Criteria For Rating Of Trading Entities
7th October 2019 (Version 3)

Executive Summary

Trading entities are firms / companies involved in distribution, bulk breaking, retailing and trading of basic commodities, as well as products / finished goods with little or no processing. This rating methodology explains the approach adopted by Acuité to evaluate the business and financial risk profile of Trading Companies.

Trading entities are known to face challenges such as commodity / product price risks, foreign currency fluctuation risks, low margins and a competitive environment with low entry barriers. Acuité's credit risk assessment is based on the entity's scale of operations, level of supplier and customer concentration, value addition, if any (in terms of logistics, branding, retailing among others), exposure to forex fluctuation and extent of mitigation, inventory holding policy and volatility in the commodities being traded.

While evaluating a trading entity, Acuité takes into consideration Business Risk, Management Risk and Financial Risk but in a different light as compared to the methodology adopted for manufacturing companies.

Business Risk Analysis

While evaluating a trading entity's business risk analysis, Acuité considers the following factors:

• Size of Business and Sustainability
• Supplier Risk
• Inventory Risk
• Customer/Debtor Risk
• Forex Risk
• Level of Value Addition
• Regulatory Risk

Detailed explanation of the above factors is given below:

A. Size of Business and Sustainability

Higher scale of business indicates a more sustainable business position that enables an entity to have a greater influence over business trends and pricing to withstand various economic cycles. Scale also highlights the entity's bargaining power with customers and suppliers, economies of scale, preferential tie-ups with vendors and customers. With greater scale, usually the trading entity's diversification over geographies, products, suppliers and customers is high.

B. Supplier Risk

While analysing a trading entity, Acuité also tries to understand the supplier profile, length of relationship with the supplier, credit terms and preferential tie-ups if any. Acuité believes that the dependence on a few large suppliers could impact the business profile of the entity, although the same can be mitigated to some extent by the length of the relationship. Also, the fortune of the trading entity gets linked to the fortunes of the large supplier.

C. Inventory Risk

Acuité analyses a trading entity's inventory risk under three areas:-

• Inventory Holding Policy: The business model of the entity is analysed along with past trends, to understand the inventory holding requirements that a trading entity may have. Businesses involving low value addition such as bulk breaking and high seas sales of basic commodities generally have lower inventory holding requirements. Whereas, entities in retailing, distribution and trading of slightly more complex products with several stock keeping units (SKUs) are generally seen to have higher inventory holding requirements. For entities that have order backed trading operations, or back-to-back trading model, the inventory risk is low. However, for other entities, generally, higher the inventory holding requirement, higher is the inventory risk.
• Volatility in the commodity being traded and hedging mechanism: Acuité then goes on to analyse the volatility in commodity prices being traded along with the entity's inventory holding requirements. Thus a jeweller (retailer) or a distributor of steel products will have more exposure to inventory risk. Acuité also evaluates the hedging mechanism the trading entity employs and the effectiveness of the same to mitigate price risks such as booking forward contracts on the commodity exchanges.
• Ability to pass on the price increase to customers: Acuité evaluates the trading entity's ability to pass on significant price increase to customers. Entities that have well defined price escalation clauses with their customers or arrangements with their suppliers to share the downward price movements in the traded commodities, generally have better stability in profit margins.

D. Customer/Debtor Risk

Generally, entities having low bargaining power with their customers tend to extend higher credit to enhance their competitive advantage. Also, concentration of debtors from a few large customers would lead to higher risk of working capital stretch or defaults in payments. In such cases, the credit profile of customers itself becomes a key input while assessing the business risk profile of a trading entity.

The entities with well laid out credit policies are more insulated from counterparty risks. Credit policies can broadly cover limits on credit lines extended to counterparties, method of computation of credit limits, limits on trade volume, to name a few. Acuité also analyses the mode of collection of payment, such as Letter of Credit, post-dated cheques, advance payment against supplies etc., to understand the counterparty credit risk associated with an entity. 

E. Forex Risk

While analysing the trading entity's business risk profile, Acuité evaluates the entity's exposure to currency fluctuation risk. A trading entity's foreign currency risk is more acute when it imports goods on credit (either LC or clean credit) and sells the same domestically or procures domestically and exports. Acuité also evaluates the effectiveness of the various hedging mechanisms employed by such entities to mitigate significant fluctuation in forex rates. Additionally, Acuité positively factors in any natural hedge that may exist in case the entity has forex earnings and spending of comparable levels.

F. Level of value addition

Lastly, Acuité evaluates the level of value addition of the trading entity in the entire value chain that would invariably lead to higher margins and better return indicators. Trading entities involved in packaging and retailing (both online and the conventional models), branding, distribution, logistics and basic levels of processing, would have higher margins and better ability to absorb price shocks.

Regulatory Risk

In India, the regulatory environment is fairly stringent for certain sectors, restricting free trade, sourcing, warehousing and even pricing of essential commodities. In an attempt to strike a balance between the welfare of the agricultural community and ensuring supplies at competitive rates, the government also engages directly in sourcing and pricing (by setting minimum support prices) of essential commodities. Given these considerations, Acuité carries out detailed analysis of the regulatory framework and factors it in the overall business risk profiles of the trading entities.

Financial Risk Analysis

The debt contracted by a trading entity is generally short term, self-liquidating in nature, to fund its inventory and debtor requirements, with minimal to nil long term debt. Also, the reliance on non fund based limits such as letter of credit forms a large part of the entity's liabilities, especially for those engaged in import of commodities. Acuité takes into account these factors while analysing the entity's financial risk profile.  
Acuité assesses the entity's adequacy of cash flows to meet indebtedness, while also assessing the management's policies with regard to financial risk. The historical financials, fund and cash flow statements and financial projections provide essential information about the entity's operations. Some of the sub-factors considered in financial risk analysis are:

• Trend: Sales, sales returns, profitability, debt-equity, debt servicing cover
• Margins: Operating profit margins, PAT margins among others
• Liquidity: Current ratio, quick ratio, inventory days, receivable/payable/working capital days
• Return Measures: Return on net worth, Return on capital employed and Return on assets
• Debt and Debt Coverage: Debt equity mix, Total outside liabilities (TOL) to Net worth ratio, Interest coverage ratio.

Acuité's financial risk evaluation also includes trend analysis and peer comparison to understand the relative risk standing of the entity. Understanding an entity's financial and accounting policies is a must to ascertain the accounting quality. Several analytical adjustments are also required to evaluate financial risk.

A detailed review of the past financial statements is done to understand the influence of all business and financial risk factors on the entity's performance. While current and historical information is necessary to establish an entity's condition and financial track record, future financial projections are required to estimate the expected performance. Projections are sensitized to assess the future financials under conditions of stress.

Management Risk Analysis

Evaluating the quality, capability and stability of management is vital to an entity's long term prospects. Accordingly, operational success, risk tolerance capacity and vision of the management is taken into account. Management integrity is an essential part of the rating process. Charting a definitive course of action and effectively executing various aspects of business form key functions of any management team. Acuité believes that management's track record, second tier management, formal succession plan, and high degree of expertise including corporate governance are vital to the long term sustainability of the entity. A critical evaluation of the organisational structure, quality of systems and procedures is also essential for assessing management risk. Moreover, the management's philosophy with respect to leverage and aggressiveness is also assessed.