CRISIL s Executive Summary A company may choose to tap into new business opportunities within the ambit of its own operations. Alternatively, for legal, tax, and regulatory considerations, it may choose to conduct these businesses through a separate legal entity -- a subsidiary, a special purpose vehicle (SPV), or associate/ group company. Indian companies have increasingly diversified into new lines of business, markets, or countries through complex corporate structures. Several acquisitions by Indian companies have been leveraged buy-outs, undertaken through SPVs. Other expansions have been through leveraged project finance structures. Both structures permit the deployment of considerable debt, without weighing down the acquirer s own balance sheet. These entities may also isolate or ring-fence the cash flows of the target company from those of the acquirer. Companies have also resorted to cross-investments and interlocking of equity in related entities 1. In the absence of a clear definition by the parent of the rated company s obligations and liabilities, intra-group transactions may have a bearing on its financial position, and, therefore, its ability to repay debt. CRISIL believes that in analysing the credit risk profile of a company that has direct or indirect controlling interest in another entity, it is important that the financials of the company and its related entity be considered on a consolidated basis. Consolidation of accounts makes for a fair representation of the group s financial health, net worth, and leverage levels. Consolidated accounts are important in assessing the liabilities that the rated company needs to honour in the event of exigencies in a related entity, which the standalone financials will not capture. Scope This criteria document highlights the need for consolidating the company being rated and its related entities, and outlines CRISIL s approach to consolidation. It articulates how CRISIL s criteria on consolidation takes into consideration the continuum of support extended by the parent to all its related entities. The criteria goes beyond the situation of full consolidation or no consolidation, and factors all other forms of support in its analysis. It also assists in determining whether or not to consolidate a particular related entity and elaborates on the framework to be used in order to assess the integration between the parent and its related entities. 1 Related entities include subsidiaries, Special Purpose Vehicles (SPVs), associate companies, group companies and companies under the same management.
CRISIL s CRISIL s approach to consolidation CRISIL s approach, however, extends beyond financial consolidation; CRISIL analyses the business risk of the group and not just the company being rated. The analysis covers each business the group has a presence in or is likely to have a presence in -- during the period of analysis. The approach adopted by CRISIL in analysing the business and management risks of the group will be the same as the one it would adopt if the businesses were conducted as divisions of the company being rated (Refer example presented in Box 1) Box 1: The case for consolidation Consider a parent company, P Ltd, which has a subsidiary S Ltd. The subsidiary markets more than 80 per cent of P Ltd s products. It is clear that S Ltd s existence is critical to the operations of the parent, as it accounts for a significant share of the sales of the parent. It is, therefore, reasonable to expect that P Ltd will support its subsidiary in the event of financial distress. P Ltd s standalone business risk profile, which does not factor in S Ltd s marketing network, will, thus, not be comparable to the networks of P Ltd s competitors. Also, P Ltd s standalone financial statements will not reflect the actual sale price to end customer, or the related marketing and selling costs, and will thus present an incomplete picture. Therefore, it is necessary that P Ltd s consolidated operations and financials be taken into account to capture all these factors, and make the analysis of P Ltd s credit risk profile comparable with that of its competitors. This example highlights the importance of consolidation in the rating process. Pooling of interests: CRISIL s method of consolidation There are several ways to consolidate accounts, as per the international accounting standards: these are the equity method, the pooling of interests method, and purchase method. The choice of method will depend on the facts of the case, and the purposes for which the consolidation is carried out. By consolidating, all related entities are treated as a single economic entity. CRISIL adopts the method of consolidation called pooling of interests, which is also the one adopted by Accounting Standard 21 (AS21, issued by the Institute of Chartered Accountants of India, refer box 5 for background on AS21), to assess a group s overall financial risk profile and its impact on the rated company. The consolidating process cancels out all off-setting reciprocal pairs such as assets and liabilities, revenues and costs, and investment and equity accounts, which appear in the financial statements of the related entities. For instance, the pooling of interests method nullifies all intra-group transactions. In the balance sheet, investments in related entities are netted off from the group s net worth, and borrowings within the group are netted off from advances/investments. One advantage of this method is that it does not necessitate a valuation exercise or creation of goodwill. (Please refer example in box 2)
Box 2: Consolidation by pooling of interests Consider a company P Ltd having a share capital of Rs.200 million with an investment of Rs.80 million in the share capital of S Ltd, its subsidiary. If the share capital of S Ltd is Rs.100 million, then the share capital of P Ltd on consolidation will be Rs.220 million; this is calculated as follows: Rs. (in million) Share capital of P Ltd (Parent company) 200 Add: Share capital of S Ltd (Subsidiary company) 100 Less: Investment by P Ltd in S Ltd 80 Share capital of P Ltd on consolidation 220 Each item of the balance sheet and income statement is consolidated in a similar manner, after adjusting for intercompany transactions. Thus, a clear picture of the economic resources controlled by the group, its obligations, and the results it has achieved with the given resources, are available for assessment. The consolidated financials indicate the exact nature of group liabilities, the group s profitability and interest cover, and performance on other parameters. Finally, key parameters such as the group s debt, gearing, interest cover, and profitability are estimated; these are crucial inputs that CRISIL requires in assessing a company s financial risk profile. Identifying entities for consolidation The primary criterion in determining whether or not to consolidate a related entity is the willingness and/or compulsion of one entity to support another in exigencies. Hence, while AS21 stipulates consolidation of subsidiaries in specific cases, CRISIL assesses consolidated financials based on its analytical judgement of the parent s willingness and /or compulsion to support the subsidiary in the event of distress. CRISIL generally consolidates all subsidiaries, with the following exceptions: Where the subsidiary does not operate in the same sector as the parent (for example, a manufacturing parent entity having a finance or insurance subsidiary, or a bank having an insurance subsidiary); or Where the subsidiary is explicitly ring-fenced (typically in the case of SPVs) However, even in such cases, CRISIL factors in the potential impact of cash flow support to the unconsolidated subsidiary. For instance, if the subsidiary and the parent entity operate in different sectors, a capital allocation approach is followed to determine the rating of the parent and the unconsolidated subsidiary (Refer box 3 for details on capital allocation approach). The potential impact of support is also considered for associate companies or other investments.
CRISIL s Box 3: Capital allocation approach Where there is a finance subsidiary of a manufacturing parent or an insurance subsidiary of a bank, in some instances, CRISIL may decide to notch up the rating of the unconsolidated subsidiary on account of a stronger parent (Please refer to our detailed criteria present on the CRISIL website under the Criteria and Methodology section - Criteria for Notching up Stand Alone Ratings of Companies based on Parent Support ). In such instances, CRISIL internally follows a capital allocation approach to determine the appropriate rating of the parent and the unconsolidated subsidiary based on the capital allocated to the subsidiary. Under the capital allocation approach, some amount of capital, objectively assessed through the level of parent support envisaged, is deducted from the parent s net worth and is allocated to the unconsolidated subsidiary. The capital support from the parent uplifts the subsidiary s rating from its standalone level to its final rating assigned by CRISIL. Accordingly, as this capital is no longer deemed to be available with the parent for its own operations, the parent s net worth is adjusted to the extent of the capital allocated to the subsidiary and is appropriately factoring in its rating. CRISIL believes that the willingness or compulsion of one entity to support another in the event of exigencies is largely driven by the linkages between them; which can take various forms. In some cases, the rated company may have no major shareholding in group companies, and yet transactions between them may have cash-flow implications for both. For instance, three companies all held by the same promoter, and performing specific parts - such as raw material sourcing, production, and marketing of the value chain for the same product, will necessitate consolidation to evaluate the creditworthiness of any one entity in the value chain. Or, companies may hold substantial equity but have no management control over other entities; as a result, transactions between them may be limited to arm s length dealings. It is therefore critical to assess the possibility and extent of cash flow transactions between the two entities. Evaluation of inter-linkages between rated entity and any related entity The approach that CRISIL adopts to evaluate the linkages or perceived relationships between the company being rated and the related entity, focuses on the extent and likelihood of support from parent to the related entity, reflecting the economic risks that remain with, or will come upon, the parent. This analysis involves the following steps: Step 1: CRISIL evaluates the extent of linkages between the parent and the related entities based on the economic importance of the related entity for the parent, the extent to which cash flows of one entity can be used by another, the stated posture of the management, extent of shareholding of one entity in the other, and the presence of a shared name. (Refer Box 4 for the detailed framework used for this assessment)
Box 4: CRISIL s Framework for assessing level of integration CRISIL uses the following parameters in assessing the integration between the parent and the related entity: 1. Economic importance of related entity for parent: CRISIL believes that this is the strongest factor affecting the extent of linkage between related entities and their parent companies. CRISIL evaluates the magnitude of the economic importance based on various factors, which include the related entity s strategic importance to the parent, the level of the parent s exposure in the related entity in relation to its own net worth, and the expected financial returns from the entity. 2. The extent to which cash flows are fungible: Movement of cash across entities indicates a stronger likelihood of support from parent to related entities. Cash flows across entities may include inter-corporate deposits, advances and loans, or equity infusions. Such groups will generally have common treasury operations; but the presence of a common treasury does not necessarily mean that cash flows move freely through the group. 3. Documentary support: The documentary support (such as guarantees, letters of comfort, or letters of awareness) provided by the parent to related entity s lenders, brings out the intent of the promoter to support the entity. It thus provides an insight into the level of integration between the two entities. 4. Management s stated posture: CRISIL evaluates the parent s stated posture on support (or otherwise) to a related entity, and its track record in similar situations. It is also important to think ahead to potential stress scenarios, and assess how the parent may act in such circumstances. 5. Percentage of ownership: Large holdings by the promoter or group companies reflect a high level of commitment to the related entity. CRISIL assesses current and prospective shareholding patterns to make the analysis forward-looking. 6. Shared name: CRISIL believes that a common name between the parent and a related entity obligates the parent to support the entity in times of financial distress. A common group logo or name and other forms of association with the group are manifestations of strong integration of the entity with the group. Step 2: Based on its assessment of the level of integration, CRISIL categorises related entities into one of three classes (See Chart 1): fully integrated with parent, moderately integrated with parent, or held as a financial investment by parent.
CRISIL s Chart 1: The Three Classes of Associates FULLY INTEGRATED INVESTMENTS Full Integration Full analytical consolidation with parent Moderately Moderate Integrated No Integration consolidation. No consolidation. Factor in additional CRISIL factors in investment additional investment and support and support Financial Investment Financial Investment No No consolidation. consolidation. CRISIL analyses the Analyse value of investment the value of for investment. impairment Factor in dividend income Step 3: Based on the classification of the related entity, CRISIL adopts the appropriate analytical treatment for factoring in the potential impact of support to the entity, from the company being rated. This is as follows: Fully integrated with parent: Related entities that are fully integrated are consolidated with the parent company: the business and financial risk profiles of the parent fully incorporate those of these entities. The operations of these entities are critical to the parent. CRISIL, therefore, believes that there is significant economic incentive for the parent to provide full support to such related entities in times of distress. Moderately integrated with parent: In the case of moderately-linked entities, CRISIL estimates the level of additional investment or support that may be required in the event of distress; these are then factored into the analysis of the parent company. CRISIL also tests the value of investments held by the parent in the entity for impairment, and adjusts the parent s net worth if required. No consolidation is done in such cases even though the related entity may legally be a subsidiary. Consider, for instance, a construction company with an investment 15 per cent of its net worth in an SPV with limited recourse that is executing a toll road project. The SPV may legally be a subsidiary of the parent company. However, considering the limited recourse that the lenders to the SPV have to the parent company in this project, CRISIL will not consolidate the financials of the SPV while analysing the parent company. The level of additional investment or support that may be required in the event of distress will be factored into the analysis of the parent company. Held as a financial investment by parent: CRISIL treats a related entity as a financial investment if it is of little strategic importance to the parent; and/or offers minimal economic incentive for the parent to provide distress support; and/or features adequate ring fencing, and is insulated by an explicit public stated posture of non-support. In such cases, the parent s credit risk profile is assessed independently, without factoring in the debt obligations of the related entity. However, the value, volatility, and liquidity of the investment by the parent in a related entity are analysed as CRISIL would analyse any other equity investment; this includes testing the investment for any impairment in value.
Box 5: Consolidation in India AS21 Under AS21, a company is deemed to have control over another company in two specific cases: When one company has a majority stake (of more than 50 per cent) in another When management control of one entity vests with another entity, which has the voting power or the power to appoint or remove members on the board of directors of the first entity. Consolidation of group company accounts is mandatory for parent companies that satisfy either of these criteria. AS21 requires the controlling or parent company to present consolidated financials for the entire group, together with its own standalone financials. Consolidated financial statements need to be in the same format as ordinary financial statements, and need to include a consolidated profit and loss account, balance sheet, and cash flow statement. Even finance subsidiaries of a manufacturing parent need to be consolidated under AS21; CRISIL believes that this does not present a true picture of the parent's financial risk profile, and therefore excludes finance subsidiaries when evaluating a manufacturing parent's financial profile.
About CRISIL Limited CRISIL is a global analytical company providing ratings, research, and risk and policy advisory services. We are India's leading ratings agency. We are also the foremost provider of high-end research to the world's largest banks and leading corporations. About CRISIL Ratings CRISIL Ratings is India's leading rating agency. We pioneered the concept of credit rating in India in 1987. With a tradition of independence, analytical rigour and innovation, we have a leadership position. We have rated over 60,000 entities, by far the largest number in India. We are a full-service rating agency. We rate the entire range of debt instruments: bank loans, certificates of deposit, commercial paper, non-convertible debentures, bank hybrid capital instruments, asset-backed securities, mortgage-backed securities, perpetual bonds, and partial guarantees. CRISIL sets the standards in every aspect of the credit rating business. We have instituted several innovations in India including rating municipal bonds, partially guaranteed instruments and microfinance institutions. We pioneered a globally unique and affordable rating service for Small and Medium Enterprises (SMEs).This has significantly expanded the market for ratings and is improving SMEs' access to affordable finance. We have an active outreach programme with issuers, investors and regulators to maintain a high level of transparency regarding our rating criteria and to disseminate our analytical insights and knowledge. CRISIL Privacy Notice CRISIL respects your privacy. We use your contact information, such as your name, address, and email id, to fulfil your request and service your account and to provide you with additional information from CRISIL and other parts of McGraw Hill Financial you may find of interest. For further information, or to let us know your preferences with respect to receiving marketing materials, please visit www.crisil.com/privacy. You can view McGraw Hill Financial s Customer Privacy Policy at http://www.mhfi.com/privacy. Last updated: May, 2013 CRISIL Limited CRISIL House, Central Avenue, Hiranandani Business Park Powai, Mumbai 400 076 Phone: +91 22 3342 3000 Fax: +91 22 3342 3001 www.crisil.com