KOREA INVESTORS SERVICE

Ratings Services
Understanding Credit Ratings

A Credit Rating is an opinion regarding the relative future credit risk of a debt or financial obligation, or an issuer of such a debt or financial obligation, using an established ranking system of rating categories. KIS defines credit risk as the risk that an entity may not meet its contractual, financial obligations as they come due.
An issuer’s ability and willingness to meet its financial obligations is determined by the level of expected future cash flows, rather than past or present cash flows. One of the most critical aspects of credit ratings is the ability to accurately predict future cash flows based on all relevant factors.

Credit ratings serve as foundation of financial markets in keeping its role as an independent and objective publisher of opinions for both issuers and investors alike.
Credit ratings boost the efficiency of financial markets, helping investors make informed investment decisions whether to buy, hold or sell their securities, and providing a basis for risk premium in the market. Issuers seek credit ratings to reduce funding risks arising from changing market conditions and to strengthen their ability to access capital.

Credit ratings are generally required for following instruments:
1) Unsecured bond
2) CP
3) ABS
4) Extension of Credit Facility
In addition, the creditworthiness of corporates, schools, and financial institutions is assessed for various purposes stated in ‘Purpose’ section.

Credit ratings for corporates should be preceded by an analysis on macroeconomic trends, financial markets, industry attributes and trends, as well as fundamental research on rated entities’ financial profiles, business performance, and management status. A rigorous analysis should follow to assess corporate fundamentals, such as business nature, competitive strengths, senior management, and management strategies, so as to evaluate an issuer’s creditworthiness or debt service capacity on specific obligations.

There are varying risk factors that affect companies’ debt service capacity depending on their internal and external conditions. In particular, cash-flow related factors are more complicated to assess on a stand-alone basis as they are closely interrelated. However, to ensure consistent and efficient ratings approach, credits are reviewed by five major rating factors – managerial risk, affiliate risk, industry risk, business risk and financial risk, and checklists by each rating factor.

Each of the five risk factors above is broken down into a number of detailed checklists during the ratings process. The weights assigned to each checklist item may vary by individual industry and entity, and major rating factors for each industry are described in detail in Rating Methodology section. During the ratings process, KIS reviews risks and opportunities associated with each of these closely linked rating factors. The final rating is derived based on comparative and comprehensive analysis on the opportunities and positive factors as well as different weights for each risk factor. Although relative importance of checklist items may differ by industry when assessing risks and opportunities for each rating factor, a coherent approach is needed when analyzing the same risk factors, and reaching conclusions based on comprehensive review of such factors.

Managerial risk is a credit risk associated with corporate management group, one of the most important components that constitute companies’ credit quality. It is related to management quality and predictability, senior management’s intention, management plans and strategies, which may vary depending on the management team’s philosophy towards accounting/financial policies, and their risk appetites.

One of the most representative factors of managerial risk is governance structure, while management team’s capacity and nature of management strategies also serve as important points for consideration. Despite its significant importance in credit ratings, it is complicated to analyze managerial risk due to lack of objective indicators, limitations in obtaining data, potential errors in subjective judgment, and weak causality between managerial risk and creditworthiness. Still, corporate creditworthiness is becoming more affected by governance structure stability, adequate internal control system, senior management’s capacity, disclosure and transparency, and ethical management. Therefore, it is essential to analyze managerial risk based on corporate history, management’s work experience, management plans and performance, relations between senior management and majority shareholders, and other unique factors acquired through press or other informal routes.

Checklist:: Ownership and Governance Structure, Internal Control System, Capacity and Propensity of Management Team, Corporate Values and Culture, Management Policies and Strategies, Other unique factors, etc.

A close linkage between a rated entity and its affiliates is one of the crucial rating factors, considering strong affiliate relationship found in Korean firms’ governance structure. In order to analyze companies’ creditworthiness using affiliate factor, one should first generate stand-alone rating and consolidated rating. After setting guideline on affiliate risk through consolidated rating, the level of linkage between the rated entity and its affiliates, and impact of affiliate risk are assessed. Final rating is generated by making adequate adjustments on the stand-alone rating as necessary. The scope of affiliates subject to consolidated rating is not defined by corporate groups as prescribed in the Fair Trade Act and banking industry supervisory regulations, but by a de facto single economic entity that makes uniform decisions across affiliates given the ownership structure, intra-group mutual guarantees, operating relationship and management control.

Checklist:: Business and Financial Risk of Affiliated Group, Linkage and Inter-dependence of Cash flows among Affiliates, Funding Support from Affiliates, Ability to Provide Payment Guarantee/Collateral, etc.

Industry risk analysis looks into external factors that equally affect companies within a particular industry to understand industry attributes and market structure that are directly related to corporate operating activities. For such analysis, one should examine industry profile – industry characteristics, trends, supply & demand - and industry structure – competitive factors and pressures – to identify determinants of a particular industry’s competitiveness. Industry characteristics, which are assessed through industry trends and competitive landscape, have an impact on the company’s long term performance. Using such industry characteristics for projecting an entity’s future would produce much more objective and reasonable ratings results.

Checklist:: Industry Characteristics and Definition, Industry Conditions, Stages in Industry Lifecycle, Sensitivity to Economic Cycles, Supply-Demand Balance, Competitive Landscape, Risks to New Entrants, Bargaining Power against Downstream/upstream Industries, etc.

Business risk analysis looks into various risk factors reflected in companies’ product or business portfolio, business competitiveness and market position, return on invested capital, and business policies. To analyze business competitiveness and market position in particular, sources of competitiveness should be identified considering internal management resources, operating status and performance, based on which management strategy analysis and due diligence are conducted.

Checklist:: Business Portfolio, Market Share, Revenue Generation Capacity, Operational Efficiency, Business Strategies, etc.

The purpose of credit ratings is to allow for more efficient asset allocation by evaluating debt service capacity and providing investors with information about the relative credit risk of certain issuers and debt issues. In this context, credit ratings are ultimately a process of evaluating financial risk. Financial risk analysis is conducted in connection with other rating factors as it looks at financial statements which show companies’ past and present stance, as well as many other factors that affect financial profile. The rating process is carried out with a focus on the impact each rating factor has had and will have on future financial profile.

Checklist:: Accounting Policies, Cash Flows, Liquidity, Profitability, Leverage, Financial Flexibility

Investors use credit ratings to help assess credit risk when making investment decisions and managing their portfolios, while issuers use them to determine terms of issuing debt securities, such as corporate bonds. The ratings serve as a type of shorthand for communicating opinions about the relative credit quality of issuers to market participants. In addition, credit ratings also serve following purposes:

Loan underwriting standards of financial institutions, such as banks and non-bank lending institutions
To calculate premium of guarantee bonds, etc. for guarantee providers
To establish thresholds for investment guidelines of domestic and international institutional investors– investment trust, mutual fund, etc.
To review qualifications of contractors that bid for orders placed by the Public Procurement Service, KEPCO, etc.
To assess creditworthiness of business entity
To help anticipate the interest rate (or yield) to be offered