DRC RATING

CREDIT RATING METHODOLOGY FOR CORPORATIONS


Overview of the methodology
DRC RATING's methodology is based on its research on companies, industries, and rated organizations, including the knowledge it has accumulated in financial markets and its expectations for future cash flows.

DRC RATING's corporate credit rating methodology is both quantitative and qualitative. Three key components drive DRC RATING's credit rating methodology and credit rating model; Components of our methodology:

It consists of (1) business risk, (2) a set of prospective reviews of financial risks based on our estimates of cash flows and financial liabilities, and (3) supplementary rating components.

A company's scores in each of the three components are included in our corporate credit rating with industry-specific weights. The corporate credit rating is our view on our estimate of the institution's capacity to meet its financial obligations when due and in accordance with borrowing terms.

At the core of our rating analysis is a focused methodology, a robust, standardized set of procedures, and key financial risk and valuation tools. DRC RATING uses a credit rating model that combines qualitative and quantitative risk measures of its three components. The model is a method of producing risk-based credit ratings by consistently integrating DRC RATING's research on sectors, performed by expert analysts as an important input to a rigorous rating committee process where the final rating is determined.

The rating is an opinion. However, this opinion emerges as a result of a scientific study in which many data are taken into account. Here, the method followed for the formation of an opinion is presented with the main lines.

The activities of the rated entity, whether in the manufacturing sector or in the service sector, are subject to the same analysis method and the examination is carried out within the framework of three main risk areas. Financial Risk Analysis, which is one of the risk analyzes in these three areas, mainly consists of quantitative factors, others mainly qualitative factors. However, there are qualitative elements in Financial Risk Analysis such as the appropriateness and adequacy of internal control systems and accounting policies. On the other hand, quantitative factors such as market share in business risk are also taken into account. The weights given to qualitative and quantitative factors in rating analyzes vary according to the sector and over time.

The rating analysis includes at least three years of operating history and financial data, as well as future performance projections of DRC RATING. The results of studies on this subject are used in a comparative analysis, in which the strength of the issuer's business risk and financial risk profile is examined relative to other companies in its industry or peer group in the rating category.

As DRC RATING, we evaluate the national rating as the Government of the Republic of Turkey and its borrowings are rated with “AAA” as issuer and issue. When we give “AAA” to any joint stock company or organization or their borrowings, we mean that the risk of non-repayment in these issuers or issues is very, very low. Our Corporate rating and other rating methodologies are not the same as our central government rating methodologies.
 
No matter how robust a company may be, if it operates in an unstable political or economic environment, it may face a lower credit rating than a similar company operating under better conditions. For companies located outside of Turkey or with significant foreign operations, we conduct country risk assessments where appropriate. The political and economic environment in emerging markets tends to be less stable by definition than in more developed markets. In addition, the scale of any change can be much greater, causing the company's operations to deteriorate or its value loss to be much more dramatic. Therefore, macroeconomic volatility and business/operating environment risk are taken into account in country risk assessment.

Macroeconomic Volatility - Factors in this area include inflationary trends, exchange rate stability, and the depth and diversity of the economy; It should be carefully considered in the context that growth prospects reduce the predictability of future cash flows to be used for debt service.

Business Environment - assessed in the context of country risk through a comprehensive analysis of the business environment in which the company operates. Determining the level of accessibility to the needs of companies for imported raw materials is also related to the availability of relevant permits and adequate local infrastructure such as port facilities, distribution and communication systems, beyond the problems arising from exchange rate risk. On the other hand, the political environment is particularly important. Political instability brings uncertainty about future laws that may affect a company's operations, or unrest that may disrupt all or part of a company's production chain or distribution. At the political level, corruption creates direct and indirect costs and, in some cases, can restrict the active participation of foreign companies in the local economy, whether investors, suppliers or buyers. These political issues pose additional risk that, to date, analysts have included in the overall analysis. The absence of a strong and diversified financial sector, an unstable banking environment can be a major constraint on a company's financial health. A shallow domestic capital market can expose a company to unreasonable costs, and the costs are felt more in times of economic stress.

When the ratings are given as long-term and short-term; short-term ratings focus specifically on analyzing liquidity and other short-term financial strength characteristics. The relationship between long-term and short-term ratings may be somewhat asymmetrical in some cases, for example, when an entity has a low risk of default in the short-term due to temporary support from third parties. In this case, the relatively low short-term credit risk may be associated with a higher credit risk in the long-term.

DRC RATING's corporate rating methodology, which organizes the analysis process according to a common framework and divides it into categories where all relevant aspects of the process are taken into account. It consists of subheadings.

  1. Business Risk
  2. Financial Risk Profile
  3. Supplementary Note Components
   
1. Business Risk Analysis
The business risk profile includes the risk and return potential in the markets in which a company operates, the competitive climate in these markets, country risks, competitive advantage or disadvantages. In a sense, the business risk profile affects the financial risk that a company may bear as an independent credit profile and forms the basis of the expected economic success of the company. Therefore, country risk, industry risk, and competitive position are combined to assess the company's business risk profile.

The main purpose of business risk analysis is to analyze whether a company has the power to generate the necessary cash flow to continue its main activities and fulfill its financial obligations. Business risk is the risk of the company losing revenue due to changes in the industry, cyclical fluctuations, changes in customer preferences, product obsolescence or technological innovations.
 
1.1. Sector Outlook and Analysis of Risk
It is examined what kind of risks exist in the business area / fields or sector / sectors in which an organization operates. Each industry has its own unique conditions and these conditions include both today's risks and future risks. For this reason, it is necessary to investigate the characteristics of the sector with all its aspects and to evaluate the trends and threats in the sector very well.

1.2. Competitiveness and Position
At this stage, the characteristics of the company are evaluated rather than the characteristics of the sector. Competitiveness refers to the strengths and weaknesses of a company compared to other equivalent companies in the industry in which it operates. In competitive analysis, the market position of the company is looked at and it is examined whether its production and marketing strategies can provide superior performance compared to its competitors.

1.2.1. Market Share Indicators
Sales proceeds


Sales revenues are still the main indicator used to measure market share. However, depending on with whom the competition is made, the sales revenue is looked at both at the country scale, at the regional scale and at the scale of the product range. It examines which factors are behind the market share.

1.2.2. Indicators of Dominating the Market


1.2.3. Components of Analysis of Competitive Factors

 
1.2.4. Factors of Advantage in Competing on Cost

 
1.2.5. Diversification Indicators

 
1.2.6. Company Scale
Large companies often have more power to survive because of their large resource base and have features that make them better off against economic downturn. With these features, such as economies of scale, backups, broader market access or customer base, multiple product or venture value (franchise value), they often have stronger hedges. They also have a larger amount of spare assets other than their core assets, such as real estate, which they can dispose of or provide as collateral to raise funds. Measures of a company's size are sales, assets, equity or funds used including capital.
 
1.2.7. Whether Hidden Reserves are Available
The presence of hidden reserves on the company's balance sheet can be an important assurance against sudden income losses. The most common hidden reserves are unrealized real estate, rights such as patents and royalty, and other fixed assets recorded at book/cost value in the company's balance sheet.
 
2. Financial Risk Analysis
Financial risk analysis is the section where mainly numerical data are evaluated. Financial risk is examined under four subheadings:

 
2.1. Profitability
Profitability is a measure of the earnings of companies against the resources used in a given period. In general, company partners measure the success of their investments by the profitability ratio.

a. Net Operating (Operating) Profitability: It is the ratio of the company's revenues from operating activities to its total net sales revenues. In other words, net operating profitability; is the ratio of interest expenses, interest income and profit before tax to net income and it is generally necessary to compare it with the ratios of peer companies in the same industry.

b. Return on Assets Ratio (Return on Assets): The return on total assets calculated before tax expresses the profitability of all asset items. Return on Assets Ratio is calculated in order to determine to what extent the assets are used profitably by the company. It is possible to calculate the rate in two different ways, based on both the profit after tax and the profit before tax. However, since the tax amount is not under the control of the company and companies are affected differently by tax practices, it is preferred to use the profit for the period.

Return on Assets Ratio = Period Profit/Total Assets

c. Return on Equity: The return on equity, which is calculated only by looking at the capital structure of the company, gives the profitability ratio in the narrowest sense.
i. The Ratio of Net Profit for the Period to Equity is calculated by dividing net profit by equity.

Equity Net Profit Ratio = Period Net Profit / Equity

This ratio is calculated in order to determine to what extent the values allocated to the companies by the partners are used effectively and efficiently. It shows the company's return on equity. A high rate is positive. Inflation may be effective on this rate. Because the numerator and denominator forming the ratio are not affected by inflation at the same rate. While net profit for the period is directly affected by inflation, own funds may lag behind inflation due to the relative staticity of capital within own funds. In this case, the rate tends to increase. In the years of capital increase, the ratio may decrease.

ii. The Ratio of Profit for the Period to Equity is calculated by dividing the profit for the period by the shareholders' equity. It is a ratio that complements the equity net profitability ratio. The ratio of profit before tax to own funds allows to avoid analysis errors that may arise from tax burden.

Return on Equity Ratio = Profit for the Period / Equity

d. Return on Fixed (Permanent) Capital: Average resources are the sum of equity and foreign resources. Return on fixed capital is a narrower measure.
e. Dividend Distribution Ratio: Dividend ratio shows the amount of earnings to be distributed per share.
f. Undistributed Profit Ratio: It is the ratio of the amounts that are not distributed but kept in the business or transferred to the capital to the total assets.
g. Interest Expenses Coverage Ratio (After Depreciation): The interest coverage ratio measures the number of times the company incomes before interest and taxes cover gross interest expenses.
h. Coverage Ratio for Interest and Financial Leasing Expenses (After Depreciation): It is desirable that the operating income before interest and tax is twice or more than the interest and financial leasing expenses in companies that have an investment grade credit rating.
 
2.2. Cash Generation Ability / Debt Payment Capacity
Since cash flow provides the main source of funds for a company to repay its debts, Cash Flow Ability and Debt Payment Capacity are closely related. Operating cash flow is also defined as funds from the operation.

Operating and non-operating cash inflows are compared with cash outflows over the years. This table should cover the movements of the last 5 years, as well as give the expectations of the company for the coming years, show how much the company was dependent on foreign resources in the past and how much it will be dependent on in the future.

  1. Interest Coverage Ratio (before amortization): It is found how many times the company has earned the interest it has to pay in a period.
  2. Funds from operations / total debt: The ratio of funds from operations / total debt compares funds from operating activities with total debt.
  3. Free cash flow / total debt: (net income from operations + depreciation +/- deferred tax +/- funds from other operations - investment expenditures +/- changes in working capital) / (short-term + long-term debt total)
  4. Funds from operations / capital expenditures (Capex): It is a ratio generally related to the intensity of fixed investment expenditures in sectors.
  5. Investment expenditures / depreciation expenses: The ratio of capital expenditures / depreciation expenses shows how quickly the worn-out facilities and machinery in a company are replaced with new ones.
 
2.3. Capital Adequacy
The extent to which the company finances its operations with equity and to what extent it finances it by borrowing plays an important role in its rating. Leverage is a measure of the extent to which companies' operations rely on external funding. Companies with low levels of borrowing have low leverage.

  1. Short-term capitalization ratio: It is the ratio of short-term debt burden to equity.
  2. Long-term capitalization ratio: It is the ratio of the long-term debt burden to the sum of capitalized debt and Tier 1 capital.
  3. Financial Leverage Multiplier: Total short-term and long-term debt (total liabilities) / total equity.
  4. Total debt / total debt + equity (market value) ratio: It is a ratio that can only be applied to companies whose shares are publicly traded.
  5. Total debt / EBITDA: This multiplier compares a company's liabilities with its ordinary, unleveraged and untaxed fund flows.
 
2.4. Financial Elasticity / Liquidity Ratios
Liquidity is a measure of companies' ability to meet their short-term liabilities from internal and external sources.

The concept of financial flexibility evaluates liquidity measurement together with the capacity to access alternative financing sources. Factors that may restrict financial flexibility (such as legal cases, environmental problems) are examined under this heading. Many ratios are used to measure the liquidity position of the company. Traditionally:

  1. Cash Ratio: By deducting the stock, receivables and other short-term receivables from the current assets of the enterprise, it is found how much of the remaining values cover the short-term debts.
  2. Acid Test Ratio: This ratio shows whether current assets without inventory cover short-term debts or to what extent.
  3. Current Ratio: It is measured how many times the current assets of the company meet the short-term liabilities.
  4. Working capital / Total assets Ratio: It is another liquidity ratio that shows the working capital needs of companies.
  5. Trade Receivable Turnover Rate: Average trade receivables (sales on credit) / net sales revenue x 365/1.
  6. Inventory Turnover: Inventories / cost of goods sold x 365/1. Although it is closely related to the characteristics of the industries, it should be compared with the averages of peer companies operating in the same sector.
  7. Trade Debt Turnover: Average trade debt / cost of goods sold x 365/1. Trade debt turnover shows the course of vendor loans and the timing of the company's payments to its suppliers.
 
3. Supplementary Rating Components

3.1. Stress Test Analysis
While analyzing the company's financial history as well as its future performance, it should be tested how much the company's income losses in its main activities as a result of external shocks put the company under stress, how much borrowing can be created, how its financial ratios can change, and to what extent it can fulfill its obligations with the revenues obtained from the activities.

3.2. Internal Systems, Accounting and Internal Control Risk
Independent audit reports and financial statements, footnotes and related explanations are the primary source of financial performance about the company or organization. Which accounting system does the company or organization apply? Have there been any recent changes in the independent audit company? Is the independent audit firm's opinion positive or is there a qualified opinion? Rating analysts review the answers to these questions, including but not limited to, to understand accounting policies.

3.3. Management and Corporate Governance Analysis
This section covers both the review of the shareholding structure, the quality of the management and the analysis of the company's compliance with the best practices regarding Corporate Governance practices.
 
3.3.1. Management

 
3.3.2. Corporate Management Features

 
3.3.3. In line with the principles of Equality, Transparency, Accountability and Responsibility, the company:


To what extent are they ready for it?
 
3.4. General
The following questions are helpful when assessing the extent to which a company's strategic direction and plans are acceptable.

 
Naturally, being able to see how the management reacts and control power in an economic crisis is a very good opportunity to evaluate crisis management. Here again, a fundamental question is how well the company's development has been planned over the years.

Issues that are especially important in terms of Corporate Governance are based on 4 basic concepts. These are,


3.5. Management Evaluation
Management should be evaluated by its operational and financial successes and failures. But at the same time, the amount of risk he is willing to take in formulating his strategy and policies must also be considered. An objective analysis of the history of management is meaningful. So what is the level of risk taken, what is the return on investment, is this risk/return balanced?

Strategy and operational plans should be evaluated with a realistic eye. The firm's deviations from its strategies in the past form an opinion about future deviations. The credibility of the management is especially important in stressful times. During these periods, creditors look at whether they can trust the creditworthiness of the management in terms of creditworthiness.

4. Rating Scale[1]
Credit ratings are symbols that express the obligor's general creditworthiness or opinions about a particular debt instrument. Opinions with a maturity of more than 1 year on the obligatory or debt instrument are considered as long-term credit rating, and opinions with a maturity of less than 1 year are considered as short-term credit ratings.

In long-term credit ratings, the strongest credit quality is indicated as AAA. A grade of D indicates the lowest credit quality. Short-term ratings are designated as “A1” for the highest quality and “D” for the lowest quality.

Long Term[2]
 
Credit Rating: AAA
Definition: Highest credit quality
Description:Indicates the lowest expectation of default risk.
Type: Investment

Credit Rating: AA
Definition: Very high credit quality
Description: Indicates a very low expectation of default risk.
Type: Investment

Credit Rating: A
Definition: High credit quality
Description: Indicates low default risk expectation.
Type: Investment

Credit Rating: BBB
Definition: Medium credit quality
Description: Default expectation is medium.
Type: Investment

Credit Rating: BB
Definition: Speculative credit quality
Description: The ability to meet financial commitments has the potential to be adversely affected.
Type: Speculative

Credit Rating: B
Definition: Highly speculative credit quality
Description: Default risk expectations are relatively high.
Type: Speculative

Credit Rating: CCC
Definition: High credit risk
Description: High or very high default risk.
Type: Speculative

Credit Rating: D
Definition: Default
Description: Default has occurred.
Type: Speculative
 
Short Term
 
Credit Rating: A-1
Definition: Highest short-term credit quality
Description: Outstanding short-term financial strength
Type: Investment

Credit Rating: A-2
Definition: Good short-term credit quality
Description: Has strong short-term financial strength
Type: Investment

Credit Rating: A-3
Definition: Reasonable short-term credit quality
Description: Sufficient short-term financial strength
Type: Investment

Credit Rating: B
Definition: Speculative short-term credit quality
Description: Acceptable short-term financial strength but contains speculative features Speculative
Type: Speculative

Credit Rating: C
Definition: High short-term default risk
Description: Short-term financial ability is questionable and vulnerable to non-payment.
Type: Speculative

Credit Rating: D
Definition: Default
Description: Default has occurred
Type: Speculative
 
Copyright © 2018 DRC Rating Services Inc. (DRC RATING). All rights reserved. Reproduction or transfer, in whole or in part, is prohibited without the permission of DRC RATING. DRC RATING is a nationally recognized rating agency by the Capital Markets Board of the Republic of Turkey. DRC RATING provides credit ratings for financial institutions (eg banks), company issuers and asset-backed securities, and corporate governance ratings for these institutions, under the CMB license.
 The information, credit ratings and other opinions (content) contained herein have been obtained or derived from DRC RATING sources believed to be reliable. DRC RATING is not an independent audit firm and does not independently confirm or endorse the information, credit ratings or other opinions contained therein used in the preparation of the rating report. THE CONTENT IS PROVIDED "AS IS" AND MAKES NO WARRANTY OR WARRANTIES OF ANY KIND, EXPRESS OR IMPLIED, INCLUDING WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. The content here is for informational purposes only. Content, including credit ratings and other opinions issued by DRC RATING, should be construed as opinion only, not statements of fact regarding creditworthiness or recommendations for purchasing, holding or selling securities or making other investment decisions. DRC RATING may charge fees for performing ratings or other analytical activities from issuers of securities or third parties involved in the issuance or marketing of securities. DRC RATING credit ratings and related analyzes should not be considered without understanding and reviewing the methodologies, disclaimers, disclosures and other important information available at www.drcrating.com. DRC RATING shall not be liable for any damages or other losses arising out of or related to the use of the Content contained herein.
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Disclaimer: This text is an unofficial translation into the English language for convenience and information purposes only, that originally were prepared in the Turkish language. DRC RATING is not liable for any inaccuracies in translated materials or misunderstandings due to language usage or dialect. While reasonable efforts are made to provide accurate translations, portions may be incorrect, therefore, DRC RATING cannot guarantee the accuracy of the converted text. The full, legal and binding version of the report for all purposes is the Turkish version, filed by the DRC RATING with the Capital Market Board of Turkey and published on the DRC RATING website. In the event of a contradiction or inconsistency or a discrepancy between this translation and the Turkish version of the text, the provisions of the Turkish version shall prevail. DRC RATING does not guarantee that the translation fully, correctly or accurately reflects the Turkish version of text and its contents. 
Neither the DRC RATING, nor any of its directors, employees, advisors or other office holders, accept any responsibility on any grounds whatsoever to any other person in connection with this translation into English of the report. DRC RATING shall not be liable for any inaccuracies or errors in the translation or for any loss or damage of any kind, including without limitation, indirect or consequential loss or damage arising from or in connection with the use of this translated version of the report.
No liability is assumed by DRC RATING for any errors, omissions, or ambiguities in the translations provided in this report. Any person or entity that relies on translated content does so at their own risk. DRC RATING shall not be liable for any losses caused by reliance on the accuracy or reliability of translated information. If you would like to report a translation error or inaccuracy, we encourage you to please contact us. Where there is any question, the English version is always the authoritative version of the report. Any discrepancies or differences created in the translation are not binding and have no legal effect for compliance or enforcement purposes.
 


[1] For more detailed information, please refer to www.drcrating.com/creditratingsscale
 
[2] DRC RATING may use +,- signs to indicate their relative position in the main credit rating categories.
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