Factors Considered in Assigning a Rating In conducting its examination, the rating agencies consider the four Cs of

Factors Considered in Assigning a Rating In conducting its examination, the rating agencies consider the four Cs of

credit—character, capacity, collateral, and covenants. The first of the Cs stands for character of management, the foundation of sound credit. This includes the ethical reputation as well as the business qualifications and operating record of the board of directors, management, and execu- tives responsible for the use of the borrowed funds and repayment of those funds. Character analysis involves the analysis of the quality of management. Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is management’s ability to react appro-

Intermediate and Long-Term Debt

priately that will sustain the company’s performance. In assessing man- agement quality, the analysts at Moody’s, for example, try to understand the business strategies and policies formulated by management.

The next C is capacity or the ability of an issuer to repay its obliga- tions. In assessing the ability of an issuer to pay, an analysis of the finan- cial statements is undertaken. In addition to management quality, the factors examined by Moody’s, for example, are (1) industry trends, (2) the regulatory environment, (3) basic operating and competitive posi- tion, (4) financial position and sources of liquidity, (5) company struc- ture (including structural subordination and priority of claim), and (6) parent company support agreements. In considering industry trends, the rating agencies look at the vulnerability of the company to economic cycles, the barriers to entry, and the exposure of the company to techno- logical changes. For firms in regulated industries, proposed changes in regulations must be analyzed to assess their impact on future cash flows. At the company level, diversification of the product line and the cost structure are examined in assessing the basic operating position of the firm.

The rating agencies must look at the capacity of a firm to obtain additional financing and backup credit facilities. There are various forms of backup facilities. The strongest forms of backup credit facili- ties are those that are contractually binding and do not include provi- sions that permit the lender to refuse to provide funds. An example of such a provision is one that allows the bank to refuse funding if the bank feels that the borrower’s financial condition or operating position has deteriorated significantly. (Such a provision is called a “material adverse change clause.”) Noncontractual facilities such as lines of credit that make it easy for a bank to refuse funding are of concern to the rat- ing agency. The rating agency also examines the quality of the bank pro- viding the backup facility. Other sources of liquidity for a company may

be third-party guarantees, the most common being a contractual agree- ment with its parent company. When such a financial guarantee exists, rating agencies undertake a credit analysis of the parent company.

The third C, collateral, is looked at not only in the traditional sense of assets pledged to secure the debt, but also to the quality and value of those unpledged assets controlled by the issuer. In both senses the collat- eral is capable of supplying additional aid, comfort, and support to the bond and the bondholder. Assets form the basis for the generation of cash flow that services the debt in good times as well as bad.

The final C is for covenants, the terms and conditions of the lending agreement. Covenants lay down restrictions on how management oper- ates the company and conducts its financial affairs. Covenants can restrict management’s discretion. A default or violation of any covenant

FINANCING DECISIONS

may provide a meaningful early warning alarm enabling investors to take positive and corrective action before the situation deteriorates fur- ther. Covenants have value because they play an important part in mini- mizing risk to creditors. They help prevent the unconscionable transfer of wealth from debtholders to equityholders.