METHODOLOGY tel.: faks: E-pošta

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1 METHODOLOGY 1

2 FINANCIAL RATING The financial rating and assessment shows the operations of a company in the previous year and is calculated once a year. The ratings are designated by letters from A to E, with the letter A being the highest grade and the letter E being the lowest grade. Figure 1: The distribution of population by credit rating on the basis of financial data for % 25% 20% 15% 10% 5% 0% A B C D E Credit grade The process of assigning a credit rating is based on the classification of companies in individual categories. Firstly, an individual company is classified into one of ten categories according to the amount of assets and into one of the categories according to the total revenues. The first category includes the smallest companies and companies with the lowest revenues; tenth category includes the largest companies and companies with highest revenues. After classification of companies into categories, in the next step companies are classified according to individual financial indicators. In further classification, six financial indicators are used, while the final credit rating is formed on the basis of the classification of an individual company among the companies in the corresponding category in terms of individual indicators. For each indicator, only one of two possible classifications is used from the first step, either classification based on the size of assets or classification based on the amount of total revenues. The selection of financial indicators is limited to five of the most representative indicators that are most often used in practice by the industry. Every company must be solvent in order to survive and prosper, which is why indicators are divided into liquidity and performance indicator. The financial assessment is not carried out for entities for which an individual financial indicator cannot be calculated. Reasons may include missing financial data or inadequate values of certain financial items. 2

3 LIQUIDITY INDICATORS The share of liabilities in financing activities Formula: DDVF * Description: [00303] Financial and business liabilities [003] Total liabilities Definition: The share of liabilities in financing activities indicates the amount of assets financed by foreign capital. The higher the value of the indicator, the more a company is financed from foreign sources (short-term and long-term liabilities). A high value of the indicator represents a high risk for creditors. As a rule, foreign financing is a less expensive form of financing as opposed to self-financing. It is better for owners if the company is financed by foreign sources because, as a rule, this increases the profitability of the company. Borrowing from foreign sources usually increases profitability, but excessive borrowing may lead to insolvency. Although foreign sources are often a less expensive form of financing, they involve a higher risk for creditors. A company can overcome excessive borrowing on the condition that the growth of operations is sufficient to bear the burden of financing from foreign sources and the current costs. On the contrary, the risk increases, which may cause insolvency problems. The indicator represents long-term solvency. Long-term solvency is of vital importance for the long-term existence and operations of a company. The structure of liabilities is of vital importance for the longterm survival of a company. Characteristics of the indicator: The higher the value of the indicator, the higher the risk for a creditor. If a company has a high indicator value, this means that it finances its operations from foreign sources. For example: if the indicator value is 0.6, this means that the company finances 60% of all assets from foreign sources. A value above 1 means that the company finances all its assets from foreign sources. This indicates that the company is in negative equity and thus undercapitalized. Companies with an indicator value below 1 usually have positive equity. It may also happen that these companies are in negative equity, but only in the event that they have a high level of provisions or accrued costs and deferred revenue in assets. The equity of companies with the value of 1 usually equals zero. Companies that perform activities in which the turnover of assets is quick have less difficulty in bearing the burden of a higher indicator value. The indicator is not calculated if the denominator is zero. This means that the company has no assets. The value of the indicator is zero if the numerator is zero. This means that the company has no liabilities. 3

4 Payment capability Formula: [00102 ] PS Description: [00102] Short-term assets [ ] Short-term financial and operating liabilities Definition: This indicator shows the amount of short-term assets that settles short-term liabilities. It does not give an estimate of a company' solvency, but only indicates the factors that may affect it. A high indicator value means that the company will have less difficulty meeting its current liabilities. The value of the indicator decreases if current liabilities grow faster than short-term assets, which can increase the risk of insolvency in the future. The value of the indicator may decrease if any item among short-term assets is neutralized (the write-off of impaired receivables or a decrease in inventories) or if the company suddenly increases its short-term liabilities (the company is in financial difficulty and therefore takes out new short-term loans). In practice, there is a rule that the minimum ratio ensuring certain security requires short-term assets to be twice the amount of short-term liabilities. If the value of the indicator is too high, we can conclude that the company ineffectively uses its capital. This means that the quantity of the company's inventories for the market is too large or the company gives customers too much credit. The indicator represents short-term solvency. Short-term solvency shows the ability of the company to have a sufficient amount of liquid assets in the short term in order to settle liabilities. Characteristics of the indicator: The higher the value of the indicator, the better for a creditor. In that case, short-term assets settle short-term liabilities. The problem lies in the fact that short-term assets and short-term liabilities do not have the same maturity. An overly high value of the indicator warns us that capital is not used effectively, since the company has an excessively high value of inventories and gives customers too much credit. We assume that the company is faced with the problem of marketing their product or service, which can lead to insolvency in the long term due to a decline in operating income. The indicator is always positive and has no upper limit. The normal value of the indicator is approximately 1.5 to 2, depending on the activity and the economy. If the indicator value is below 1, this means that the company has a lower value of short-term assets than short-term liabilities. If the indicator value is above 1, short-term assets are higher than short-term liabilities. Companies that have a low value of short-term assets will also have a low indicator value. Companies that have a low value of inventories or conduct business according to the "just in time" strategy will have a low indicator value. Even companies that do not finance customers in accordance with their business practice will have a low indicator value. Companies that have a low value of short-term liabilities usually have a high indicator value. Companies that have a high indicator value and a high value of the share of liabilities in financing activities incur greater debt 4

5 in the long term than in the short term. If they have a high value of solvency indicator and a low value of the share of liabilities in financing activities, this means that they use relatively few foreign sources to finance their operations. The indicator is not calculated if the denominator is zero. This means that companies have no shortterm liabilities. The value of the indicator is zero if the numerator is zero. This means that companies have no shortterm assets. Debt servicing Formula: - Calculation of indicator for companies and cooperatives excluding entrepreneurs: SD - Calculation of indicator for entrepreneurs: SD Description: [075] Net business result for the accounting period [071] Total business result for the accounting period (prior taxes) [057] Write-offs (Depreciation, Amortization and Revaluation) [0702] Total costs Definition: Short-term solvency means that a company is solvent. The best indicator of short-term solvency is an updated cash flow statement, but this data is difficult to obtain by external users. For that reason, we used a short version of cash flow. Many analytics use the sum of profit or loss and amortization/depreciation as a quick indicator of the value of cash flow in the accounting period. Cash flow considered as inflow is used to settle liabilities at maturity. The mature liabilities are considered outflows. The precise value of outflows for an individual company is the information that is impossible to obtain by external users. Therefore, we have considered outflows to be equal to expenditure, although we are aware that outflows may not always be expenditure and expenditure may not always be outflows. The indicator of debt servicing consists of cash flow in the numerator and the total expenditure in the denominator. A high value of the indicator means that cash flow largely covers expenditure. This is positive for the company because it means that it will incur less debt to settle its current liabilities. Characteristics of the indicator: The higher the value of the indicator, the better it is. In that case, expenditure is covered by the cash flow generated in the accounting period. If the indicator has a negative value, this means that the company has a negative cash flow the sum of profit or loss and amortization/depreciation is negative. 5

6 If the value of the indicator is below 1, this means that the company has a lower value of generated cash flow in comparison with expenditure. If the indicator is above 1, the generated cash flow is higher than the total expenditure. Companies that perform activities for which they do not generate a high level of expenditure during their operations will have a higher indicator value than companies that perform activities for which they generate a high level of expenditure during their operations (costs of material). The indicator is not calculated if the denominator is zero. This means that companies have no total expenditure. In that case, we have proposed a hypothesis that the company is dormant. The value of the indicator is zero if the numerator is zero. This means that companies do not generate cash flow. Credit exposure from operations Formula: KI 059 Description: [ ] Short-term operating receivables [059] Operating revenues Definition: The indicator measures relationship between claims and operating income on last working day of the current fiscal year. This relationship show credit risk of the subject from business and became one of the ratios that measure the company s liquidity. In the case of greater participation of non-payable claims company can enter into liquidity problems and may have influence on increasing of the company`s short-term borrowing or even on starting bankruptcy or liquidation proceeding. Features of the indicator: Increasing the indicators show a greater share of unpaid claims of the company. A large proportion of unpaid claims mean more credit exposure to its customers. The indicator measures only the credit risk exposure from operations and does not include the credit exposure from loans given. The best case would be that this type of exposure will be short-term. The value of indicators also depends on the branches of activity in which the company operates. In certain sectors of the normal deferred payments for several months, so that has the influence on the indicators, because the increase in delay of payment increases the share of unpaid claims. In activity indicator also depends on the size of the company and credit policy of the company. PERFORMANCE INDICATORS Net return on assets Formula: The formula differs with regard to the existence of financial data for the penultimate year. 6

7 [059] + [051] [060] ROA = [001]+[001P] Description: [001] Assets [001P] Assets (previous year) [051] Changes in the value of inventories of products and work-in-process [059] Operating revenues [060] Operating expenses Definition: Net return on assets shows the effective use of assets by a company. It shows the profitability of the company arising from its basic business activity. A creditor must pay attention to companies that have a very high level of return on assets as well as a high value of the indicator of the share of liabilities in financing activities, which means that the company boosts its performance due to borrowing. If a company does not increase or at least maintain the level of revenue, it is more likely to become insolvent. Characteristics of the indicator: If the value is high, this is better for the company because it is more profitable and more effectively uses its own assets. Activities that have a low value of assets will have a high indicator value; for example, service activities. If the indicator has a negative value, the company has negative EBIT, which means that its basic activity is not profitable. If the indicator value is 1 or more, the company usually has a low value of assets and EBIT that has an equal or higher value than reported assets. Companies that perform activities for which a small amount of assets is needed for their operations have this indicator value: for example, 'new economy' or service activities. The indicator is not calculated if the denominator is zero. This means that the company has no assets. The value of the indicator is zero if the numerator is zero. This means that the company discloses EBIT or profit or loss as the zero value. 2 Asset turnover ratio Formula: The formula differs with regard to the existence of financial data for the penultimate year. KOS ( P ) 2 Description: [0701] Total revenues [001] Assets [001P] Assets (previous year) Definition: 7

8 This indicator measures the share of the total revenue of assets. It may be considered the turnover indicator if the given value is divided by the number of days in a year. This value would show the annual turnover of assets. Otherwise, it can be defined as the indicator of profitability or performance. The indicator is intended for owners and creditors. This indicator shows creditors the total revenue generated per given assets by an individual company. If the indicator value is high, the company operates successfully and has a shorter turnover. The shorter the turnover, the more solvent the company and lower the likelihood, that the company would have solvency problems. A short turnover means that assets require less time for the transition from illiquid to liquid status. Companies that have a high value of the indicator of the share of liabilities in financing activities and a low value of the asset turnover ratio are more likely to become insolvent. This indicator was selected in order to show the performance of companies from the viewpoint of their whole operations. Net return on assets only shows performance arising from the main business activity without financing. A company that has a high net return on assets arising from its operations and a low value of the asset turnover ratio has difficulty in financing (high financial expenses) itself or has recorded an unpredictable event (extraordinary expenses). Characteristics of the indicator: If the indicator value is high, it is better for the company and a larger share of total revenue covers total assets. The indicator value is always positive because total revenue and assets cannot be negative. If the indicator value is 1 or more, total revenue is greater than or equal to the value of total assets, which means that the turnover of assets is faster and the company has a shorter turnover. The indicator is not calculated if the denominator is zero. This means that the company has no assets. The value of the indicator is zero if the numerator is zero. In that case, the company has no total revenue. Companies that have no total revenue are considered to be dormant or non-active. If the value of the indicator increases due to total revenue, this is a clear indication for the company that it has increased its financial strength. Steady growth in revenue is an assurance that the company will be able to settle its debts. The comparison of credit ratings By comparing the credit ratings of entities for two consecutive years, we strive to determine the stability of the model. A credit rating should be stable and, in principle, may not be significantly changed from year to year for an individual company. By using the migration matrix, we strive to identify the extent to which the model meets the requirement for stability. into year 2012 Table1: Migration matrix by years from year 2011 A B C D E A 60,73% 20,81% 9,12% 4,97% 3,18% 8

9 B 24,25% 41,11% 26,83% 13,64% 7,04% C 7,43% 19,48% 29,06% 19,67% 8,60% D 5,25% 12,74% 24,06% 37,87% 23,08% E 2,33% 5,85% 10,93% 23,85% 58,10% In neighboring 84,98% 81,41% 79,95% 81,39% 81,18% It is clear that the majority of transitions (in case of changes) are made to adjacent grades. 9

10 DYNAMIC RATING Dynamic rating takes into account changes that happened in a company in the past and also current everyday changes. That is why rating can change daily. All active companies with at least one bank account and are not in insolvency proceedings have the rating. It is calculated from the indicators listed below: activity; location; profile; lawsuits; blocks; payment index; financial data. Dynamic rating indicators Activity Indicator activity adds the risk of activity to the dynamic rating. A company can be active in an activity where the results are below the average and therefore the risk is bigger or it can be active in an activity where the results are above average and therefore the risk is lower. Location Location indicator adds the risk off location to the dynamic rating. If a company is active in a municipality or region where the results are below average an therefore the risk is higher or is active in a municipality or region where the results are above average and therefore the risk is lower. Profile With the profile indicator registration data is added to the dynamic rating. The indicator takes into account variables like age of the company, information on bank accounts etc. Lawsuits The lawsuits indicator is based on the data gathered from the courts in the last three years. The variables that are considered in this indicator are statistics of combined value of lawsuits, number of lawsuits and the role of the company in those lawsuits. Blocks Each company may have one or more transaction accounts. According to the law (ZIZ-UPB1,2004 or ZDavP-1- UPB2,2006) bank can block transaction account, if there are not sufficient assets to cover distinct obligations of the account owner. Points are given on the basis of statistic of account blocks in the last year and are the main contributor to the overall dynamic rating of a company. 10

11 Payment index Points in the payment index indicator are based on the statistics for the last 14 months. This indicator is only calculated for the companies for which we have the necessary data available to calculate the payment index. Financial data Points for the financial data indicator are based on the last balance sheet available for the company which cannot be older than two years. The indicator is only calculated for the capital companies, sole entrepreneurs and cooperative societies. The five financial indicators that are used for calculating dynamic rating are not necessarily the same as in the financial rating. The indicators used here are the ones that more likely reflect future liquidity problems. Explanation of the dynamic rating classes Dynamic rating in Bonitete.si is presented with the help of plus (+) or minus (-) characters. Pluses/minuses are used to show minor/higher probability of account block in the next 365 days (blocked account for more than 60 days). Every active company that is not in insolvency case and has at least one active bank account is considered. Statistics for distribution of rates (companies with bank account blocks in the past are predominant the ones with minuses): - two plus (++): 25% of population - average probability of a company not having a bank account block in the next 365 days is 99% - one plus (+): 39% of population - average probability of a company not having a bank account block in the next 365 days is 96% - one minus (-): 23% of population - average probability of a company having a bank account block in the next 365 days is 14% - two minus (--): 13% of population - average probability of a company having a bank account block in the next 365 days is 75% Companies whose company type is not known cannot have more than one plus (+). The same goes for the companies that have negative capital, which are younger than two years or companies of legal types capital companies, sole entrepreneurs and cooperative societies for which we do not have at least one balance sheet from the last two years. Approximately 12.7% of companies have blocked bank accounts yearly in Slovenia and most of these blocks are sings of blocks in previous years. 11

12 TRAFFIC LIGHT Traffic light sums three different ratings into one quick and easy to read indicator. The three ratings included are financial rating, dynamic rating and labels. Red Red light is on in following situations: - company has a status: cancelled, insolvent, blocked or warning; - companies with probability of blocked bank account in the next twelve months more than 86%; - company has no dynamic rating and financial rating is very bad (at least five indicators have less than three points). Yellow Yellow light is on in following situations: - company has no financial rating and probability of having a blocked bank account in the next twelve months is lower than 86%; - company's dynamic rating is one minus (-) but its financial rating is not critical (at least two indicators have more than 3 points); - company's financial rating is weak (at least five indicators are below three points) but it's dynamic rating is two plus (++); - company has no dynamic rate but its financial rate is not critical (at least two indicators have more than three points). Green Red light is on in following situations: - company has no financial rate but its dynamic rate is excellent (++); - company's dynamic rating is one minus (-) but financial rating is not critical (at least two indicators have more than three points); - company has no dynamic rate but its financial rate is good (at least five indicators have five points). 12

13 CREDIT LIMIT Credit limit is a recommended upper amount of credit that a business or a company could grant to the client in a form of deferred payment for a period of 3 months. It is based on an assessment of a potential trade volume of the client and its risk of non-payment. The credit limit amount can be used as a reference when deciding when to ensure a debt or while setting limits for outstanding payments for clients. What affects the amount of the credit limit? Higher the potential trade volume of a company and lower the risk of non-payment, higher the amount of the credit limit. Lower the potential trade volume and higher the risk of non-payment, lower the level of the credit limit. Credit limit is not evaluated for insolvent companies. CREDIT MARGIN Credit margin is a recommended minimum credit margin for granting a deferred payment to a client for a period of 3 months. It is based on an assessment of the clients risk of non-payment. It is an assessment of an expected loss from not paid obligations when doing business with the company in question. What affects the height of a credit margin? Lower the non-paying risk, lower the credit margin. Higher the non-paying risk, higher the credit margin. Credit margin is not evaluated for insolvent companies. 13

14 KICK-OFF CRITERIA Rating is NOT calculated for the subjects operating in the following sectors: ID Description of Sector Other monetary financial institutions - public Other monetary financial institutions - national private Other monetary financial institutions - foreign controlled Insurance corporations and pension funds - public Insurance corporations and pension funds - national private Insurance corporations and pension funds - foreign controlled Rating is NOT calculated for all subjects operating in»financial and insurance activities«, except for subjects operating in the following sectors: ID Employers Description of Sector Rating is NOT calculated for all subjects operating in»management of real estate on a fee or contract basis«. Rating is NOT calculated for start-ups, these are companies that did not operate for full 12 months in given financial year. 14