Understanding and evaluating business risk is a crucial part of determining a company's credit rating. Key factors to evaluate include country risk, industry dynamics, company position, and profitability analyses.
Key Insights
- Business risk refers to a company's ability to generate enough revenue to cover operational expenses.
- Country risk is important to consider especially when a company’s operations are mainly located in one country, the sovereign rating typically acts as the ceiling rating.
- Industry dynamics include competition, substitution risk, technological changes, regulatory changes, cyclicality, and barriers to entry.
- Company position is evaluated based on product diversity, price setting, product quality, execution effectiveness, management quality, and market share.
- Profitability analysis and comparison with peer groups help in the evaluation process.
- A comprehensive evaluation of these factors gives an idea of a company's business risk which impacts the credit rating of the company.
Business Risk Factors
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Revenue Volatility
Cyclical industries swing more with economic conditions.
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Customer Concentration
Heavy reliance on a few customers magnifies risk.
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Cost Structure
High fixed costs amplify earnings volatility (operating leverage).
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Competitive Position
Moats and barriers protect against new entrants.
Business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses. To evaluate business risk we would look into:
- Country risk
- Industry dynamics
- Company position
- Profitability/peer group analysis
If the company’s operations are mainly located in one country the sovereign will normally be the ceiling rating.
Industry Dynamics:
- Competition
- Substitution risk—Porter’s threat of substitutes definition is the availability of a product that the consumer can purchase instead of the industry’s product. A substitute product is a product from another industry that offers similar benefits to the consumer as the product produced by the firms within the industry. According to Porter’s 5 Forces, the threat of substitutes shapes the competitive structure of an industry.
- Technological change – especially no when the technology is improving with such a great speed and the companies have to keep up to be on top of it
- Regulatory change may affect industry dynamics
- Cyclicality—Cyclical risk is the risk of business cycles or other economic cycles adversely affecting an individual company's profits.
- Barriers to entry—factors that can prevent newcomers into a market or industry sector, and so limit competition. These can include high start-up costs, regulatory hurdles, or other obstacles that prevent new competitors from easily entering a business sector.
Company Position:
- Diversity of products is important, so clients have different options
- The price setter reflects a company’s position as a luxury, premium, or mass-market brand. And also shows how competitive the prices are.
- Product quality is also very important
- Execution – how effective is the execution strategy of the company. It’s easy to come up with great ideas, the right implementation is the key
- Management quality reflects the company position as it’s a part of the brand and execution strategy for the company.
- The market share shows how penetrated the company is within its industry.
The combination of all factors mentioned above gives us a good idea of where the company stands in terms of business risk, and as a result – in terms of credit rating for the company.
Video Transcription:
Full Video Transcript
Understanding Business Risk Fundamentals
Business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses. To evaluate business risk, we should look into country risk, industry dynamics, company position, profitability, and peer group analysis.
If the company's operations are mainly located in one country, the sovereign will normally be the ceiling rating for the company. If I go to Moody's and put United States here, the Government of United States of America has a long-term rating of AAA. As we remember, it's the highest rating Moody's provides, which means extremely strong capacity to meet commitments. So for all companies located in the US, AAA would be a ceiling rating, and then depending on the industry and company financial situation, the rating would be assigned for a specific company.
If we go to Russia, where I'm from, we can see that the Government of Russia has a rating of Baa3. This rating means adequate capacity to meet financial commitments, but more subject to adverse economic conditions. So all the companies that are located in Russia will have the ceiling rating of Baa3, and it cannot be higher for those companies than this particular rating.
Industry Dynamics and Competitive Forces
When evaluating business risk, we also are looking into industry dynamics, which means we're looking into competition within that industry and substitution risk. Porter's threat of substitutes definition is the availability of a product that the consumer can purchase instead of the industry's product. A substitute product is a product from another industry that offers similar benefits to the consumer as the product produced by the firms within the industry. According to Porter's Five Forces, threat of substitutes shapes the competitive structure of an industry.
We also would look into technological change within the industry, especially now when the technology is improving with such a great speed and the companies have to keep up on the top of it to be competitive. We would also look into regulatory change that may affect industry dynamics.
Cyclicality, or cyclical risk, is the risk of business cycles or other economic cycles adversely affecting an individual company's profit. Last but not least, we'll look into barriers to entry within that industry, which are factors that can prevent new entrants into a market or industry sector and so limit competition. This can include high startup costs, regulatory hurdles, or other obstacles that prevent new competitors from easily entering a business sector.
US Industry Rating Examples
Here's an example of the US industry ratings. For example, system software has a AA+ rating, which is pretty high. Integrated oil and gas has a pretty high rating as well as the industry. If we look into airlines or healthcare facilities, we can see that the rating is much lower.
In this case, for auto manufacturers, it would be BB+, which would mean less vulnerable in the near term but faces major ongoing uncertainties to adverse business, financial, and economic conditions. So the next ceiling for the company would be the industry rating.
Company Position and Peer Analysis
To evaluate business risk, we would also look into company position and peer-to-peer analysis. We would look into diversity of products, which is important so clients have different options. Price setter reflects a company's position as luxury, premium, or mass market brand, and also shows how competitive the prices are for the products or services of this company.
We would also look into product quality, which is very important in the overall evaluation of the company. We would also look into execution strategy—how effective is the execution strategy of the company? It's easy to come up with great ideas, but the right implementation is key. We would also look into management quality, which reflects the company's position as it's part of the brand and execution strategy for the company. Market share shows how penetrated the company is within its industry.
Food Industry Peer Comparison
Here are the companies from the food industry, and you can see some of the critical financial ratios and values listed here. For example, Walmart Stores are rated as AA, which is a very high rating. You can see that total debt to EBITDA ratio is looking really good here, EBITDA margin is 7.39%, and two-year growth rate is 1.84%. In addition to that, the revenue for the last twelve months is tremendous compared to other peer companies.
At the same time, if we look into Target Corporation, it's rated as A, which is still a good rating but lower than AA. We can see that debt to EBITDA ratio is higher here. Even though the margin is slightly higher and their growth rate is actually higher, their revenue for the last twelve months is dramatically lower in volume, and that's why the credit rating is lower here.
If we take a look into Whole Foods Market, it's a BBB- rating, but you can see that debt to EBITDA ratio is very low, which is great. Even the margin is pretty high, which is amazing, and two-year growth rate is high as well. But it just has a lower revenue for the last twelve months and is rated lower as well. So we evaluate both actual values for the revenue and profit and are looking into financial ratios in the peer-to-peer analysis to come up with a credit rating.
The combination of all the factors mentioned above gives us a good idea on where the company stands in terms of business risk and, as a result, in terms of credit rating for the company.
