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Methodology

SMERA rating framework considers a number of financial and non financial parameters of the enterprise and the impact of the macro economic factors like government policies, trade policies and regulations and the industry specific dynamics. SMERA believes that the industry in which a SME operates has a direct bearing on the overall performance of the SME and therefore rates SMEs based on industry benchmarks. SMERA Rating is a comprehensive assessment of the enterprise taking into considerations the overall financial and non financial performance of the subject company vis-à-vis the other peers in the industry in the same line of business and size criteria.

Based on its assessment and understanding, SMERA has developed rating methodology framework which mainly addresses the following areas

A) Industry Risk
The industry in which an enterprise operates plays a crucial role in the credit risk assessment. It is a key determinant of the level and volatility in earnings of any business.
B) Business Risk
Business risk is the possibility of a credit customers failing to pay because of circumstances connected with the customer’s business activities and management. I) Market Risk : Market risk is the exposure of the unit to the forward and backward linkage in the course of conducting its business, and the risk of facing sustained periods of unfavorable trends in such factors as product prices, raw material prices, single product dependence, pricing inflexibility, etc. II) Operating Efficiency In markets where competitiveness is largely determined by costs, the market position is determined by the unit’s operational efficiency. The result of these factors is reflected in the ability of the unit to maintain /improve its market share and command differential in pricing. In a competitive market, it is critical for any business unit to control its costs at all levels. This assumes greater importance in commodity or "me too " businesses, where low cost producers almost always have an edge. Cost of production to a large extent is influenced by location of the production unit(s), access to raw materials, access to human resources, scale of operations, technology, level of integration , experience and the ability of the unit to efficiently use its resources.
C) Management Risk
Management risk refers to the instance of risk of non payment arising out of a business failure due to the perceived inefficacies of the management. The elements in management risk are assessing the management quality judged on the basis of the basic educational qualification, professional experience of the entrepreneur; and business attitude that is related to the motivation of carrying out the business and pursuing business strategies. Majority of the Indian SMEs are essentially managed by one or two key persons. In this scenario, the quality of management personnel becomes critical. In assessing management quality three factors are critical: Character - relate to the willingness to pay. Apart from the characteristic disposition of honesty and integrity, several aspects are judge in terms of Track record of previous borrowing and payment is an indicator. Whether the owners/ directors have a financial interest in the business. Business premises given the impression of a well-run unit. Ability - relates basically to the ability to pay. Credit worthiness of the buttoner/borrowing company is assessed, including financial strength, and Capacity - refers to the borrower having technical, managerial and financial abilities in order to operate profitably and succeed in business. Quality of management would determine level of control, overall organizational capability, willingness to service loan, etc. Absence or inadequate of presence of these factors would lead towards greater risks. Type of organizational also adds to the management risk. Past experience of the management in handling similar business, performance of group companies and their track record, vision and mission of the management, organisation structure, succession issues, networth and corporate governance also plays an important role in assessing the management.
D) Financial Risk
Financial risk analysis involves thorough evaluation of the financials of the SMEs. Careful analysis of the audited financials, observations of auditors in the auditors report and notes to accounts, consistent treatment of financials play an important role. Key ratio analysis, trend ratios, financial disclosures and off Balance sheet items and their impact on the profitability is studied and analysed in depth. Further the source of financial funding and their impact on the capital employed structure needs to be analysed. Availability of liquid investments, unutilized lines of credit, financial strength of group companies, market reputation, relationship with financial institutions and banks, enterprise perceptions and experience of tapping funds from different sources also play an important role in financial analysis. Past performance of the company, level of financial transparency i.e. quality of documents and future plans plays an important role in the determination of rating. While the focus of rating exercise is to evaluate the future cash flow adequacy for servicing debt obligations, a detailed review of the past financial statements is critical for better understanding of the influence of all the business and financial risk factors. Evaluation of the existing financial position is also important for determining the sources of secondary cash flows and claims that may have to be serviced in future.
E) New Project risks:
The scale and nature of new projects can significantly influence the risk profile of any . Unrelated diversifications into new products are invariably assessed in greater detail. The main risks from the new projects are time and cost overruns, even non-completion in an extreme case, during construction phase; financing tie-up; operational risks; and market risk. Besides clearly establishing the rationale of new projects, the protective factors that are assessed include track record of the management in project implementation, experience and quality of the project implementation team, experience and track record of technology supplier, implementation schedule, status of the project, project cost comparisons, financing arrangements, tie-up of raw material sources, composition of operations team and market outlook and plans. Other parameters Besides these 5 broad heads other parameters like applicability of pollution control certificate, impact of subsidies and sales tax deferral loans, impact of changes in accounting policies, unabsorbed depreciation and business loss, impact of non insurance or inadequate insurance of assets, extraordinary or windfall gains and losses, analysis of bank statements, violations of accounting standards if any, change in management, impact of the new monetary or fiscal policies or significant development in the industry are thoroughly assessed on case to case basis. Legal risks, foreign exchange fluctuation risk and hedging mechanism followed by the enterprise if any, is studied in detail.

Rating Methodology (Non - Manufacturing)

SMERA rating framework considers a number of financial and non financial parameters of the enterprise and the impact of the macro economic factors like government policies, trade policies and regulations and the industry specific dynamics. SMERA also believes that the industry in which a SME operates has a direct bearing on the overall performance of the SME and therefore rates SMEs based on industry benchmarks SMERA Rating is a comprehensive assessment of the enterprise taking into considerations the overall financial and non financial performance of the subject company vis-à-vis the other peers in the industry in the same line of business and size criteria.

Based on its assessment and understanding, SMERA has developed rating methodology framework which mainly addresses the following areas

A) Industry Risk
The industry in which an enterprise operates plays a crucial role in the credit risk assessment. It is a key determinant of the level and volatility in earnings of any business.
B) Business Risk
Business risk is the possibility of a credit customers failing to pay because of circumstances connected with the customer’s business activities and management. Business risk can impact a company at the enterprise, business unit or business process level. The elements of business risks can be identified under the broad heads of market risk and operational efficiency risk. I) Market Risk : Market risk is the exposure of the unit to the forward and backward linkage in the course of conducting its business, and the risk of facing sustained periods of unfavorable trends in such factors as product prices, employee cost, single product dependence, pricing inflexibility, etc. Single products/Services dependence implies dependence on single revenue stream as compared with diversified products/Services range, which also provides customers with more choices and hence greater chance of success in business. Further limited geographical extent of market for the products brings common risk during economic downturn. II) Operating Efficiency In markets where competitiveness is largely determined by costs, the market position is determined by the unit’s operational efficiency. The result of these factors is reflected in the ability of the unit to maintain /improve its market share and command differential in pricing. In a competitive market, it is critical for any business unit to control its costs at all levels. This assumes greater importance in commodity or "me too " businesses, where low cost service provider almost always have an edge. Cost of services to a large extent is influenced by location of the unit(s), access to skilled human resource, scale of operations, technology, level of integration, experience and the ability of the unit to efficiently use its resources. A comparison with the peers is done to determine the relative efficiency of the unit. Some of the indicators for measuring production efficiency are: resource productivity (both assets and manpower), input-output ratios and energy consumption. Collection efficiency is a important indicators of both the market position and operational efficiency.
C) Management Risk
Management risk refers to the instance of risk of non payment arising out of a business failure due to the perceived inefficacies of the management. The elements in management risk are assessing the management quality judged on the basis of the basic educational qualification, professional experience of the entrepreneur; and business attitude that is related to the motivation of carrying out the business and pursuing business strategies. Majority of the Indian SMEs are essentially managed by one or two key persons. In this scenario, the quality of management personnel becomes critical. In assessing management quality three factors are critical: Character - relate to the willingness to pay. Apart from the characteristic disposition of honesty and integrity, several aspects are judge in terms of Track record of previous borrowing and payment is an indicator. Whether the owners/ directors have a financial interest in the business. Business premises given the impression of a well-run unit. Ability - basically to the ability to pay. Credit worthiness of the buttoner/borrowing company is assessed, including financial strength, and Capacity - refers to the borrower having technical, managerial and financial abilities in order to operate profitably and succeed in business. Quality of management would determine level of control, overall organizational capability, willingness to service loan, etc. Absence or inadequate of presence of these factors would lead towards greater risks. Type of organizational also adds to the management risk. Past experience of the management in handling similar business, performance of group companies and their track record, vision and mission of the management, organisation structure, succession issues, networth and corporate governance also plays an important role in assessing the management.
D) Financial Risk
Financial risk analysis involves thorough evaluation of the financials of the SMEs. Careful analysis of the audited financials, observations of auditors in the auditors report and notes to accounts, consistent treatment of financials play an important role. Further compliance to corporate governance issues and tax audit requirements –. Key ratio analysis, trend ratios, financial disclosures and off Balance sheet items and their impact on the profitability is studied and analysed in depth. Further the source of financial funding and their impact on the capital employed structure needs to be analysed. Availability of liquid investments, unutilized lines of credit, financial strength of group companies, market reputation, relationship with financial institutions and banks, enterprise perceptions and experience of tapping funds from different sources also play an important role in financial analysis. Past performance of the company, level of financial transparency i.e. quality of documents plays an important role in the determination of rating. While the focus of rating exercise is to evaluate the future cash flow adequacy for servicing debt obligations, a detailed review of the past financial statements is critical for better understanding of the influence of all the business and financial risk factors. Evaluation of the existing financial position is also important for determining the sources of secondary cash flows and claims that may have to be serviced in future.
E) New Project Risks
The scale and nature of new projects can significantly influence the risk profile of any . Unrelated diversifications into new products are invariably assessed in greater detail. The main risks from the new projects are time and cost overruns, even non-completion in an extreme case, during construction phase; financing tie-up; operational risks; and market risk. Besides clearly establishing the rationale of new projects, the protective factors that are assessed include track record of the management in project implementation, experience and quality of the project implementation team, experience and track record of technology supplier, implementation schedule, status of the project, project cost comparisons, financing arrangements, tie-up of raw material sources, composition of operations team and market outlook and plans. Besides on the assessment of various project risks, assumptions about completion and contribution to/from these projects are incorporated in the issuer’s overall projections.It needs to be emphasized that the impact of the project risk on the rating depends on the scale of projects in relation to the size of assets and cash flows of the existing operations. Other parameters Besides these 5 broad heads other parameters like applicability of pollution control certificate, impact of subsidies and sales tax deferral loans, impact of changes in accounting policies, unabsorbed depreciation and business loss, impact of non insurance or inadequate insurance of assets, extraordinary or windfall gains and losses, analysis of bank statements, violations of accounting standards if any, change in management, impact of the new monetary or fiscal policies or significant development in the industry are thoroughly assessed on case to case basis. Legal risks, foreign exchange fluctuation risk and hedging mechanism followed by the enterprise if any is studied in detail.

Brownfield / Greenfield Grading Rationale

SMERA Project/Startup Enterprise Grading is a comprehensive assessment of all the risk factors affecting the project completion and its continued operations thereafter. It is an independent, third party assessment of a unit providing a clear indication of the likelihood of viable operations post project completion.

The risk parameters proposed to be captured inter alia include following:

A) Construction and Project Specific Risks
Completion risk refers to the inability of a project to commence commercial operations on time and within the budgeted cost. The construction risk is high at the project commencement stage and requires efficient monitoring. According to SMERA, the risk associated at construction stage is high and the risk perception is influenced by credit worthiness, past project expertise and track record of the key stakeholders.
B) Management Risk
The factors in this category provide an indication about the quality of management and the clarity of the promoters about the project, the project management expertise and the promoters’ integrity. Parameters like educational qualification, professional experience, previous track record in implementing projects of similar size and nature, networking ability, ability to raise funds, tie up with customer and suppliers etc are considered under this risk.
C) Operational Risk / Business Risks
The factors in this category provide an indication about operational risks and business risks associated with the project. This category analyze factors such as: location risk, access to raw materials, access to customers, logistic risks, product complexity, product obsolescence risks, competition risks, backward and forward synergies enjoyed by the unit, the fiscal and the tax advantages etc are analysed.
D) Market Risk / Industry Risk
While assessing the application of a startup/new project, SMERA evaluates the industry/market risks associated with the project. Factors such as entry/exit barriers within the industry, level of competition, demand and supply dynamics, logistic factors etc. are considered while evaluating Industry Risk. Also, macro risks such as: risks arising from economic instability, recessionary economic conditions, impact of global factors etc. are also considered while assigning risk grades. Similarly, industry characteristics are also factored while assessing the project, hence growth vs. maturity phase or organized vs. un-organized type, distributed vs. consolidated phase are explored while assessing the risk of the project. Government policies also play an important part while assessing the project, hence changes in taxation policy, framework pertaining to taxation, reservation of products, patenting rules, duties and levies on products, withdrawals/introduction of special fiscal incentives, subsidies etc has direct bearing on the viability of the project.
E) Financial Risk
While undertaking the financial analysis of the project, a comparison is carried out of the submitted projects’ financial ratios with the relevant industry financial ratio benchmarks. Financial factors of the project such as: breakeven point analysis, discounted cash payback, the sensitivity analysis vis-à-vis the assumptions of the project, debt service coverage ratio, future cash flows etc are analyzed in detail to assess the financial risk associated with the project
F) Sustainability Risk
Under this category, the applicants’ understanding & preparedness in seeking the essential clearances from respective authorities is understood and compared with the requirements of the industry for starting the operations. In absence of proper understanding and clarity on the matters related to mandatory clearances to start operations, it is observed that projects have suffered cost overrun & losses and, on some occasions, resulted in closure of the unit by the regulatory or statutory authorities. Clearances such as: pollution clearance, power clearance, water clearance etc are considered before assigning a risk grade to the project. Similarly, location of the project near the industrial area, or place of historical importance, or wildlife area, or forests or wetland regions etc are also considered from the future sustainability of the project.

MFI Rating Methodology

SMERA MFI Rating is an independent, third party comprehensive assessment of risks involved of underlying portfolio of MFI and its resultant impact. Besides evaluating creditworthiness of MFIs, SMERA ratings also assess trustworthiness, operational excellence, quality of loans etc of a Micro Finance Institution, amongst other subjective parameters. The assessment of MFIs also covers financial risk, operational risk, management risk, political risk and matters related to its internal governance, strategic positioning, social responsiveness, liability of lenders and social profile.

Based on its assessment and understanding, SMERA has developed rating methodology framework which primarily addresses the following areas:

A) Business Orientation & Outreach
Business Orientation and Outreach of a MFI is an important parameter to assess the growth strategies employed by the MFI and its impact on MFIs’ development. Amongst other things, following factors are considered while assessing the business orientation and outreach of a MFI, factors such as: number of active borrowers covered, self help groups covered , their reach in number of villages & districts, number of branches opened since inception, size of the loan cycle, variety of loan products, increase in Gross Loan Portfolio etc. Similarly, parameters such as direction & clarity of the management, its vision and commitment, dependence on Government grants & subsidies, ability to raise variety of funds from the investors and lenders, degree of association with promoter institutions, audit reviews etc are also part of the analysis while assessing the MFIs’ business orientation.
B) Management Quality
Management risk pertains to the risk of non-payment arising out of business failure due to the perceived management weakness. The primary parameter assessed under the management risk is the quality of management, & this is judged on the basis of the educational qualification, professional experience and business attitude of the entrepreneur towards the business. Under quality of management other parameters such as: level of control, overall organizational capability, willingness to service loan, etc is also assessed under the management evaluation process.
C) Operational Efficiency and Risk Management
Under this category analysis of MFIs internal manual is undertaken where in following factors are assessed: target market definition & its characteristics, loan origination, appraisal, approval, disbursement, monitoring and recovery processes and procedures; loan classification & provisioning; policies for interest accrual / non-accrual etc. Further, MFIs internal controls are also assessed by evaluating information systems for loan tracking; their capacity, reliability, and effectiveness for generating portfolio related information and report. The capacity assessment refers to the ability of MFI’s internal system to cope with the transaction volumes, generation of variety of reports-including client payment history, loan delinquencies and their ageing, branch/geographic area/sector/credit officer wise break-ups, details and trends; details of rescheduled loans etc. Group cohesiveness is a key determinant in evaluation of MFI. MFIs criterion for selection of group, consistent Group Training and Group Recognition tests, loan utilization checks, recovery mechanisms etc are also analyzed under the capacity assessment of a MFI. Assessment of asset liability mismatch is undertaken in detail while assessing a MFI. On initiation of MFIs activity, liquidity and asset-liability management of the institution starts becoming complex & hence, under the study, MFIs ability to deal with this complexity is assessed. Similarly, MFIs ability to deal with the fluctuating demand, prepayments by borrowers, varying interest rates and tenor of loans, their re-payment track record etc is assessed.
D) Portfolio Quality
Loan portfolio is the most important asset of any MFI, as it is the primary income generating source for MFIs. Most failures amongst financial institutions stem from deterioration in the quality of loan portfolio. Thus it is imperative to track the year on year growth of the loan portfolio and its quality. SMERA analyses the portfolio quality of the MFIs by doing ageing analysis, sectoral analysis, product wise analysis etc. SMERA compares the portfolio management system with organizational guidelines and generally accepted industry best practices to identify systemic inadequacies, depth of controls and resultant risks.
E) Financial Performance
Ratios like Operational Self Sufficiency, Financial Self Sufficiency, Capital adequacy Ratios, Adjusted Return on Assets, Adjusted Return on Equity, Productivity ratios etc are analyzed. Yield on Portfolio, Loan loss reserve to Gross o/s portfolio, cost of funds ratio etc also require analysis.
F) Social and Lenders Responsibility
MFIs outlook towards the social objectives while starting the enterprise is assessed. Hence following parameters are assessed: developmental and livelihood programmes run by the MFI, training provided, transparency and approach of the MFI towards client grievances, interest rate transparency, multiple lending’s etc are assessed. Thus an evaluation of MFI would be comprehensive assessment based on the financial and non financial parameters of any MFI.

Criterias for Rating Various Industries

A) Auto Ancillary Industry
Indian Auto Ancillary Industry is relatively small by global standards. The auto ancillary industry is a significant contributor to the country’s overall growth, both in terms of exports and employment. The performance of auto ancillary sector is closely linked to the auto sector. Demand swings in any of the segments (cars, two-wheelers, commercial vehicles) have an impact on auto ancillary demand. Demand is derived from original equipment manufacturers (OEM) as well as the replacement market. The total market size is estimated to be around INR 763 Bn in FY 2009. The industry has grown at a CAGR of about 18.7% during the period FY 2005-09. Client base of the market is dominated by Original Equipment Manufacturers (OEMs) with a share of 50% followed by replacements market at 35% and balance 15% by the exports market. The unorganized market holds a significant share (approx 23%) in this industry made up of more than 6,000 companies whilst the balance of about 77% is made up of approximately 595 companies in the organized segment which are registered with Automotive Components Manufacturers’ Association (ACMA). SMERA has rated MSMEs operating in various businesses and positions in the value chain. Auto ancillary industry faces pricing pressure as well as cyclical demand from its customers. Business Risk Analysis *Customer Concentration Risk* Most of the auto ancillary units face customer concentration risk. Due to high dependence on few customers, the performance of their customers is important for the auto ancillary unit. Diversified customer base would result in lesser volatility and less correlation performance with specific OEM. *Performance of the OEM* Past and expected performance of the OEM as well as share of OEM in the automobile market should be considered. Expansion plans helps to understand the increase in potential orders. *Balance between direct sales to domestic OEM, Export and Aftermarket* Perfect balance with direct sales to domestic OEM, export and aftermarket ensures smooth functioning of the auto ancillary units in various business cycles. *Position & Significance in the Value Chain* Position of the auto ancillary unit in the value chain is important to understand its significance in the value chain. Higher the position in the supply chain ensures lesser threat of new entrants and less risk of price erosion. *Technology & Processes* Technology used by auto components in the developed countries is much better than developing countries like India. Japanese automobile industry has influence on the Indian automobile industry and its allies. OEM also checks the quality management practices that are adopted by the auto ancillary units. OEM also ascertains as to whether the auto ancillary unit practices like Six Sigma, JIT, etc are practiced. Auto ancillary units have quality improvement methodologies such as Quality Control, TPM (total productivity management), TQM (total quality management) and Zero Defects. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the auto ancillary industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion The key success factors of the Auto Ancillary industry are Customer Concentration Risk Position & Significance in the Value Chain Technology & Processes
B) Chemical Industry
Indian Chemical industry has a strong and diversified base encompassing many areas such as organic and inorganic chemicals, plastics, fibers, dyestuffs, paints, pesticides, insecticides, specialty chemicals, drugs and pharmaceuticals. Broadly the chemical industry is divided into two segments that are; bulk chemicals and specialty chemicals. Bulk chemicals category includes those chemicals and materials which are produced in large quantities, typically using continuous processes. The price of these chemicals tends to be a more important factor than their performance. In the strictest sense, specialty chemicals are chemical products that are sold on the basis of their performance, rather than for their composition. They can be single-chemical entity or formulations/combinations of several chemicals whose composition sharply influences the performance and processing of the customer’s product. Products and services in the specialty chemicals industry require intensive knowledge and powerful innovation. Business Risk Analysis Product Mix MSMEs in the chemical industry are largely determined by the product mix and competitive position of the product in the market. SMERA has identified major factors which have impacted the margins of the MSMEs in specialty and bulk chemical segments. Specialty chemicals tend to be across a wide range, with smaller production quantities, but higher purity levels, it is observed that specialty chemical offers better margins to players as compared to bulk chemicals as the specialty chemical segment is backed by unique technology and process. Proportion of specialty chemicals in the cost of production is immaterial and hence their price volatility does not impact the end product. On the other hand, bulk chemicals are pure commodities and their prices are highly volatile and have a bearing on the cost of production on very specific players Demand and Supply position Capital spending cycles can also create negative pressures, particularly when competing companies are flush with cash at the same time. The bunched capacity additions can disrupt supply dynamics and lower product prices for considerable period of time until the new capacity is absorbed by slower growing demand. Government policies can affect the industry. Introduction of large increments of new supply as oil and natural gas rich nations seek to develop what are, in some instances, "stranded" (very low cost) raw materials into higher margin chemical products. This can create supply/demand imbalances. Diversity A Chemical unit may be helped by the diversity of the industry. The diverse nature of a company's product portfolio may help mitigate the risk that accrues from volatile prices and demand in specific products. External risk As many of the raw materials used by chemical manufacturers are petroleum based, they have significant direct and indirect exposure to the price of crude oil/natural gas. Upsurges in crude oil and natural gas prices are a negative not only in the way that they can increase operating expense, but also because there may be material delays passing these higher costs through to the customer. Price and Margin Trend Consumers of specialty chemicals make purchasing decisions based primarily on performance, but price can be a factor in their decision making process. As a result, specialty chemical manufacturers invest heavily in marketing efforts to demonstrate the ability of their products to meet the specific performance requirements of their customers. Price trend of bulk drugs are seen to be direct reflection of the variation in either down stream product price or input prices. Thus SMERA analyzes these price determinants to understand the trend. Environmental issues The Chemical industry’s work with environmental issues is even more important than in other industries. Chemical products with environmentally hazardous properties are one of the main environmental concerns in the chemical industry. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the chemical industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion At the end it is concluded that the key success factors of the chemical industry are Cost competitiveness Diversified product mix for domestic as well as international market Technology capabilities Environmental and safety measure
C) Engineering Industry
Indian Engineering Industry is a major contributor to the country’s economy. The engineering goods sector consisting mainly of intermediate and capital goods have fared better during 2007-08. The engineering sector has emerged as the largest contributor to India’s total merchandise exports, even ahead of gems & jewellery. India’s export of engineering goods was USD 33.7 billion in the year 2007-08. The industry exports grew by 27.34% in 2007-08 as against the same period in 2006-07. The engineering industry comprises of both heavy and light engineering sectors. The heavy engineering market contributes to about 80% of the net engineering production. The segments in the engineering sector are diverse, including power equipment, heavy electrical machinery, textile machinery, machine tools, earthmoving & construction equipment, mechanical equipment, road construction equipment, oil & gas equipment, sugar machinery (Distilleries), cement machinery, processing plants and industrial furnaces. The Union Government’s focus on the infrastructure and power sector has given a strong momentum to the engineering and capital goods sector. Business Risk Analysis Order Concentration Order visibility and order quality are the main analytical aspects that distinguish heavy manufacturing companies from general or light manufacturers. An order for heavy equipment is usually placed when the industrial customer expects rising demand for products or when production machinery becomes obsolete. The impact on cash flows can be mitigated by diversification across regions as well as customer industries, flexible delivery schedules if accepted by the customer, and most of all, a lean and flexible cost base. A strong backlog of orders relative to annual production volumes provides visibility for future work flows as well as flexibility in planning production for optimal capacity utilization. The diversification of the customer serves to mitigate order and revenue volatility in the heavy engineering industry. The MSMEs which have diversified customer base and flexibility in the production pattern have maintained the market position. Other factors that could provide stability to sales are export sales, a reasonable proportion of spare part sale and other job work services. End User Profile The major end-user industries for heavy engineering goods are power, infrastructure, steel, cement, petrochemicals, oil & gas, refineries, fertilisers, mining, railways, automobiles, textiles, etc. Light engineering goods are essentially used as inputs by the heavy engineering industry. The customers are typically industrial companies, or utilities which acquire the machinery under their capital expenditure budgets and depreciate the equipment over a number of years. The rated heavy manufacturing industry, as defined in this methodology, comprises a relatively high number of companies of varying size, product and customer mix, and regional focus. The large orders bear advantages as well; competition is often less intense than for standard products, which in turn enhance profitability. The ability to extract advance payments from customers can also be an indication of the market position and pricing power of a manufacturer. Advance payments will also signal the liquidity and solvency of the customers thereby reducing credit risk exposure. Diversification The Diversification has three principal dimensions: geographical, segments/products and customer diversification. Diversification provides a platform from which to stabilise sales and protect earnings by offsetting variations in demand in a given product or market. Geographical diversification is viewed a positive factor because it reduces: (i) the company’s vulnerability to the vagaries of a single region, (ii) the impact of economic cyclicality in individual regions, and (iii) the impact of regional regulatory, environmental, product liability or safety issues. Segmental and product diversification balances and offsets exposure to the volatility of demand and price competition in particular industries and mitigates weaknesses in any one market or product line. Key Cost drivers It was observed that the MSMEs that have continuously focused on inventory management have maintained their position in the market even in the economic down turn. The input cost in any engineering companies is around 55- 60%. Further power also impacts the cost structure of heavy engineering manufacturer. Another large component of the cost structure is efficient workforce. The flexibility of labour is important to mitigate the volatility of order and work flow. Many manufacturers have opted to shift labor-intensive production to improve on productivity as well as labor cost. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the engineering industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion The key success factors of the Engineering industry are Focusing on order trends and quality Diversification Market structure and competitive position Cost position and profitability Financial policy, liquidity and capital structure
D) Food and Food Processing Industry
India is the world's second largest producer of food next to China, and has the potential of being the largest producer. The growth of the food industry in India stems from the consistently increasing agricultural output. The Indian food market accounts for about two thirds of the total Indian retail market. Total market size of the food processing sector is estimated to be around INR 3.3 Tn in FY 2010. The sector has grown steadily in the range of CAGR 11-13% during the period FY 2005-09. Rising income levels, changing age profile, changing lifestyle and growth of the food retail sector are driving the demand for food products and thereby Food Processing. The total food production in India is likely to double in the next ten years and there is an opportunity for large investments in food and food processing technologies, skills and equipment, especially in areas of Canning, Dairy and Food Processing, Specialty Processing, Packaging, Frozen Food/Refrigeration and Thermo Processing. Fruits & Vegetables, Fisheries, Milk & Milk Products, Meat & Poultry, Packaged/Convenience Foods, Alcoholic Beverages & Soft Drinks and Grains are important sub-sectors of the food processing industry. The food processing industry provides crucial linkages between industry and agriculture. To aid the growth of the food processing industry, the government has implemented schemes including setting up of food parks, packaging centers, integrated cold chain facilities, value-added centers, and modern abattoirs. Business Risk Analysis *Business profile* The MSMEs rated by SMERA are mainly engaged in trading of agricultural commodities, food processing and processing of edible and non-edible oil. Edible oil in India is widely consumed and therefore, the revenue pattern of edible oil business is more stable then any other in food industry. *Price and Margin trend* The Indian food industry, both primary and processed, is poised for a positive growth on account of retail evolution. For food processing business it is important to have the right product concept that meets consumer expectations and in this, the industry is no exception. In food processing sector it was found that the companies who have focused on innovative products and fast changing consumer needs have improved their margins and revenue. On the other hand MSMEs engaged in the business of oil refining and trading in agriculture has largely depended on the climatic condition. Therefore the prices of the product are highly volatile which some times put pressure on margins. Further inventory management plays important in maintaining the margin in food business as most of products are perishable. *Technology* In a global business environment, to keep pace with fast changing technology/ innovations, it is essential have world class R&D and manufacturing facility. This is the key to building capacity. It was studied that the MSMEs which have adapted R & D trend in their manufacturing have performed well. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the food processing industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion At the end it is concluded that the key success factors of the Food and Food processing industry are Diversified product mix for domestic as well as international market Strong research and development capabilities. Efficient inventory management
E) IT & ITes Industry
The Indian Information Technology (IT) and ITes-BPO sector plays a vital role in the growth of the Indian economy. The industry grew at a rate of 33% in FY 2008 and earned revenue of around USD 64 billion. The industry’s contribution to the country’s GDP has grown significantly from 1.8% in 1999-2000 to around 5.5% in 2007-08. The industry has grown from INR 1240 Billion in FY 2005 to INR 3185 Billion in FY 2009, registering a CAGR of 27%. Software and Services exports account for 68% of the industry’s revenues. Over the past decade, IT industry has become one of the fastest growing industries in India. India has emerged as the fastest growing IT hub in the world, its growth dominated by software and services such as Custom Application Development and Maintenance (CADM), System Integration, IT Consulting, Application Management, IT Outsourcing, Infrastructure Management. Strong demand over the past few years has placed India amongst the fastest growing IT markets in the Asia-Pacific region. Business Risk Analysis *Market position* Product mix The highly competitive software services includes companies that provide a wide range of services ranging data processing, training, consulting, maintenance, engineering services and final product. The industry’s vertical market exposure is well diversified across several mature and emerging sectors. Banking, Financial Services and Insurance (BFSI) remained the largest vertical market for Indian IT-BPO exports, followed by High-technology and Telecom. The horizontal segment that most Indian software companies operate are in training, software service and projects consultancy as well as productized services. SMERA examines various risks pertaining to technology, growth and user of products. Geographical diversification in export Geographic diversification can potentially offset the impact of cyclicality, depending on economic trends in different geographic markets. SMERA’s assessment of geographic diversification therefore takes into consideration differences in economic trends between regions and countries. It also takes into account the profitability of the MSMEs in IT & ITES in any given location. Geographic diversification is a positive factor in cases where the entity has overcome the start-up costs of entering the market. Our assessment of geographic diversification also covers diversification in export market. For example, MSMEs providing services in Europe and US would score better than an entity operating only in Europe. Human resources and knowledge It is widely believed that the key to the success of the Indian software exports is the supply of trained, low cost software professionals. It is estimated that wage costs in India are about 1/3rd to 1/5th of the corresponding US levels for comparable work. The size of the talent pool complements the cost advantage. In IT & ITES industry the attrition rate of the employees is high. SMERA analyzes the MSME in terms of its ability to attract, train and retain the employees. Management quality is key feature in evaluating the non financial parameter. Customer base Vertical and horizontal segments in IT & ITES industry would invariably have varying degrees of exposure to the very large players. The credit quality, operating performance and market position of these companies will have a significant bearing on the performance of the service provider market. Any improvement in diversity is likely to result in profits. Over-dependency on a single or a limited number of customers can result in the risk of greater volatility and high correlation of performance of that customer. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the IT & ITES. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion At the end it is concluded that the key success factors of the IT & ITES industry are Diversified domestic as well as international market Technology capabilities Effective management of manpower
F) Logistic (Land) Industry
Logistics is defined as the process of planning, implementing, and controlling the efficient, cost effective flow and storage of raw materials, in-process inventory, finished goods and related information from point of origin to point of consumption so as to meet customer requirements. The Indian logistics industry is characterized by dominance of an unorganized market. It is a highly fragmented industry and broadly covers freight transportation, warehousing, packaging, customs clearing and forwarding, inventory management, labeling and order processing. Logistic service providers allow companies to focus on their core competence. The infrastructure required for moving goods from one place to another involves the active roles of Roads, Railways, Ports & Shipping, Airlines and Express Cargo / Courier companies. Business Risk Analysis *Revenue Stability* For the purpose of analysis, a value chain view of the logistics sector is adopted and unique segments within the sector are identified. The road transportation and warehousing segment in logistic industry would perhaps show the greatest growth potential in coming years. These segments traditionally are extremely fragmented, small scale and scattered geographically. A majority of players in this industry have been small entrepreneurs running family owned businesses. Because reliability is a good predictor of revenue stability, SMERA reviews the customer service performance history, percentage of on-time deliveries and arrivals, contract renewal rates, lost or diverted shipments, and safety record. We also consider the customer service programs and how they influence overall operations. SMERA believes that shippers are generally willing to pay premium rates for higher quality service. Just in time approach is one of key element of good rated company. *Customer concentration* SMERA looks for predictability in revenue from long-term contracts with shippers, regional or product dominance, and core demand for the product being shipped (for example, the long-term demand stream for metal is more predictable than for footwear). We also take into account concentration risk and the potential impact should the organisation fail to perform under these major contracts. SMERA also recognizes the long-term relationships with the customers as providing the basis for revenue stability. *Manpower skills* The lack of focus on developing manpower and skills for the logistics sector has resulted in a significant gap in the numbers and quality of manpower in the sector. This gap, unless addressed urgently, is likely to be a key impediment in the growth of the logistics sector in India, and consequently, could impact growth in industry. This underscores the need for identifying areas where such manpower and skill gaps are critical, and developing focused action plans to improve the situation. SMERA has also emphasized on this parameter because efficient manpower skill will improve the quality and efficiency of logistics service providers Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the textile industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion The key success factors of the Logistic (land transportation) industry are: Quality Service Customer concentration in terms of their long term relationship Quality manpower
G) Steel Industry
Iron and Steel both are the main ingredients for any major manufacturing industry. Both heavy and light engineering industrial products largely use iron and steel as its major inputs. Steel is crucial to the development of any modern economy and is considered to be the backbone of the human civilization. The level of per capita consumption of steel is considered as one of the important indicators of socio-economic development and living standard of the people in any country. Business Risk Analysis *Market Position* Market share and the customer profile are the main features of any steel making company to define a market position. Indian steel industry is characterized by fragmentation, particularly in the downstream segment, with a large number of unorganized players. According to SMERA, the steel industry can be classified in three different ways. The most significant is classification by type of plants, namely, integrated steel plants and secondary steel plants. Integrated steel plants engage in the entire spectrum of steel making operations, commencing from extracting iron ore and coal until the stage of steel manufacture. Secondary steel units undertake only a portion of the operations. Primary producers (Integrated Steel Producers (ISPs)) in the country produce majority of flat products and secondary producers (mini steel plants) produce most of the long products. A number of companies are also active in distribution and trading of steel and other commodities, as well as non-related businesses. Most of the MSMEs in India are the secondary producer of the steel. *Customer Profile* Customer profile in any segment of the steel industry determines its business position. Some of the major steel consumption sectors like automobiles, oil & gas, shipping, consumer durables and power generation enjoy high bargaining power and get favorable deals. However, small and retail consumers who are scattered and consume an insignificant part do not enjoy these benefits. SMERA believes effective diversification of customer base exhibits a greater degree of revenue consistency. Diversification may also be across the geographies including export sales. *Level of competition* The steel industry is truly global in terms of competition with leading producing countries like China significantly influencing global prices through aggressive exports. Steel, being a commodity, branding is not common and there is little differentiation between competing products. The intensity of the competition is influenced by the demand and supply of the company’s product and their concentration in different geographies. The demand pattern of the steel industry is highly cyclical according to the end user industry. The competition in secondary is high as their products are mainly used in infrastructure sector. Flat product consumption is higher in developed countries as they are used in automobiles, consumer durables, etc *Product mix* The nature of products produced, industries sold to, and the mix between commodity and value-added products are an important part of the rating criteria. In steel industry the product range may cover several grades and product type. Typically steel industry product ranges from flats to long products. Primary producers are those players who process the mined ore into primary metal, which is commercially available in the form of rods, ingots, cathodes, products like foils, extrusions, dry batteries, castings etc. either by procuring the metal from the primary producers or from scrap. The extent of value addition is another crucial factor for differentiating steel companies. Value product offers high realisation of the company which in turn boost the company profitability. *Technology* The future growth prospects of MSMEs in steel industry largely depend on efficient use of available energy resources. It was recognized that small and medium enterprises not only need greater awareness but also technical, financial and institutional support in order to develop and adopt efficient technologies. The art of using efficient technology can enable company to achieve a competitive cost position. *Operating Efficiencies* Given the industry characteristics of underlying pricing volatility, limited producer pricing power, sensitivity to underlying economic conditions, and a relatively high fixed-cost base, particularly at the integrated producers; elements that are within a unit's ability to manage, such as cost structure and operating efficiency, are important considerations in the rating analysis. Factors that measure costs and operating efficiency help in assessing a company's ability to operate through economic downturns and its ability to not only continue servicing its debt, but meet other obligations, which can vary extensively on a geographic basis due to regulatory, environmental compliance and other differences. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the steel industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion The key success factors of the Steel industry are Diversified customer base Cost Efficiency and Profitability Diversification in client base Value addition in product mix
H) Textile Industry
The Textile sector is important to the country on account of its contribution to income generation, employment and exports. The industry is self-reliant and complete in value chain, right from availability of raw materials to manufacture of garments. India is the third largest producer of cotton in the world. However, the Indian textile industry that used to dominate the world trade until the early 1960s has a very small share now. SMERA has rated number of companies right from yarn manufacturer to ready made garments. It has been observed, that the MSMEs in textile industry have adapted themselves to the cyclical nature of the industry and simultaneously diversified the product range to minimize the risk. For example, organized players in MSMEs have modernized their manufacturing process and therefore have entered the export market. Factors impacting the risk and credit quality of the textile industry are outlined below: Business Risk Analysis *Business Volatility* Seasonality is a factor for most apparel producing entities. Even general apparel units that sell year round tend to generate bulk of their income in the fall/winter season, when unit prices are higher, and during holiday, when unit demand is high. Higher volatility creates lesser room for error in product or operational execution. It has been observed that the textile units which have command on the volatility of the business have maintained their market position. *Excellence in the product and assortment* In any yarn market the quality of the product is distinguished by the range of the count. More the count of the yarn, the finer is the quality. Further the price of yarn also depends on the number of the counts. Price of finer count yarn is substantially higher than the coarser count. Fabric manufacturers are distinguished by the commodity texture and the colour range. Fabric quality depends on its processing. The least processed fabric before it goes to garmenting will have least price elasticity. Readymade garment is the final stage of textile chain. In this stage adding variety to the product range is not difficult because it is not commoditized in nature. *Diversified Product mix* SMERA has observed that diversified product mix in yarn as well as fabric has strengthened the market position of the players. Further, diversified product mix and backward integration in garment units has reduced the impact of commodity price fluctuations on profitability. Likewise the fabric manufacturers which have expanded the range of fabric, colour and designs have been successful in developing relationship with exporters and international retailers. *Geographical diversification* Geographical diversification both in the country as well as internationally and diversified customer base are key factors for the long term revenue generation. India is seen as one of the major supplier of textile products all over the world. In SMERA’s view, MSME having effective cost control, modern plants and good export exposure is placed in globalised trade regime. *Efficient procurement of raw materials* The units in textile industry have maintained the profit margin by efficient procurement of raw material. Raw cotton is the major raw material for most of fabric manufacturer. It accounts for around 60-65% of the cost of production and has significant impact on operational performance of textile units. Commodity like cotton is price sensitive, so fluctuations in the prices would impact the procurement pattern of the textile unit. Further, Indian textile units are increasingly influenced by the international price movements. This is because of the liberalization of import and growth in trade around the world. Hence combination of imported and domestic cotton would command the price as well as margins of the business. *Cost Structure* Labour: Labour is a major cost element in handloom units in the textile Industry. Given the industry’s labour intensive nature, affable relations help ensure uninterrupted operations and controlled the labour cost. The frequent labour problems in any textile unit will impact the labour efficiency and profit of the organisation. Power: Power is one important cost element in the power loom units in textile industry. It accounts for around 10 percent of the cost of the production. It has been observed by SMERA that frequent power cuts have impacted the quality of yarn as well as fabric. It as been also surveyed that many units in the textile industry have put up captive power plants as a measure to reduce power cost. The units in the coastal regions have opted for the alternative source of power such as wind mill. The factors like captive generation facilities, power cost reduction measure; efficient power consumption would impact the over all operations of textile units. *Modernization* It is observed that MSMEs in the textile units lag behind in meeting the international standards of technology and modernization. Only few financially strong units resort to continuous modernization. The units which have done continuous modernization have improved the installed capacity as well as captured export market. Financial Risk Analysis SMERA follows the standard criteria used in all manufacturing companies for the financial risk analysis of the textile industry. Here various financial ratios are tracked to have an idea of the performance of the industry. Conclusion The key success factors of the Textile industry are Efficient raw material procurement Diversified customer base Diversified product mix for domestic as well as international market Efficient method for controlling power and labour cost

Criteria for Bond Rating

Rating Criteria

SMERA's rating criteria consist of identification and evaluation of drivers of credit quality of the enterprise being rated covering both qualitative and quantitative aspects. Typically, it is a 360 degree assessment of an enterprise as the factors impinging on the credit quality could emerge from any aspect of the enterprise. The rating methodology and the factors considered are discussed here. The relative importance placed and the focus of analysis would differ from enterprise to enterprise depending on the nature of business, the nature of enterprise and the circumstances.:

A) Business Risk
This broadly consists of Industry Risk, Market Position and Operating Efficiency. a) Industry Risk Fortunes of a particular business enterprise are to a significant extent determined by the industry it belongs to. The industry characteristics are common for all the players in a particular industry. India’s competitiveness in the said industry globally is studied. For example, availability of skilled man power and relatively lower wage costs make Indian software industry globally competitive. Factors like the industry’s importance to the country’s economy, entry barriers, capital intensity, bargaining power of the suppliers and customers, threat of substitute products and technological changes are looked into. Industry growth trends, prospects of the user industries, business cycles, commodity or value added nature of the industry, intensity and availability and manpower, industrial relations scenario and Government policies, regulations, price and distribution controls, environment impact, duties and taxes, and tariff barriers and quantitative barriers are also studied. For example, sugar industry is highly regulated with respect to pricing and distribution resulting in a significant lack of freedom to the players in the industry. b) Market Position Factors studied include the comparative standing of the enterprise vis-a-vis its competitors, market share and its trend, presence and extent of unorganised sector, ability to dictate prices, geographical and customer diversity, bargaining position vis-a-vis customers, criticality of product to the customer, customer profile, price volatility, export presence/dependence, and commodity/value added nature of the product. Further, business certainty and outlook are assessed based on orders on hand, the demand drivers and the prospects of the user industries and the demand/supply dynamics. c) Operating Efficiency Here the effectiveness and efficiency of different operational aspects of the enterprise are seen in detail. Efficient operations apart from ensuring quality of product or service, also lead to cost competitiveness. Factors include raw material availability and price volatility, import dependence, labour availability and wages, industrial relations, work stoppages, power intensity, presence of captive power, level of sophistication of technology, vulnerability to obsolescence, technical expertise, access to resources water, supply chain linkages, level of integration, capacity utilisation, operational flexibility to change product mix, scalability, uniqueness of the product, sustainable competitive advantages, compliance with environment norms.
B) Management Risk
This is a very important aspect of the evaluation. Management quality has a crucial bearing on the performance of enterprises. The assessment focuses on the quality, competence, governance and attitude to risk of the management. Aspects seen include the vision, mission, background of the promoters, level of professionalism, depth of management, level of delegation, qualifications and experience, performance track record, systems and processes, strength of MIS, HR policies, project execution skills, tendency for unrelated diversification and track record with respect to debt payment.
C) Financial Risk
A good business and management should ultimately reflect in the financial position of the enterprise. Here the focus is on accounting quality, reputation of auditors, financial performance track record in terms of growth, profitability, break even, value addition, liquidity, cash flow adequacy, financial flexibility, level of indebtedness, level of overall outside liabilities, quality of receivables, and quality of investments. Aspects like contingent liabilities, auditor’s qualifications and notes to accounts are studied in detail. Significant stress is laid on projected performance in terms of assumptions, sensitivity to changes in assumptions, etc. While a number of financial ratios are considered, important ones are debt/equity, return on capital employed, profitability margin, asset turnover, interest cover, debt service coverage, cash accruals to debt and the size of networth. The relative importance placed on different ratios would depend on the nature business. These ratios are compared with peers and bench marks for different ratings.
D) Project Risk
Projects are important for growth. But, projects undertaken by an enterprise could significantly alter its risk profile. Nature of the project in terms of green field, brown field, diversification, expansion is examined. Unrelated diversification and taking up projects of very large size in relation existing operations increase the risk. A view is taken on the project by considering all aspects of project appraisal like the cost of project, means of financing, financial closure, product, technology, implementation risk, raw material availability, market, financial projections, schedule of implementation, project implementation skills and track record of the management in project implementation. All assumptions are validated and a sensitivity analysis done to see the impact of different variables on the financial position.
E) Parent and Group support
An enterprise belonging to an established business group or a company is on a different footing compared to a stand-alone enterprise. The former could benefit from the parent/group in terms of credibility, brand equity, managerial, business and financial support.