in their
investment-grade ratings—are unlikely to see dynamics, affecting industry sectors different-
their ratings changed significantly due to fac- ly. For example, the soaring interest rates that
tors deemed to be purely cyclical—unless the accompanied the recession of 1980-1981 had a
cycle is either substantially different from what particularly adverse affect on sales of con-
was anticipated or the company’s performance sumer durables, such as automobiles.
is somehow exceptional relative to what had Sometimes, sluggish demand for large-ticket
been expected. items can spur demand for other, less costly
consumer products.
Analytical challenges In any case, purely cyclical factors are diffi-
The notion of “rating through the cycle,” cult to differentiate from coincident secular
while conceptually appealing, presupposes changes in industry fundamentals, such as the

emergence of new competitors, changes in companies, but entire industries. Favorable

technology, or shifts in customer preferences. market conditions may spur industry-wide
Similarly, it may be tempting to view cyclical acquisition activity or capacity expansion.
benefits—such as good capacity utilization— Standard & Poor’s is also cognizant that
as a secular improvement in an industry’s public sentiment about cyclical credits may
competitive dynamics. fluctuate between extremes over the course of
A high degree of rating stability for a com- the cycle, with important ramifications for
pany throughout the cycle also should entail financial flexibility. Whatever Standard &
consistency in business strategy and financial Poor’s own views about the long-term staying
policy. In reality, management psychology is power of a given company, the degree of pub-
often strongly influenced by the course of a lic confidence in the company’s financial via-
cycle. For example, in the midst of a pro- bility is critical for it to have access to capital
longed, highly favorable cyclical rebound, a markets, bank credit, and even trade credit.
given management’s resolve to pursue a con- Accordingly, the psychology and the percep-
servative growth strategy and financial policy tions of capital providers must be taken into
may be weakened. Shifts in management account.
psychology may affect not just individual

Regulation
The regulatory relationship can be a benign and should allow for consistent performance—
one—or it can be adversarial. It affects virtual- if it is to be viewed positively in the ratings
ly all corporates to one extent or another, and context.
is obviously critical in the case of utilities—
where it is a factor in all assessments of Aspects of Regulation
business risk. The role of the regulator is evident in:
Evaluation of governmental involvement/ • Rate setting,
regulation encompasses legislative, administra- • Operational oversight, and
tive, and judicial processes at the local and • Financial oversight.
national levels. This evaluation considers the Setting rates is obviously important. To sup-
current environment—and the potential for port credit quality, a utility must be assured of
change. For example, a system that requires earning a fair—and consistent—rate of return.
legislative action to modify regulations is more Different regulators can be more—or less—
stable—and is viewed more positively—than generous with respect to the levels allowed —
one that is subject to ministerial whim, as or with respect to which assets are included in
exists in some Asian countries. Similarly, a reg- the “returns” calculations. They can choose to
ulatory framework enacted with regard to a overlook—or to penalize—a utility for any
recently privatized system is more prone to be service shortcomings in service.
revisited by government regulators. Operational regulation pertains to technolo-
The impact of regulation runs the gamut— gy, to environmental protection considera-
from regulation’s providing of direct, tangible tions, safety rules, facility siting, and service
support to its being a hindrance. For a utility levels—and the freedom a company has to pur-
business profile to be considered “well above sue initiatives involving each of these areas.
average” usually requires strong evidence of Regulatory inflexibility can hamstring the util-
government support or regulatory sheltering. ity in its attempt to be competitive. For exam-
Support can be explicit—such as in Canada and ple, if a utility faces new competition for its
in other locales where a government guarantees large users, it may want to lower the rates it
a utility’s obligations. Or it can take the form of charges its commercial/industrial customers—
strong and obvious implicit support, such as in and make up its lost revenues by raising the
Greece. rates at the expense of residential customers.
Japanese investor-owned utilities have his- The regulators may object and insist that resi-
torically been insulated from competition and dential rates continue to be subsidized—creat-
been protected by a very cooperative, coordi- ing a problem for the company.
nated, rate-setting process. Other governments Financial oversight refers to the regulator’s
may facilitate the utility’s access to external ability to maintain—and interest in maintain-
sources of capital, especially where the utility ing—a particular level of credit quality at the
is a direct instrument of government policy. In utility. This is a separate consideration from
the U.S., municipally owned utilities have also how benign the relationship might be in other
been sheltered—at least they have in the past. respects. If the situation warrants it, the rating
(Deregulation has unleashed competitive pres- evaluation may rely on the regulator to
sures, but politics makes it difficult to make enforce—or at least encourage—a certain level
adjustments that would affect either residential of financial strength at the utility. In this
rates or the city’s own general fund.) respect, the regulator’s role can take different
Short of such outright support, regulatory forms:
treatment should be transparent and timely

• Approval is the most basic element. That a negatively affected—since it is deprived of full
utility requires approval to sell debt or pay access to the subsidiary’s assets and cash flow.)
dividends creates an obstacle with respect to With utilities’ competition and consolidation
its fiscal aggressiveness. increasing and with shifts to new forms of reg-
• Influence refers to the economic incentives ulation that are coming into existence, howev-
that a regulator can provide to maintain a er, there is less reason to expect such regulato-
certain level of credit quality. In jurisdictions ry intervention. Just as there is less and less
with rate-of-return regulation, regulators can basis to rely generally on regulators to main-
effectively mandate their view of an “appro- tain a level of credit quality—as discussed
priate” balance sheet by specifying return on above—so, too, there is less basis for regulato-
equity. Even when regulation is not classic ry separation.
“rate base rate of return”—such as with Rating policy has evolved in tandem with
price cap or banded rate of return—regula- these trends. The bar has been raised with
tors may still desire a minimum level of cred- respect to factoring in expectations that regu-
it quality. In past Standard & Poor’s surveys, lators would interfere with transactions that
regulators articulated a concern about credit would impair credit quality. To achieve a rat-
quality’s falling below ‘A’. Now, however, ing differential for the subsidiary requires a
attitudes are changing about regulating with higher standard of evidence that such interven-
an eye toward credit quality. tion would be forthcoming. (See sidebar
• Regulatory mandate—the explicit demand “Telecommunications Ratings Policy
of a specified level of credit quality—is rare Revised.”)
today. In the past, some regulators would In the past, the mere existence of regulation
impose penalties if a company’s credit rating was given considerable weight when determin-
dropped below the desired minimum. ing the adequacy of protection for the sub-
As competition intensifies, regulators have sidiary’s assets and cash flow. Now Standard
focused on service quality, and are less con- & Poor’s analyzes regulatory insulation on a
cerned with credit quality. (After all, even a case-by-case basis. The key is a regulator’s
bankrupt utility can continue to deliver ser- demonstrated willingness to protect creditwor-
vices!) Of course, not all regulatory jurisdic- thiness. Some examples of U.S. state jurisdic-
tions will follow the trend in identical fashion. tions where protective measures have been
In the U.S., there are currently few instances implemented are Oregon, New York, Virginia,
where ratings rely heavily on regulators to and California.
maintain credit quality; outside the U.S., how- The Oregon Public Utilities Commission
ever, there is a greater basis for depending on approved the Enron Corp./Portland General
regulators in this regard. Electric Co. merger, based on various restric-
tive conditions. Likewise, the New York Public
Regulatory Separation Service Commission, in approving the Keyspan
Utilities are often owned by companies that Energy/Long Island Lighting Co. merger,
own other, riskier businesses or that that are required a cap on leverage, a prohibition of
saddled with an additional layer of debt at the certain types of loans, and a limit on holding-
parent level. Corporate rating criteria would company investment in nonutility operations.
rarely view the default risk of an unregulated Outside the U.S., regulators in many coun-
subsidiary as being substantially different from tries still play a more significant role in the
the credit quality of the consolidated economic finances of utilities—making the case for reg-
entity (which would fully take into account ulatory separation in those countries.
parent-company obligations). Regulated sub- Moreover, some recent transactions—notably
sidiaries can be treated as exceptions to this in the U.K.—have employed (or at least have
rule—if the specific regulators involved are considered employing) structural insulation
expected to create barriers that insulate a sub- techniques to achieve “ring-fencing” for the
sidiary from its parent. acquired utility subsidiary. In these instances,
In those cases that benefit from regulatory setting up independent directors, minority
insulation, the rating on the subsidiary is more ownership stakes, and so forth combine with
reflective of its “stand-alone” credit profile. regulatory oversight to insulate the subsidiary
(As a corollary, the parent-company rating is and achieve higher ratings.

TELECOMMUNICATIONS RATINGS POLICY REVISED

Standard & Poor’s no longer allows the cor- ed Standard & Poor’s assessment that there
porate credit rating (CCR) of a regulated tele- was sufficient evidence that specific state reg-
phone operating company to be higher than ulators could and would use their regulatory
the CCR of its parent. role to ensure maintenance of some minimum
The revised approach represents a further credit quality. As a result of that methodology
evolution of the rating methodology for U.S. revision, there were a number of rating
local exchange companies (LECs) that reflects changes that narrowed the rating gap between
the important regulatory and business devel- higher-rated telephone operating subsidiaries
opments that have occurred in the telephone and their respective parents.
industry recently. The impact of the policy, on The new methodology that Standard &
companies for which the former regulatory Poor’s now uses recognizes the vast industry
separation methodology was applicable, in changes that have occurred in the three years
general, is a lowering of telephone operating since the Telecommunications Act of 1996,
company CCRs and a raising of parent amounting to a secular transformation of the
company CCRs. telecommunications’ competitive environment,
Regulatory separation is the factor that and tangible evidence of regulators’ lack of
historically enabled telephone operating com- response to credit-weakening events.
panies to have higher debt ratings than their
Of LECs and CLECs
parent companies. (In contrast, for nonutility
In general, although LECs still maintain very
corporates, subsidiary debt ratings have, all
favorable market positions, the days of the LEC
along, been constrained by the rating of the
monopoly are clearly numbered. Driven by the
parent.) This constraint is based on the con-
regulatory changes resulting from the
cept that, although a subsidiary may—on a
Telecommunications Act of 1996 and fast-
stand-alone basis—appear to be a better
moving technological developments, competi-
credit than its parent, the financially less-cred-
tive local exchange companies (CLECs) are
itworthy parent ultimately controls the sub-
becoming formidable competitors to the LECs.
sidiary’s financial actions and so can avail
In addition to the vast number of CLECs enter-
itself of the financial resources of the sub-
ing the market for both voice and data, AT&T
sidiary. Under Standard & Poor’s regulatory
Corp. is poised to be a major alternative tele-
separation methodology, LECs were deemed to
phone provider. AT&T’s goal is not just to be
benefit from a buffer between the LEC sub-
the largest cable provider, but to modify the
sidiary and its parent—that buffer arising from
wires of its owned and affiliated cable sys-
the ability and willingness of state regulators
tems to offer local telephone service to mil-
to impose some level of credit quality at the
lions of potential customers. This multibillion-
regulated subsidiary.
dollar investment in cable upgrades, if suc-
In April 1997, following a review of the sta-
cessful, would make AT&T the largest CLEC,
tus and impact of regulatory separation,
putting it in direct competition with its former
Standard & Poor’s modified its criteria regard-
regional Bell operating company affiliates.
ing the application of regulatory separation and
The growth of CLECs and the potential for
the impact on ratings of U.S. telephone parent
lower-cost wireless service as a wireline
companies and their LEC subsidiaries. The 1997
replacement portend genuine competition for
policy revision acknowledged the continued,
most regulated LECs. This more competitive
but generally decreasing, impact of regulatory
environment will erode the historical notion
separation on ratings and led to modified
that the LEC was a bottleneck monopoly of a
guidelines for assessing the ratings impact of
vital service. It was this view of the LEC as a
regulatory separation. These guidelines reflect-

TELECOMMUNICATIONS RATINGS POLICY REVISED (CONTINUED)

monopoly of a vital public service that led to Commission (PSC), the rating downgrade will
the regulatory view that such companies restrict dividends from Frontier for a period of
should exhibit a pristine balance sheet. time, importantly, the PSC did not try to pre-
Accordingly, state regulators are likely to shift vent the acquisition.
their regulatory focus away from oversight of a Similarly, Standard & Poor’s lowered its
company’s financial policy and toward ensur- CCR on Cincinnati Bell Telephone Co. (CBT) to
ing an open marketplace. Specifically, ‘BBB-’ from ‘AA-’ following parent company
Standard & Poor’s anticipates that regulators Cincinnati Bell Inc.’s (doing business as
will increase efforts to ensure that competitors BroadWing Inc.) acquisition of ‘B’-rated IXC
to the LECs have the necessary tools, including Communications Inc. This acquisition was
collocation and the ability to purchase the dependent on obtaining Ohio Public Utilities
existing network elements, to mount a chal- Commission (PUCO) approval prior to debt
lenge to the entrenched LEC. This expected issuances at CBT, thereby limiting the parent
shift in the regulatory paradigm means that company’s ability to leverage the telephone
state regulators will be increasingly less likely operating company. However, despite the
to provide a financial buffer between the credit pressures placed on CBT by its parent’s
telephone operating company and its parent. proposed purchase of the much lower rated
Protection that formerly inured to bondholders IXC, PUCO did not create any roadblocks for
of the telephone operating company will consummation of the transaction or impose
dissipate. any financial penalty on CBT for a weaker
In addition to the technical and regulatory credit profile.
trends noted above, there is also tangible evi- In June 1999, US West Communications
dence that the notion of bondholder protection Inc., rated ‘A+’, announced it would be
from regulatory separation is becoming obso- acquired by Qwest Communications
lete. During the past couple of years, regula- International Inc. Standard & Poor’s noted that
tors have had the opportunity to react to merg- the CCR of the combined entity could fall as
er proposals that weakened the credit quality low as ‘BBB-’. The thrust of regulatory concern:
of the regulated company. In fact, the regulato- areas of service quality, ensuring access by
ry response has generally been focused on competitors to the US West network, and
open market and service quality issues, and interoperability of operating systems between
has not been focused on the issue of diminu- US West and competitors. The issue of lower
tion of the regulated operating companies’ credit quality at US West, at this juncture,
credit quality. does not appear to be a hurdle factor in gain-
ing regulatory approval.
Recent Industry Actions
Standard & Poor’s believes that the preced-
When Global Crossing Ltd. announced its
ing examples of regulatory responses are
ambition to purchase Frontier Telephone of
supportive of its revised telephone rating
Rochester Inc. (Frontier), Standard & Poor’s
methodology that recognizes a new regulatory
indicated that the Frontier ratings could fall
and competitive paradigm. Telephone compa-
significantly. Indeed, the Frontier CCR was
nies can expect to deal with an array of
eventually lowered to ‘BB+’ from ‘AA-’ as a
increasingly formidable competitors, and tele-
result of the Global Crossing transaction.
phone company bondholders can no longer
Although, because of an earlier agreement
look to state regulators for protection.
with the New York State Public Service

Loan Covenants
Rationale for Covenants • Signals and triggers. Signals and triggers
Covenants provide a framework that lenders assure the steady flow of information, provide
can use to reach an understanding with a bor- early warning signals of credit deterioration,
rower regarding how the borrower will con- and place the lender in a position of influence
duct its business and financial affairs. The should deterioration occur. Since triggers can
stronger the covenant package is, the greater bring the parties to the table, to enable the
the degree of control the lender can exercise lender to decide whether it might be appropri-
over the investment. Borrowers typically seek ate to modify or waive restrictions, they must
the least restrictive covenant package they can therefore be set at appropriate levels, to signal
negotiate, since they want maximum flexibility deterioration before the credit drops to unac-
to conduct their business in the way they see fit. ceptable levels. Among tests that perform this
Covenants’ intended functions include: function are net-worth maintenance tests,
• Preservation of repayment capacity. Some cross-default provisions, and merger and con-
covenants limit new borrowings and assure solidation restrictions.
lenders that cash generated both from ongoing In many cases, covenants can serve more
operations and from asset sales will not be than one function. For example, a well-written
diverted from servicing debt. Covenants can debt test will not only help preserve repayment
prevent shareholder enrichment at the expense capacity, but will also serve as a signal of
of creditors. Credit quality is preserved by potential credit deterioration and provide pro-
share-repurchase and dividend restrictions, tection against damaging recapitalizations.
which seek to maintain funds available for Public-market participants long ago stopped
debt service. Finally, to ensure that the base of demanding significant covenant protection,
earning assets is maintained, covenants can perhaps because poorly written covenant
govern asset sales and investment decisions. packages with weak tests and significant loop-
• Protection against financial restructurings. holes enabled managements to circumvent
All lenders are concerned with the risk of a them. Furthermore, in a widely held transac-
sudden deterioration in credit quality that can tion, a covenant violation that normally would
result from a takeover, a recapitalization, or a be waived could deteriorate into a payment
similar restructuring. Properly crafted default, due to the difficulty of having all the
covenants may prevent some of these credit- investors act in unison. Moreover, investors in
damaging events from occurring without the publicly traded debt instruments have little
debt’s first having been repaid or the pricing’s interest in working with borrowers and proba-
first having been adjusted. bly have fewer resources to do so. Their pri-
• Protection in the event of bankruptcy or mary protection is their ability to sell their
default. These covenants preserve the value of investments if things should turn sour.
assets for all creditors and—what is particular- Traditional private-placement investors and
ly important—safeguard the priority positions bank lenders do have the resources and the
of particular lenders. Such covenants assure the expertise to work out problem credits. Such
lenders that subsequent events or actions will investors negotiate covenant packages careful-
not materially affect their ultimate recourse. ly, to give themselves the most advantageous
Protection is provided through negative-pledge position from which to exercise control, and
clauses, cross-acceleration (or cross-default) they expect to be compensated adequately for
provisions, and limits on obligations that either accepting covenants that are weak, those that
are more senior or rank equally. might allow management more leeway to
cause a deterioration in credit quality.

In general, covenant packages are more For all these reasons, in most cases, Standard
relaxed than in the past, however, because, & Poor’s does not believe that a particular
now, liquidity has increased, and financial covenant or group of covenants can improve a
markets broadened. rating. Generally, there is no point in analyzing
fine variations among different covenant pack-
Covenants and Ratings ages, which certainly will not affect a particu-
Covenants do not play a significant enhanc- lar borrower’s ability to meet its obligations in
ing role in determining the credit ratings a timely fashion.
assigned to companies. In assigning ratings, Relying on covenants to insulate a sub-
there are several flaws in a strategy of relying sidiary from its parent company is similarly
on covenants to protect credit quality: problematic. Accordingly, Standards & Poor’s
• Covenants don’t address fundamental would usually not rate a subsidiary based on
credit strength. Covenants do not and cannot its strong “stand-alone” profile, even if there
affect the borrower’s facing business adversity, were significant covenant restrictions.
competitive reverses, and so forth. The level of The main reason to be aware of a rated enti-
a covenant is often inconsistent with the rating ty's covenants is quite the opposite: Tight
level desired. For example, a covenant that covenants could imperil credit quality by, in the
allows a company to leverage itself no more event of their violation, provoking a crisis with
than 60% has little bearing on the company’s the lenders, since the lender would have the dis-
achieving a ‘BBB’ rating, if 40% is the maxi- cretion to accelerate the debt, causing a default
mum leverage tolerated for that specific that might otherwise have been avoided.
company as a ‘BBB’. A covenant package can be helpful as an
• Enforcement is dubious. A company that is expression of management’s intent. Since most
determined to do so can often, with the assis- companies (especially public companies)
tance of its lawyers, find ways to evade the let- would be expected to honor, not evade, com-
ter of the agreement embodied in covenants. mitments they make, covenants can provide an
They could even choose to ignore them alto- insight into management’s plans. An analyst
gether! A court will usually not force a com- would consider how complying with
pany to comply with covenants. Rather, the covenants were consistent with other articulat-
court will award damages—if the breach of ed strategic goals. Management’s willingness
covenants is considered the cause of the dam- to agree to certain restrictive covenants, in
ages. So long as the company continues to pay essence, “puts their money where their mouth
principal and interest, the court is unlikely to is.” For example, if a company had tradition-
recognize any damages as having occurred. ally been highly leveraged but planned to
Enforcement is more likely if there is a specific deleverage in the future, the analyst would
remedy that is provided for in the event of a expect to see a debt test that ratcheted down
breach of the covenant. Usually, the remedy is over time.
the ability to declare an event of default and
accelerate the loan. However, this remedy is so Typical Covenants
severe that, more often than not, lenders Covenants typically vary according to the
choose not to precipitate a default by demand- level of credit quality. They increase in number
ing immediate repayment—despite a stipulated and grow more stringent as the quality of the
right to do so. Instead, the lender may prefer to credit declines. They also vary depending on
take a security position, to raise rates, or to whether the debt is issued publicly or private-
provide more input into the company’s deci- ly. Private lenders tend to require a complete
sions. Such actions could be valuable to that and exacting package. These lenders are also
lender—without enhancing credit quality for likely to negotiate—and are more capable of
the benefit of all creditors. In practice, lenders renegotiating—covenants in the event of a
also waive covenants for a variety of reasons. change in strategy or of a covenant default. In
Waivers might result from company/bank rela- addition, the tenor of the loan will govern
tionship issues, a lack of understanding of the which specific covenants are appropriate.
magnitude of problems, or a realization that There are certain basic covenants that are
the original levels were unnecessarily tight. present in all loan documents, irrespective of
• Finally, if the covenants appear only in cer- credit quality or type of financing. While these
tain issues, those issues could be refinanced. covenants may be worded in different ways,

they are considered important by all creditors • Restrictions on certain payments (includ-
for purposes of managing their investments. ing dividends, stock purchases, loans, and
They are: investments),
• Information requirements (which financial • Changes of control provisions, and
and other information must be provided at • Net-worth maintenance requirements.
which times); Bank loan agreements may also contain pro-
• Default (which events might constitute visions for periodic paying down of outstand-
defaults and which remedies might be pro- ing balances.
vided, possibly including cross-default and Over time, the lists will change, as the mar-
cross-acceleration provisions); and ket’s willingness to accept certain conditions
• Modifications (how and under which con- changes. (For example, in the late 1980s and
ditions the loan documents might be amend- early 1990s, when event risk loomed large due
ed, including defeasance provisions, if any). to LBOs and takeovers, issues that contained
Beyond these provisions, covenants are covenants providing event-risk protection typ-
transaction-specific. While investment-grade ically enjoyed a price advantage over those
transactions have few negative covenants, without such protection. With the end of the
there are some that are common, including: LBO boom, however, the market no longer
• A limitation on liens (with a negative demanded these clauses).
pledge); When reviewing a covenant package for any
• A limitation of sale/leaseback transactions; purpose, it is necessary to check its terms and
and definitions carefully. What is and—sometimes,
• A limitation on mergers, consolidations, or what is more important—what is not included
sales of assets. significantly affect the level of protection.
As one moves to speculative-grade transac- Often, specified ratio calculations are not stan-
tions, other covenants are usually added to dardized, and it may be necessary to have
those above. Some of the most common are: management supply calculations and compli-
• Limitations on the incurring of additional ance documents.
debt (including debt at subsidiary levels),

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Industrials and Utilities

RATING METHODOLOGY ■ Corporate Ratings Criteria 17

18 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 19

RATING FACTORS FOR ELECTRIC UTILITIES

20 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING FACTORS FOR AIRLINES

RATING METHODOLOGY ■ Corporate Ratings Criteria 21

22 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 23

24 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 25

Preferred stock Cash flow adequacy

26 RATING METHODOLOGY ■ Corporate Ratings Criteria

Cash flow ratios Where long-term viability is more assured

MEASURING CASH FLOW

RATING METHODOLOGY ■ Corporate Ratings Criteria 27

28 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 29

The Global Perspective

30 RATING METHODOLOGY ■ Corporate Ratings Criteria

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32 RATING METHODOLOGY ■ Corporate Ratings Criteria

LOCAL CURRENCY CREDIT RATING: FOREIGN CURRENCY CREDIT RATING:

A current opinion of an obligor’s overall A current opinion of an obligor’s overall

RATING METHODOLOGY ■ Corporate Ratings Criteria 33

34 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 35

Capital structure/financial flexibility:

36 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 37

38 RATING METHODOLOGY ■ Corporate Ratings Criteria

Government ownership and Governing law

RATING METHODOLOGY ■ Corporate Ratings Criteria 39

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RATING METHODOLOGY ■ Corporate Ratings Criteria 41

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emergence of new competitors, changes in companies, but entire industries. Favorable

RATING METHODOLOGY ■ Corporate Ratings Criteria 43

44 RATING METHODOLOGY ■ Corporate Ratings Criteria

RATING METHODOLOGY ■ Corporate Ratings Criteria 45

TELECOMMUNICATIONS RATINGS POLICY REVISED

46 RATING METHODOLOGY ■ Corporate Ratings Criteria

TELECOMMUNICATIONS RATINGS POLICY REVISED (CONTINUED)

RATING METHODOLOGY ■ Corporate Ratings Criteria 47

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RATING METHODOLOGY ■ Corporate Ratings Criteria 49

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