Non-banking financial companies have an edge over traditional banks. These organisations are governed independently and have operational and lending flexibility.
However, with these flexibilities comes a risk of whether the NBFC is carrying out its operations wisely or due to fewer regulatory requirements, its lending money without due diligence.
Here’s where credit rating agencies step in. These agencies do a credibility check for NBFCs and provide a specific rating indicating how reliable the NBFC is, if an investor invests their money in the debt instruments offered by them.
This blog aims to list all the parameters that every credit agency looks for in an NBFC and provide a rating. We will also discuss the interpretation of various ratings and why it is safe enough to invest in NBFCs with less than an AAA rating.
Rating Agency Methodology
Credit Rating agencies like CRISIL and ICRA have their way of rating NBFCs. However, the underlying concept of analyzing NBFCs remain the same.
While some agencies categorize the parameters into business risk and Financial risk-related parameters, the other agencies straightaway scrutinize the functions of the NBFCs and apply the parameters directly without classifying them.
7 Parameters Every Rating Agency Uses to Rate an NBFC
CRISIL, ICRA, CARE Limited, etc., are some of India’s leading credit rating agencies.
They have particular procedures to scrutinize an NBFC’s operations and management, and other factors. Moreover, all these parameters are not applied equally to all the NBFCs. Every NBFC is different and based on their performance and other circumstances, the weightage of each parameter changes.
For example, a well-established NBFC may be ranking well in the capital adequacy (a statutory reserve that every financial institution must have) parameter.
Still, a newly started NBFC cannot be rated based on its performance or capital adequacy as it will not have enough data, since it has just started its operations.
Keeping certain important factors in mind, let’s check out the 7 paramteres that rating agenies use to deem an NBFC.
To meet debt commitments, NBFCs must maintain a sufficient level of liquidity.
One should not overlook the funding activities and the debt commitments. Rating agencies stress that NBFCs should maintain a good liquidity level for effective operations.
2. Asset Quality
Rating agencies classify assets into standard, sub-standard, doubtful, and loss.
In addition, the recovery record of the questionable and loss assets is thoroughly inspected to understand its functioning better.
3. Management and Governance
This qualitative parameter evaluates the management’s capability and robust governance structure.
The effective policies and procedures by the management, expectations by stakeholders, etc., form a part of this parameter. Here, the rating agency assesses the quality of leadership and governance.
4. Risk Management
Broadly, there are two types of risks involved;
a. Business risk — Includes failure on the part of the management to make it a successful business
b. Financial risk — Financial risk refers to the inability of the business to meet its financial obligations and displaying poor financial health to its stakeholders.
5. The Operating Environment
The operating environment considers the growth of the NBFCs and quality of asset categories to ensure the entity works on a ‘going concern basis’.
There are no other indications that create a threat against the company.
Profitability is an essential aspect of the rating parameter. Agencies lookout for profitable NBFCs that are not as well-established but have the potential to generate more income.
7. Capital Adequacy
Under this parameter, the agencies evaluate whether an NBFCs’ assets are sufficient to absorb the possible losses.
A high capital adequacy ratio is interpreted as more capability of the company to tackle failures and protect debt holders’ interests.
Understanding Credit Ratings
|AAA, AA+, AA, AA||When any NBFC is rated in the range of AAA to AA, its creditworthiness is considered highest, and the chances of such NBFCs to default or go bankrupt is significantly low.|
|A+, A, A-||Such NBFCs represent a strong debt-repayment capacity and are financially stable, but they are prone to changing economic conditions.|
|BBB+, BBB, BBB-||These ratings are not the best, but they are still reliable for investing. Often called ‘high-yield’ investments, BBB- rated investment instruments can generate higher returns, but they are risky. Hence, they fall in the ‘speculative category.’|
|B+, B, B-||Instruments with B ratings are extremely risky investments, and hence, they offer more returns. The rating suggests that the NBFC has a higher chance to default, or its going concern is doubtful.|
The AAA rating indicates the highest creditworthiness for an NBFC, which means the chances of that NBFC defaulting or going bankrupt is quite less.
Whereas, ratings such as BB or C+ suggest that the product offered by the NBFC is high-yield, meaning they have a high potential to generate more returns, but carry increased risk.
A simple rule in investing denotes that instruments generating higher returns will be highly risky. On the other hand, if you want to invest in less risky products, the returns may not be as high. However, it will be a more stable investment.
Ratings below AAA does not indicate that the NBFC will default in repaying your money, or it will go bankrupt. Instead, it suggests a speculative grade of the NBFC, which means that the NBFC will be more volatile to changing economic needs.
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The Bottom Line
Credit ratings guide an investor’s decision-making as the ratings are given considering various qualitative and quantitative parameters.
However, if you only base your decisions on credit ratings, it would not serve the purpose, which is, optimization of returns.
Moreover, everyone’s financial goal is different and too much reliance on ratings can prevent you from making a good investment decision.
Further, you should also do an independent analysis of the company in which you are planning to invest rather than relying purely on rating agencies’ views. In past, we have seen good performance from non AAA rated entities and at the same time few AAA rated entities have also defaulted.
Therefore, the best investment strategy would be to invest your money in instruments that suit your risk-taking ability, so that you can earn subsequent returns.