INDIAN FINANCIAL SYSTEM AND CREDIT RATING AGENCIES

Presented by: Akshata Koli Snehal Mhatre : 10-722 : 10-725

Harshada Sambare : 10-742 Kushal Sangoi : 10-743

INDIAN FINANCIAL SYSTEM

Introduction
Indian financial system is an institutional framework existing in a country to enable financial transactions. It provides the principal means by which savings are transformed into investments. Economic growth and development of any country depends upon a well-knit financial system. Financial system comprises a set of sub-systems of financial institutions financial markets, financial instruments and services which help in the formation of capital. Thus a financial system provides a mechanism by which savings are transformed into investments and it can be said that financial system play an significant role in economic growth of the country by mobilizing surplus funds and utilizing them effectively for productive purpose.

The financial system is characterized by the presence of integrated, organized and regulated financial markets, and institutions that meet the short term and long term financial needs of both the household and corporate sector. Both financial markets and financial institutions play an important role in the financial system by rendering various financial services to the community. They operate in close combination with each other.

The following are the three main components of Indian Financial system: 1. Financial assets (loans, deposits, bonds, equities, etc.)

2. Financial institutions (banks, mutual funds, insurance companies, etc.)

3. Financial markets (money market, capital market, forex market, etc.) Regulation is another aspect of the financial system (RBI, SEBI, and IRDA)

Functions of Financial System

1. Payment system: It provides a payment system for the exchange of goods and services. Depository financial intermediaries such as banks are the pivot of the payment system. Credit card companies play a supplementary role. 2. Pooling of funds: It enables the pooling of funds for undertaking large scale enterprise. Modern business enterprise requires large investments which can be facilitate by mechanisms like financial markets and financial intermediaries. 3. Transfer of resources: It provides a mechanism for spatial and temporal transfer of resources. 4. Risk management:

It provides a way for managing uncertainty and controlling risk. The 3 basic methods of managing are Hedging, Diversification and Insurance.

5. Price information for Decentralized Decision Making: It generates information that helps in co-ordinating decentralized decision making. 6. Dealing with incentive problem: It helps in dealing with the incentive problem when one party has an informational advantage. When one party to a transaction has information those other doesnt have informational asymmetry exists. So the financial intermediaries like banks and venture capital organizations can solve the problem of informational asymmetry by handling sensitive information discreetly and developing a reputation for profitable activity.

Financial assets/instruments
Financial assets/instruments enable channelizing funds from surplus units to deficit units. There are instruments for savers such as deposits, equities, mutual fund units, etc. There are instruments for borrowers such as loans, overdrafts, etc. It is like businesses, governments to raise funds through issuing of bonds, Treasury bills, etc. Instruments like PPF, KVP, etc. are available to savers who wish to lend money to the government. It includes institutions and mechanisms which i. ii. iii. Affect generation of savings by the community Mobilisation of savings Effective distribution of savings

Institutions are banks, insurance companies, and mutual funds- promote/mobilize savings. Individual investors, industrial and trading companies- borrowers.

Financial markets
A financial market is a market for creation and for the exchange of financial assets. If you buy or sell financial assets you participate in financial markets in some way or the other. 3

Functions of financial markets: Financial markets play a vital role in allocating resources in an economy by performing three important functions: 1. Financial markets facilitate price discovery. The continual interaction among numerous buyers and sellers who thong financial markets help in establishing the prices of financial assets. Well organised financial markets seem to be remarkably efficient in price discovery. That is why financial economists say If you want to know the value of financial asset simply look at its price in the financial market 2. Financial markets provide liquidity to financial assets. Investors can readily sell their financial assets through the mechanism of financial markets. In the absence of financial markets the motivation of the investors to hold financial assets will be considerably diminished. Thanks to the negotiability and transferability of the securities through the financial markets, it is possible for the companies to raise long term funds from the investors with short term and middle term horizons. While one investor is substituted for the other, when a security is transacted, the company is assured of long term availability of funds. 3. Financial markets considerably reduce the cost of transacting. Two major costs associated with transaction are search cost and information cost. Search cost consists of explicit cost such as expenses incurred on advertising when one wants to buy or sell an asset or implicit cost such as the effort and time one has to put to locate a customer. Information cost refers to the cost incurred in evaluating the investment merits of a financial asset.

Classification of financial Markets: There are different ways of classifying financial markets One way is by the type of financial claim 1. The debt market is the financial market for fixed claims. 2. The equity market is the financial market for residual claims. Another way is by the maturity of claims 1. The money market is for the short term financial claims. 2. The capital market is for the long term financial claims. Here the cut of between long term and short term has been fixed arbitrary as a year. Third way is whether the claim represents a new issue or an outstanding issue

1. The primary market is where issuers sell new claims. 2. The secondary market is where investors trade outstanding securities. Fourth way to classify is by timing of delivery. 1. A cash or spot market is where delivery occurs immediately. 2. A forward or future market is where delivery occurs at a predetermined time in future. Fifth way to classify is by nature of its organizational structure. 1. An exchange traded market is a centralized organization with a standardised procedure. 2. An over the counter market is a decentralized market with customised procedure.

DIGRAMATIC REPRESENTAION

Financial market returns: Every day we are bombarded with news and reports on financial markets like interest rates and equity returns over various media. Interest rate is a rate of return promised by the borrower to the lender. Different interest rates apply to different kinds of borrowing and lending. E.g. Mortgage rate for home loans and lending rates for industrial loans. The interest rate on any type of loan depends on several factors, the most important being the unit of account, the maturity and the default risk. The unit of account is the medium such as rupees, dollars, pounds, yen or gold in which payments are dominated. The maturity of a loan is the period over which it is paid back.

The default risk is the possibility that the borrower may not honour his commitment to pay interest and principle as promised. Rates of returns on Risky assets: interest rates represent promised returns on debt instruments. However, many assets do not promise a given return. How one should measure the rate of return on risky asset like equity stock? The return from such from such an asset comes from two sources: cash dividend and capital gain(or losses) r = (cash dividend/beginning price) + [(ending price-beginning price)/beginning price] r=one year return. The first component is called dividend income component (or dividend yield) and the second component is called the capital change component (or capital yield) Inflation and real interest rate: to make meaningful economic comparisons over time, the prices of goods and services must be corrected for the effects of inflation. A distinction to be made between nominal prices or prices in terms of some currency and real prices or prices in terms of purchasing power. Just as distinction is made between the real prices and the nominal prices, a distinction is made between real and nominal interest rates. The nominal interest rate on a bond is the rate of return in nominal terms where as the real rate is the nominal rate corrected for inflation factor. The general relationship between these rates is as follows Real rate= (Nominal rate-inflation rate)/ (1+inflation rate)

Determinants of Rates of return: The principle factors are 1. Expected productivity of capital 2. Degree of uncertainty characterizing the productivity of the capital. 3. Time preference of people 4. Degree of risk aversion.

Equillibrium in Financial markets:

The supply and demand for various commodities(such as aliminium) are cleared at their respective equilibrium prices in the real market.likewise, an equilibrium price clears the market for loanable funds. Put differnetly, at the equilbrium price, supply and demand for loanable funds are matched. It is expressed as an interest rate-the amount per rupee per annum that the lender gets and borrower pays.

Interest rates in India:

Interest rate in India is highly regulated. There was time when bank rates, interest rates, corporate deposit rates etc where regulated by the government. But are financial liberisation, most of these rates are substantially deregulated. There are varieties of interest rates in India. Some of the key interest rates are as follows:1. Bank rate 2. Repo rate 3. Treasury bill rate 4. Prime lending rate 5. Bank deposit rate 6. 10 year government bond rate The key interest rates in India in year 2006 are as follows:-1. Bank rate2. Repo rate3. Treasury bill rate4. Prime lending rate5. 3 year Bank deposit rate6. 10 year government bond rate6% 6% 6.94% 11-11.50% 8% 7.50%

Financial Intermediaries:
Financial Intermediaries are the firms that provide services and products that customer may not be able to get more efficiently by themselves. The important products and services of financial intermediaries are: checking accounts, saving accounts, loans, mortgages, mutual fund schemes, credit ratings etc. What are the benefits to individual investors when they invest indirectly through financial intermediaries??? 1. Diversification 7

2. Low transaction cost 3. Economies of scale 4. Confidentiality 5. Signalling

KEY FINANCIAL INTERMEDIARIES IN INDIA:

The key financial intermediaries in India are: Commercial banks Financial institutions Insurance companies Mutual funds Non-banking financial institutions Non-banking financial service companies

Commercial banks:
Commercial banks consist of public, private and foreign banks. This is the most important financial intermediaries in India. Public sector banks consist of SBI and its associates. These banks have a great reach in rural parts of India. They have high mobilisation of deposits. These banks dominate the banking sector. Foreign banks consist of CITIBANK; have been India for long time and steadily increasing their operations in India. Private sector banks consist of new entrants like ICICI bank and HDFC bank. These banks have shown remarkable growth in banking industry.

Financial institutions:
An elaborate structure of financial institutions consisting of ALL INDIA term lending institutions such as IFCI, IDBI, ICICI, State financial corporations and State industrial development corporations.

Insurance Companies:
Till recently there were two insurance companies in India that are LIC and GIC. 8

With liberalisation of insurance sector, many private sector players like ICICI-Prudential, TATA-AIG, BAJAJ ALLIANZ, BIRLA SUNLIFE and HDFC Insurance have entered insurance sector. Insurance companies have massive resources at their command because of savings mentality in INDIANS.

Mutual Funds:
A mutual fund is a collective investment vehicle.it mobilises resources from investors and invest in various securities. There are various players in mutual funds which are as follows: ICICI Prudential mutual fund Reliance mutual fund etc

Non- Banking Financial companies: From the mid- eighties many non-banking financial companies have come into being in the public sector as well as the private- numerically ,of course , most of them are in the private sector. Some of the well know non banking finance companies are SBI capital markets, Kotak Mahindra finance, Sundaram Finance and Infrastructure Leasing and finance corporation. Non Banking financial companies engage in a variety of fund based as well as non fund based activities.The principal fund-based activities are issue management, corporate advisory services, loan syndication and forex advisory services.

Other Organisations Merchant banks ,Veture capital firms,and information services are some of the other financial intermediaries. Merchant Banks: Merchant banks are firms which help business, government , and other entities raise finances by issuing securities.They also facilitate merger, acquisitions and divestitures. The leading merchant banks in In dia are SBI Capital markets, DSP Merrill Lyunch and JP Morgan. Venture Capital: Venture Capital firms are somewhat similar to merchant banks except that they assist start firm rather than established companies.Yong firms with limited managerial expertise often require advice in running the business in addition to finance. Venture Capital firm provide managerial support as well as capital. Information Service: Many financial service firms provide information as a supplementary service, but there are firms that specialise in giving information.The most well known are credit
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rating agencies like CRISIL, CARE, and ICRA and capital market information services like CMIE, probity research, and capital market.

REGULATORY INFRASTRUCTURE:

1. RBI Provides currency & operates the clearing system for the banks. Formulates & implements monetary & credit policies. Functions as the bankers bank. Supervises the operations of credit institutions. Regulates forex transactions. Moderates the fluctuations in the exchange value of the rupee. Promotes the development of new institutions. Influences the allocation of credit. Encourages the extension of the commercial banking sys in the rural areas. Seeks to integrate the unorganized financial sector with the organized financial sector

2. SEBI

Regulate the business in stock exchange & any other securities markets.

Register &regulate the capital market intermediaries. Register & regulate the working of MFs.

Promote & regulate self-regulatory org.

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Prohibit fraudulent & unfair trade practices in securities markets.

Promote investors education and training of intermediaries of securities markets.

Prohibit insider trading in securities.

CRADIT RATING AGENCIES IN INDIA

A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations. Credit ratings are often confused with credit scores. Credit scores are the output of mathematical algorithms that assign numerical values to information in an individual's credit report. The credit report contains information regarding the financial history and current assets and liabilities of an individual. A bank or credit card company will use the credit score to estimate the probability that the individual will pay back loan or will pay back charges on a credit card. However, in recent years, credit scores have also been used to adjust insurance premiums, determine
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employment eligibility, as a factor considered in obtaining security clearances and establish the amount of a utility or leasing deposit. A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects. A poor credit score indicates that in the past, other individuals with similar credit reports defaulted on loans at a high rate. The credit score does not take into account future prospects or changed circumstances. For example, if an individual received a credit score of 400 on Monday because he had a history of defaults, and then won the lottery on Tuesday, his credit score would remain 400 on Tuesday because his credit report does not take into account his improved future prospects. Objectives:

It provides guidance to investors or creditors in determining a credit risk associated with debt instrument or credit obligation.

Establishes a link between risk and return.

Helps investors in making investment decisions.

Credit rating shows the exact worth of the organization

To assist the regulators in promoting the transparency in the financial market

Who uses Credit Rating?

Investors In absence of credit rating system, risk evaluation depends on name recognition. Credit rating helps investors in selecting appropriate instrument from broad spectrum

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of investment options. Banks use ratings of other banks for decisions regarding interbank lending, swap

agreements, etc. Credit rating agencies also provides services like industry reports, corporate reports,

seminars and open access to the analysts of the agencies.

Issuers Compared to unrated securities, issuers of rated securities have access to much wider

investor base & more faith is placed. Investor confidence enables issuers of highly rated instruments to access market even

under adverse market conditions.

Intermediaries

Merchant bankers use rating for planning, pricing, underwriting, placement. Brokers and dealers in securities use rating as an input for their monitoring of risk

exposures.

Regulators Level

Restrict entry to market of new issues rated bellow a particular grade. Prohibit investors from purchasing or holding of instruments rated bellow a particular

What can be Credit Rated? INDIVIDUAL CORORATE

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 SOVEREIGN FINANCIAL INSTRUMENTS Bonds Bank Deposits Commercial Paper Term Loans PreferenceS hares Secured Debt Unsecured Debt Securities

FUNCTIONS OF CREDIT RATING AGENCIES: Superior information Low cost information Basis for proper risk, return & Trade off Healthy discipline on corporate borrowers Formulation of public policy guidelines on Institutional investment

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Benefits of Credit Rating: Low cost information Quick investment decision Independent investment decision

Investor protection

Credit Rating Agencies in India: 1) Credit Rating Agencies in India 2) Credit Rating Information Services Limited (CRISIL) 3) Investment Information and Credit Rating Agency of India (ICRA) 4) Credit Analysis and research (CARE) 5) Duff Phelps Credit Rating Pvt. Ltd. (DCR India)

1) Credit Rating Information Services Ltd.: The first credit agency floated on January 1, 1988. It was jointly started by ICICI and UTI with an equity capital of 4 crores. CRISIL is India's leading rating agency, and is the fourth largest in the world. With over a 60% share of the Indian Ratings market, CRISIL Ratings is the agency of choice for issuers and investors. CRISIL Ratings is a full service rating agency that offers a comprehensive range of rating services.
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CRISIL Ratings provides the most reliable opinions on risk by combining its understanding of risk and the science of building risk frameworks, with a contextual understanding of business. The principal objective of CRISIL is to rate the debt obligations of Indian companies.Its rating guide the investors about the risk of timely payment of interest and principal on a particular debt instrument. CRISIL's rating process and rating committee are designed to ensure that all assigned ratings are based on the highest standards of independence and analytical rigor. The rating committee comprises members who have the professional competence to meaningfully assess the credit analysis that underlies the rating, and have no interest in the entity being rated. A team of analysts carries out the credit analysis

CREDIT RATING SYMBOLS: Debenture Rating Symbols: High Investment Grades: AAA (triple A): Highest Safety AA (double A): High Safety

Investment Grades: A: Adequate Safety BBB (triple B): Moderate Safety

Speculative Grades: BB: Inadequate Safety

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B: High Risk C: Substantial Risk D: Default

2) Investment Information and Credit Rating Agency of India (ICRA): Investment Information and Credit Rating Agency of India (ICRA) ICRA Limited (an Associate of Moody's Investors Service) was incorporated in 1991 as an independent and professional company. ICRA is a leading provider of investment information and credit rating services in India. ICRAs major shareholders include Moody's Investors Service and leading Indian financial institutions and banks. With the growth and globalisation of the Indian capital markets leading to an exponential surge in demand for professional credit risk analysis, ICRA has been proactive in widening its service offerings, executing assignments including credit ratings, equity gradings, specialised performance gradings and mandated studies spanning diverse industrial sectors.

In addition to being a leading credit rating agency with expertise in virtually every sector of the Indian economy, ICRA has broad-based its services for the corporate and financial sectors, both in India and overseas, and currently offers its services under the following banners: Rating Services Information, Grading and Reasearch Services Advisory Services Economic Research Outsourcing

Investment Information and Credit Rating Agency of India (IICRA): Investment Information and Credit Rating Agency of India (IICRA) IICRA was set up by Industrial Finance Corporation of India on 16th January 1991. It is a public limited company

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with an authorized share capital of 10 crores. The initial paid up capital of Rs. 3.50 crores was subscribed by IFC, UTI, LIC, GIC SBI and others. Investment Information and Credit Rating Agency of India (IICRA): Long term Debentures Bonds and Preference shares-Rating Symbols LAAA: Highest Safety LAA: High Safety LA: Adequate Safety LBBB: Moderate Safety LBB: Inadequate Safety LB: Risk prone LC: Substantial Risk LD: Default, Extremely speculative 3) Credit Analysis and Research Limited (CARE): Credit Analysis and Research Limited (CARE). The CARE was promoted in 1993 jointly with investment companies, banks and finance companies. Services offered by CARE are Credit rating Information Service Equity Research etc

Credit Analysis and Research Limited (CARE): Long term debt instruments-Rating Symbols CARE AAA: Highest Safety CARE AA : High Safety CARE A : Adequate Safety

CARE BB : Inadequate Safety CARE B : High Risk

For medium term debt instruments CARE AAA: Highest Safety

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CARE AA: High Safety CARE A: Adequate Safety CARE BB: Inadequate Safety CARE C: High Risk

The process/procedure followed by all the major credit rating agencies in the country is almost similar and usually comprises of the following steps:

1. Receipt of the request: The rating process begins, with the receipt of formal request for rating from a company desirous of having its issue obligations under proposed instrument rated by credit rating agencies. An agreement is entered into between the rating agency and the issuer company. The agreement spells out the terms of the rating assignment and covers the following aspects:

i. It requires the CRA (Credit Rating Agency) to keep the information confidential. ii. It gives right to the issuer company to accept or not to accept the rating. iii. It requires the issuer company to provide all material information to the CRA for rating and subsequent surveillance.

2. Assignment to analytical team: On receipt of the above request, the CRA assigns the job to an analytical team. The team usually comprises of two members/analysts who have expertise in the relevant business area and are responsible for carrying out the rating assignments.

3. Obtaining information: The analytical team obtains the requisite information from the client company. Issuers are usually provided a list of information requirements and broad framework for discussions. These requirements are derived from the experience of the issuers business and broadly confirms to all the aspects which have a bearing on the rating. The analytical team
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analyses the information relating to its financial statements, cash flow projections and other relevant information.

4. Plant visits and meeting with management: To obtain classification and better understanding of the clients operations, the team visits and interacts with the companys executives. Plants visits facilitate understanding of the production process, assess the state of equipment and main facilities, evaluate the quality of technical personnel and form an opinion on the key variables that influence level, quality and cost of production. A direct dialogue is maintained with the issuer company as this enables the CRAs to incorporate non-public information in a rating decision and also enables the rating to be forward looking. The topics discussed during the management meeting are wide ranging including competitive position, strategies, financial policies, historical performance, risk profile and strategies in addition to reviewing financial data.

5. Presentation of findings: After completing the analysis, the findings are discussed at length in the Internal Committee, comprising senior analysts of the credit rating agency. All the issue having a bearing on rating is identified. An opinion on the rating is also formed. The findings of the team are finally presented to Rating Committee.

6. Rating committee meeting: This is the final authority for assigning ratings. The rating committee meeting is the only aspect of the process in which the issuer does not participate directly. The rating is arrived at after composite assessment of all the factors concerning the issuer, with the key issues getting greater attention.

7. Communication of decision: The assigned rating grade is communicated finally to the issuer along with reasons or rationale supporting the rating. The ratings which are not accepted are either rejected or

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reviewed in the light of additional facts provided by the issuer. The rejected ratings are not disclosed and complete confidentiality is maintained.

8. Dissemination to the public: Once the issuer accepts the rating, the credit rating agencies disseminate it through printed reports to the public.

9. Monitoring for possible change: Once the company has decided to use the rating, CRAs are obliged to monitor the accepted ratings over the life of the instrument. The CRA constantly monitors all ratings with reference to new political, economic and financial developments and industry trends. All this information is reviewed regularly to find companies for, major rating changes. Any changes in the rating are made public through published reports by CRAs. RATING METHODOLOGY

Rating methodology used by the major Indian credit rating agencies is more or less the same. The rating methodology involves an analysis of all the factors affecting the creditworthiness of an issuer company e.g. business, financial and industry characteristics, operational efficiency, management quality, competitive position of the issuer and commitment to new projects etc. A detailed analysis of the past financial statements is made to assess the performance and to estimate the future earnings. The companys ability to service the debt obligations over the tenure of the instrument being rated is also evaluated.

In fact, it is the relative comfort level of the issuer to service obligations that determine the rating. While assessing the instrument, the following are the main factors that are analysed into detail by the credit rating agencies. 1. Business Risk Analysis 2. Financial Analysis 3. Management Evaluation 4. Geographical Analysis
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5. Regulatory and Competitive Environment 6. Fundamental Analysis

These are explained as under:

I. Business Risk Analysis

Business risk analysis aims at analysing the industry risk, marketposition of the company, operating efficiency and legal position of the company. This includes an analysis of industry risk, market position of the company, operating efficiency of the company and legal position of the company.

a. Industry risk: The rating agencies evaluates the industry risk by taking into consideration various factors like strength of the industry prospect, nature and basis of competition, demand and supply position, structure of industry, pattern of business cycle etc. Industries compete with each other on the basis of price, product quality, distribution capabilities etc. Industries with stable growth in demand and flexibility in the timing of capital outlays are in a stronger position and therefore enjoy better credit rating.

b. Market position of the company: Rating agencies evaluate the market standing of a company taking into account: i. Percentage of market share ii. Marketing infrastructure iii. Competitive advantages iv. Selling and distribution channel v. Diversity of products vi. Customers base
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vii. Research and development projects undertaken to identify obsolete products viii. Quality Improvement programs etc.

c. Operating efficiency: Favorable locational advantages, management and labor relationships, cost structure, availability of raw-material, labor, compliance to pollution control programs, level of capital employed and technological advantages etc. affect the operating efficienc y of every issuer company and hence the credit rating.

d. Legal position: Legal position of a debt instrument is assessed by letter of offer containing terms of issue, trustees and their responsibilities, mode of payment of interest and principal in time, provision for protection against fraud etc. e. Size of business: The size of business of a company is a relevant factor in the rating decision. Smaller companies are more prone to risk due to business cycle changes as compared to larger companies. Smaller companies operations are limited in terms of product, geographical area and number of customers. Whereas large companies enjoy the benefits of diversification owing to wide range of products, customers spread over larger geographical area. Thus, business analysis covers all the important factors related to the business operations over an issuer company under credit assessment.

II. Financial Analysis

Financial analysis aims at determining the financial strength of the issuer company through ratio analysis, cash flow analysis and study of the existing capital structure. This includes an analysis of four important factors namely: a. Accounting quality b. Earnings potential/profitability c. Cash flows analysis d. Financial flexibility

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Financial analysis aims at determining the financial strength of the issuer company through quantitative means such as ratio analysis. Both past and current performance is evaluated to comment the future performance of a company. The areas considered are explained as follows.

a. Accounting quality: As credit rating agencies rely on the audited financial statements, the analysis of statements begins with the study of accounting quality. For the purpose, qualification of auditors, overstatement/ understatement of profits, methods adopted for recognising income, valuation of stock and charging depreciation on fixed assets are studied. b. Earnings potential/profitability: Profits indicate companys ability to meet its fixed interest obligation in time. A business with stable earnings can withstand any adverse conditions and also generate capital resources internally. Profitability ratios like operating profit and net profit ratios to sales are calculated and compared with last 5 years figures or compared with the similar other companies carrying on same business. As a rating is a forward-looking exercise, more emphasis is laid on the future rather than the past earning capacity of the issuer.

c. Cash flow analysis: Cash flow analysis is undertaken in relation to debt and fixed and working capital requirements of the company. It indicates the usage of cash for different purposes and the extent of cash available for meeting fixed interest obligations. Cash flows analysis facilitates credit rating of a company as it better indicates the issuers debt servicing capability compared to reported earnings.

d. Financial flexibility: Existing Capital structure of a company is studied to find the debt/equity ratio, alternative means of financing used to raise funds, ability to raise funds, asset deployment potential etc. The future debt claims on the issuers as well as the issuers ability to raise capital is determined in order to find issuers financial flexibility.

III. Management Evaluation Any companys performance is significantly affected by the management goals, plans and strategies, capacity to overcome unfavorable conditions, staffs own experience and skills,
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planning and control system etc. Rating of a debt instrument requires evaluation of the management strengths and weaknesses.

IV. Geographical Analysis

Geographical analysis is undertaken to determine the locational advantages enjoyed by the issuer company. An issuer company having its business spread over large geographical area enjoys the benefits of diversification and hence gets better credit rating. A company located in backward area may enjoy subsidies from government thus enjoying the benefit of lower cost of operation. Thus geographical analysis is undertaken to determine the locational advantages enjoyed by the issuer company.

V. Regulatory and Competitive Environment

Credit rating agencies evaluate structure and regulatory framework of the financial system in which it works. While assigning the rating symbols, CRAs evaluate the impact of regulation/deregulation on the issuer company.

VI. Fundamental Analysis

Fundamental analysis includes an analysis of liquidity management, profitability and financial position, interest and tax rates sensitivity of the company. This includes an analysis of liquidity management, profitability and financial position, interest and tax rates sensitivity of the company.

1. Liquidity management involves study of capital structure, availability of liquid assets corresponding to financing commitments and maturing deposits, matching of assets and liabilities.

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2. Asset quality covers factors like quality of companys credit risk management, exposure to individual borrowers and management of problem credits etc. 3. Profitability and financial position covers aspects like past profits, funds deployment, revenues on non-fund based activities, addition to reserves. 4. Interest and tax sensitivity reflects sensitivity of company following the changes in interest rates and changes in tax law.

Fundamental analysis is undertaken for rating debt instruments of financial institutions, banks and non-banking finance companies.

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