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Significance of a Customized Rating Approach for MSMEs
D.R. Dogra, MD & CEO, CARE Ratings
Sep 2011
Sep 2011
Garmering Better Credit Terms
The NSIC-CARE Performance and Credit Rating for any SSI entity indicates the relative level of financial strength and performance capability of an SSI entity compared to other SSIs. It is issuer specific and a onetime rating and is not a debt specific rating. This rating helps SSIs to obtain quicker and cheaper credit, facilitate capability assessment of SSIs by their clients and garner better credit terms from suppliers. This Scheme was formulated with the help of The Indian Bank Association (IBA). The Government has subsidized the fees for SSI ratings up to 75 per cent, enabling SSIs to get the rating at a lower cost.
What does the rating exercise involve? The rating exercise takes into account the management capability, industry dynamics, operational performance, financial risk characteristics and the project risks involved.
a. Management Capability. In light of the informal structures in the Indian SME space, it is important to identify the level of dependence on the key-man of the organization and analyze elements of succession planning. Analysis of management competency parameter is also guided by the type of constitution of the unit.
b. Industry Dynamics. Relatively lower entry barriers, high degree of regional element in the demand supply position, availability of the substitutes, relatively few competitive differentiations and dependence on Governmental support are some of the factors that define the industry dynamics for SMEs in India. The cluster approach being followed by Government of India and the priority sector status accorded to SSI units within SME sector adds another dimension to the analysis. The sensitivity of the unit to the availability of raw materials is also studied in detail.
c. Operational Performance. The unit is assessed for the operational performance parameters with an aim to identify its position among peers and also to judge the efficiency of its operations. The availability of enabling infrastructure facilities and technology are important considerations as many of these units are established in areas with inadequate infrastructure which seriously constrain the efficient operations of the unit. Rather than seeing in isolation, the operational performance is seen in light of overall framework of economy and industry.
d. Financial Risk. For analysis of financial risk, apart from analyzing the present performance of the unit, it is required to look into financial flexibility enjoyed by the unit in the form of availability of credit lines and support from promoter in the form of intrinsic networth. Credit lines from bigger corporates and banking relationship are some of the important parameters. Reliability of the accounts, submitted to CARE by the SME unit, are judged from conservativeness and consistency of accounting policies and transparency of accounting information, apart from the quality of the auditors. Key financial ratios like gearing, coverage, growth, turnover, liquidity etc. are analysed from the past as well as future perspective.
e. Project Risk Analysis. Higher project risk can also affect the financial strength of an SME, which can be assessed by project implementation risk, size and structuring of the project and post-implementation risk. CARE believes that promoter's track record in project implementation and parameters like financial closure are vital.
The rating outcome is ultimately an assessment of the above risks and their inter-linkages.
CARE Ratings has been focusing on covering the SME sector at an accelerated rate given the large area to be covered. The chart below provides a profile of small scale entities rated by CARE during the quarter ended June 2011.
The Parameters
CARE has carried out an analysis of highly rated Small Scale entities during this period. The NSIC-CARE SSI ratings grade the registered SSIs on two distinct parameters viz. Performance Capability and Financial Strength. The rated units are compared with other SSIs operating in the same industry. If a unit is operating in a niche product segment, then comparison is made with SSIs having similar exposure to business and industry risk factors. The entities covered in this study are highly rated, having ratings SE 1A, SE 1B and SE 2A indicating high to highest performance capability and moderate to high financial strength. The study aims at highlighting the various characteristics of the entities which have obtained higher ratings on the SSI rating scale.
The entities covered in this study belong to diverse industries like Auto-ancillary, Engineering, FMCG, Textiles, Building materials, Power equipment and Electrical components. Further, majority of the entities are constituted as either private limited or closely-held public limited companies with only one entity constituted as a partnership firm. The Limited Liability form of a business entity is viewed more favourably by CARE as it not only indicates the entity's compliance with applicable norms, but also the promoters' commitment towards its business. In a proprietorship or partnership form of business, the ability to withdraw and infuse capital creates difficulties in judging the networth base and other financial parameters like leverage, thereby further restricting the financial flexibility of an entity with lending institutions that are generally reluctant to take exposure.
Parameters considered by CARE for arriving at the Performance Capability grade can be broadly divided into management and business risk parameters. For entities getting a high grade on the performance capability, the management profile is characterized by long operational track (usually > 10 years), vast experience of the promoter(s) in the main line of business and technically qualified promoters. Their business risk profiles are characterized by established relationships with reputed clients, efficient marketing/distribution setup, relatively diversified product portfolio and proximity to key customers & raw material suppliers. Some entities have long-term supply contracts in place with their key customers which ensure fair degree of revenue stability. However, industry downturns do affect SSI entities with derived demand and thus, units catering to various end-user industries are better placed than others.
The financial strength of the entities is characterized by healthy growth in turnover, relatively comfortable leverage position, moderate profitability and good liquidity indicators (See table below). The operating cycle, as expected, is on the higher side mainly due to the entities' position in the industry value chain resulting in relatively lower bargaining power vis-a-vis customers and high degree of competition resulting in the need to keep higher inventory and extend high credit to customers.
Besides, CARE also looks at the ability of the promoters to infuse funds through capital/unsecured loans from their own sources to support the operations as and when required. More importantly, relationship with the bankers and the regularity of servicing the debt obligations in a timely manner is also a factor while arriving at the financial strength grade for an entity.
To conclude it may be reiterated that the concept of credit rating of SMEs becomes even more critical today given the importance of this sector as well as the pressing need to bridge the information gap for potential lenders. The NSIC-CARE SSI ratings go a long way in fulfilling this aspiration and it is expected that it becomes more popular with the entities which in turn will enable a freer flow of funds.
D.R. Dogra is MD & CEO,
CARE Ratings.
1 Comments >>
Bharat Prajapati
24 Jan 2012 (06:03:31)
Dear Sir,
Request to provide the Top 3 Rating. How you will consider Top 3 rating for bank interest Benefits out of total 15 rating.
Regards,
Bharat Prajapati.
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