Executive Summary

Firm's often find it economically valuable to establish separate legal entities - such as subsidiaries (for instance, in case of FMCG products), Special Purpose Vehicles (in case of Solar Power Projects) or as associate or group companies (as in the case of firms with multiple SBUs) - as against expanding its own scale of operations. The primary rationale behind such a trend is due to the onset of diseconomies of scale with larger size, more efficient tax planning & management and other regulatory issues. As the economy prospers, firms are bound to grow in size - resulting in both the birth of such legal entities and also in the consolidation of separate entitiesinto merged entities. 

This active process of forming complex inter-firm business networks results in a complicated stream of cash flows that transpires across group companies and along with the stream of cash accruals comes a myriad of uncertainty or risk. Thus, in order to better understand the risk involved in such economic-legal structures, Acuité consolidates the financials of the parent/group company with that of the holdings - in an attempt to unravel this complex web of cash flows and risk transmission.

Typically, Acuité believes in a necessary congruence between the accounting policies and financial analysis and to this end the method for consolidation followed is as articulated in the Accounting Standard 21 by the Institute of Chartered Accountants of India. Acuité also believes that these consolidated accounts are a necessary source of key information that enables the market to better deconstruct both the business and financial risks hidden in an enterprise.

Objectives of the Document

This document is fundamentally aimed at better understanding the need for consolidation of financial statements, and Acuité's own approach towards consolidation & the ensuing analysis of the same. It also sheds significant light on the larger study of the degree of support that a parent/holding/group company extends to its subsidiaries/SPVs/group company and Acuité's view on the same.

Method of Consolidation:

Acuité follows the following 3 stage method for consolidation:

• Reciprocal pairs of assets & liabilities are identified and offset against each other. Here, investments/interoperate borrowings or lending in related entities are negated against each other and only the net value is considered.
• Adjusting the Net-worth with that of the Subsidiary/group Company. Here, the net worth of the subsidiary is added to that of the parent and any investment by the parent in the subsidiary is deducted from the net worth of the consolidated balance sheet.
• Offsetting Revenues and Costs. Here, the inter-group transactions are offset - hence limiting transfer pricing related issues in inter-group transactions. By taking a net value, the financial ratios are re-calculated and analysed.

The most significant advantage of this method is that it does not necessitate the revaluation of the assets neither does it make it necessary for us to create goodwill to equilibrate the financial statements.

Cases Relevant for Consolidation

While the degree of impact of consolidation on the risk-return metrics varies significantly across firms and business models, however the need for consolidation as an exercise is well warranted in a large pool of cases - in order to ensure due diligence in the credit risk assessment exercise. Such a support mechanism may include significant holding, past track record of financial support or mutual collaboration of business interests. 

At the same time, the actual impact on the cash accruals of the parent/group company varies from case to case and thus, to evaluate degree and nature of inter-linkages Acuité analyses the following six factors to the extent they are applicable:

• Identify the Business & Strategic Significance of the Entity being rated for the Parent/group company
• Degree of leakages and injections of funds along with ease of support to and from the parent/group company to the entity being rated
• Presence of statutory, legal or documentary assistance to establish track record and likelihood of support from the parent/group entity to the entity being rated. Acuité also factors in the management's stated posture while analysing this factor.
• Analyse the percentage shareholding/crossholding by the parent/group companies in the related entity - higher the shareholding, greater is the probability of the parent/group extending support to the latter
• Understand the Management's Attitude towards the role of the rated Entity in the Parent/Group. Acuité also analyses the degree of management control that the related entity wields over the rated entity
• Study the presence or absence of shared names, brands, business channels and other synergies

Once the related entity and the firm have been evaluated on these parameters, Acuité establishes the degree of integration of both the entities and this understanding drives the foundation for further analysis. Only in cases where strong levels of inter-linkages are established, Acuité follows the complete integration method, wherein the business, financial and management risk profiles of the related entity and the entity being rated are combined. In cases where all the entities in a group are consolidated, each of the entities may not qualify for the same credit rating or outlook. Based on various parameters, there may be deviation in the credit ratings assigned among the entities that have been consolidated. In cases where semi-strong or moderate levels of linkages are established, Acuité may apply a group/parent notch-up to the ratings of the entity being rated. (Please refer Acuité's criteria on Group and Parent Notch up).