The credit analysis of an entity is governed by the degree of its exposure to industry risk, business risk, financial risk and management risk. The relative impact of each of these broad risk categories on an entity’s credit risk may vary from case-to-case and is assessed by Baptista Research based on both quantitative considerations as well as qualitative judgments. Baptista Research’s credit evaluation approach also involves an assessment of the entity’s management quality and governance practices. In addition to these considerations, an entity’s credit evaluation may also be influenced by its ownership, the nature of linkages with its parent or group entities, degree of financial flexibility, the corporate legal structure, track record of operations and that of debt servicing, vulnerability to discrete event risks, and other factors. We follow a two-pronged approach to proceed with our credit evaluation:
1 – Financial Strength Indicator
2 – Credit Evaluation Score
Financial Strength Indicator
The Financial Strength Indicator is Baptista Research’s proprietary quantitative mechanism that provides the most objective evaluation of a company’s financial statements, narrowing it down to one number. For the calculation of the Financial Strength Indicator, we use all the key ratios of the company with respect to value creation (Revenue Growth, EBITDA margin, EBITDA expansion, Net margin, cash flow generation etc.), working capital management (receivable days, inventory days, payable days, current ratio etc.), and of course, leverage (Debt-equity, Net-debt-to-EBITDA, Coverage ratios). We also use some of the latest metrics that have gained immense relevance over the past few years in credit analysis – the Altman Z-score and the Beneish M-score. As a part of our process, we assign weights to different ratios and determine scores based on industry benchmarks.
Needless to mention, every industry is characterized by different averages for each of these ratios. For example, it would be unfair to have the same scoring mechanism for the ratios of a fast-growing tech major like Microsoft and a global retail behemoth like Walmart. Given that Microsoft has significantly higher margins and a faster top-line growth, it should score significantly higher on a common platform but at the end of the day, it would be like comparing apples to oranges.
For this sake, Baptista Research has developed a strong database of industry data to have the right benchmarks for the comparison of different financial ratios of a company. The biggest differentiation factor of the Financial Strength Indicator is that it is a pure, objective quantitative metric that provides a true measure of the company’s financial risk. It looks at the numbers alone which is why there could easily be companies which have a decent Credit Evaluation Score (which includes the Financial Strength Indicator metrics + adds qualitative factors like industry risks, ESG risks, and so on) and yet do not have a good enough Financial Strength Indicator. The Financial Strength Indicator is measured on a scale of 5 and its interpretation is as follows:
Credit Evaluation Score
The Credit Evaluation Score is Baptista Research’s proprietary mechanism to carry out an assessment of a company’s creditworthiness. It is a measure of the degree of safety with respect to timely servicing of financial obligations. Each time we assign a company a score, it remains valid until the publication of its next annual financial results, unless we provide an interim upgrade/ downgrade depending on the quarterly performance or the occurrence of any significant events that might affect its creditworthiness. Our Credit Evaluation Score factors all the quantitative elements used in the calculation of the Financial Strength Indicator and adds to it, an evaluation of many key qualitative risk factors that we evaluate essentially using a checklist-based approach – regulatory risk, industry risk, concentration risk, forex risk, management risk, and ESG risks. The interpretation of the credit evaluation score is as follows:
Company Score Interpretation AAα (Highest Safety) Companies with this score are considered to have the highest degree of safety with respect to timely servicing of financial obligations. Such companies carry the lowest credit risk. Aα (High Safety) Companies with this score are considered to have high degree of safety with respect to timely servicing of financial obligations. Such companies carry very low credit risk. A (Adequate Safety) Companies with this score are considered to have adequate degree of safety with respect to timely servicing of financial obligations. Such companies carry low credit risk. BBβ (Moderate Safety) Companies with this score are considered to have moderate degree of safety with respect to timely servicing of financial obligations. Such companies carry medium credit risk. Bβ (Moderate Risk) Companies with this score are considered to have moderate risk of default with respect to timely servicing of financial obligations. B (High Risk) Companies with this score are considered to have high risk of default with respect to timely servicing of financial obligations. C (Very High Risk) Companies with this score are considered to have very high risk of default with respect to timely servicing of financial obligations. D (Default) Companies with this score are either in default or expected to be in default soon.