VIS Corporate

MAY 2023
Credit Rating Company Ltd.

VIS
Credit Rating Company Limited.

CORPORATE RATING
METHODOLOGY

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Table of Contents

SCOPE OF CRITERIA ..........................................................................................................................................................................3

SUMMARY OF CRITERIA CHANGES ..........................................................................................................................................3

AN OVERVIEW OF RATINGS FRAMEWORK ..........................................................................................................................3

RATING METHODOLOGY- STANDALONE RATINGS .........................................................................................................4

A. BUSINESS RISK ASSESSMENT ..............................................................................................................................................4

A. (i) Industry Risk .......................................................................................................................................................................5
A. (ii) Management & Organizational Profile ....................................................................................................................7
A. (iii) Operational Risk ..............................................................................................................................................................8
B. FINANCIAL RISK ASSESSMENT ........................................................................................................................................ 10
B. (i) Capital Structure & Access to Capital .................................................................................................................... 10
B. (ii) Profitability ..................................................................................................................................................................... 11
B. (iii) Cash Flow Generation ................................................................................................................................................ 11
B. (iv) Liquidity .......................................................................................................................................................................... 12

KEY RATIOS ........................................................................................................................................................................................ 13

CASH FLOW & COVERAGE RATIOS .................................................................................................................................... 13

LIQUIDITY RATIOS ..................................................................................................................................................................... 13
PROFITABILITY RATIOS ........................................................................................................................................................... 13
CAPITALIZATION ........................................................................................................................................................................ 13

RATING SUPPORT FACTORS...................................................................................................................................................... 14

THE RATING SCALE & HORIZON .............................................................................................................................................. 14

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SCOPE OF CRITERIA
The criteria ‘Corporate Rating Methodology’ applies to a wide range of Industrial and services sector non-financial
corporate issuer / entity ratings conducted by VIS Credit Rating Company Limited (VIS). Entity ratings reflect the overall
ability and willingness of a company to repay its senior unsecured creditors while debt instrument ratings also take into
account the structure of that particular instrument and its priority in the capital structure which strengthens or weakens
its recovery prospects vis- à-vis the unsecured creditors.

It is important to recognize that rating is an opinion on the overall ability and willingness of a company to make timely
payments and the rating bands denote the relative risk associated with the ratings. Rating is not a guarantee against loss.
A rating does not constitute a recommendation to purchase, sell, or hold a particular security. In addition, a rating does
not comment on the suitability of an investment for a particular investor. It is important to recognize that rating is an
opinion on the overall ability and willingness of a company to make timely payments and the rating bands denote the
relative risk associated with the ratings. Rating is not a guarantee against loss. A rating does not constitute a
recommendation to purchase, sell, or hold a particular security. In addition, a rating does not comment on the suitability
of an investment for a particular investor.

SUMMARY OF CRITERIA CHANGES

The fundamental criteria as outlined in ‘Rating Methodology - Industrial Corporates’ dated August 2021 remains the
same with no changes to the ratings framework itself. This document encompasses revision to the short-term rating
scale. The addition to the rating scale aims to bring greater clarity for short-term obligations.

As markets develop and ratings universe continues to expand, VIS continues to deepen its understanding of the debt
market and makes regular updates to account for changing market conditions. Sectoral Research are regularly
disseminated in the Sector Updates posted in the Knowledge Center on the VIS website.

AN OVERVIEW OF RATINGS FRAMEWORK

VIS ratings framework has two broad components: (A) Business Risk and (B) Financial Risk, with several sub-factors. Each
area is assessed during the ratings process and the individual assessments are combined to arrive at the final rating.
Weaknesses in one area may be offset by strengths in another or vice versa. While some factors such as financial ratios
have clearly articulated benchmarks for each rating band, some areas require subjective assessment; this makes rating
as much an art as a science.

Through several years of experience, VIS has established weightages for the different rating factors. However, these
weightages are subject to change over time and across industries. For entities operating for 5 years or more, it is
recommended to allocate higher weight of up to 60% to financial risk, as matured operational dynamics and consistent
financial results are expected from such companies. On the other hand, a higher weight for business risk is recommended
for entities with shorter performance history.

The Business Risk assessment itself is performed at two levels; first at the industry level and then at the company specific
level. The industry risk assessment focuses on the degree of cyclicality and the strength of competitive forces along with
the extent of capital intensity, vulnerability to technological change and level of regulatory interference in the industry.

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At the company specific level, business risk analysis includes management quality assessment, organizational structure,
and operational risk factors. The objective of this analysis is to ascertain the strength of a corporate entity’s business
model, franchise value, diversity, competitive advantage and adequacy of operational systems, together with a review of
quality of management and organizational structure.

Financial Risk analysis includes an appraisal of the historic and projected financials, risk entailed by the capital structure,
level of profitability and, adequacy of cash flows to meet operational requirements and debt servicing obligations.
Financial statements may be re-casted to assess the company’s performance over a timeline. The projected financials are
studied for management’s expectations regarding future economic environment and are also sensitized for different
scenarios to determine the company’s ability to bear operational and financial risk. While review of history is important
to judge the company’s track record of performance, it is the potential for future performance which primarily drives the
ratings.

Finally, ratings take into account the external support available to the entity and may be enhanced on the basis of the
nature of support from sponsors / shareholders, associated companies etc. and the relative credit standing of the
supporting entity.

Business Risk Financial Risk

Capital
Industry Risk
Structure
External
Standalone Support Issuer Credit
Management Credit Profile (if available) Rating
& Organization Profitability
Profile

Operational Cash Flow

Risk Generation

Liquidity

*Weightages assigned according to stage of industry/entity life cycle

RATING METHODOLOGY- STANDALONE RATINGS

Our assessment model is based on some key factors, qualitative and quantitative, which may further be broken down into
sub-factors to comprehensively capture the rating drivers.

A. BUSINESS RISK ASSESSMENT BUSINESS RISK SUB-FACTORS

Industry risk along with operational risk and management & organizational Industry Risk
profile of a specific company determines mainly the business risk of an
Management & Organization Profile
entity. The business risk of a company to a large extent dictates the extent
of financial risk it can afford by affecting the level and predictability of cash Operational Risk

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flows that the companies operating in that industry are likely to generate. Higher and predictable cash flow streams will
lower the business risk.

A. (i) Industry Risk

As mentioned earlier, rating analysis begins with an assessment of the
INDUSTRY RISK SUB-FACTORS
environment in which the company operates. The industry risk assessment
provides guideline for rating ceiling of individual entities within a given Cyclicality
industry. For example, given the stage of the industry life cycle of the jute Competition
sector, ratings in the sector may not breach “A” band, regardless of how
Capital Intensity
conservative the financial risk profile at a point of time may be. On the other
hand, certain industries may feature strong growth prospects, robust Technology Risk
margins and flexibility in timing and amount of capital outlays – such as the Regulatory Framework
pharmaceutical sector. While all companies in sectors with such traits may Energy Sensitivity
not have high ratings, but the strong industry fundamentals provide cushion
against financial risks.

VIS analyzes the dynamics of the business to determine the degree of cyclicality in a given business. Corporate entities
are said to be highly cyclical when financial performance fluctuates significantly because of changes in the economic
environment. VIS categorizes all industries for cyclicality and other sub-factors on a spectrum of High to Low risk. In an
economic boom when consumer confidence and incomes are high, highly cyclical industries such as automobiles will
experience increased sales, while sales usually suffer during economic downturns as people try to save money on large
expenses. Similarly, steel manufacturers do well when the economy is doing well. Vibrant economy triggers more
construction thereby resulting in more demand for steel. When the economy is in depression, there is austerity all around
resulting in fewer construction activities and hence subdued performance of steel companies.

Commodity based industries are also prone to swings. For example, companies in the oil sector remain vulnerable to
changes in international oil prices. Even the strongest players in the industry are exposed to fluctuations in margins and
profitability due to changes in commodity prices. Conversely, some industries are more stable. They demonstrate steady
demand growth and are resilient to economic expansion as they are to economic recession. Consumer goods sectors such
as soaps, detergents, food items and pharmaceutical industry all exhibit low cyclicality.

VIS evaluates industries through their cycle. While rating through the cycle, it is possible that during economic upturns,
certain ratings may appear depressed and vice versa; however, it is the ability of a company to weather potential
downturns that will determine its long-term rating. As long as reversal in performance can reasonably be expected
following a downturn, there may be no need to lower the ratings during the downturn.

Financial flexibility and liquidity are important considerations as cash can accumulate and be consumed very rapidly
in cyclical industries. Generally, companies in cyclical industries accumulate cash during the boom cycle to provide a
buffer during the downturn. The strength of the cash flows from year to year is hard to determine due to volatility,
especially if it is in both input and output prices and volumes, and large capital expenditures spread variably across the
cycle. Relative cost position then becomes a competitive strength in the industry as in a downturn the lowest cost
producer has the room to cut prices up to breakeven level to maintain or increase market share which may result in
unsustainable losses for the higher cost producers.

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It is also important to understand the timing and level of capital expenditures in cyclical industries. Generally, capacity
increases come near the peak of the cycle on an industry-wide basis. Whether demand will remain as robust till the time
the new capacities come online becomes critical and may be difficult to predict. For instance, the Pakistan cement
industry had tripled its capacity from 15 million tons in 2001 to 45 million tons in 2009. Unfortunately for the industry,
that expanded capacity and the associated debt payments came online right after the economic crash of 2008, which
resulted in a painful few years for the industry that saw depressed profits and companies struggled to repay their debts.

Analysis of the competitive factors affecting an industry is also a key consideration in assessing industry risk. Competitive
risk may be analyzed through the effectiveness of barriers to entry, risk of substitution and prospects for growth. Low
entry barriers, competition from other industries or from alternative technologies within the industry and prospect of
declining revenues or rapid growth in an early industry age can be major elements of risk. In the domestic context,
fertilizer industry is categorized as low risk with high barriers to entry, low risk of substitution and moderate growth
prospects.

Capital intensity in terms of initial capital outlay as well as maintenance or expansionary capex, can increase industry risk
especially for those with a long-term return horizon. Financial strength and access to funds becomes an important
determinant for supporting long-term growth in such industries. For example, automobile manufacturing is considered a
capital intensive industry with heavy capital expenditure required for facilities, infrastructure, and manufacturing
equipment. Power sector also requires large outlays and therefore capital intensity is rated as a high risk factor for
players in this sector.

Changing technology and consumer preferences makes some industries obsolete more rapidly than others, requiring
constant capital investment. This vulnerability to technological change is more evident in certain industries such as
information technology, telecommunication and consumer durables. The technology inherent in an industry, including
the industry’s rate of innovation or the rate of a product’s obsolescence, creates an expectation from customers
concerning the development of new products. This requires skilled employees and an effective innovation process which
may also act as a significant hurdle for many companies.

Regulatory framework in terms of licensing, approvals, tariffs, taxation, environmental regulations and price controls, is
analyzed since it affects business strategy and future performance. If the regulatory environment is overly restrictive, it
may hamper industry growth potential. On the other hand, balanced regulations establish a safety net for operators in
the industry enhancing their financial performance. Margins in the pharmaceutical industry remain constrained due to
price regulations by the government. In view of this, the regulatory framework is rated as a high risk factor for the
pharmaceutical industry. The degree of regulatory support the industry receives is also a function of its contribution to
economic growth which will determine its importance to the economy and to policy makers.

Another factor affecting rating is the sensitivity of the industry to energy requirements. To determine future profitability
of industries such as cement and steel that have high energy requirements constituting a sizeable portion of their input
cost, an analysis of uninterrupted supply of energy becomes critical.

The industry risk assessment sets the stage for analyzing more specific company risk factors and establishing the priority
of these factors in the overall evaluation. For example, if an industry is determined to be highly competitive, market share
of the entity and its sustainability over the long-term needs to be assessed. Similarly, if the industry has huge capital
requirements, sponsors’ financial strength and company’s ability to access capital assumes greater importance.

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When a company has units operating in multiple sectors, each business unit is separately analyzed. An overall industry
risk assessment is arrived at by weighting each business unit as per its importance to the overall organization. The
potential benefits of diversification, which may not be apparent from the additive approach, are then considered. In such
a business setup, the management’s ability to run diverse business operations is one of the most critical factor in
addition to the industry specific challenges posed by each sector in which the company participates.

OIL & GAS- POWER TELECOMMUNI-

INDUSTRY RISK AUTOMOBILE CEMENT FERTILIZER PHARMA SUGAR
REFINERIES GENERATION CATIONS

Cyclicality High High Low High Low Low High Low

Medium Medium to Medium to Medium

Competition Low Low Low Medium to Low
to Low Low Low to Low
Medium to
Capital Intensity High High High High High Medium High
Low

Technology risk Medium Low Low Medium Low Medium Medium High

Regulatory Medium
Medium High to Low High High High High High
framework To Low
Energy
Medium High Medium High Low Medium to Low Low High
Sensitivity
Overall Industry Medium to High to Medium to
Medium Medium Medium to Low Medium Medium
risk Low Medium Low

A. (ii) Management & Organizational Profile

MANAGEMENT RISK SUB-FACTORS
The credibility of the management is evaluated by the convergence of the
management strategy and established business goals and its performance Organizational Structure
against those objectives. Business performance that is consistent with
Management Information
plans and objectives reflects positively on the management. VIS also
Systems
analyzes the extent to which good performance is a result of good
management, or achieved despite muted management! This becomes Internal Controls
more apparent with results across business cycles.

Management meetings are an integral component of the ratings exercise which allow VIS team to understand the profile
of the team beyond what is reflected in numbers and plans. Management is assessed for its operational effectiveness and
for its risk tolerance. The stability of the management team and the relevance of their credentials to their tasks are also
important considerations.

Organizational structure depicts the overall management philosophy and determines operational efficiency and success.
Over-dependence on just a few individuals, absence of succession planning, heavy orientation towards family versus
professional management, indistinct management structure, too much interference by the board in day-to-day
operations, absence of delegation, etc. become rating constraints. The formulation of a vision by the top management
and its communication at all levels is a pre-requisite for organization building. Employee awareness of the overall goals
and objectives of the company and the short-term and long-term strategy towards achievement of those goals is
important for business growth.

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The legal structure of a company also has a strong bearing on the ratings. Sole proprietorships and partnerships generally
lack appropriate governance and reporting mechanisms which may affect credit ratings as operational risk for such
entities is generally higher. Key man risk is more prominent in sole proprietorships, making succession planning analysis
more pertinent. Similarly, due to unlimited liability, ring fencing of personal and business assets and set-off clauses
particularly in case of litigation are also taken into account since eventual recovery prospect for lenders is given due
weightage particularly for investment grade ratings.

If the composition of ownership is within a family structure, it is important to distinguish the management control from
ownership structure, i.e., determining silent majority partners. Here the important element is to study the partnership
agreement between the partners to understand the nature and extent of sharing of profit and loss, particularly between
investing partners and the working partners to identify potential conflicts. Drawings by the partners over time need to
be reviewed.

Other important factors in assessment of sole proprietors and partnership entities include the length of time the entity
has been in operation and the educational, work experience and financial strength of controlling partners to support
business operations, when needed. Historical track record through various business cycles is a key rating consideration.

Given the changing business dynamics and higher exposure to business risk, review frequency for sole proprietorships
and partnerships may be higher compared to other corporate structures.

In limited liability companies whether listed or not, the extent of disclosures beyond minimum statutory requirements
are important from risk assessment perspective. Also the voluntary adoption of governance best practices reflects
positively on the objective and transparent approach of management.

Over time, assessment of management information systems for their adequacy together with a review of security
features, disaster recovery and business continuity plans has become increasingly important for credit ratings. The level
of IT integration with core operations may help determine the operational risks associated with the entity.

Internal controls play a critical role in both public and private companies because they not only safeguard an organization
from financial loss but also assist in maintaining reliable financial reporting and maximizing effective operations. In a non-
regulated industry, aggressive financial policies supported by a weak internal risk management framework are assessed
as high risk.

A. (iii) Operational Risk INDUSTRY RISK SUB-FACTORS

The company’s product lines and its market share for each determines its Market Share
ability to govern the market supply and, hence, output prices and may
Competitive Advantage
render it an advantage over other market players. VIS is cognizant that large
shares are not always synonymous with industry dominance and if an Diversification
industry is highly fragmented, even the large firms may lack pricing Access to Raw Material
leadership potential. The textile industry is an example with several large Availability of Skilled Labor
players in the local market.
Financial Flexibility
Companies with a competitive advantage generally allow for better margins Growth Potential
and greater stability and control over output price. Leading brands are
Quality of Plant & Machinery
generally associated with superior pricing power and more stable earnings
due to customer loyalty. Factors that could contribute to competitive Regulatory issues
Availability of Substitutes

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advantage include the size of the entity, diversity of product or services, strategic location, demonstrated track record of
superior service or product development, efficient distribution channels and significant intellectual property. While
there is no specific criterion for size associated with different rating bands, size becomes an important factor if it is able
to translate into market advantage. On the other hand, small companies can also possess competitive advantage in rare
situations.

Diversification within the industry including variety in product lines and target markets in most contexts is viewed
favorably as it mitigates business risk to operations. Larger well diversified companies generally have greater resilience
due to their extensive resource base and stronger shields in terms of economies of scale, broader market access or
customer base and large number of products which may enable them to better withstand economic downturns. Smaller
companies in the growth stage generally lack the above strengths; a weak financial structure would add to their
vulnerability in times of economic or business downturn.

Similarly, the supply and price risk of raw materials is assessed including the availability and nature of market of raw
materials together with foreign markets, supplier relationships and substitutes, if any. For industries / companies
dependent upon foreign markets for input supply or for sales, timely access and fluctuations in exchange rate pose major
risks.

Over time, while labor union issues have become less common, availability of skilled labor has gained greater importance.
For instance, technology has had profound effects on labor markets. Automation and digital advances have shifted labor
demand away from routine low- to-middle- level skills to higher-level and more sophisticated analytical, technical, and
managerial skills, which may be particularly relevant for industries such as engineering. The widening skills gap poses
challenges for industries looking to move towards automation.

Financial flexibility is an important factor assessed by VIS in their ratings. Well-developed multiple banking relationships
with access to full array of banking facilities and competitive pricing are viewed favorably. Lack of adequate working
capital lines or asset mismatch is usually a negative factor in the case of small companies. Short term funding coverage
against liquid assets of less than 1x is assessed as high risk.

Future earnings growth potential of the company and management plans for achieving that growth is of particular
importance. At a first glance, a mature cash generating company may come across as favorable, however, if the company
fails to achieve earnings growth over the long run, it can become a limitation. For rating purposes, companies with a lack
of growth potential are considered high risk.

Business risk of manufacturing concerns is also affected by the quality of plant and machinery, capex spends and optimal
utilization of existing capacity together with timely execution of expansion plans. This becomes more important for
businesses that are technology dependent. Failure to keep up with competition in terms of technology upgrades may
affect the ratings negatively.

Regulatory issues facing the company are duly weighed upon. Regular instances of non- compliance may signal higher
operational risk impacting the rating assessment accordingly. Additionally, long standing legal disputes may create
reputational issues for the company and ultimately result in financial costs.

The availability of substitute products can create more competition and decrease profit potential for the company.
Examples of substitute products include sugar and artificial sweeteners, powdered milk and fresh milk and newspapers

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and digital news channels. The existence of substitute products may lead to greater marketing spend to protect market
share which in turn may affect the operating profitability of the company; hence considered high risk for rating purposes.

B. FINANCIAL RISK ASSESSMENT

The financial risk assessment is primarily driven by an objective analysis FINANCIAL RISK SUB-FACTORS
of the company’s performance against predefined benchmarks. In Capital Structure & Access to
undertaking this analysis, VIS not only looks at the absolute levels of Capital
ratios, we also focus on trends and compare these ratios with those of Profitability
competitors. Financial ratios are also evaluated in context of a firm’s
business risk. A company with stable cash flows and favorable business Cash Flow Generation
prospects may take up added financial risk than a company having higher Liquidity
business risk.

B. (i) Capital Structure & Access to Capital

The financial policy of the management is assessed to determine the degree of flexibility in the capital structure of the
company as compared to its business risk. Common shares provide the greatest cushion to creditors, as they do not entail
any fixed obligations. Preference shares, depending upon their features, also have greater flexibility in payments vis-à-
vis pure debt instruments as the dividend payments are made out of available profits, although they pose a greater strain
on cash flows as compared to common equity.

While the definitions of equity and debt remain standardized, certain adjustments are at times necessary to evaluate the
capital structure of the company on the basis of the structure and intent of the instrument. Preference shares may bear
greater characteristics of debt if they are cumulative and carry a redeemable option which has high probability of being
exercised. Debt instruments may also carry options for conversion into equity; however, such is not accounted for until
the event takes place as the interest payments are most likely fixed and payable by the company till conversion. Sponsor
loan may also be considered as quasi-equity for rating purposes if the same is fully subordinated, interest free and
repayable at the discretion of the company. Any un-provided losses or provisions are typically netted off including dead
investments or lending with little likelihood of repayment. On the other hand, a company is given the benefit of hidden
reserves, if any, in the form of high value assets not reflected on the books. Revaluation surpluses on fixed assets are
generally treated as illiquid unless they are occurring from easily marketable assets.

Leverage translates into higher returns enhancing shareholder’s value, however, at the same time, increases the risk
level as fixed obligations increase. An analysis of the source of funding, tenor and the associated costs with respect to the
assets being financed is conducted to assess the re-financing risk of the balance sheet. The level of unencumbered assets
to total assets is also considered to determine room for additional leverage. A higher leverage would generally be
considered risky and viewed with caution in rating analysis.

The capital structure of the company will also affect the profitability through the burden of debt servicing costs and
unless matched by high gross margins is detrimental to financial risk profile. As the risk associated with the capital
structure increases, lenders may demand greater compensation for their exposure.

VIS also examines company’s access to capital under stress. A company’s experience with different financial instruments
and debt and capital markets gives it several options in case funds from a particular source dry up for any reason. Also,
limited domestic capital market may prevent a company from accessing local markets at reasonable rates or at times of

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stress. In case of outstanding lawsuit against a firm, suppliers or customers may be reluctant to continue doing business,
and the company’s access to capital may also be impaired, at least temporarily.

Large firms have substantial staying power and banks may have high level of exposure to these firms within their loan
books. This may sometimes create a reluctance to abandon them during times of stress. On the other hand, liquidity may
be pulled back more easily from small companies, even with previously committed lines. Investor perception and
confidence in the company’s viability is critical to have access to capital.

B. (ii) Profitability
Strong profitability over time, coupled with judicial retention, is able to attract external capital as well as withstand weak
business cycles. Historical trends and the current and expected market situations are examined to project future
profitability to form a broad idea of stable, improved or deteriorating profitability position in the intermediate to the
long-term. The projected profitability levels are subject to various stress tests including reduced volumes, unfavorable
change in input and output prices, unfavorable change in exchange rates if there is currency risk involved and increased
burden of financial costs.

Sales stabilize and gross margins improve generally as a company moves towards value-addition, develops a
differentiated product or a market niche, operates at higher capacity utilization and develops economies of scale. For
commodities, there may be risk of both price and off take as may be observed in the sugar and cotton spinning sectors.
Global supply and demand risk is also evaluated for companies with significant exports or imports or where prices are
linked with international markets.

The profitability position of a company ultimately attests to the management quality and the value of the assets it holds.
While the level of profitability in and of itself is important, the extent to which it translates into balance sheet strength
by way of retention of earnings assumes greater importance in ratings process.

B. (iii) Cash Flow Generation

Cash flow analysis is the single most critical aspect of all credit rating factors. While there is generally a strong
relationship between profitability and cashflows, it is ultimately the free cashflows available for debt servicing that would
enable a company to meet its debt obligations in a timely manner. The current and projected level of debt and debt
servicing requirements vis-à-vis the cashflows generated annually are examined to determine the projected risk of the
company.

The Funds flow From Operations (FFO) level reflects the capacity of the cash generated from operations to meet working
capital, capital expenditure and debt servicing requirements. The sensitivity of revenues from core operations to
business cycles is evaluated to determine the precision of the cash flow forecasts.

Cashflow From Operations (CFFO) incorporates the impact of stress created by working capital changes. At the level of
Free Cash Flow (FCF), company’s capability to service both regular and strategic expenditures is considered. Since the
assumption is that of a going concern, VIS evaluates the company’s ability to internally generate funds to modernize /
maintain its assets as well as to obtain external funds for expansions.

The dividend paying capacity is evaluated at the level of Discretionary Cash Flow (DCF). A stable dividend payout history
provides investors with confidence in their investment and encourages them to contribute to future capital requirements
of the company. The crux of the cash flow analysis is to determine the ability of the company to produce sufficient funds

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from operations to meet debt servicing requirements and incur capital expenditure. VIS places significant emphasis on
the level of cash flows from operations and its relation to the outstanding debt level, i.e. debt servicing coverage from
cash flow.

High cash flow coverage ratios may not necessarily constitute strength if they are arising from low level of capital
expenditure or decline in debt levels which can indicate complacency on the part of the management and shall affect
future growth.

A company with stable and predictable cash flows can undertake a comparatively aggressive capital structure without
largely compromising creditworthiness. For example, the cash flows of the oil and gas exploration industry are dependent
upon the quantum of present proven reserves which will go into production; therefore, it continually invests significant
capital in exploration activities to build up reserves. However, since a successful hit is not assured, cash flows tend to
be volatile and low debt leverage is preferable for the sector. On the other hand, the pharma industry exhibits
comparatively stable demand patterns, and hence, stable cash flows, and can afford comparatively higher debt leverage.

B. (iv) Liquidity
Liquidity remains a key consideration in VIS ratings as a company with the healthiest balance sheet and strongest
competitive position can fail if it does not have appropriate levels of liquidity.

For industries dependent upon seasonal agricultural crops for production, like the sugar and cotton spinning industry,
debt leverage peaks during the production season with seasonal borrowings to finance inventories and then declines.
For such industries, average liquidity position is assessed through the cycle as well as the maximum stress on the
financials during the peak production time. It is important in assessing liquidity to determine the ease of marketability of
the inventories. Products such as sugar, wheat, raw cotton, petrol, diesel, edible oils, etc. have ready marketability and
can be offloaded to an extent to generate liquidity.

Other sources of liquidity on the balance sheet are also accounted for during the ratings process. These may include
marketable investments that may readily be liquidated without loss in value. The availability of undrawn working capital
lines, and the extent of unencumbered assets are factors considered in analyzing liquidity. Unencumbered assets can
more easily be used to obtain additional facilities in times of need. Any reliance on investment sales, external support or
any future liquidity events are all accounted for.

If a company is part of a business group, often access to borrowings at favorable terms for weak companies is also
achieved through obtaining guarantees from the stronger group companies. It is also possible that the other group
companies are weaker and require support from the company being rated. The prospective burden is assessed in light of
past instances or future potential commitments on behalf of weaker associated concerns and is accordingly reflected in
the ratings.

Liquidity is an important factor for corporates more exposed to cyclicality. For sole proprietorship concerns, this assumes
greater importance as their access to capital may be weaker than other corporate structures.

Working capital cycle also reflects on the liquidity of the company. The quality and concentration of trade debtors and
the credit terms extended to them are evaluated, past track record of payments is analyzed, including its impact on the
length of cash cycle of the company. A positive cash cycle indicates the market strength of the company and is accordingly
recognized.

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KEY RATIOS
CASH FLOW & COVERAGE RATIOS
• Funds Flow from Operations (FFO): profit before financial expenses and taxes + adjustment for impact of non-cash
items – payment for financial expenses and taxes.
• Net Infection: NPL – provision for NPL / net advances
• Cash Flow from Operations (CFFO): FFO +/- changes in working capital requirements
• Free Cash Flow (FCF): CFFO – impact of capital expenditure undertaken and disposal offixed assets
• Discretionary Cash Flow (DCF): FCF – dividends paid during the period
• Debt Coverage Ratios:
• FFO / Total Debt
• FFO / Long-term Debt
• Debt Servicing Coverage Ratios: (FFO + financial charges paid) / (Periodic principal repayment + financial charges
paid)

LIQUIDITY RATIOS
• Current Ratio: Current Assets / Current Liabilities
• Net Working Capital: Current Assets – Current Liabilities
• Days to Sell Inventory: Days of Raw Material Inventory Turnover + Days of WIP Inventory Turnover + Days of
Finished Goods Inventory Turnover
• Collection Period: (Average Trade Debtors / Net Sales)*365
• Payable Cycle: [Average Creditors / (Cost of Goods Manufactured – Depreciation & Amortization)]*365
• Net Cash Cycle: Days to Sell Inventory + Collection Period - Payable Cycle

PROFITABILITY RATIOS
• Gross Margin: Gross Profit / Net Sales
• Cash Margin: Gross Profit +Depreciation &Amortization / Net Sales
• Operating Profit Margin: Operating Profit / Net Sales
• Net Margin: Net Profit / Net Sales
• ROAA: Net Profit / Average Total Assets
• ROAE: Net Profit / Average Net Worth
• Effective Interest Rate: Financial Charges / Average Total Debt
• Effective Tax Rate: Taxation / Profit before Tax

CAPITALIZATION
• Gearing: Borrowings / Net Worth
• Debt Leverage: Total Liabilities / Net Worth

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RATING SUPPORT FACTORS

Entity ratings may be enhanced on the basis of the extent of support from sponsors / shareholders, associated companies,
etc. VIS takes into account how important the company is to the group, the relative financial health of the group and any
explicit or implicit support to the company being rated. VIS seeks to analyze the particular instances in which assistance
was required by the company being rated and the degree of support provided by the sponsors in the past. Evaluation of
the financial strength of the group then becomes important to give any benefit in credit ratings including its franchise
value, access to funds and diversification element.

Any institution holding an external guarantee will be rated equivalent to the guarantor if the guarantee is explicit and
provides full and timely coverage to obligations. However, in other cases where the guarantee is present but timeliness
is not ensured, notching down from the guarantor is usually the practice. The ultimate sponsor / guarantor will be the
government which is rated risk free or AAA where LCY rating is concerned. Details on government support are outlined
in the ‘Government Supported Entities’ criteria.

In the event that a company / obligation is supported by two entities carrying independent credit risks, then the support
provided is generally superior as compared to the situation in which only the stronger entity was supporting the company
being rated. This concept arises from the viewpoint that the probability of both the supporting entities defaulting at the
same time is lower than the probability of either one defaulting. Limited benefit of joint support is given to associated /
group companies or companies in the same sector to ensure independent risk drivers.

Debt instruments may be notched from entity ratings on considerations of asset protection and ranking. For details on
notching, please see ‘Rating the Issue’ by VIS.

THE RATING SCALE & HORIZON

Rating scale and Definitions may be accessed at (https://docs.vis.com.pk/docs/VISRatingScales.pdf)

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Credit Rating Company Ltd.

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VIS Corporate
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Credit Rating Company Ltd.

Islamic International Rating Agency – Bahrain – iira.com 128/C, 25th Lane off Khayaban-e-Ittehad,
Credit Rating Information & Services Ltd. – Bangladesh – crislbd.com Phase VII, DHA, Karachi

Tel: (92-21) 35311861-64

Japan Credit Rating Agency, Ltd. - Japan

China Chengxin International Credit Rating Company Limited - China 431, Block-Q, Commercial Area, Phase-II,
D.H.A. Lahore - Cantt.
Tel: (92-42) 35723411-13

VIS www.vis.com.pk
Credit Rating Company Ltd. info@vis.com.pk

DISCLAIMER
Information herein was obtained from sources believed to be accurate and reliable; however, VIS does not guarantee the accuracy, adequacy or completeness of any information
and is not responsible for any errors or omissions or for the results obtained from the use of such information. Rating is an opinion on credit quality only and is not a recommendation
to buy or sell any securities. Copyright VIS Credit Rating Company Limited. All rights reserved. Contents may be used by news media with credit to VIS.

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