What could go wrong
Promoters love to talk about the grand future they visualise and rarely about the risks of turning it into reality. Borrowing from the international market at low rates looks attractive; add currency risk to the discussion and the picture turns on its head. Entrepreneurs are risk takers by nature with the psychological ability to bear shocks: Rupert Murdoch failed thrice before he built the Star empire, and Steve Jobs was thrown out of Apple, his own company, started another successful venture in the meantime, and was later called back. Businessmen can bear such risks; not all investors can.
Every business carries risks, from business to operational to execution aspects and beyond, some apparent and known, others unknown. Analysts must focus on risk across every dimension and keep asking one question: what could go wrong in the business?
If a promoter states that nothing could go wrong, the syllabus files him among the people who do not know that they do not know, and says such promoters must be avoided. A good businessman is always aware of the risks in the business and of the steps needed to protect it from their effects.
An analyst meets the founder of a fast-growing lender who describes branch expansion, new products and a listing. The analyst asks what happens if funding costs jump, if a large borrower segment defaults, or if the regulator tightens capital rules. A founder who has thought about each, with contingency steps, has passed the test the syllabus sets; one who waves the questions away has failed it.
Credit rating
A credit rating rates a borrower's ability to service its debt obligations. Ratings are issued by credit rating agencies at the issuer level and for individual debt instruments, with separate ratings for short-term and long-term debt.
A company can return anything to equity investors only after its lenders are serviced. The rating therefore tells an investor the level of financial risk in the company, and that drives the return an investor should expect. Higher financial risk demands higher expected return; a strong rating lowers the bar.
The history of a rating says something else. Rating reports specify the factors that led the agency to its conclusion and what it regards as key concerns. If the company has worked on those concerns, its management has been responsive to external feedback. Reading successive reports and noting how the concerns changed, or did not, from one to the next is how the analyst gets that insight.
- Promoters describe the dream, rarely the risks: borrowing abroad at low rates looks attractive until currency risk enters the discussion. Entrepreneurs are risk takers with the psychology to absorb shocks (Rupert Murdoch failed three times before building the Star empire; Steve Jobs was thrown out of Apple, started another venture, and was called back); investors may not share that tolerance.
- Risks range across business, operational and execution aspects and may be known or unknown. The analyst keeps asking what could go wrong. A promoter who says nothing can go wrong does not know what he does not know and should be avoided; a good businessman knows the risks and the steps that protect against them.
- A credit rating grades a borrower's ability to service debt. Agencies rate the issuer and individual instruments, with separate short-term and long-term ratings. It matters to equity holders because lenders are serviced first, so it signals financial risk and shapes return expectations.
- Rating reports state the factors behind the rating and the agency's key concerns; reading the history of ratings and how concerns changed from one report to the next shows whether management responds to external feedback.