FINANCIAL SERVICES

Unit 5 – Fee Based Financial Services II – Stock Broking, Depositories and credit
rating.

Meaning:

Secondary market is a place for buying and selling of existing securities. These securities can be either
the government securities or semi government securities or securities of the joint stock companies.
Eg: shares, debentures, bonds, treasury bills etc….

Definition:

Securities contract (Regulation) Act, 1956. “Stock exchange means any -body of individuals,
whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the
business of buying, selling in securities.”

Functions / services of stock market:

The following are the functions performed by secondary market for the benefit of the investors,
companies and economy as a whole.

1. Liquidity: It is a place where the securities can be converted into cash at any time according to the
discretion of the investor by selling them at the listed prices.

2. Marketability of securities: They create a ready outlet for dealing in securities by facilitating buying
and selling of securities at listed prices by providing continuous marketability to the investors in respect
of securities they hold or intend to hold.

3. Safety of funds: The dealings at stock exchanges are governed by well defined rules and regulations
of securities contract (Regulation) Act, 1956. There is no scope for manipulating transactions. Every
contract is done according to the procedure laid down and there is no fear in the minds of contracting
parties. The safety in dealings brings confidence in the minds of all concerned parties and helps in
increasing various dealings.

1 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

4. Supply of long term funds: The securities traded in the stock market are negotiable and transferable
in character and as such they can be transferred with minimum of formalities from one hand to another.
So, when a security is transacted, one investor is substituted by another, but the company is assured of
long term availability of funds.

5. Motivation for improved performance by companies: stock market provides room for price
quotation for those securities listed by it. This public exposure makes a company conscious of its status
in the market and it acts as a motivation to improve its performance further.

6. Promotion of investment opportunities: stock exchange mobilizes the savings of the public and
promotes investment through capital issues. Unless there is an effective secondary market investment
opportunities will not be available to the investors.

7. Availability of business information: the changing business conditions in the economy are
immediately reflected on the secondary market or stock exchanges. Booms and depressions can be
identified through the dealings in the stock exchanges. Thus a stock market reflects the prevailing
economic situation to all concerns so that suitable actions can be taken.

Organization of stock exchange:

The first organized stock exchange in India was started in Bombay in 1875 with the formation of the
‘Native Share and Stock Broker’s Association’. Thus the Bombay Stock Exchange is the oldest one in
the country. With the growth of joint stock companies, the stock exchanges also made s steady growth
and at present there are more than 23 stock exchanges and more than 6000 stock brokers.

Classification of organization structure:

The stock exchange can be broadly classified into Association Of Persons (AOP) eg.. BSE, ASE,
MPSE...and Companies eg… BGSE, CSE, DSE, HSE etc...

Recognition of stock exchanges:

The stock exchanges in India have to be recognized by the Central Government under SCRA and SEBI
and they have to comply with the provisions of the SCRA and SEBI and also the bye-laws and
regulations duly approved by the Government.

2 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Any stock exchange which needs recognition under SEBI Act has to submit an application in the
prescribed manner to the central government. This application must be accompanied by the following
documents:

1. A copy of Bye-laws of the stock exchange for its operation.

2. A copy of the rules relating to its constitution, governing body, powers and duties of the office
bearers, the admission procedure etc…

Grant of Recognition:

Recognition will be granted by the Central Government provided the following conditions are fulfilled.

1. The rules and bye-laws of the stock exchanges applying for registration must ensure fair dealings and
protect the interest of investors.
2. The stock exchanges concerned must be willing to comply with any other conditions that may be
imposed by the government from time to time.
3. The grant of recognition must be in the interest of trade as well as in the public interest.

While granting recognition, the central government may prescribe conditions regarding the
qualifications for membership, the method of entering into contracts, the representation of the central
government on the stock exchange and the maintenance of accounts and their audit.

Renewal of Recognition:
If any stock exchange intends to renew its recognition, it must once again make an application to the
central government in the aforesaid manner three months before the expiry of the period of recognition.

Withdrawal of Recognition:
The central government may withdraw the recognition granted to any stock exchange at any time if it
opines that the recognition granted is against the interest of trade or public interest.
Who is a Stock Broker?
Brokers—also known as trading members—perform a vital function in the stock market. They execute
transactions such as the buying and selling of stocks on behalf of their clients. In return for this, they
charge a brokerage commission.

3 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

But stock market brokers provide other services too. These include portfolio management and financial
advice, for example. With stock market transactions taking place online, brokers also offer multiple
platforms through which investors and traders can access the stock market.

Types of Brokers

1. Full-service broker
A full-service broker provides a large variety of services to its clients. Most full-service brokers have
offices in major cities where customer service staff can meet clients in person. These brokers offer
customised support through tailored brokerage plans and services for investors with different interests
and varying levels of expertise. Clients with large holdings could even engage dedicated service
managers to handle their portfolios.

2. Discount brokers
While full-service brokers provide a whole catalogue of services, discount brokers focus on the basics.
Discount brokers carry out buy and sell orders for their clients but do not offer any additional services.
For this reason, they also charge a much lower commission. In some cases, the charge may be as low as
Rs 10 per transaction.

Registration of Brokers:

1. He has to apply through the stock exchange of which he is a member.

2. The application must be forwarded by the exchange to SEBI within 30 days from the date of the
receipt.
3. The exchange should also include a statement to the effect that no complaints/ arbitration cases
are pending against the applicant.
4. SEBI checks whether or not he is eligible to be member of a stock exchange.
5. He should have the necessary infrastructure including manpower to discharge his activities.
6. He needs to have past experience in the business of buying, selling or dealing in securities.
7. He should pay registration fees along with the application in prescribed manner
8. After satisfying all the conditions license will be sanctioned

General Obligation and Responsibilities of a stock Broker:

4 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Stockbrokers buy and trade financial securities for their clients. Some stockbrokers may also act as a
financial and stock market consultant. Stockbrokers have the following responsibilities:

1. Manage client portfolios, deciding about when to buy or trade financial securities
2. Work closely with clients to understand their financial goals and risks
3. Consult clients on the buying and selling price of different stocks
4. Stay updated on the latest regulations regarding stocks, taxes and financial news
5. Use market knowledge to maximize client returns
6. The stock broker shall inform the client and keep him apprised about trading/settlement cycles,
delivery/payments, schedules, any changes therein from time to time, and it shall be the
responsibility in turn of the client to comply with such schedules/procedures of the relevant stock
exchange where the trade is executed.
7. The stock broker shall ensure that the money/securities deposited by the client shall be kept in a
separate account, distinct from his/its own account or account of any other client and shall not be
used by the stock broker for himself/itself or for any other client or for any purpose other than
the purposes mentioned in Rules, Regulations, circulars, notices, guidelines of SEBI and/or
Rules, Regulations, Bye-laws, circulars and notices of Exchange.
8. The stock broker shall provide the client with the relevant contact details of the concerned
Exchanges and SEBI.
9. The stock broker shall co-operate in redressing grievances of the client in respect of all
transactions routed through it and in removing objections for bad delivery of shares, rectification
of bad delivery, etc.
10. The stock broker shall ensure faster settlement of any arbitration proceedings arising out of the
transactions entered into.
11. The stock broker shall ensure due protection to the client regarding client’s rights to dividends,
rights or bonus shares, etc. in respect of transactions routed through it and it shall not do
anything which is likely to harm the interest of the client with whom and for whom they may
have had transactions in securities.
12. The stock broker and client shall reconcile and settle their accounts from time to time as per the
Rules, Regulations, Bye Laws, Circulars, Notices and Guidelines issued by SEBI and the
relevant Exchanges where the trade is executed.

DEPOSITORIES:

Meaning of Depository system:

5 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Depository system is a system wherein the securities of investors are held in the electronic
form with the depository at the request of the investors and transfer of securities takes place by means
of book entries on the ledger of the depository.

Depository Act:

The Depositories Act, 1996, which came into force from 20th September 1995, provides a legal
framework for establishment of depositories to facilitate holding of securities including shares in
the demat form (electronic form) and to effect transfer of shares through book entry in accounts
maintained by the depository.

Benefits of Depository System to investors:

1. A depository ensures that only pre-verified assets with good title are traded. Therefore, an investor is
always assured of assets with good title. Moreover, the problems of bad deliveries and all the risks
associated with physical certificates, such as loss, theft, mutilation etc. are avoided.
2. Electronic transaction of securities saves time. Time spent on preparation of share certificates and
transfer deed is avoided.
3. Electronic transactions reduce the settlement time.
4. Instant transfer of securities enables the investor to get dividend, right and bonus without delay.
5. Transaction costs are reduced as transfers in electronic form are exempt from stamp duty.
6. There is no problem of odd lots as the marketable lot in depository is fixed as one share.
7. The interest rate on loan against pledge of dematerialised shares is comparatively lower.
8. As a security measure, the account holder can totally freeze his account for any desired period.
9. Depositories enable the investors to deliver shares in any part of the country without exposing
themselves to the risk and cost of transportation.
10. The investor is able to revise his portfolio more frequently due to low transaction costs and quick
transfer of securities.

Benefits of Depository System to Company

1. The depository system enables the company management to maintain and update information about
shareholding pattern of the company. The company is able to know the particulars of beneficial owners
and their holdings periodically.
2. The issue cost gets drastically reduced because of dematerialisation of securities.
3. Paperless trading is a boon for the company management.

6 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

4. Distribution of cash corporate benefits (dividends) and non-cash corporate benefits (rights and bonus)
will be quicker as the ownership can be easily identified.
5. The transfer process under depository system is prompt and free from defects. So, complaints against
the company by an investor are avoided in this regard. This helps the company build a good corporate
image.

Benefits of Depository System to capital market:

1. As the trading, clearing and settlement mechanism are automated and inter-linked with the
depository, the capital market is more transparent.
2. Use of computers and improved communication technology in the depository system has made
capital market activities efficient.
3. Investors repose a high degree of confidence in the capital market.
4. Use of depository system attracts foreign investors.
5. Volume of trade in capital market substantially increases.
6. More and more middle income group become involved either directly or through mutual funds.

Depository Participant (DP)

The Depository Participant is the link between the owner of the securities and the depositors. He is
deemed to be an agent of the depository. Accordingly, he is authorized to offer depository services to
investors. As per SEBI regulations and Depository Act, a depository cannot interact directly with
beneficial owners. He has to deal with its agents called Depository Participant. Neither can the investors
directly approach the depository for any services. They have to interact through the DP.

Services provided by a depository

The following services are provided by a depositor through a DP:

1. Opening a Demat Account

The first step is to open a Demat Account. Demat Account is the short form for Dematerialisation
Account. It is the process of holding investments like mutual funds, shares, bonds, government
securities, etc. It does away with the hassles of maintenance of physical documents.

7 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

2. Dematerialization

This process is the conversion of physical shares to electronic shares. When a shareholder uses this
facility, the Company takes back the physical shares through the depository system and equal numbers
of shares are credited into the shareholder’s account.

Benefits of Dematerialization:

a) Elimination of all risks associated with physical certificates

b) Elimination of Bad deliveries

c) Immediate transfer and registration of securities

d) Faster settlement cycles

e) Faster receipt of securities in case of bonus/ split/ mergers

f) Waiver of stamp duty

g) Facilitates ease in recording change of address, transmission etc

h) Ease of portfolio monitoring

3. Rematerialization

This is the exact opposite of Dematerialization. Here physical securities are issued in place of securities
in electronic form.

4. Other services

• Pledging Dematerialized shares

Dematerialized shares can be pledged. After the loan is repaid a request can be made through one’s DP
to close the pledge through a standard format.

• Initial Public Offerings

Public offer credits can be directly received into the Demat account.

8 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

 • Receipt of cash/non-cash benefits

When rights or bonus or dividend is announced by any corporate event for a particular security, the
depository will give the details of all the clients having electronic holdings to the registrar as on that
date. The registrar will then calculate the benefits due to all the shareholders.

• Stock lending and borrowing

Securities in the Demat form can be easily lent/ borrowed. Instructions are to be given to DP through a
standard format (which is available with DP).

• Transmission of securities

In case there is a need for transmission of securities due to death, lunacy, bankruptcy, insolvency, or by
any other lawful means, it is possible through the depository system. The claimant will have to fill in a
transmission request form supported by valid documents.

• Freezing Account with DP

If at any time one wishes that no transaction should be effected in one’s account, one may advise one’s
DP accordingly. DP will freeze the account of the investor until further instructions.

Depositories in India:

There are two depositories operating in India, NSDL established in 1996 and co-promoted by NSE and
CDSL established in 1999 and co-promoted by BSE.

NSDL, established in 1996, is today one of the largest Depositories in the world. As a depository, it
enables holding of shares and other types of securities in electronic form i.e. dematerialize form. By
holding a demat account, one can own the securities in electronic form and transfer any security from
his / her demat account to any other demat account.

• NSDL is the oldest and largest depository in the country. It commenced operations in 1996 in
Mumbai. It was the first depository to provide trading services in the electronic format.
• According to data from SEBI, this national depository has around 1.7 crore active investors with
more than 30,500 depository participant service centres across 2,000 cities.
• NSDL is entrusted with the safekeeping of following financial securities in the electronic format:
o Stocks
o Bonds

9 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

 o Debentures
o Commercial papers
o Mutual Funds
o
• NSDL offers a wide range of services, like:
o Dematerialisation services
o Rematerialisation services
o Transfers between depositories
o Off-market transfers
o Lending of securities
o Collateral and mortgage of securities

• This central depository started operations in Mumbai in 1999. This is the second- largest
depository in the country after NSDL.
• Similar to NSDL, it provides all services, like holding financial securities in the electronic
format along with facilitation of trade and settlement of orders. All forms of stocks and securities
- just like NSDL - are held at this central depository.
• According to data from SEBI, it has more than 1.6 crore active customer accounts with around
19,000 depository participant service centres.

Registration of DPs with NSDL and CDSL:

A stock broking firm usually selects registration with either of the depositories on the basis of fees and
charges, services, and aspects like ease of doing business etc. As an investor, you can check with your
DP to know whether they are registered with NSDL or CDSL. Some stock brokers are also registered
with both the depositories.

Difference between NSDL and CDSL :

• In terms of services to investors, there is no key difference between having a demat account with
a DP registered either with NSDL or CDSL. Both are regularised by the government and provide
similar services.
• The only difference between both the depositories is their operating markets. While NSDL has
National Stock Exchange (NSE) as the primary operating market, CDSL has Bombay Stock
Exchange (BSE) as the primary market.
• According to industry experts, an investor can have a demat account linked to any of the
depositories.

Role of NSDL and CDSL in transforming investment in stock markets:

Both the depositories transformed trading in stock markets by providing the facility to hold stocks,
securities etc. in the electronic format. They paved the way for safe, secure and convenient trading
transactions by adopting digital technology.

10 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Benefits of NSDL and CDSL (advantages of Depository system can be written)

CREDIT RATING

Meaning:

A credit rating is a measurement of a person or business entity's ability to repay a financial

obligation based on income and past repayment histories. Usually expressed as a credit score, banks
and lenders use a credit rating as one of the factors to determine whether to lend money.

Need for Credit Rating:

*It is necessary in view of the growing number of cases of defaults in payment of interest and
repayment of principal sum borrowed by way of fixed deposits, issue of debentures or preference shares
or commercial papers.

*Maintenance of investor’s confidence, since defaults shatter the confidence of investors in corporate
instruments.

*Protect the interest of investors who cannot into merits of the debt instruments of a company.

*Motivate savers to invest in industry and trade.

Objectives of Credit Rating:

The main objective is to provide superior and low cost info to investors for taking a decision regarding
risk return trade off, but it also helps to market participants in the following ways:

• To improve a healthy discipline on borrowers.

• Lends greater credence to financial and other representations.

• Facilitates formulation of public guidelines on institutional investments.

• Helps merchant bankers, brokers, regulatory authorities etc., in discharging their functions
related to debt issues.

• Encourages greater information disclosure, better accounting standards and improved financial
information (helps in investor’s protection)

• May reduce interest costs for highly rated companies.

• Acts as a marketing tool.

11 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Types of Credit Rating:

Sovereign Credit Rating: A Sovereign credit rating is the credit rating of a sovereign entity i.e., a
national government. The sovereign credit rating indicates the risk level of the investing environment of
a country and is used by investors looking to invest abroad. It takes political risk into account.

Short term rating: A short term rating is a probability factor of an individual going into default within
a year. This is in contrast to long term rating which is evaluated over a long time frame. In the past
institutional investors preferred to consider long term ratings. Now a days short term ratings are
commonly used.

Corporate credit ratings: The credit rating of a corporation is a financial indicator to potential
investors of debt securities such as bonds. Credit rating is usually of a financial instrument such as a
bond, rather than the whole corporation and has letter designations such as A, B and C. The standard
and Poor rating scale could be excellent to poor: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-,
BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, CC, C, D.. Anything lower than a BBB- rating is
considered a speculative or junk bond.

Bond/ Debenture rating: rating the debentures/ bonds issued by corporate, government etc is called
debenture or bond rating

Equity Rating: Rating of equity shares by a company is called equity rating.

Preference share rating: Rating of preference share issued by a company is called preference share
rating.

Commercial Paper rating: Commercial papers are instruments used for short term borrowings.
Commercial papers issued by manufacturing companies, finance companies, banks and financial
institutions and rating of those instruments are called commercial paper rating.

Fixed deposits rating: Fixed deposits programmes are medium term unsecured borrowings. Rating of
such programmes is called as fixed deposits rating.

Advantages of Credit Rating:

1. Helps in Investment Decision

2. Freedom of Investment Decisions
3. Assurance of safety
4. Choice of Instruments
5. Dependency on Rating
6. Continuous Monitoring
7. Easy to Raise Fund
8. Good Corporate Image
9. Lower the Cost of Public Issue
10. Easy and Lowers Cost of Borrowing
11. Help Non-popular Companies
12. Rating Facilitates Growth

12 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Benefits to the Investor

Following are the benefits of credit rating to the investor:

• Helps in Investment Decision
• Freedom of Investment Decisions
• Assurance of safety
• Choice of Instruments
• Dependency on Rating
• Continuous Monitoring
Helps in Investment Decision
Credit rating gives an idea of the creditworthiness of the issuing company and the risk associated with a
particular security. Depending upon the credit rating investor can decide whether to invest in such
company or not.

Freedom of Investment Decisions

For common people it is very difficult to take investment decisions. Before taking investment decisions
they seek advice from the stock brokers, merchant bankers or portfolio managers. Credit rating service
makes the task easy by attaching rating symbols to a particular security.

Rating symbol assigned to a particular instrument suggests the creditworthiness of the instrument and
indicates the degree of risk involved in it.

Assurance of safety
A high rating assures the investor about the safety of the instrument. Companies having high ratings of
their instruments maintain healthy financial discipline.

Choice of Instruments
By rating the securities, credit rating agencies enables an investor to select a particular instrument from
many alternatives available.

Dependency on Rating
The ratings assigned to the instruments are authentic and reliable. The rating firms are independent of
issuing company and have no business connection with. Hence, they give a fair rating to the
instruments. This brings confidence among the investors.

Continuous Monitoring
Credit rating agencies not only assign rating symbols but also continuously monitor them. The Rating
agency downgrades or upgrades the rating symbols depending upon performance and position of the
company.

Following are the benefits of credit rating to the company:

• Easy to Raise Fund
• Good Corporate Image
• Lower the Cost of Public Issue
• Easy and Lowers Cost of Borrowing
• Help Non-popular Companies
• Rating Facilitates Growth
Easy to Raise Fund
It become very easy for a company to raise fund from the market if the instruments issued by the
company are highly rated. A high rating gives confidence to the investors. Many investors always like

13 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

to make investments in such instrument, which ensure safety and easy liquidity rather than high rate of
return.

Good Corporate Image

High credit rating of securities helps in improving the corporate image of a company. A high credit
rating increases the level of confidence among the investors. This helps in creating a good corporate
image of the company.

Lower the Cost of Public Issue

A company with highly rated instruments has to make least efforts in raising funds through public issue.
A good credit rating gives good publicity to the company. Companies with highly rated instruments
enjoy better goodwill and corporate image in the eyes of customers, shareholders, investors and
creditors.

Investors feel secured of their investments and creditors are assured of timely payments of interest and
principal.

Easy and Lowers Cost of Borrowing

A company with highly rated debt instruments has to make least efforts in raising funds from the
market. A high rating indicates low risk. High rated instrument will enable the company to offer low
rate of interest. The investors will accept low interest because of low risk involvement.

High credit rating gives the company wider spectators for borrowing. It can easily approach financial
institutions, banks, investing companies, public etc. for borrowings.

Help Non-popular Companies

Good credit rating gives exposure to the company. If the instruments issued by a company get publicity,
the company with low publicity gets popularity. It will now become easy for the company to raise fund
from the market.

Rating Facilitates Growth

Rating motivates the management of the company to undertake expansion of their operations or
diversify their production activities thus leading to the growth of the company in future.

Disadvantages of Credit Rating:

Following are the disadvantages of credit rating:

1. Non-disclosure of Important Information
2. Possibility of Biasness
3. Problems for New Company
4. Static in Nature
5. Rating is Not Certificate of Soundness
6. Difference in Rating Grades
Non-disclosure of Important Information
The firm being rated may not furnish all material or important information to the credit rating agency.
Any decision taken in absence of such important information may put investors at a loss.

Possibility of Biasness
The rating given by credit rating agency is based on the information collected from the company. The
information collected by the rating agency may be subject to personal bias of the rating team.

14 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Problems for New Company
Rating agencies give ratings on the basis of information supplied by the company. But, a new company
may not be able to provide sufficient information to prove its financial soundness. Therefore, it may get
lower credit rating. A low credit rating may create problem in raising funds from the market.

Static in Nature
Rating is done on the basis of a static study of present and past data of the company at one particular
point of time. There are numbers of political, economical, social and environmental factors which have
direct bearings over the affairs of the company. Any changes after the rating may defeat the very
purpose of rating.

Rating is Not Certificate of Soundness

Rating grades by the rating agencies are only an opinion about the capability of the company to meets
its interest obligations. Rating symbols do not pinpoint towards financial soundness or quality of
products or management or staff etc. In other words rating does not give a certificate of the complete
soundness of the company.

Difference in Rating Grades

Same instrument may be rated differently by different rating agencies because of many factors. This
may create confusion among the investors.

Process of Credit Rating

The rating process begins with the receipt of formal request from a company desirous of having its issue
obligations rated by credit rating agency. A credit rating agency constantly monitors all ratings with
reference to new political, economic and financial developments and industry trends.

The process/ procedure followed by all the major credit rating agencies in the country is almost similar
and usually comprises of the following steps.

1. Receipt of the Request

2. Assignment to Analytical Team
3. Obtaining Information
4. Plant Visits and Meeting with Management
5. Presentation of Findings
6. Rating committee meeting
7. Communication of Decision
8. Dissemination to the Public
9. Monitoring for Possible Change
Receipt of the Request
The rating process begins, with the receipt of formal request for rating from a company desirous of
having its issue obligations under proposed instrument rated by credit rating agencies. An agreement is
entered into between the rating agency and the issuer company. The agreement spells out the terms of
the rating assignment and covers the following aspects:

• It requires the CRA (Credit Rating Agency) to keep the information confidential.
• It gives right to the issuer company to accept or not to accept the rating.
• It requires the issuer company to provide all material information to the CRA for rating and
subsequent surveillance.
Assignment to Analytical Team

15 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

On receipt of the above request, the CRA assigns the job to an analytical team. The team usually
comprises of two members/analysts who have expertise in the relevant business area and are responsible
for carrying out the rating assignments

Obtaining Information
The analytical team obtains the requisite information from the client company. Issuers are usually
provided a list of information requirements and broad framework for discussions. These requirements
are derived from the experience of the issuers business and broadly confirms to all the aspects which
have a bearing on the rating.

The analytical team analyses the information relating to its financial statements, cash flow projections
and other relevant information.

Plant Visits and Meeting with Management

To obtain classification and better understanding of the client’s operations, the team visits and interacts
with the company’s executives. Plants visits facilitate understanding of the production process, assess
the state of equipment and main facilities, evaluate the quality of technical personnel and form an
opinion on the key variables that influence level, quality and cost of production.

A direct dialogue is maintained with the issuer company as this enables the CRAs to incorporate non-
public information in a rating decision and also enables the rating’ to be forward looking. The topics
discussed during the management meeting are wide ranging including competitive position, strategies,
financial policies, historical performance, risk profile and strategies in addition to reviewing financial
data.

Presentation of Findings
After completing the analysis, the findings are discussed at length in the Internal Committee,
comprising senior analysts of the credit rating agency. All the issue having a bearing on rating are
identified. An opinion on the rating is also formed. The findings of the team are finally presented to
Rating Committee.

Rating committee meeting

This is the final authority for assigning ratings. The rating committee meeting is the only aspect of the
process in which the issuer does not participate directly. The rating is arrived at after composite
assessment of all the factors concerning the issuer, with the key issues getting greater attention.

Communication of Decision
The assigned rating grade is communicated finally to the issuer along with reasons or rationale
supporting the rating. The ratings which are not accepted are either rejected or reviewed in the light of
additional facts provided by the issuer. The rejected ratings are not disclosed and complete
confidentiality is maintained.

Dissemination to the Public

Once the issuer accepts the rating, the credit rating agencies disseminate it through printed reports to the
public.

Monitoring for Possible Change

Once the company has decided to use the rating, CRAs are obliged to monitor the accepted ratings over
the life of the instrument. The CRA constantly monitors all ratings with reference to new political,
economic and financial developments and industry trends.

16 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

All this information is reviewed regularly to find companies for ,major rating changes. Any changes in
the rating are made public through published reports by CRAs.

Rating Methodology:

Rating methodology used by the major Indian credit rating agencies is more or less the same. The rating
methodology involves an analysis of all the factors affecting the creditworthiness of an issuer company
e.g. business, financial and industry characteristics, operational efficiency, management quality,
competitive position of the issuer and commitment to new projects etc.

A detailed analysis of the past financial statements is made to assess the performance and to estimate the
future earnings. The company’s ability to service the debt obligations over the tenure of the instrument
being rated is also evaluated.

In fact, it is the relative comfort level of the issuer to service obligations that determine the rating. While
assessing the instrument, the following are the main factors that are analysed into detail by the credit
rating agencies.

1. Business Risk Analysis

2. Financial Analysis
3. Earnings Potential
4. Cash Flow Analysis
5. Management Evaluation
6. Geographical Analysis
7. Regulatory and Competitive
8. Fundamental Analysis
Business Risk Analysis
Analysis Business risk analysis aims at analysing the industry risk, market position of the company,
operating efficiency and legal position of the company. This includes an analysis of industry risk,
market position of the company, operating efficiency of the company and legal position of the company.

Industry Risk
The rating agencies evaluates the industry risk by taking into consideration various factors like strength
of the industry prospect, nature and basis of competition, demand and supply position, structure of
industry, pattern of business cycle etc.

Industries compete with each other on the basis of price, product quality, distribution capabilities etc.
Industries with stable growth in demand and flexibility in the timing of capital outlays are in a stronger
position and therefore enjoy better credit rating.

Market position of the Company

Rating agencies evaluate the market standing of a company taking into account:

• Percentage of market share

• Marketing infrastructure
• Competitive advantages
• Selling and distribution channel

17 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

• Diversity of products
• Customers base
• Research and development projects undertaken to identify obsolete products
• Quality Improvement programs etc
Operating Efficiency
Favorable locational advantages, management and labor relationships, cost structure, availability of
raw-material, labor, compliance to pollution control programs, level of capital employed and
technological advantages etc. affect the operating efficiency of every issuer company and hence the
credit rating.

Legal Position
Legal position of a debt instrument is assessed by letter of offer containing terms of issue, trustees and
their responsibilities, mode of payment of interest and principal in time, provision for protection against
fraud etc.

Size of Business
The size of business of a company is a relevant factor in the rating decision. Smaller companies are
more prone to risk due to business cycle changes as compared to larger companies. Smaller companies
operations are limited in terms of product, geographical area and number of customers.

Whereas large companies enjoy the benefits of diversification owing to wide range of products,
customers spread over larger geographical area. Thus, business analysis covers all the important factors
related to the business operations over an issuer company under credit assessment.

Financial Analysis
Financial analysis aims at determining the financial strength of the issuer company through ratio
analysis, cash flow analysis and study of the existing capital structure. This includes an analysis of four
important factors namely: a. Accounting quality b. Earnings potential/profitability c. Cash flows
analysis d. Financial flexibility

Financial analysis aims at determining the financial strength of the issuer company through quantitative
means such as ratio analysis. Both past and current performance is evaluated to comment the future
performance of a company. The areas considered are explained as follows.

Accounting Quality
As credit rating agencies rely on the audited financial statements, the analysis of statements begins with
the study of accounting quality. For the purpose, qualification of auditors, overstatement/
understatement of profits, methods adopted for recognising income, valuation of stock and charging
depreciation on fixed assets are studied.

Earnings Potential
Profits indicate company’s ability to meet its fixed interest obligation in time. A business with stable
earnings can withstand any adverse conditions and also generate capital resources internally.
Profitability ratios like operating profit and net profit ratios to sales are calculated and compared with
last 5 years figures or compared with the similar other companies carrying on same business.

As a rating is a forward-looking exercise, more emphasis is laid on the future rather than the past
earning capacity of the issuer.

Cash Flow Analysis

18 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Cash flow analysis is undertaken in relation to debt and fixed and working capital requirements of the
company. It indicates the usage of cash for different purposes and the extent of cash available for
meeting fixed interest obligations. Cash flows analysis facilitates credit rating of a company as it better
indicates the issuer’s debt servicing capability compared to reported earnings.

Financial Flexibility
Existing Capital structure of a company is studied to find the debt/equity ratio, alternative means of
financing used to raise funds, ability to raise funds, asset deployment potential etc. The future debt
claims on the issuer’s as well as the issuer’s ability to raise capital is determined in order to find issuer’s
financial flexibility

Management Evaluation
Evaluation Any company’s performance is significantly affected by the management goals, plans and
strategies, capacity to overcome unfavorable conditions, staff’s own experience and skills, planning and
control system etc. Rating of a debt instrument requires evaluation of the management strengths and
weaknesses.

Geographical Analysis
Geographical analysis is undertaken to determine the locational advantages enjoyed by the issuer
company. An issuer company having its business spread over large geographical area enjoys the
benefits of diversification and hence gets better credit rating.

A company located in backward area may enjoy subsidies from government thus enjoying the benefit of
lower cost of operation. Thus geographical analysis is undertaken to determine the locational
advantages enjoyed by the issuer company.

Regulatory and Competitive

Environment Credit rating agencies evaluate structure and regulatory framework of the financial system
in which it works. While assigning the rating symbols, CRAs evaluate the impact of regulation/
deregulation on the issuer company.

Fundamental Analysis
Fundamental analysis includes an analysis of liquidity management, profitability and financial position,
interest and tax rates sensitivity of the company. This includes an analysis of liquidity management,
profitability and financial position, interest and tax rates sensitivity of the company

• Liquidity management involves study of capital structure, availability of liquid assets corresponding
to financing commitments and maturing deposits, matching of assets and liabilities.

• Asset quality covers factors like quality of company’s credit risk management, exposure to individual
borrowers and management of problem credits etc.

• Profitability and financial position covers aspects like past profits, funds deployment, revenues on
non-fund based activities, addition to reserves.

• Interest and tax sensitivity reflects sensitivity of company following the changes in interest rates and
changes in tax law.
Fundamental analysis is undertaken for rating debt instruments of financial institutions, banks and non-
banking finance companies.

19 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college

Credit Rating Agency in India:

• Credit Rating Information Services of India Limited (CRISIL): CRISIL is the largest and first
credit rating agency of India and a global leader in research, ratings and risk & policy advisory
services.

• Investment Information and Credit Rating Agency of India Limited (ICRA): CRA was
promoted by Industrial Finance Corporation of India jointly with other leading financial/ investment
institutions, commercial banks and financial services companies as an independent and professional
investment Information and Credit Rating Agency.

• Credit Analysis & Research Ltd. (CARE): CARE was incorporated in April 1993 as a credit rating
information and advisory services company. t is a credit rating and information services company
promoted by the Industrial Development Bank of India (IDBI) jointly with financial institutions,
public / private sector banks and private finance companies.

• Fitch India Limited: With the acquisition of Duff and Phelps Credit Company in April 2000 by
Fitch Ratings, Duff and Phelps Rating India Private Limited became Fitch India Limited. Duff and
Phelps Credit Rating India Private Ltd was the first joint venture rating company promoted by JM
Financials, Alliance Group and the international rating agency Duff and Phelps.

• ONICRA Credit Rating Agency of India Limited: ONICRA Credit Rating Agency is one of the
leading Credit and Performance Rating agencies in India. The company is based in Gurgaon and
founded in 1993. It provides ratings, risk assessment and analytical solutions to Individuals, MSMEs
and Corporates.

• Brickwork Ratings India Pvt. Limited (BWR): Brickwork Rating India Pvt. Ltd. was founded in
2007 by group of professionals to provide rating of public issues and others to help investors take
information decisions.

• SME Rating Agency of India Limited (SMERA): SMERA is a joint venture started by Small
Industrial Development Bank of India (SIDBI), Dun & Brand Street Information Services India
Private Limited (D& B) and several leading banks in India.

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20 FS notes By Vijayalakshmi. R, Assistant professor, Dept of commerce, SSMRV college