Corporate Ratings

Corporate Ratings
Criteria
2006
For the most complete and up-to-date ratings criteria, please visit
Standard & Poors Web site at www.corporatecriteria.standardandpoors.com.
To Our Clients
tandard & Poors Ratings Services criteria publications represent our
endeavor to convey the thought processes and methodologies employed
in determining Standard & Poors ratings. They describe both the quantitative and qualitative aspects of the analysis. We believe our rating product
has the most value if users appreciate all that has gone into producing the
letter symbols.
Bear in mind, however, that a rating is, in the end, an opinion. The rating
assignment is as much an art as it is a science.
Solomon B. Samson
Chief Rating Officer, Corporate Ratings
Standard & Poors
Corporate Ratings Criteria 2006
Analytical Contacts
Solomon B. Samson
New York (1) 212-438-7653
Scott Sprinzen
New York (1) 212-438-7812
Emmanuel Dubois-Pelerin
Paris (33) 1-4420-6673
Kenneth C. Pfeil
New York (1) 212-438-7889
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Contents
Standard & Poors Role in the Financial Markets
Ratings Definitions
The Rating Process
7
11
15
Rating Methodology: Industrials & Utilities

Factoring Cyclicality Into Corporate Ratings
Loan Covenants
Country Risk
19
33
35
37
Ratings and Ratios
42
Rating Each Issue: Distinguishing Issuers and Issues

Junior Debt: Notching Down
Well-Secured Debt: Notching Up
Commercial Paper
Preferred Stock
45
46
54
55
59
Secured Debt/Recovery Ratings, Overview

Bank Loan Rating Methodology
Collateral Value Analysis
Debtor-in-Possession (DIP) Financing
61
63
65
72
Equity Credit: What It Is and How You Get It

Factoring Future Equity Into Ratings
Tax-Deductible Preferred and Other Hybrids
Streamlining Hierarchy of Hybrid Securities
Modified Hybrid Hierarchy
74
77
80
83
83
Parent/Subsidiary Links
General Principles
Subsidiaries/Joint Ventures/Nonrecourse Projects
Finance Subsidiaries Rating Link to Parent
85
85
86
89
Operating Lease Analytics

Using The Methodology
Limitations of the Model
92
92
94
Postretirement Obligations
96
Corporate Asset-Retirement Obligations
112
The Role of Corporate Governance in Credit Rating Analysis
115
Securitizations Effect on Corporate Credit Quality
118
Short-Term Speculative-Grade Rating Criteria
123
Standard & Poors
Standard & Poors

Role in the Financial Markets
tandard & Poors Ratings Services traces its history back to
1860. It currently is the leading credit rating organization and
a major publisher of financial information and research services

on U.S. and foreign corporate and municipal debt obligations.
Standard & Poors was an independent, publicly owned corporation until 1966, when all of its common stock was acquired by
McGraw-Hill Inc., a major publishing company. Standard & Poors
is now a business unit of McGraw-Hill. In matters of credit analysis and ratings, Standard & Poors Credit Market Services operates entirely independently of McGraw-Hill. Investment Services
and Corporate Value Consulting are the other units of Standard &
Poors. They provide investment, financial, and trading information, data, and analysesincluding on equity securitiesbut
operate separately from the ratings group.
Standard & Poors now rates more than $13
trillion in bonds and other financial obligations of obligors in more than 50 countries.
Standard & Poors rates and monitors
developments pertaining to these issues and
issuers from an office network based in 21
world financial centers.
Despite its tremendous growth over the
years, Standard & Poors core values remain
the same: to provide high-quality, objective,
Standard & Poors
value-added analytical information to the

worlds financial markets.
What is Standard & Poors?
Standard & Poors is an organization of
professionals that provides analytical
services and operates under the basic
principles of:
Independence;
Objectivity;
Credibility; and
Disclosure.
Standard & Poors operates with no government mandate and is independent of any
investment banking company, bank, or similar organization.
Standard & Poors recognition as a rating
agency ultimately depends on investors
willingness to accept its judgment. We
believe it is important that all users of our
ratings understand how we arrive at those
ratings, and regularly publish ratings
research and detailed reports on ratings criteria and methodology.
Credit Ratings
Standard & Poors began rating the debt of
corporate and government issuers decades
ago. Our credit rating criteria and methodology have grown in sophistication and
have kept pace with the introduction of
new financial products. For example,
Standard & Poors was the first major rating agency to assess the credit quality of,
and assign credit ratings to, the claims-paying ability of insurance companies (1971);
financial guarantees (1971); mortgagebacked bonds (1975); mutual funds (1983);
asset-backed securities (1985); and secured
loan recovery (2003).
A credit rating is Standard & Poors opinion of the general creditworthiness of an
obligor, or the creditworthiness of an obligor with respect to a particular debt security
or other financial obligation, based on relevant risk factors. Over the years, these credit ratings have achieved wide investor
acceptance as easily usable tools for
differentiating credit quality, because a
Standard & Poors credit rating is judged by
the market to be reliable and credible. A
rating does not constitute a recommendation to purchase, sell, or hold a particular
security. In addition, a rating does not comment on the suitability of an investment for
a particular investor.
Standard & Poors credit ratings and symbols originally applied to debt securities. As
described below, we have developed credit
ratings that may apply to an issuers general
creditworthiness or to a specific financial
obligation. Standard & Poors historically
www.corporatecriteria.standardandpoors.com
has maintained separate and well-established rating scales for long-term and shortterm instruments. (A separate scale for
preferred stock was integrated with the debt
scale in February 1999. There is an additional scale exclusively for medium-term
municipal notes.)
Credit ratings are based on information
furnished by the obligors or obtained by us
from other sources we consider reliable.
Standard & Poors does not perform an
audit in connection with any credit rating
and may, on occasion, rely on unaudited
financial information. Credit ratings may be
changed, suspended, or withdrawn as a
result of changes in, or unavailability of,
such information.
Long-term credit ratings are divided into
several categories, ranging from AAA
reflecting the strongest credit qualityto D,
reflecting the lowest. Long-term ratings from
AA to CCC may be modified by the addition of a plus or minus sign to show relative
standing within the major rating categories.
A short-term credit rating is an assessment
of an issuers credit quality with respect to an
instrument considered short term in the relevant market. Short-term ratings range from
A-1, for the highest-quality obligations, to
D, for the lowest. The A-1 rating may also
be modified by a plus sign to distinguish the
strongest credits in that category.
Issue-Specific Credit Ratings
A Standard & Poors issue credit rating is a
current opinion of the creditworthiness of an
obligor with respect to a specific financial obligation, a specific class of financial obligations,
or a specific financial program. This opinion
may reflect the creditworthiness of guarantors,
insurers, or other forms of credit enhancement
on the obligation, and takes into account statutory and regulatory preferences.
On a global basis, Standard & Poors issue
credit-rating criteria have long identified the
added country-risk factors that give external
debt a higher default probability than domestic obligations. In 1992, we revised our criteria to define external rather than domestic
obligations by currency instead of by market
of issuance. This led to the adoption of the
local currency/foreign currency nomencla-
tures for issue credit ratings. Because rating

coverage now has expanded to a growing
range of emerging-market countries, the
analysis of political, economic, and monetary
risk factors are even more important.
Long-term Credit Ratings
Notes, note programs, certificate of deposit
programs, syndicated bank loans, bonds and
debentures (AA, AA...D); shelf registrations (preliminary).
Debt Types:
Equipment trust certificates;
Secured;
Senior unsecured;
Subordinated;
Junior subordinated; and
Preferred stock and deferrable
payment debt.
Recovery Ratings (1-5)
Municipal Note Ratings (tenor: less than
three years) (SP-1+, SP-1...SP-3)
Short-Term Ratings (A-1+, A-1...D):
Commercial paper programs;
Put bonds/demand bonds; and
Certificate of deposit programs.
Issuer Credit Ratings
Long-Term Ratings and Short-Term Ratings
Corporate credit ratings;
Counterparty ratings; and
Certificate of deposit programs.
Other Rating Products
Mutual Bond Fund Credit Quality Ratings
(AAAf...CCCf);
Money Market Fund Safety Ratings
(AAAm...BBBm);
Mutual Bond and Managed Fund Risk
Ratings (aaa, aa,...ccc);
Financial strength ratings for insurance
companies (also, pi ratings based on quantitative model);
Ratings estimates; and
National-scale credit ratings.
Issuer Credit Ratings
In response to a need for rating evaluations
on a company when no public debt is outstanding, Standard & Poors provides an
issuer credit ratingan opinion of the
obligors overall capacity to meet its finan-
Standard & Poors
cial obligations. This opinion focuses on the

obligors capacity and willingness to meet
its financial commitments as they come due.
The opinion is not specific to any particular
financial obligation, because it does not
take into account the specific nature or provisions of any particular obligation. Issuer
credit ratings do not take into account
statutory or regulatory preferences, nor do
they take into account the creditworthiness
of guarantors, insurers, or other forms of
credit enhancement that may pertain to a
specific obligation.
Counterparty ratings, corporate credit
ratings, and sovereign credit ratings are all
forms of issuer credit ratings.
Because a corporate credit rating provides
an overall assessment of a companys creditworthiness, it is used for a variety of financial and commercial purposes, such as
negotiating long-term leases or minimizing
the need for a letter of credit for vendors.
If the credit rating is not assigned in conjunction with a rated public financing, the
company can choose to make its rating public or to keep it confidential.
Rating Process
Standard & Poors provides a rating only
when there is adequate information available
to form a credible opinion, and only after
applicable quantitative, qualitative, and legal
analyses are performed.
The analytical framework is divided into
several categories to ensure that salient qualitative and quantitative issues are considered. For
example, with industrial companies, the qualitative categories are oriented to business analysis, such as the companys competitiveness
within its industry and the caliber of management; the quantitative categories relate to
financial analysis.
The rating process is not limited to an
examination of various financial measures.
Proper assessment of credit quality for an
industrial company includes a thorough
review of business fundamentals, including
industry prospects for growth and vulnerability to technological change, labor unrest,
or regulatory actions. In the public finance
sector, this involves an evaluation of the
basic underlying economic strength of the
public entity, as well as the effectiveness of

the governing process to address problems.
In financial institutions, the reputation of
the bank or company may have an impact
on the future financial performance and the
institutions ability to repay its obligations.
Standard & Poors assembles a team of
analysts with appropriate expertise to
review information pertinent to the rating.
A lead analyst is responsible for conducting
the rating process. Members of the analytical team meet with the organizations management to review, in detail, key factors that
have an impact on the rating, including
operating and financial plans and management policies. The meeting also helps analysts develop the qualitative assessment of
management itself, an important factor in
many rating decisions.
Following this review and discussion, a
rating committee meeting is convened. At
the meeting, the committee discusses the
lead analysts recommendation and the
pertinent facts supporting the rating.
Finally, the committee votes on the
recommendation.
The issuer subsequently is notified of the
rating and the major considerations supporting it. A rating can be appealed prior to
its publicationif meaningful new or additional information is to be presented by the
issuer. Obviously, there is no guarantee that
any new information will alter the rating
committees decision.
Once a final rating is assigned, it is disseminated to the public through the news media. In
the U.S., Standard & Poors assigns and publishes its ratings irrespective of issuer request, if
the financing is a public deal. In the case of private transactions, the company has publication
rights. (Most 144A transactions are viewed as
public deals.) In most markets outside the U.S.,
ratings are assigned only on request, so the
company can choose to make its rating public
or to keep it confidential. (Confidential ratings
are disclosed by Standard & Poors only to
parties designated by the rated entity.) After a
public rating is released to the media
by Standard & Poors, it is published
in CreditWeek or another Standard &
Poors publication, with the rationale and
other commentary.
10
Surveillance and Review

All ratings are monitored, including continual
review of new financial or economic information. Our surveillance is ongoing, which
means staying abreast of all current developments. Moreover, it is routine to schedule
annual review meetings with management,
even in the absence of the issuance of new
obligations. These meetings enable analysts to
discuss potential problem areas and be
apprised of any changes in the issuers plans.
As a result of the surveillance process, it is
sometimes necessary to reassess a rating.
When this occurs, the analyst undertakes a
review, which may lead to a CreditWatch listing, if the likelihood of change is sufficiently
high. This is followed by a comprehensive
analysisincluding, if warranted, a meeting
with managementand a presentation to a
rating committee. The rating committee evaluates the circumstances, arrives at a rating
decision, notifies the issuer, and entertains an
appeal, if one is made. After this process, the
rating change or affirmation is announced.
Issuers Use of Ratings
It is common for companies to structure
financing transactions to reflect rating criteria
so they qualify for higher ratings. However,
the actual structuring of a given issue is the
function and responsibility of an issuer and
its advisors. We will react to a proposed
financing, publish and interpret its criteria for
a type of issue, and outline the rating implications for an issuer, underwriter, bond counsel,
or financial advisor, but do not function as
an investment banker or financial advisor.
Adoption of such a role ultimately would
impair the objectivity and credibility that are
vital to our continued performance as an
independent rating agency.
Standard & Poors guidance also is sought
on credit quality issues that might affect the
rating opinion. For example, companies solicit our view on hybrid preferred stock, the
monetization of assets, or other innovative
financing techniques before putting these into
practice. Nor is it uncommon for debt issuers
to undertake specific and sometimes significant actions for the sake of maintaining their
ratings. For example, one large company
faced a downgrade of its A-1 commercial
paper rating because of a growing component

of short-term, floating-rate debt. To keep its
rating, the company chose to restructure its
debt maturity schedule in a way consistent
with our view of what was prudent.
Many companies go one step further and
incorporate specific rating objectives as corporate goals. Indeed, possessing an A rating, or at least an investment-grade rating,
affords companies a measure of flexibility
and may be worthwhile as part of an overall financial strategy. Beyond that, we do
not encourage companies to manage themselves with an eye toward a specific rating.
The more appropriate approach is to operate for the good of the business as management sees it and to let the rating follow.
Ironically, managing for a very high rating
can sometimes be inconsistent with the
companys ultimate best interests, if it
means being overly conservative and forgoing opportunities.
Ratings Definitions
Credit ratings can be either long term or
short term. Short-term ratings are assigned to
those obligations considered short term in the
relevant market. In the U.S., for example,
that means obligations with an original maturity of no more than 365 daysincluding
commercial paper.
Commercial paper ratings pertain to the
program established to sell these notes. There
is no review of individual notes. Nonetheless,
such program ratings characterize the notes
as rated paper.
Short-term ratings also are used to indicate
the creditworthiness of an obligor with
respect to put features on long-term obligations. The result is a dual rating, in which the
short-term rating addresses the put feature in
addition to the usual long-term rating.
Medium-term notes (MTNs) are assigned
long-term ratings. A rating is assigned to the
MTN program and, subsequently, to individual notes, as they are identified.
Issue and issuer credit ratings use the identical symbols (shown below), and the definitions closely correspond to each other. Issuer
ratings and short-term issue ratings focus
entirely on the default risk of the entity.
Standard & Poors
Long-term issue ratings also take into

account risks pertaining to loss-given-default.
However, both the issuer and issue rating definitions are expressed in terms of default risk,
which refers to the capacity and willingness
of the obligor to meet its financial commitments on time, in accordance with the terms
of the obligation. As noted, issue credit ratings also take into account the protection
afforded by, and relative position of, the obligation in the event of bankruptcy, reorganization, or other arrangement under the laws of
bankruptcy and other laws affecting creditors rights.
Therefore, in the cases of junior debt and
secured debt, the rating may not conform
exactly with the category definition. Junior
obligations typically are rated lower than the
issuer credit rating (i.e., default risk) to reflect
the lower priority in bankruptcy, as noted
above. (Such differentiation applies when an
entity has both senior and subordinated obligations, secured and unsecured obligations,
operating company and holding company
obligations, or preferred stock.) Debt that
provides good prospects for ultimate recovery
(such as secured debt) often is rated higher
than the issuer credit rating.
Long-term credit ratings
AAA: An obligation rated AAA has the
highest rating assigned by Standard &
Poors. The obligors capacity to meet its
financial commitment on the obligation is
extremely strong.
AA: An obligation rated AA differs from
the highest-rated obligations only to a small
degree. The obligors capacity to meet its
very strong.
A: An obligation rated A is somewhat
more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in higher rated categories. However, the obligors capacity to
meet its financial commitment on the obligation is still strong.
BBB: An obligation rated BBB exhibits
adequate protection parameters. However,
adverse economic conditions or changing circumstances are more likely to lead to a weak-
11
ened capacity of the obligor to meet its financial commitment on the obligation.
Obligations rated BB, B, CCC, CC,
and C are regarded as having significant
speculative characteristics. BB indicates the
least degree of speculation, and C the highest. While such obligations likely will have
some quality and protective characteristics,
these may be outweighed by large uncertainties or major exposure to adverse conditions.
BB: An obligation rated BB is less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing
uncertainties or exposure to adverse business, financial, or economic conditions that
could lead to the obligors inadequate
capacity to meet its financial commitment
on the obligation.
B: An obligation rated B is more vulnerable to nonpayment than obligations rated
BB, but the obligor currently has the capacity to meet its financial commitment on the
obligation. Adverse business, financial, or
economic conditions likely will impair the
obligors capacity or willingness to meet its
financial commitment on the obligation.
CCC: An obligation rated CCC currently is vulnerable to nonpayment and is
dependent on favorable business, financial,
and economic conditions for the obligor to
meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is
not likely to have the capacity to meet its
financial commitment on the obligation.
CC: An obligation rated CC currently is
highly vulnerable to nonpayment.
C: The C rating may be used when a
bankruptcy petition has been filed or similar
action has been taken but payments on this
obligation are being continued. C is also
used for a preferred stock that is in arrears
(as well as for junior debt of issuers rated
CCC- and CC).
D: The D rating, unlike other ratings, is
not prospective; rather, it is used only when a
default actually has occurrednot when a
default is only expected. Standard & Poors
changes ratings to D:
On the day an interest and/or principal
payment is due and is not paid. An exception is made if there is a grace period and
12
we believe a payment will be made, in

which case the rating can be maintained;
Upon voluntary bankruptcy filing or similar action. An exception is made if we
expect debt-service payments will continue
to be made on a specific issue. In the
absence of a payment default or bankruptcy filing, a technical default (i.e., covenant
violation) is not sufficient for assigning a
D rating;
Upon the completion of a distressed
exchange offer, whereby some or all of an
issue is either repurchased for an amount
of cash or replaced by other securities having a total value that clearly is less than
par; or
In the case of ratings on preferred stock or
deferrable payment securities, upon nonpayment of the dividend, or deferral of the
interest payment.
With respect to issuer credit ratings (i.e.,
corporate credit ratings, counterparty ratings,
and sovereign ratings), failure to pay a financial obligationrated or unratedleads to a
rating of either D or SD. Ordinarily, an
issuers distress leads to general default, and
the rating is D. SD (selective default) is
assigned when an issuer can be expected to
default selectively, i.e., continue to pay certain issues or classes of obligations while not
paying others. In the corporate context, selective default might apply when a company
conducts a distressed or coercive exchange
with respect to one or some issues, while
intending to honor its obligations regarding
other issues. (In fact, it is not unusual for a
company to launch such an offer precisely
with such a strategyto restructure part of
its debt to keep the company solvent.)
Nonpayment of a financial obligation subject to a bona fide commercial dispute or a
missed preferred stock dividend does not
cause the issuer credit rating to be changed.
Plus (+) or minus (-): The ratings from
AA to CCC may be modified by the addition of a plus or minus sign to show relative
standing within the major rating categories.
r: In 1994, Standard & Poors initiated a
symbol to be added to an issue credit rating
when the instrument could have significant
non-credit risk. The symbol r was added
to such instruments as mortgage interest-
only strips, inverse floaters, and instruments

that pay principal at maturity based on a
non-fixed source, such as a currency or
stock index. The symbol was intended to
alert investors to non-credit risks and
emphasizes that an issue credit rating
addressed only the credit quality of the obligation. Use of the r was discontinued in
July 2000.
Short-Term Credit Ratings
A-1: A short-term obligation rated A-1 is
rated in the highest category by Standard &
Poors. The obligors capacity to meet its
strong. Within this category, certain obligations are designated with a plus sign (+). This
indicates that the obligors capacity to meet
its financial commitment on these obligations
is extremely strong.
A-2: A short-term obligation rated A-2 is
somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than obligations in higher
rating categories. However, the obligors
capacity to meet its financial commitment on
the obligation is satisfactory.
A-3: A short-term obligation rated A-3
exhibits adequate protection parameters.
However, adverse economic conditions or
changing circumstances are more likely to lead
to a weakened capacity of the obligor to meet
its financial commitment on the obligation.
B: A short-term obligation rated B is
regarded as having significant speculative
characteristics. The obligor currently has the
capacity to meet its financial commitment on
the obligation; however, it faces major ongoing uncertainties that could lead to the obligors inadequate capacity to meet its financial
commitment on the obligation.
Standard & Poors is currently experimenting with an expanded short-term rating scale
for the speculative-grade part of the rating
spectrum. The B short-term rating category
has been divided into B-1, B-2, and B-3.
A full explanation of this rating product
extension can be found in the last chapter of
this book: Short-Term Speculative Grade
Rating Criteria.
C: A short-term obligation rated C
currently is vulnerable to nonpayment and
Standard & Poors
is dependent on favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the
obligation.
D: The same as the definition of D under
Long-term credit ratings.
Investment and Speculative Grades
The term investment grade originally was
used by various regulatory bodies to connote
obligations eligible for investment by institutions such as banks, insurance companies,
and savings and loan associations. Over time,
this term gained widespread use throughout
the investment community. Issues rated in the
four highest categoriesAAA, AA, A, and
BBBgenerally are recognized as being
investment grade. Debt rated BB or below
generally is referred to as speculative
grade. The term junk bond is merely an
irreverent expression for this category of
more risky debt. Neither term indicates which
securities we deem worthy of investment,
because an investor with a particular risk
preference may appropriately invest in securities that are not investment grade.
Ratings continue as a factor in many regulations, both in the U.S. and abroad, notably
in Japan. For example, the Securities &
Exchange Commission (SEC) requires investment-grade status in order to register debt on
Form-3, which, in turn, is one way to offer
debt via a Rule 415 shelf registration. The
Federal Reserve Board allows members of
the Federal Reserve System to invest in securities rated in the four highest categories, just
as the Federal Home Loan Bank System permits federally chartered savings and loan
associations to invest in corporate debt with
those ratings, and the Department of Labor
allows pension funds to invest in commercial
paper rated in one of the three highest categories. In similar fashion, California regulates investments of municipalities and
county treasurers; Illinois limits collateral
acceptable for public deposits; and Vermont
restricts investments of insurers and banks.
The New York and Philadelphia stock
exchanges fix margin requirements for mortgage securities depending on their ratings,
and the securities haircut for commercial
paper, debt securities, and preferred stock
13
that determines net capital requirements is

also a function of the ratings assigned.
Currency
Standard & Poors devised two types or ratings in order to comment on the risks associated with payment in currencies other than
the entitys home country. These ratings types
are defined as follows:
Local Currency Credit Rating: A current
opinion of an obligors overall capacity to
generate sufficient local currency resources to
meet its financial obligations (both foreign
and local currency), absent the risk of direct
sovereign intervention that may constrain
payment of foreign currency debt. Local
currency credit ratings are provided on
Standard & Poors global scale or on separate
national scales, and they may take the form
of either issuer or specific issue credit ratings.
Country or economic risk considerations pertain to the impact of government policies on
the obligors business and financial environment, including factors such as the exchange
rate, interest rates, inflation, labor market
conditions, taxation, regulation, and infrastructure. However, the opinion does not
address transfer and other risks related to
direct sovereign intervention to prevent the
timely servicing of cross-border obligations.
Foreign Currency Credit Rating: A current
opinion of an obligors overall capacity to
meet its foreign-currency-denominated
financial obligations. It may take the form
of either an issuer or an issue credit rating.
As in the case of local currency credit ratings, a foreign currency credit opinion on
Standard & Poors global scale is based on
the obligors individual credit characteristics,
including the influence of country or economic risk factors. However, unlike local
currency ratings, a foreign currency credit
rating includes transfer and other risks related to sovereign actions that may directly
affect access to the foreign exchange needed
for timely servicing of the rated obligation.
Transfer and other direct sovereign risks
addressed in such ratings include the likelihood of foreign-exchange controls and the
imposition of other restrictions on the
repayment of foreign debt.
14
National Scale Ratings

Standard & Poors produces national scale
ratings in several countries, including
Mexico, Brazil, and Argentina. These ratings
are expressed with the traditional letter symbols, but the rating definitions do not conform to those employed for the global scale.
The rating definitions of each national scale
and its correlation to global scale ratings are
unique, so there is no basis for comparability
across national scales.
CreditWatch Listings and Rating Outlooks
A Standard & Poors rating evaluates default
risk over the life of a debt issue, incorporating an assessment of all future events to the
extent they are known or can be anticipated.
But we also recognize the potential for
future performance to differ from initial
expectations. Rating outlooks and
CreditWatch listings address this possibility
by focusing on the scenarios that could
result in a rating change.
Ratings appear on CreditWatch when an
event or deviation from an expected trend has
occurred or is expected, and additional information is necessary to take a rating action. For
example, an issue is placed under such special
surveillance as the result of mergers, recapitalizations, regulatory actions, or unanticipated
operating developments. Such rating reviews
normally are completed within 90 days, unless
the outcome of a specific event is pending.
A listing does not mean a rating change is
inevitable. However, in some cases, it is certain that a rating change will occur, and only
the magnitude of the change is unclear. In
those instancesand generally, whenever
possiblethe range of alternative ratings that
could result is shown.
An issuer cannot automatically appeal a
CreditWatch listing, but analysts are sensitive to issuer concerns and the fairness of
the process.
Rating changes also can occur without the
issue appearing on CreditWatch beforehand.
In fact, if all necessary information is available, ratings should immediately be changed
to reflect the changed circumstances; there
should be no delay merely to signal via a
CreditWatch placement that a ratings change
is to occur.
A rating outlook is assigned to all long-term

debt issuers and assesses the potential for a rating change. Outlooks have a longer time frame
than CreditWatch listingstypically, two
yearsand incorporate trends or risks with
less certain implications for credit quality. An
outlook is not necessarily a precursor of a rating change or a CreditWatch listing.
CreditWatch designations and outlooks
may be positive, which indicates a rating
may be raised, or negative, which indicates
a rating may be lowered. Developing is
used for those unusual situations in which
future events are so unclear that the rating
potentially may be raised or lowered.
Stable is the outlook assigned when ratings likely will not be changed, but it should
not be confused with expected stability of the
companys financial performance.
The Rating Process

Most corporations approach Standard &
Poors to request a rating prior to sale or
registration of a debt issue. That way, firsttime issuers can receive an indication of
what rating to expect. Issuers with rated
debt outstanding also want to know in
advance the impact on their ratings of the
companys issuing additional debt. (In any
event, as a matter of policy, in the U.S., we
assign and publish ratings for all public corporate debt issues over $100 millionwith
or without a request from the issuer. Public
transactions are defined as those registered
with the SEC, those with future registration
rights, and other 144A deals that have
broad distribution.)
In all instances, Standard & Poors staff will
contact the issuer to elicit its cooperation. The
analysts with the greatest relevant industry
expertise are assigned to evaluate the credit
and commence surveillance of the company.
Our analysts generally concentrate on one or
two industries, covering the entire spectrum of
credits within those industries. (Such specialization allows accumulation of expertise and competitive information better than if junk-bond
issuers were followed separately from highgrade issuers.) While one industry analyst takes
the lead in following a given issuer and typically handles day-to-day contact, a team of expe-
Standard & Poors
rienced analysts is always assigned to the rating

relationship with each issuer.
Meeting with Management
A meeting with corporate management is an
integral part of Standard & Poors rating
process. The purpose of such a meeting is to
review in detail the companys key operating
and financial plans, management policies, and
other credit factors that have an impact on the
rating. Management meetings are critical in
helping to reach a balanced assessment of a
companys circumstances and prospects.
Participation
The company typically is represented by its
chief financial officer. The chief executive officer usually participates when strategic issues
are reviewed (usually the case at the initial rating assignment). Operating executives often
present detailed information regarding business
segments. Outside advisors may be helpful in
preparing an effective presentation. We neither
encourage nor discourage their use: it is entirely up to management whether advisors assist in
the preparation for meetings, and whether they
attend the meetings.
Scheduling
Management meetings usually are scheduled
at least several weeks in advance, to assure
mutual availability of the appropriate participants and to allow adequate preparation time
for our credit analysts. In addition, if a rating
is being sought for a pending issuance, it is to
the issuers advantage to allow about three
weeks following a meeting for Standard &
Poors to complete its review process. More
time may be needed in certain cases, for
example, if extensive review of documentation is necessary. However, where special circumstances exist and a quick turnaround is
needed, we will endeavor to meet the requirements of the marketplace.
Facility Tours
Touring major facilities can be very helpful
for Standard & Poors in gaining an understanding of a companys business. However,
this is generally not critical. Given the time
constraints that typically arise in the initial
rating exercise, arranging facility tours may
15
not be feasible. As discussed below, such

tours may well be a useful part of the subsequent surveillance process.
Preparing for Meetings
Corporate management should feel free to
contact its designated Standard & Poors
credit analyst for guidance in advance of the
meeting regarding the particular areas that
will be emphasized in the analytic process.
Published ratings criteria, as well as industry
commentary and articles on peer companies
from CreditWeek, may also be helpful to
management in appreciating the analytic
perspective. However, Standard & Poors
prefers not to provide detailed, written lists
of questions, because these tend to constrain
spontaneity and artificially limit the scope of
the meeting.
Well in advance of the meeting, the company should submit background materials (ideally, several sets), including:
five years of audited annual financial
statements;
the last several interim financial statements;
narrative descriptions of operations and
products; and
if available, a draft registration statement
or offering memorandum, or equivalent.
Apart from company-specific material, relevant industry information also may be useful.
While not mandatory, written presentations
by management often provide a valuable
framework for the discussion. Such presentations typically mirror the format of the meeting discussion, as outlined below. Where a
written presentation is prepared, it is particularly useful for Standard & Poors analytical
team to be afforded the opportunity to review
it in advance of the meeting. There is no need
to try to anticipate all questions that might
arise. If additional information is necessary to
clarify specific points, it can be provided subsequent to the meeting. In any case, our credit
analysts generally will have follow-up questions that arise as the information covered at
the management meeting is further analyzed.
Confidentiality
A substantial portion of the information set
forth in company presentations is highly
sensitive and is provided by the issuer to
16
Standard & Poors solely for the purpose of

arriving at ratings. Such information is kept
strictly confidential by the ratings group.
Even if the assigned rating is subsequently
made public, any rationales or other information Standard & Poors publishes about
the company will refer only to publicly
available corporate information. It is not to
be used for any other purpose, nor by any
third party, including other Standard &
Poors units. Standard & Poors maintains a
Chinese Wall between its rating activities
and its equity information services.
Conduct of Meeting
The following is an outline of the topics we
typically expect issuers to address in a management meeting:
the industry environment and prospects;
an overview of major business segments,
including operating statistics and comparisons with competitors and industry norms;
managements financial polices and financial performance goals;
distinctive accounting practices;
managements projections, including
income and cash flow statements and balance sheets, together with the underlying
market and operating assumptions;
capital spending plans; and
financing alternatives and contingency
plans.
It should be understood that Standard &
Poors ratings are not based on the issuers
financial projections or managements view
of what the future may hold. Rather, ratings
are based on our assessment of the companys prospects. However, managements
financial projections are a valuable tool in
the rating process, because they indicate
managements plans, how management
assesses the companys challenges, and how
it intends to deal with problems. Projections
also depict the companys financial strategy
in terms of anticipated reliance on internal
cash flow or outside funds, and they help
articulate managements financial objectives
and policies.
Management meetings with companies new
to the rating process typically last two to four
hoursor longer if the companys operations
are particularly complex. If the issuer is
domiciled in a country new to ratings or participates in a new industry, more time is usually required. When, in addition, there are
major accounting issues to be covered, meetings can last a full day or two. Short, formal
presentations by management may be useful
to introduce areas for discussion. Our preference is for meetings to be largely informal,
with ample time allowed for questions and
responses. (At management meetings, as well
as at all other times, we welcome the companys questions regarding our procedures,
methodology, and analytical criteria.)
Rating Committee
Shortly after the issuer meeting, a rating committee, normally consisting of five to seven
voting members, is convened. A presentation
is made by the industry analyst to the rating
committee, which has been provided with
appropriate financial statistics and comparative analysis. The presentation follows the
methodology outlined in the methodology
section of Corporate Ratings Criteria. Thus,
it includes analysis of the nature of the companys business and its operating environment; evaluation of the companys strategic
and financial management; financial analysis;
and a rating recommendation. When a specific issue is to be rated, there is an additional
discussion of the proposed issue and terms of
the indenture.
Once the rating is determined, the company is notified of the rating and the major considerations supporting it. It is our policy to
allow the issuer to respond to the rating decision prior to its publication by presenting
new or additional data. Standard & Poors
entertains appeals in the interest of having
available the most information possible and,
thereby, the most accurate ratings. In the case
of a decision to change an extant rating, any
appeal must be conducted as expeditiously as
possible, i.e., within a day or two. The committee reconvenes to consider the new information. After notifying the company, the
rating is disseminated via the media, or
released to the company for dissemination in
the case of private placements or corporate
credit ratings.
In order to maintain the integrity and
objectivity of the rating process, Standard &
Standard & Poors
Poors internal deliberations and the identities of those who sat on a rating committee
are kept confidential, and not disclosed to
the issuer.
Surveillance
Corporate ratings on publicly distributed
issues are monitored for at least one year. The
company can then elect to pay Standard &
Poors to continue surveillance. Ratings
assigned at the companys request have the
option of surveillance, or being on a pointin-time basis. Surveillance is performed by
the same industry analysts who work on the
assignment of the ratings. To facilitate surveillance, companies are requested to put the
primary analyst on mailing lists to receive
interim and annual financial statements, press
releases, and bank documents, including compliance certificates.
The primary analyst is in periodic telephone contact with the company to discuss
ongoing performance and developments.
Where these vary significantly from expectations, or where a major, new financing
transaction is planned, an update management meeting is appropriate. We also
encourage companies to discuss hypotheticallyagain, in strict confidencetransactions that perhaps are only being
contemplated (e.g., acquisitions, new financings), and we endeavor to provide frank
feedback about the potential ratings implications of such transactions.
In any event, management meetings routinely are scheduled at least annually. These
meetings enable analysts to keep abreast of
managements view of current developments, discuss business units that have performed differently from original
expectations, and be apprised of changes in
plans. As with initial management meetings,
Standard & Poors willingly provides guidance in advance regarding areas it believes
warrant emphasis at the meeting. Typically,
there is no need to dwell on basic information covered at the initial meeting.
Apart from discussing revised projections,
it is often helpful to revisit the prior projections and to discuss how actual performance
varied, and why.
17
A significant and increasing proportion of

meetings with company officials takes place
on the companys premises. There are several
reasons: to facilitate increased exposure to
management personnelparticularly at the
operating level; obtain a first-hand view of
critical facilities; and achieve a better understanding of the company by spending more
time reviewing the business units in depth.
While we actively encourage meetings on
company premises, time and scheduling constraints on both sides dictate that arrangements for these meetings be made some time
in advance.
Because the staff is organized by specialty,
credit analysts typically meet each year with
most major companies in their assigned area
to discuss the industry outlook, business
strategy, and financial forecasts and policies. This way, competitors forecasts of
market demand can be compared with one
another, and we can assess implications of
competitors strategies for the entire industry. The credit analyst can judge managements relative optimism regarding market
growth and relative aggressiveness in
approaching the marketplace.
Importantly, the analyst compares business
strategies and financial plans over time and
seeks to understand how and why they
changed. This exercise provides insights regarding managements abilities with respect to forecasting and implementing plans. By meeting
with different managements over the course of
a year and the same management year after
year, analysts learn to distinguish between
18
those with thoughtful, realistic agendas and

those with wishful approaches.
Management credibility is achieved when
the record demonstrates that a companys
actions are consistent with its plans and
objectives. Once earned, credibility can help
to support continuity of a particular rating
level, because Standard & Poors can rely
on management to do what it says to
restore creditworthiness when faced with
financial stress or an important restructuring. The rating process benefits from the
unique perspective on credibility gained by
extensive evaluation of management plans
and financial forecasts over many years.
Rating Changes
As a result of the surveillance process, it
sometimes becomes apparent that changing
conditions require reconsideration of the
outstanding debt rating. When this occurs,
the credit analyst undertakes a preliminary
review, which may lead to a CreditWatch
listing. This is followed by a comprehensive
analysis, communication with management,
and a presentation to the rating committee.
The rating committee evaluates the
matter, arrives at a rating decision, and
notifies the companyafter which
Standard & Poors publishes the rating.
The process is exactly the same as the
rating of a new issue.
Reflecting this surveillance, the timing of
rating changes depends neither on the sale
of new debt issues nor on our internal
schedule for reviews.
Rating Methodology:
Industrials & Utilities
tandard & Poors uses a format that divides the analytical
task, so that all salient issues are considered. The framework
we use looks first at fundamental business analysis; then comes

financial analysis.
Credit ratings often are identified with financial analysis, and especially ratios. But it is
critical to realize that ratings analysis starts
with the assessment of the business and competitive profile of the company. Two companies with identical financial metrics are rated
very differently, to the extent that their business challenges and prospects differ.
Standard & Poors developed the matrices
shown below to make explicit the rating outcomes that are typical for various business
risk/financial risk combinations.
Business Risk/
Financial Risk Matrix
Table 1 illustrates the relationship of business
and financial risk profiles to the issuer credit
rating. Table 2 shows the financial risk ratios
for industrial companies.
How can one use the matrices to better
understand rating conclusions? Here is
one illustration:
Company ABC is deemed to have a satisfactory business risk profile. (It is typical, in that
respect, of investment-grade industrial corporateswhat we previously labeled average.)
If ABCs financial risk were intermediate,
the expected rating assignment should be
BBB. The table of indicative ratios can be
used as a simple starting point. ABCs ratios
Standard & Poors
of cash flow to debt of 35% and debt leverage of 40% are characteristic of intermediate financial risk. In reality, of course, the
assessment of financial risk is not so simplistic! It encompasses financial policies and risk
tolerance; several perspectives on cash flow
adequacy, including free cash flow and the
degree of flexibility regarding capital expenditures; and various measures of liquidity,
including coverage of short-term maturities.
Company ABC can aspire to being
upgraded to the A category, by reducing its
debt burden to the point that cash flow to
debt is over 60% and debt leverage is only
25%. Conversely, ABC may choose to
become more financially aggressivesay, to
reward shareholders by borrowing to repurchase shares. It can expect to be rated in the
BB category if its cash flow to debt ratio is
20% and debt leverage remains below 55%,
and there is a commitment to keeping
finances at these levels.
The rating outcomes indicated are not
meant to be precise. There can always be
small positives and negatives that would
lead to a notch higher or lower than the
typical outcomes. Moreover, there will
always be exceptionscases that do not fit
neatly into this analytical framework: For
example, liquidity concerns or litigation
could pose overarching risks.
19
Rating Methodology
The matrix does not address the lowest

rungs of the credit spectrum, i.e., the CCC
category and below. Those ratings always
reflect some impending crisis or extraordinary vulnerability. The balanced approach
that underlies the matrix framework just does
not work well for such situations.
Standard & Poors strives for transparency
around the rating process. It should be apparent, however, that the ratings process cannot
be entirely reduced to a cookbook approach:
Ratings incorporate many subjective judgments, and remain as much an art as a science.
Corporate credit analysis factors.
There are several categories underlying both
the business and financial risk assessments.
These can vary by industry, in order to focus
on the most relevant factors.
Business risk
Country risk
Industry characteristics
Company position
Product portfolio/Marketing
Technology
Cost efficiency
Strategic and operational management
competence
Profitability/Peer group comparisons
Financial risk
Accounting
Corporate governance/Risk
tolerance/Financial policies
Cash-flow adequacy
Capital Structure/Asset Protection
Liquidity/Short-term factors
Table 1Business
Industry risk
Each rating analysis begins with an assessment of the companys environment. The
degree of operating risk facing a participant
in a given business depends on the dynamics
of that business. This analysis focuses on the
strength of industry prospects, as well as the
competitive factors affecting that industry.
The many factors assessed include industry
prospects for growth, stability, or decline,
and the pattern of business cycles (see
Cyclicality). It is critical, for example, to
determine vulnerability to technological
change, labor unrest, or regulatory interference. Industries that have long lead times or
that require fixed plant of a specialized
nature face heightened risk. The implications
of increasing competition obviously are crucial. Standard & Poors knowledge of investment plans of the major players in any
industry offers a unique vantage point from
which to assess competitive prospects.
While any particular profile category can
be the overriding rating consideration, the
industry risk assessment can be a key factor
in determining the rating to which any participant in the industry can aspire. It would
be hard to imagine assigning AA and AAA
debt ratings to companies with extensive
participation in industries of above-average
risk, regardless of how conservative their
financial posture. Examples of these industries are integrated steel makers, tire and
rubber companies, home-builders, and most
of the mining sector.
Conversely, some industries are regarded
favorably. They are distinguished by such
traits as steady demand growth, ability to
maintain margins without impairing future
Risk/Financial Risk
Financial Risk Profile
20
Business Risk Profile
Minimal
Modest
Intermediate
Aggressive
Highly Leveraged
Excellent
AAA
AA
BBB
BB
Strong
AA
A-
BBB-
BB-
Satisfactory
BBB+
BBB
BB+
B+
Weak
BBB
BBB-
BB+
BB-
Vulnerable
BB
B+
B+
B-
For any particular company, one or more

factors can hold special significance, even if
that factor is not common to the industry.
For example, the fact that a company has
only one major production facility normally
is regarded as an area of vulnerability.
Similarly, reliance on one product creates
risk, even if the product is highly successful.
For example, a pharmaceutical company has
reaped a financial bonanza from just two
medications. The companys debt is reasonably highly rated, given its exceptional profits
and cash flow, but it would be viewed still
more favorably were it not for the dependence on only two drugs (which are, after all,
subject to competition and patent expiration).
prospects, flexibility in the timing of capital

outlays, and moderate capital intensity.
Industries possessing one or more of these
attributes include manufacturers of branded
consumer products, drug companies, and
publishing and broadcasting. High marks in
this category do not translate into high ratings for all industry participants, but the
cushion of strong industry fundamentals provides helpful support.
Again, the industry risk assessment sets the
stage for analyzing specific company risk factors and establishing the priority of these factors in the overall evaluation. For example, if
technology is a critical competitive factor,
R&D prowess is stressed. If the industry produces a commodity, cost of production
assumes major importance.
Diversification factors
When a company participates in more than
one business, each segment is separately analyzed. A composite is formed from these
building blocks, weighting each element
according to its importance to the overall
organization. The potential benefits of diversification, which may not be apparent from
the additive approach, are then considered.
A truly diversified company will not have
a single business segment that is dominant.
One major automobile company received
much attention for diversifying into aerospace and computer processing. But it never
became a diversified company, because its
success was still determined substantially by
one line of business.
Limited credit is given if the various lines
of business react similarly to economic cycles.
For example, diversification from nickel into
copper cannot be expected to stabilize per-
Keys to success
As part of the industry analysis, key rating
factors are identified: the keys to success
and areas of vulnerability. A companys rating is, of course, crucially affected by its
ability to achieve success and avoid pitfalls
in its business.
The nature of competition is, obviously,
different for different industries. Competition
can be based on price, quality of product,
distribution capabilities, image, product differentiation, service, or some other factor.
Competition may be on a national basis, as is
the case with major appliances. In other
industries, such as chemicals, competition is
global, and in still others, such as cement,
competition is strictly regional. The basis for
competition determines which factors are
analyzed for a given company.
Table 2Financial
Risk Indicative Ratios*
Cash flow (Funds from operations/Debt) (%)
Debt leverage (Total debt/Capital) (%)
Minimal
Over 60
Below 25
Modest
45-60
25-35
Intermediate
30-45
35-45
Aggressive
Highly leveraged
15-30
45-55
Below 15
Over 55
* Fully adjusted, historically demonstrated, and expected to consistently continue
Standard & Poors
21
Rating Methodology
formance; similar risk factors are associated

with both metals.
Most critical is a companys ability to manage diverse operations. The skills and practices needed to run a business differ greatly
among industries, not to mention the challenge posed by participation in several different industries. For example, a number of
old-line industrial companies rushed to diversify into financial services, only to find themselves saddled with unfamiliar businesses they
had difficulty managing.
Some companies have adopted a portfolio
approach to their diverse holdings. The business of buying and selling businesses is different from running operations and is analyzed
differently. The ever-changing character of the
companys assets typically is viewed as a negative. On the other hand, there is often an
offsetting advantage: greater flexibility in
raising funds if each line of business is a discrete unit that can be sold off.
Size considerations
Standard & Poors has no minimum size criterion for any given rating level. However,
size turns out to be significantly correlated to
ratings. The reason: size often provides a
measure of diversification, and/or affects
competitive position.
Small companies also can possess the competitive benefits of a dominant market position, although that is not common. Obviously,
the need to have a broad product line or a
national marketing structure is a factor in
many businesses and would be a rating consideration. In this sense, sheer mass is not
important; demonstrable market advantage is.
Market-share analysis often provides
important insights. However, large shares
are not always synonymous with competitive
advantage or industry dominance. For
instance, if an industry has a number of
large but comparably sized participants,
none may have a particular advantage or
disadvantage. Conversely, if an industry is
highly fragmented, even the large companies
may lack pricing leadership potential. The
textile industry is an example.
Small companies are, almost by definition,
more concentrated in terms of product, number of customers, or geography. In effect, they
22
lack some elements of diversification that can

benefit larger companies. To the extent that
markets and regional economies change, a
broader scope of business affords protection.
This consideration is balanced against the performance and prospects of a given business.
In addition, lack of financial flexibility is
usually an important negative factor in the case
of very small companies. Adverse developments that would simply be a setback for companies with greater resources could spell the
end for companies with limited access to funds.
There is a controversial notion that small,
growth-oriented companies represent a better
credit risk than older, declining companies.
While this is intuitively appealing to some, it
ignores some important considerations. Large
companies have substantial staying power,
even if their businesses are troubled. Their
constituenciesincluding large numbers of
employeescan influence their fates. Banks
exposure to these companies may be quite
extensive, creating a reluctance to abandon
them. Moreover, such companies often have
accumulated a lot of peripheral assets that
can be sold. In contrast, the promise of small
companies can fade very quickly and their
minuscule equity bases will offer scant protection, especially given the high debt burden
some companies deliberately assume.
Fast growth often is subject to poor execution, even if the idea is well conceived. There
also is the risk of overambition. Moreover,
some companies tend to continue high-risk
financial policies as they aggressively pursue
ever-greater objectives, limiting any creditquality improvement. There is little evidence
to suggest growth companies initially receiving speculative-grade ratings have particular
upgrade potential. Many more defaulted over
time than achieved investment grade. Oil
exploration, retail, and high technology companies especially have been vulnerable, even
though their great potential was touted at the
time they first came to market.
Management evaluation
Management is assessed for its role in determining operational success and also for its
risk tolerance. The first aspect is incorporated
in the business-risk analysis; the second is
weighed as a financial policy factor.
Subjective judgments help determine each

aspect of management evaluation. Opinions
formed during the meetings with senior management are as important as managements
track record. While a track record may seem
to offer a more objective basis for evaluation, it often is difficult to determine how
results should be attributed to managements
skills. The analyst must decide to what
extent they are the result of good management; devoid of management influence; or
achieved despite management.
Plans and policies are judged for their realism. How they are implemented determines
the view of management consistency and
credibility. Stated policies often are not followed, and the ratings may reflect skepticism
until management has established credibility.
Credibility can become a critical issue when
a company is faced with stress or restructuring, and the analyst must decide whether to
rely on management to carry out plans for
restoring creditworthiness.
Other organizational/corporate
culture considerations
Standard & Poors evaluation is sensitive to
potential organizational problems. These
include situations where:
The company has a highly aggressive
business model, e.g., growing through
large acquisitions or expansion into
unproven markets;
The company has made frequent and significant changes to its strategy;
The company has a history of retrenchment
and restructuring;
There is significant organizational reliance
on an individual, especially one who may
be nearing retirement;
The transition from entrepreneurial or family-bound to professional management has
yet to be accomplished;
Management compensation is excessive
or poorly aligned with the interests of
stakeholders;
There is excessive management turnover;
The company is involved in legal, regulatory, or tax disputes to a significantly greater
extent than its peers;
Measuring performance and risk

Having evaluated the issuers competitive
position and operating environment, the
analysis proceeds to several financial categories. To reiterate: the companys businessrisk profile determines the level of financial
risk appropriate for any rating category.
Financial risk is portrayed largely through
quantitative means, particularly by using
financial ratios. Profitability benchmarks
vary greatly by industry, but broad measures of financial risk are correlated to the
companys level of business risk (which
incorporates both the industry and position
within the industry).
Several analytical adjustments typically
are required to calculate ratios for an
individual company. Cross-border comparisons require additional care, given the differences in accounting conventions and
local financial systems.
Standard & Poors
The company has an excessively complex

legal structure, perhaps employing intricate
off-balance-sheet structures;
The relationship between organizational
structure and management strategy
is unclear;
Shareholders impose constraints on management prerogatives;
The finance function and finance considerations do not receive high organizational
recognition;
The company is particularly aggressive in
the application of accounting standards, or
demonstrates a lack of opaqueness in its
financial reporting (see also Accounting
Characteristics, below), and;
Managements financial policy is exceptionally aggressive, as evidenced by heavy debt
usage or a history of aggressive actions to
directly reward shareholders (see also
Financial Policy, below).
(See also The Evolving Role of Corporate
Governance in Credit Rating Analysis.)
Accounting characteristics
and information risk
Financial statements (and related disclosures)
serve as our primary source of information
regarding the financial condition and financial performance of industrial or utility com-
23
Rating Methodology
panies. The analysis of financial statements

begins with a review of accounting characteristics. The purpose is to determine whether
ratios and statistics derived from the statements can be used appropriately to measure a
companys performance and position relative
to both its direct peer group and the larger
universe of corporates. The rating process is,
in part, one of comparisons, so it is important to have a common frame of reference.
The starting point of accounting quality
analysis is an understanding of different
national and international accounting frameworks, as these vary widely. Recent moves to
adopt International Financial Reporting
Standards (IFRS) in many countriesincluding Australia, Canada, and across the
European Unionas well as an ongoing
effort to effect convergence between U.S.
GAAP and IFRS, ultimately could enhance
comparability among companies. However,
this ought not be seen as a panacea. Within
IFRS, just as within the separate national
accounting systems, companies are called
upon to chose among numerous alternative
methodsfor example, cost as opposed to
fair-value methodsand the resulting differences can have a significant effect on comparability among peers. In addition, even in
applying the same methods within the same
accounting frameworks, companies show
varying degrees of aggressiveness in the
underlying estimates and judgments they
employ. Moreover, the carrying value of
assets can be greatly influenced by the historical development of a companyfor example,
whether it has grown primarily through internal development or through acquisitions, or
whether it previously underwent a leveraged
buyout or bankruptcy reorganizationand
this also affects many of the quantitative
measures employed in financial analysis.
Some of the accounting issues to be
reviewed include:
Consolidation basis. The accounting
approach to consolidation may differ from
how we define the economic entity for analytical purposes.
Revenue and expense recognition. For
example, percentage of completion compared with completed contract in the construction industry;
24
Cash and investments. For example, are

investments valued at cost or market?
Receivablestrade and finance. For example, how conservative are loss provisions?
Inventory valuation methods. For example,
FIFO or LIFO;
Fixed assetsincluding depreciation methods and asset lives;
Intangible assets, including treatment of
goodwill;
Postretirement benefits obligations (see discussion in the Criteria Topics section);
Other liabilities and contingent obligations,
recognized on the balance sheet and otherwise, such as operating leases, environmental liabilities, asset retirement obligations,
guarantees, litigation;
Derivatives and hedges;
Foreign currency;
Inflation accounting;
Cash-flow matters. For example, to what
extent are R&D and interest costs
expensed rather than capitalized? To what
extent is operating cash flow affected by
nonrecurring items?
Segment reporting. How are segments
defined, and how are transfer prices for
transactions between segments determined?
To the extent possible, analytical adjustments are made to better portray reality and
to level the differences among companies.
Although it is rarely possible to completely
recast a companys financial statements, it is
important to at least have some notion of the
extent to which different financial measures
are overstated or understated. Apart from its
importance to the quantitative aspects of the
analysis, conclusions regarding accounting
characteristics and financial transparency can
also influence qualitative aspects of the
analysis, such as the assessment of management, including financial policy and internal
information systems.
As part of its surveillance process,
Standard & Poors closely monitors the
potential impact of pending changes in
accounting standards. Such changes do not
have any direct impact on credit quality;
however, accounting changes may reveal new
information about a companyinformation
that then needs to be factored into our
understanding of the company. For example,
the ratings for a few U.S. companies were

lowered following the implementation of
new accounting for retiree medical liabilities
in the early 1990s, because little information
previously was available about these obligations. It also is possible accounting changes
could trigger financial covenant violations or
regulatory or tax consequences, and could
even influence changes in business behavior,
such as a change in hedging policy.
Standard & Poors typically relies on audited financial statements, and does not view its
role as auditing the auditors. However, a
rating can sometimes be assigned even in the
absence of audited statements. This especially
is the case when a new company is formed
from a division of another company that did
produce audited financials. In other cases,
there may be unaudited physical datasuch
as oil-production datathat corroborates
company results. In any event, to the extent
information risk exists, it can influence the
level of the rating assigned. In cases where
the information uncertainty is so significant
that it precludes a meaningful analysis, we
would decline to assign a rating.
An increasing number of companies are
faced with the finding of accounting and
financial reporting irregularities of various
types. Their auditors may identify material
weakness in the accounting systems. Actual
mistakesor even fraudmay have been
uncovered. The SEC or other regulatory
agencies may order formal or informal
investigations of the accuracy and/or adequacy of financial reporting. In many instances,
there is no way for us to immediately know
how serious any of these troubling events will
turn out to be. The underlying reality can
range from an almost trivial problem to complete audit and financial failure. (And, occasionally, a small problem can turn into a
large one, as headline risk takes a toll on
the companys access to financing.)
Standards & Poors seeks to assess the
potential ramifications, possibly through further discussions with management, in-house
or external legal counsel, auditors, independent members of the board and the audit committee. However, in some such cases, detailed
information may not be available for some
time, and we will react, if necessary, based on
Standard & Poors
the best available information, through

CreditWatch actions, intermediate rating
changes or in extreme cases with the suspension or withdrawal of the ratings.
Financial policy
Standard & Poors attaches great importance
to managements philosophies and policies
involving financial risk. A surprising number
of companies have not given this question
serious thought, much less reached strong
conclusions. For many others, debt leverage
(calculated without any adjustment to reported figures) is the only focal point of such policy considerations. More sophisticated
business managers have thoughtful policies
that recognize cash-flow parameters and the
interplay between business and financial risk.
Even companies that have set goals may not
have the wherewithal, discipline, or management commitment to achieve these objectives.
A companys leverage goals, for example,
need to be viewed in the context of its past
record and the financial dynamics affecting
the business. If management states, as many
do, that its goal is to operate with a 35%
debt-to-capital ratio, we factor that into our
analysis only to the extent it appears plausible. For example, if a company has aggressive
spending plans, that 35% goal would carry
little weight, unless management has committed to a specific program of asset sales, equity
sales, or other actions that in a given time
period would produce the desired results.
Standard & Poors does not encourage
companies to manage themselves with an eye
toward a specific rating. The more appropriate approach is to operate for the good of the
business as management sees it, and let the
rating follow. Certainly, prudence and credit
quality should be among the most important
considerations, but financial policy should be
consistent with the needs of the business
rather than an arbitrary constraint.
If opportunities are foregone merely to
avoid financial risk, the company is making
poor strategic decisions. In fact, it may be
sacrificing long-term credit quality for the
facade of low risk in the near term. One
financial article described a company that
curtailed spending expressly to become an
A-rated company. As a result, ...the
25
Rating Methodology
companys business responded poorly to an

increase in market demand. Needless to say,
the sought-after A rating continued to
elude the company.
In any event, pursuit of the highest rating
attainable is not necessarily in the companys
best interests. AAA may be the highest rating, but that does not suggest that it is the
best rating. Typically, a company with virtually no financial risk is not optimal as far
as meeting the needs of its various constituencies. An underleveraged company is not minimizing its cost of capital, thereby depriving
its owners of potentially greater value for
their investment. In this light, a corporate
objective of having its debt rated AAA or
AA is at times suspect. Whatever a companys financial track record, an analyst must
be skeptical if corporate goals are implicitly
irrational. A companys conservative financial philosophy must be consistent with its
overall goals and needs.
Profitability and coverage
Profit potential is a critical determinant of
credit protection. A company that generates
higher operating margins and returns on
capital has a greater ability to generate equity capital internally, attract capital externally, and withstand business adversity.
Earnings power ultimately attests to the
value of the companys assets, as well. In
fact, a companys profit performance offers
a litmus test of its fundamental health and
competitive position. Accordingly, the conclusions about profitability should confirm
the assessment of business risk.
The more significant measures of profitability are:
Pretax, pre-interest return on capital;
Operating income as a percentage of
sales; and
Earnings on business segment assets.
While the absolute levels of ratios are
important, it is equally important to focus on
trends and compare these ratios with those of
competitors. Various industries follow different cycles and have different earnings characteristics. Therefore, what may be considered
favorable for one business may be relatively
poor for another. For example, the drug
industry usually generates high operating
26
margins and high returns on capital. Defense

contractors generate low operating margins,
but high returns on capital. The pipeline
industry has high operating margins and low
returns on capital. Comparisons with a companys peers influence our perception of its
competitive strengths and pricing flexibility.
The analysis proceeds from historical performance to projected profitability. Because a
rating is an assessment of the likelihood of
timely payments in the future, the evaluation
emphasizes future performance. However,
the rating analysis does not attempt to forecast performance precisely or to pinpoint
economic cycles. Rather, the forecast analysis
considers variability of expected future performance based on a range of economic and
competitive scenarios.
Particularly important are managements
plans for achieving earnings growth. Can
existing businesses provide satisfactory
growth, especially in a low-inflation environment, and to what extent are acquisitions
or divestitures necessary to achieve corporate goals? At first glance, a mature, cashgenerating company offers a great deal of
bondholder protection, but Standard &
Poors assumes a corporations central focus
is to augment shareholder value over the
long run. In this context, a lack of indicated
earnings growth potential is considered a
weakness. By itself this may hinder a companys ability to attract financial and human
resources. Moreover, limited internal earnings growth opportunities may lead management to pursue growth externally, implying
greater business and financial risks.
Earnings also are viewed in relation to a
companys burden of fixed charges. Such
ratios link profit performance with pure
financing considerations, such as aggressiveness of debt usage. The two primary fixedcharge coverage ratios are:
Earnings before interest and taxes (EBIT)
coverage of interest; and
Earnings before interest and taxes and rent
(EBITR) coverage of interest plus total rents.
If preferred stock is outstanding and material, coverage ratios are calculated both
including and excluding preferred dividends,
to reflect the companys discretion over paying the dividend when under stress. Similarly,
if interest payments can be deferred, adjustments to the calculation help capture the
companys flexibility in making payments.
To reflect more accurately the ongoing
earnings power of the company, reported
profit figures are adjusted. These adjustments
remove the effect of foreign-exchange gains
and losses; litigation reserves; writedowns
and other nonrecurring or extra-ordinary
gains and losses; and unremitted equity earnings of a subsidiary.
In some countries it is not uncommon for
industrial companies to establish their treasury operations as a profit center. In Japan, for
example, the term zaiteku financing refers
to the practice of generating profits through
arbitrage and other financial-market transactions. If financial position-taking is a material
part of a companys aggregate earnings,
Standard & Poors segregates those earnings
to assess the profitability of the core business.
We also may view with skepticism the ability
to realize such profits on a sustained basis
and may treat them like nonrecurring gains.
Similarly, there are numerous analytical
adjustments to the interest amounts. Interest
that has been capitalized is added back. An
interest component is computed for debt
equivalents such as operating leases and
receivable sales. Amounts may be subtracted
to recognize the impact of borrowings in
hyperinflationary environments or borrowings
to support cash investments as part of a tax
arbitrage strategy. And interest associated
with finance operations is segregated in accordance with the methodology spelled out in
Finance Subsidiaries Rating Link to Parent.
Earnings differences
Shareholder pressures and accounting standards in certain countriessuch as the U.S.
can result in companies seeking to maximize
profits on a quarter-to-quarter or short-term
basis. In other regionsaided by local tax
regulationit is normal practice to take provisions against earnings in good times to provide a cushion against downturns, resulting
in a long-run smoothing of reported profits. Given local accounting standards, it is not
rare to see a Swiss or German company
vaguely report other income or other
expenseslargely provisions or provision
Standard & Poors
reversalsas the largest line items in a profit

and loss account. In meetings with management, Standard & Poors discusses provisioning and depreciation practices to see to what
extent a company employs noncash charges
to reduce or bolster earnings.
Capital structure/leverage
and asset protection
Ratios employed by Standard & Poors to
capture the degree of leverage used by a company include:
Total debt/total debt + equity;
Total debt + off-balance-sheet
liabilities/total debt + off-balance-sheet liabilities + equity; and
Total debt/total debt + market value
of equity.
Traditional measures focusing on longterm debt have lost much of their significance, because companies rely increasingly
on short-term borrowings. It is now commonplace to find permanent layers of shortterm debt, which finance not only seasonal
working capital but also an ongoing portion
of the asset base.
In many countries, notably in Japan and
Europe, local practice is to maintain a high
level of debt while holding a large portfolio
of cash and marketable securities. Many
companies manage their finances on a netdebt basis. In these situations, we focus on
net debt to capitaland, similarly, net interest coverage, and cash flow to net debt.
When a company consistently demonstrates
such excess liquidity, debt leverage is calculated by netting out excess liquidity from
short-term borrowings. Each situation is analyzed on a case-by-case basis, subject to additional information regarding a companys
liquidity position, normal working cash
needs, nature of short-term borrowings, and
funding philosophy. Funds earmarked for
future use, such as an acquisition or a capital
project, are not netted out. This approach
also is used, for example, in the case of cashrich U.S. pharmaceutical companies that
enjoy tax arbitrage opportunities with
respect to these cash holdings.
What is considered debt and equity
for the purpose of ratio calculation is not
always so simple (See Equity Credit: What
27
Rating Methodology
It Is, And How To Get It). In the case of

hybrid securities, the analysis is based on
their featuresnot the accounting or the
nomenclature. Pension and retiree health
obligations are similar to debt in many
respects. Their treatment is explained in
Postretirement Obligations.
Indeed, not all subtleties and complexities
lend themselves to ratio analysis. Originalissue discount debt, such as zero coupon
debt, is included at the accreted value.
However, since there is no sinking fund provision, the debt increases with time, creating
a moving target. (The need, eventually, to
refinance this growing amount represents
another risk.) In the case of convertible debt,
it is somewhat presumptuous to predict
whether and when conversion will occur,
making it difficult to reflect the real risk profile in ratio form.
A companys asset mix is a critical determinant of the appropriate leverage for a given
level of risk. Assets with stable cash flow or
market values justify greater use of debt
financing than those with clouded marketability. For example, grain or tobacco
inventory would be viewed positively, compared with apparel or electronics inventory;
transportation equipment is viewed more
favorably than other equipment, given its
suitability for use by other companies.
Accordingly, we believe it is critical to analyze each type of business and asset class in its
own right. While FASB and IAS now require
consolidation of nonhomogenous business
units, we analyze each separately. This is the
basis for our methodology for analyzing captive finance companies (See Finance
Subsidiaries Rating Link to the Parent).
Asset valuation
Knowing the true values to assign a companys assets is key to the analysis. Leverage as
reported in the financial statements is meaningless if the assets book values are materially undervalued or overvalued relative to
economic value. Standard & Poors considers
the profitability of an asset as an appropriate
basis for determining its economic value.
Market values of a companys assets or independent asset appraisals can offer additional
insights. However, there are shortcomings in
28
these methods of valuation (just as there are

with historical cost accounting) that prevent
reliance on any single measure. Similarly,
ratios using the market value of a companys
equity in calculations of leverage are given
limited weight as analytical tools. The stock
market emphasizes growth prospects and has
a short time horizon; it is influenced by
changes in alternative investment opportunities and can be very volatile. A companys
ability to service its debt is not affected
directly by such factors.
The analytical challenge of which values to
use is especially evident in the case of merged
and acquired companies. Accounting standards allow the acquired companys assets
and equity to be written up to reflect the
acquisition price, but the revalued assets have
the same earning power as before; they cannot support more debt just because a different number is used to record their value.
Right after the transaction, the analysis can
take these factors into account, but down the
road the picture becomes muddied. We
attempt to normalize for purchase accounting, but the ability to relate to pre-acquisition
financial statements and to make comparisons with peer companies is limited.
Presence of a material goodwill account
indicates the impact of acquisitions and purchase accounting on a companys equity
base. Intangible assets are no less valuable than tangible ones. But comparisons
are still distorted, because other companies
cannot record their own valuable business
intangibles, i.e., those that have been developed, rather than acquired. This alone
requires some analytical adjustment when
measuring leverage. In addition, analysts are
entitled to be more skeptical about earning
prospects that rely on turnaround strategies
or synergistic mergers.
Off-balance-sheet financing
Analysis of liabilities is not limited to those
shown on the companys balance sheet. Offbalance-sheet items factored into the leverage
analysis include:
Operating leases;
Guarantees, debt of joint ventures, and
unconsolidated subsidiaries;
Take-or-pay contracts and obligations under

throughput and deficiency agreements;
Receivables that have been factored, transferred, or securitized; and
Contingent liabilities, such as potential
legal judgments or lawsuit settlements.
Various methodologies are used to determine the proper adjustment value for each
off-balance-sheet item. In some cases, the
adjustment is straightforward. For example,
the amount of guaranteed debt can simply
be added to the guarantors liabilities to
reflect the potential burden of this contingent liability. Other adjustments are more
complex or less precise.
Nonrecourse debt of a joint venture may
be attributed to the parent companies, especially if they have a strategic tie to the operation. The analysis may burden one parent
with a disproportionate amount of the debt if
that parent has the greater strategic interest
or operating control or its ability to service
the joint-venture debt is greater. Other considerations that affect a companys willingness to walk away from such debtand
other nonrecourse debtinclude shared
banking relationships and common country
location. In some instances, the debt may be
so large in relation to the owners investment
that the incentives to support the debt are
minimized. In virtually all cases, however, the
parent likely would invest additional amounts
before deciding to abandon the venture.
Accordingly, adjustments would be made to
reflect the owners current and projected
investment, even if the ventures debt were
not added to the parents balance sheet.
In the case of contingencies, estimates are
developed. Insurance coverage is estimated,
and a present value is calculated if the payments will stretch over many years. The
resulting amount is viewed as a corporate liability from an analytical perspective. The sale
or securitization of accounts receivable represents a form of off-balance-sheet financing
(i.e, whenever such assets continue to be generated on an onging basis for the company).
If proceeds are used to reduce other debt, the
impact on credit quality is neutral. (There can
be some incremental benefit to the extent that
the company has expanded access to capital,
and this financing may be lower in cost.
Standard & Poors
However, there may also be an offset in the

higher cost of unsecured financing.) For ratio
calculations, Standard & Poors adds back
the amount of receivables and a like amount
of debt. This eliminates the distorting, cosmetic effect of using an off-balance-sheet
technique and allows better comparison with
other companies that have chosen other
avenues of financing. Similarly, if a company
uses proceeds from receivables sales to invest
in riskier assetsand not to reduce other
debtthe adjustment will reveal this increase
in financial risk.
The debt-equivalent value of operating
leases is determined by calculating the present
value of minimum operating lease obligations
as reported in the annual reports footnotes.
The lease amount beyond five years is
assumed to mature at a rate approximating
the minimum payment due in year five.
The variety of lease types may require the
analyst to obtain additional information or
use estimates to evaluate lease obligations.
This is needed whenever lease terms are
shorter than the assets expected economic
lives. For example, retailers report only the
first period of a lease written with an initial
period and several renewal options over a
long term. Another limitation develops when
a portion of the lease payment is contingent,
e.g., a percentage of sales, as is often the case
in the retailing industry.
(Traditionally, operating leases were recognized by the factor method: annual
lease expense is multiplied by a factor that
reflects the average life of the companys
leased assets. This method is an attempt to
capitalize the asset, rather than just the use
of the asset for the lease period. However,
the method can overstate the asset to be
capitalized by failing to recognize asset use
over the course of the lease. It also is too
arbitrary to be realistic.)
Preferred stock
Preferred stocks can qualify for treatment as
equity or be viewed as debtor something
between debt and equitydepending on their
features and the circumstances. The degree of
equity credit for various preferreds is discussed in Equity Credit. Preferred stocks
with a maturity receive diminishing equity
29
Rating Methodology
credit as they progress toward maturity. In

the same vein, sinking-fund preferreds are less
equity-like. The sinking fund requirements
themselves are of a fixed, debt-like nature.
Moreover, they usually are met through debt
issuance, which results in the sinking-fund
preferred being just the precursor of debt. It
would be misleading to view sinking-fund
preferredsparticularly that portion coming
due in the near to intermediate termas
equity, only to have each payment convert to
debt on the sinking funds payment date.
A preferred that may eventually be refinanced with debt is viewed as a debt equivalent, not equity, all along. Auction
preferreds, for example, are perpetual on
the surface. However, they often represent
merely a temporary debt alternative for companies that are not current taxpayersuntil
they once again can benefit from tax
deductibility of interest expense. Moreover,
the holders of these preferreds would pressure for a redemption in the event of a failed
auction or even a rating downgrade.
Redeemable preferred stock issues may
also be refinanced with debt once an issuer
becomes a taxpayer. Preferreds that can be
exchanged for debt at the companys option
also may be viewed as debt in anticipation
of the exchange. However, the analysis also
would take into account offsetting positives
associated with the change in tax status.
Often the trigger prompting an exchange or
redemption would be improved profitability.
Then, the added debt in the capital structure would not necessarily imply lower
credit quality. The implications are different
for many issuers that do not pay taxes for
various other reasons, including availability
of tax-loss carry-forwards or foreign tax
credits. For them, a change in taxpaying
status is not associated with better profitability, while the incentive to turn the preferred into debt is identical.
Cash-flow adequacy
Interest or principal payments cannot be serviced out of earnings, which is just an accounting concept; payment has to be made with
cash. Although there usually is a strong relationship between cash flow and profitability,
many transactions and accounting entries
30
affect one and not the other. Analysis of cashflow patterns can reveal a level of debt-servicing capability that is either stronger or weaker
than might be apparent from earnings.
Cash-flow analysis is the single most critical
aspect of all credit rating decisions. It takes on
added importance for speculative-grade
issuers. While companies with investmentgrade ratings generally have ready access to
external financing to cover temporary cash
shortfalls, junk-bond issuers lack this degree
of flexibility and have fewer alternatives to
internally generated cash for servicing debt.
Cash-flow ratios
Ratios show the relationship of cash flow to
debt and debt service, and also to the companys needs. Because there are calls on cash
other than repaying debt, it is important to
know the extent to which those requirements will allow cash to be used for debt
service or, alternatively, lead to greater need
for borrowing.
Some of the specific ratios considered are:
Funds from operations/total debt (adjusted
for off-balance-sheet liabilities);
Debt/EBITDA;
EBITDA/interest;
Free operating cash flow + interest/interest;
Free operating cash flow + interest/interest
+ annual principal repayment obligation
(debt-service coverage);
Total debt/discretionary cash flow (debt
payback period);
Funds from operations/capital spending
requirements, and
Capital expenditures/capital maintenance.
Where long-term viability is more assured
(i.e., higher in the rating spectrum) there can
be greater emphasis on the level of funds
from operations and its relation to total debt
burden. These measures clearly differentiate
between levels of protection over time.
Focusing on debt service coverage and free
cash flow becomes more critical in the
analysis of a weaker company. Speculativegrade issuers typically face near-term vulnerabilities, which are better measured by free
cash flow ratios.
Interpretation of these ratios is not always
straightforward; higher values can sometimes
indicate problems rather than strength. A
company serving a low-growth or declining

market may exhibit relatively strong free cash
flow, because of minimal fixed and working
capital needs. Growth companies, in comparison, often exhibit thin or even negative free
cash flow because investment is needed to
support growth. For the low-growth company, credit analysis weighs the positives of
strong current cash flow against the danger
that this high level of protection might not be
sustainable. For the high-growth company,
the problem is just the opposite: weighing the
negatives of a current cash deficit against
prospects of enhanced protection once current investment begins yielding cash benefits.
There is no simple correlation between creditworthiness and the level of current cash flow.
Measuring cash flow
Discussions about cash flow often suffer
from lack of uniform definition of terms.
Table 1 illustrates Standard & Poors terminology with respect to specific cash flow
concepts. At the top is the item from the
funds flow statement usually labeled funds
Table 3Measuring
from operations (FFO) or working capital

from operations. This quantity is net
income adjusted for depreciation and other
noncash debits and credits factored into it.
Back out the changes in working capital
investment to arrive at operating cash
flow. Next, capital expenditures and cash
dividends are subtracted out to arrive at
free operating cash flow and discretionary cash flow, respectively. Finally, cost
of acquisitions is subtracted from the running total, proceeds from asset disposals
added, and other miscellaneous sources and
uses of cash netted together. Prefinancing
cash flow is the end result of these computations, which represents the extent to which
company cash flow from all internal sources
has been sufficient to cover all internal
needs. The bottom part of the table reconciles prefinancing cash flow to various categories of external financing and changes in
the companys own cash balance. In the
example, XYZ Inc. experienced a $35.7 million cash shortfall in year one, which had to
Cash Flow
Cash flow summary: XYZ Corp.

Year One
Year Two
(Mil. $)
Funds from operations (FFO)
18.6
22.3
(33.1)
1.1
15.1
(12.6)
0.5
10.8
(Capital expenditures)
(11.1)
(9.7)
Free operating cash flow
(10.5)
1.0
Dec. (inc.) in noncash current assets

Inc. (dec.) in nondebt current liabilities
Operating cash flow
(Cash dividends)
(4.5)
(5.1)
Discretionary cash flow
(15.0)
(4.1)
(Acquisitions)
(21.0)
0.0
0.7
0.2
Asset disposals
Net other sources (uses) of cash
Prefinancing cash flow
(0.4)
(0.1)
(35.7)
(4.0)
Inc. (dec.) in short-term debt
23.0
0.0
Inc. (dec.) in long-term debt
6.1
13.0
Net sale (repurchase) of equity
0.3
(7.1)
Dec. (inc.) in cash and securities
6.3
(2.0)
35.7
4.0
Standard & Poors
31
Rating Methodology
32
be met with a combination of additional borrowings and a drawdown of its own cash.
not consummatedprovide a basis for judging prospects for future acquisitions.
The need for capital

Standard & Poors analysis of cash flow in
relation to capital requirements begins with
an examination of a companys capital needs,
including both working and fixed capital.
While this analysis is performed for all debt
issuers, it is critically important for fixed
capital-intensive companies and growth companies. Most companies seeking working
capital are able to finance a significant portion of current assets through trade credit.
However, rapidly growing companies typically experience a buildup in receivables and
inventories that cannot be financed internally
or through trade credit.
Improved working-capital management
techniques have, over the recent past, greatly
reduced the investment that might otherwise
have been required. This makes it difficult to
base expectations on extrapolating recent
trends. In any event, improved turnover experience would not be a reason to project continuation of such a trend to yet better levels.
Because we evaluate companies as ongoing
enterprises, our analysis assumes companies
continually will provide funds to maintain
capital investments as modern, efficient
assets. Cash flow adequacy is viewed from
the standpoint of a companys ability to
finance capital-maintenance requirements
internally, as well as its ability to finance capital additions. To quantify the requirements
for capital maintenance, data typically are
provided by the company.
An important dimension of cash flow adequacy is the extent of a companys flexibility
to alter the timing of its capital requirements.
Expansions are typically discretionary.
However, large plants with long lead times
usually involve, somewhere along the way, a
commitment to complete the project.
There are companies with cash flow adequate to the needs of their existing businesses, but that are known to be
acquisition-minded. Their choice of acquisition as an avenue for growth means this
activity must also be anticipated in the credit
analysis. Managements stated acquisition
goals and past takeover bidsincluding those
Liquidity analysis: Key factors

for consideration
Debt characteristics:
Maturity structure;
Dependence on commercial paper and
other confidence-sensitive forms of debt;
Exposure to interest rate fluctuationsi.e.,
fixed/floating mix;
Credit triggers;
Rating triggers;
Financial covenants;
Material adverse change (MAC) clauses; and
Defined events of default.
Other potential calls on cash:
Postretirement benefits obligations;
Environmental liabilities;
Asset retirement obligations;
Take or pay obligations;
Obligations arising from guarantees and
support agreements;
Obligations arising from derivatives;
Litigation; and
Other contingent liabilities.
Operating sources of liquidity:
Expected near-term free cash flow;
Ability to liquidate working capital; and
Flexibility to curtail spending.
Bank credit facilities:
Total amount of facilities;
Nature of bank commitments;
Availability under facilities;
Facility maturities;
Bank group quality;
Evidence of support/lack of support of
bank group; and
Credit triggers (see above).
Other alternative sources of liquidity:
Cash and other liquid assets;
Ability to tap debt and equity markets;
Ability to sell nonstrategic assets;
Flexibility to curtail common and preferred
stock dividends; and
Parental support.
Financial flexibility and liquidity

The previously discussed financial factors
(profitability, capital structure, cash flow) and
liquidity considerations are combined to
arrive at an overall view of financial health.
In addition, sundry considerations that do

not fit in other categories are examined,
including serious legal problems, lack of
insurance coverage, or restrictive covenants in
loan agreements that place the company at
the mercy of its bankers. The potential
impact of such contingencies is considered,
along with the companys contingency plans.
Access to various capital markets, affiliations
with other entities, and ability to sell assets
are important factors in determining a companys options under stress.
Flexibility can be jeopardized when a company is overly reliant on bank borrowings or
commercial paper. Reliance on commercial
paper without adequate backup facilities is a
big negative. An unusually short maturity
schedule for long-term debt and limited-life
preferred stock also is a negative. In general,
a companys experience with different financial instruments gives management better
access to capital markets. A companys size
and its financing needs can play a role in
whether it can raise sufficient funds in the
public debt markets. Similarly, a companys
role in the national economyand this is
particularly true outside the U.S.can
enhance its access to bank and public funds.
Access to the common stock market may
primarily be a question of managements
willingness to accept dilution of earnings per
share, rather than a question of whether
funds are available. (However, in some
countries, including Japan and Germany,

equity markets may not be so accessible.)
When a new common stock offering is projected as part of a companys financing plan,
Standard & Poors tries to measure managements commitment to this plan, and its sensitivity to changes in share price.
As going concerns, companies should not
be expected to repay debt by liquidating
operations. Clearly, there is little benefit in
selling natural resource properties or manufacturing facilities if these must be replaced in
a few years. Nonetheless, a companys ability
to generate cash through asset disposals
enhances its financial flexibility.
Pension obligations, environmental liabilities, and serious legal problems restrict flexibility, apart from the obligations direct
financial implications. For example, a large
pension burden can hinder a companys ability to sell assets, because potential buyers will
be reluctant to assume the liability, or to
close excess, inefficient, and costly manufacturing facilities, which might require the
immediate recognition of future pension obligations and result in a charge to equity.
When there is a major lawsuit against a
company, suppliers or customers may be
reluctant to continue doing business, and the
companys access to capital may also be
impaired, at least temporarily.
Factoring Cyclicality into

Corporate Ratings
Rating in an Ideal World...
Corporate
performance
Standard & Poors rating
AA
A
BBB
Cyclicality and business risk

Cyclicality is, of course, a negative incorporated in the assessment of a companys business risk. The degree of business risk, in turn,
Time
Standard & Poors
Standard & Poors credit ratings are meant to

be forward-looking, and their time horizon
extends as far as is analytically foreseeable.
Accordingly, the anticipated ups and downs
of business cycleswhether industry-specific
or related to the general economyshould be
factored into the credit rating all along.
Ratings should never be a mere snapshot of
the present situation. Accordingly, ratings are
held constant throughout the cycle, or, alternatively, the rating does varybut within a
relatively narrow band.
33
Rating Methodology
becomes the basis for establishing ratio standards for a given company for a given rating
category. The analysis then focuses on a companys ability to meet these levels, on average,
over a full business cycle and the extent to
which it may deviate and for how long.
The ideal is to rate through the cycle.
There is no point in assigning high ratings
to a company enjoying peak prosperity if that
performance level is expected to be only temporary. Similarly, there is no need to lower
ratings to reflect poor performance as long as
one can reliably anticipate that better times
are just around the corner.
However, rating through the cycle
requires an ability to predict the cyclical
patternusually, difficult to do. The phases
of a cycle probably will be longer or shorter, steeper or less severe, than just repetitions of earlier cycles. Interaction of cycles
from different parts of the globe and the
convergence of secular and cyclical forces
are further complications.
Moreover, even predictable cycles can affect
individual companies in ways that have a lasting impact on credit quality. For example, a
company may accumulate enough cash in the
upturn to mitigate the risks of the next downturn. (Auto manufacturers have been able
during cyclical upswingsto accumulate huge
cash hoards that should exceed cash outflows
anticipated in future recessions.) Conversely, a
companys business can be so impaired during
...And in the Real World
Corporate
performance
a downturn that its competitive position may

be permanently altered. In the extreme, a
company will not survive a cyclical downturn
to participate in the upturn!
Accordingly, ratings may well be adjusted
with the phases of a cycle. Normally, however, the range of the ratings would not fully
mirror the amplitude of the companys cyclical highs or lows, given the expectation that a
cyclical pattern will persist. The expectation
of change from the current performance
levelfor better or worsewould temper
any rating action. In most cases, then, the
typical relationship of ratings and cycles
might look more like that below.
Sensitivity to cyclical factorsand ratings
stabilityalso varies considerably along the
rating spectrum. As the credit quality of a
company becomes increasingly marginal, the
nature and timing of near-term changes in
market conditions could mean the difference
between survival and failure. A cyclical
downturn may involve the threat of default
before the opportunity to participate in the
upturn that may follow. In such situations,
cyclical fluctuations usually will lead directly
to rating changespossibly, even several rating changes in a relatively short period.
Conversely, a cyclical upturn may give companies a breather that may warrant a modest
upgrade or two from those very low levels.
In contrast, companies viewed as having
strong fundamentalsi.e., those enjoying
investment-grade ratingsare unlikely to see
their ratings changed significantly because of
factors deemed to be purely cyclical, unless
the cycle is either substantially different from
what was anticipated or the companys performance is somehow exceptional relative to
what had been expected.
Standard & Poors rating

AA
A
BBB
Time
34
Analytical challenges
Cyclicality encompasses several different phenomena that can affect a companys performance. General business cycles, marked by
fluctuations in overall economic activity and
demand, are only one type. Demand-driven
cycles may be specific to a particular industry,
e.g., product-replacement cycles lead to
volatile swings in demand for semiconductors. Other types of cycles arise from variations in supply, as seen in the pattern of
capacity expansion and retrenchment that is

characteristic of the chemicals, forest products, and metals sectors. In some cases, natural phenomena are the driving forces behind
swings in supply. For example, variations in
weather conditions result in periods of shortage or surplus in agricultural commodities.
The confluence of different types of cycles
is not unusual: a general cyclical upturn
could coincide with an industrys construction cycle that has been spurred by new
technology. The interrelationship of different national economies is an additional
complicating factor.
All these cycles can vary considerably in
their duration, magnitude, and dynamics. For
example, the unprecedented eight years of
uninterrupted, robust economic expansion in
the U.S. that followed the 1982 trough was
totally unforeseen. On the other hand, there
was no basis to assume in advance that the
downturn that followed would be so severe,
albeit relatively brief. Indeed, at any given
point, it is difficult to know the stage in the
cycle of the general economy, or a given
industrial sector. A plateau following a
period of demand growth might indicate the
peak has been reachedor represent a pause
before the resumption of growth.
Even general downturns vary in their
dynamics, affecting industry sectors differently. For example, the soaring interest rates
that accompanied the recession of 19801981 had a particularly adverse effect on
sales of consumer durables such as autos.
Sometimes, sluggish demand for large-ticket
items can spur demand for other, less costly
consumer products.
In any case, purely cyclical factors are difficult to differentiate from coincident secular
changes in industry fundamentals, such as the
emergence of new competitors, changes in
technology, or shifts in customer preferences.
Similarly, it may be tempting to view cyclical
benefitssuch as good capacity utilization
as a secular improvement in an industrys
competitive dynamics.
A high degree of rating stability for a company throughout the cycle also should entail
consistency in business strategy and financial
policy. In reality, management psychology is
often strongly influenced by the course of a
Standard & Poors
cycle. For example, in the midst of a prolonged, highly favorable cyclical rebound, a
given managements resolve to pursue a conservative growth strategy and financial policy
may be weakened. Shifts in management psychology may affect not just individual companies, but entire industries. Favorable market
conditions may spur industrywide acquisition
activity or capacity expansion.
Standard & Poors understands that public
sentiment about cyclical credits may fluctuate
between extremes over the course of the
cycle, with important ramifications for financial flexibility. Whatever our own views
about the long-term staying power of a given
company, the degree of public confidence in
the companys financial viability is critical for
it to have access to capital markets, bank
credit, and even trade credit. Accordingly, the
psychology and the perceptions of capital
providers must be taken into account.
Loan Covenants
Public-market participants long ago stopped
demanding significant covenant protection,
perhaps because poorly written covenant
packages with weak tests and significant
loopholes enabled managements to circumvent them. Furthermore, in a widely held
transaction, a covenant violation that normally would be waived could deteriorate into
a payment default, because of the difficulty of
having all the investors act in unison.
Moreover, investors in publicly traded debt
instruments have little interest in working
with borrowers and probably have fewer
resources to do so. Their primary protection
is their ability to sell their investments if
things should turn sour.
Traditional private-placement investors and
bank lenders do have the resources and the
expertise to work out problem credits. Such
investors negotiate covenant packages carefully, to give themselves the most advantageous position from which to exercise
control, and they expect to be compensated
adequately for accepting covenants that are
weak, i.e., those that might allow management more leeway to cause a deterioration in
credit quality. In general, however, covenant
packages are more relaxed than in the past,
35
Rating Methodology
because liquidity has increased, and financial

markets broadened.
Covenants intended functions include:
Preservation of repayment capacity. Some
covenants limit new borrowings or assure
lenders that cash generated both from
ongoing operations and from asset sales
will not be diverted from servicing debt.
Credit quality is preserved by share-repurchase and dividend restrictions, which seek
to maintain funds available for debt service.
Protection against financial restructurings. All lenders are concerned with the
risk of a sudden deterioration in credit
quality that can result from a takeover, a
recapitalization, or a similar restructuring. Properly crafted covenants may prevent some of these credit-damaging events
from occurring without the debts first
having been repaid or the pricings first
having been adjusted.
Protection in the event of bankruptcy or
default. These covenants preserve the value
of assets for all creditors andwhat is particularly importantsafeguard the priority
positions of particular lenders. Protection is
provided through negative-pledge clauses,
cross-acceleration (or cross-default) provisions, and limits on obligations that either
are more senior or rank equally.
Signals and triggers. Signals and triggers
assure the steady flow of information, provide early warning signals of credit deterioration, and place the lender in a position of
influence should deterioration occur. Since
triggers can bring the parties to the table, to
enable the lender to decide whether it might
be appropriate to modify or waive restrictions, they must therefore be set at appropriate levels, to signal deterioration before
the credit drops to unacceptable levels.
Enforcement is dubious. A company determined to do so can often, with the assistance
of its lawyers, find ways to evade the letter of
the agreement embodied in covenants. They
could even choose to ignore them altogether.
A court usually will not force a company to
comply with covenants. Rather, the court will
award damagesif the breach of covenants is
considered the cause of the damages. As long
as the company continues to pay principal
and interest, the court is unlikely to recognize
36
any damages as having occurred. In the event

of a breach of the covenant, the usual remedy
is the ability to declare an event of default
and accelerate the loan. However, this remedy
is so severe that, more often than not, lenders
choose not to precipitate a default by
demanding immediate repaymentdespite a
stipulated right to do so. Instead, the lender
may prefer to take a security position or to
get additional collateral, to raise rates, to
obtain a waiver fee, or to provide more input
into the companys decisions. In reality, these
are the benefits of covenant protection.
Covenants and ratings
Covenants play a limited enhancing role in
determining the corporate credit rating:
Covenants do not address fundamental
credit strength. Covenants do not and
cannot affect the potential for facing business adversity, competitive reverses, and
other risks that are outside the control of
the company.
The level of a covenant is often inconsistent
with the rating level desired. For example, a
covenant that allows a company to leverage
itself no more than 60% has little bearing
on the companys achieving a BBB rating,
if 40% is the maximum leverage tolerated
for that specific company as a BBB.
In practice, lenders waive covenants for a
variety of reasons. Waivers might result
from company/bank relationship issues, a
lack of understanding of the magnitude of
problems, or a realization that the original
levels were unnecessarily tight. The bankers
normally waive the covenant for a fee, or
extract higher interest rates. This benefits
the banker, without enhancing the credit
quality for the benefit of all creditors.
Finally, if the covenants appear only in certain issues, those issues could be refinanced.
For all these reasons, in most cases,
Standard & Poors does not believe particular
covenant or group of covenants can improve
a particular borrowers ability to meet its
obligations in a timely fashion.
The main reason to be aware of a rated
entitys covenants is quite the opposite: Tight
covenants could imperil credit quality by
causing a default that might otherwise have
been avoided. When bankers have the discre-
tion to accelerate debt because of a covenant

breach, they might do so to preserve the
advantage held (e.g., based on being secured).
Covenants can, however play a valuable
role in a more limited fashion. First, they may
protect the specific debt issue that includes
the covenantsparticularly with respect to
ultimate recovery. Second, they may prevent
certain deliberate actions that could hurt
credit quality, and that would be meaningful
in cases where the credit-rating assessment is
specifically concerned about the potential for
those actions.
Covenants may be more effective at protecting the credit quality of a subsidiary from
its parent company or group. Nonetheless,
the parent could always choose to file the
subsidiary into bankruptcy, unless it were
legally structured to be bankruptcy remote.
The benefit would then be in terms of better
recovery for the creditors of the subsidiary.
We usually would not rate a subsidiary based
on its strong stand-alone profile, even if
there were significant covenant restrictions,
because of the concerns noted above.
Moreover, a covenant package can be helpful as an expression of managements intent.
Since most companies (especially public companies) would be expected to honornot
evadecommitments they make, covenants
can provide an insight into managements
plans. An analyst would consider how complying with covenants were consistent with
other articulated strategic goals.
Managements willingness to agree to certain
restrictive covenants, in essence, puts their
money where their mouth is. For example, if
a company had traditionally been highly
leveraged but planned to deleverage in the
future, the analyst would expect to see a debt
test that ratcheted down over time.
Country Risk
It has long been Standard & Poors view that
country risk plays a critical role in determining all ratings within a given domicile.
Sovereign-related stress can have an overwhelming impact upon company creditworthiness, both direct and indirect. This was
demonstrated vividly most recently in the
Republic of Argentina (2001-2002), as well
Standard & Poors
as in the Russian Federation (1998-1999) and

in the Republics of Indonesia (1997-1998)
and Ecuador (1998-1999).
Sovereign credit ratings are suggestive of
general risk faced by local entities, but they
may not fully capture risk applicable to the
private sector. As a result, when rating corporate or infrastructure companies or projects, we look beyond the sovereign ratings to
evaluate the specific economic or country
risk that may impact the entitys creditworthiness. Such economic or country risk pertains to the impact of government policies
upon the obligors business and financial
environment, and a companys ability to
insulate itself from these risks.
Economic risk
The macroeconomic factors most relevant to
corporate credit analysis when determining
economic risk include:
Country growth prospects;
Volatility of the economy;
Inflation and real interest rate trends;
Devaluation/overvaluation risk;
Political stability;
Banking-system and payment-system risk;
Local capital-market depth; and
The extent of integration into global
trade and capital markets, and relative
sensitivity of foreign direct investment
and portfolio flows.
Industry risk
Country risk analysis also covers industry
risk specific to corporates, including:
Labor issues;
Infrastructure challenges;
Accounting and transparency; and
Institutional risk (i.e., legal and regulatory
risk and credit culture issues, tax risk, and
corruption levels).
Depending on the country, there can be
strong, creditworthy companies that demonstrate they are significantly sheltered from
sovereign and country risk, and would be
unlikely to default on their local currency
obligations during a sovereign local- and foreign-currency default scenario. On the other
hand, we also would expect there to be cases
where default levels will be much higher than
the sovereign rating benchmark would indi-
37
Rating Methodology
cate. Therefore, depending upon the country,

the degree of country risk, and relative
strength of the corporate sector in a given
jurisdiction, there can be cases where a companys local currency ratings can exceed the
foreign currency, or even the local currency,
sovereign credit rating. Otherwise, where
country risk is very high, most corporate ratings will be below that of the sovereign. In all
cases, local currency ratings are determined in
reference to our country risk framework.
It should be noted that in recent cases of
sovereign stress, corporate default levels have
been very high. The most notable example is
Argentina, where a rather extreme sovereign
default scenario has ensued. Nearly every entity rated by Standard & Poors has defaulted
on bond, bank, or supplier debt. The key
country risk factors in that case were:
Maxi-devaluation of the currency;
Price controls in the form of frozen
utility tariffs;
Frozen bank deposits, and a banking system in crisis;
Currency controls that restricted the ability
of companies to make payments abroad
and interrupted supply chains; and
A recession more than four years old.
Regulated utilities were perhaps the most
affected, although exporters also suffered
both a severe contraction in credit and multiple levels of taxes imposed by a government
in desperate need of revenue sources.
Foreign exchange-rate risk/
Foreign-exchange controls
There are many risk factors in this category,
related to both the rate and availability of
foreign exchange. Exposure to exchangerate risk includes:
Operating margin. Where costs have a significant dollar/hard currency component
while revenue is denominated in the local
currency, the company will suffer margin
compression in a currency devaluation.
Examples would be manufacturing companies that must import raw materials, media
companies that import content, or wireless
companies that import handsets. Assuming
the devaluation occurs during a time of economic recessionas often is the casethe
company typically will not be able to pass
38
on increased costs directly, at least not

immediately. The flip side of this is where
costs are in the local currency while revenue
is in or linked to a hard currency; these
companies will be affected when the currency is overvalued. Commodity exporters
based in countries with overvalued local
currencies have been harshly affected by this
risk, particularly when it coincided with
periods of weak commodity prices. Analysts
should carefully evaluate any currency mismatch between revenue and expenses.
Capital expenditures. A related risk is
where companies generate local currency
cash flows, but have hard currency capital
expenditures, e.g., must rely on imported
capital equipment.
Mismatch between local currency revenue
and foreign debt. Companies with largely
local currency cash flows, but depend on
dollar or dollar-linked debt (or another
hard currency) are most vulnerable.
Most recent cases of sovereign distress have
included sharp currency devaluations, including Argentina (where the currency lost nearly
75% of its value against the U.S. dollar, with
the exchange rate falling from a fixed 1:1 at
Dec. 31, 2001, to near 3.6 Argentine pesos
per U.S. dollar by October 2002); Russia
(where the currency lost 65% of its value in
U.S. dollar terms between July 1998 and
November 1998); and Indonesia (where the
currency lost 58% of its value over a threemonth period in early 1998).
Exposure to foreign-exchange availability
risk pertains when a company is heavily
dependent on imported supplies or imported
capital equipment. The companys operations
could be interrupted if foreign-exchange controls are imposed by the sovereign (which is
plausible in the case in event of a sovereign
foreign-currency default). For example, the
imposition of exchange controls in Argentina,
together with a prolonged period of uncertainty over the implementation of controls and relevant exchange rate, caused widespread
disruption in distribution chains because of
sharply curtailed imports (and exports).
Hedging/Financial policy
Does the company hedge foreign-exchange
risk, to the extent it is within its control to do
so? In many emerging markets, it is not practicable to hedge foreign-exchange exposure

over the long term because of the unavailability or cost of long-term hedging instruments.
Does the company show a propensity to speculate with financial arbitrage opportunities?
(For example, does the company borrow in
U.S. dollars to invest in high interest rate
local currency instruments, exposing itself to
devaluation risk?)
Political risk
Is there a history or likelihood of civil
unrest in the region or country where the
company operates that could disrupt operations? Does the company operate in a politically sensitive industry that could be subject
to expropriation?
Macroeconomic volatility risk
Are the companys prospects tied to local
economic conditions? Volatile growth rates
or extended periods of economic
recession/depression could reduce predictability of cash flows or severely hamper
sales volumes, pricing power, etc.
Institutional risk: Legal system risk/
Credit culture/Corruption
How dependable is the rule of law? Is there
an independent judicial system? Are creditors
rights respected? Is the bankruptcy code
transparent? Are there credit-culture issues
whereby companies have a cultural incentive
to default on debt? Are corruption levels generally high in the country?
Accounting and reporting transparency
Is there a strong regulatory enforcement
agency for publicly reporting companies in
the country? Are accounts generally audited
by top international accounting companies?
Are quarterly and annual financial statements
typically available within a reasonable time
after a period closes? Are disclosure levels
generally adequate, or is significant supplemental information required? In jurisdictions
where majority family ownership is common,
disclosure often lags. In addition, particularly
where there is majority family ownership, the
entire family group of companies should be
Standard & Poors
analyzed, and intercompany operations and

relationships should be scrutinized.
Taxes/Royalties/Duties
Does the company or its key investments
enjoy tax subsidies or royalty arrangements
that have renegotiation risk at the federal or
regional level? Does the government have a
history of micromanaging the current account
balance through changing taxes or duties on
imports/exports/foreign borrowings?
Government regulation
Is there a particular risk to the company that
the government may change the rules through
import/export restrictions; direct intervention
in service quality or levels; redefining boundaries of competition (such as service areas);
altering existing barriers to entry; changing
subsidies; changing antitrust legislation;
changing the maximum percentage level of
foreign ownership participation; or changing
terms to concession contracts for utilities?
For extractive industries, is there a risk of
government contract renegotiation?
Infrastructure and labor problems
To what extent might the company be vulnerable to the reduced public services and labor
strife that could accompany the sovereign
default scenario? Are there potential bottlenecks, poor transport, high-cost/inefficient
port services? Is there a need to supply electricity or other basic services/infrastructure?
Inflation risk
Where existing or potential high/accelerating
inflation is an issue, does the company have
the pricing flexibility, systems, and know-how
to keep revenue increasing in line with or
ahead of costs? How much price elasticity is
typical for the product of the company, particularly during times of economic weakness?
Price controls particularly are a threat for
regulated industries, such as telephone/electric
services, and possibly for some basic commodities such as gasoline sales. At times of
rising inflation, governments often try to
appease consumers by failing to allow fullcost passthroughs on prices in regulated
industries, and under severe stress may freeze
all prices in an effort to control inflation. For
39
Rating Methodology
example, Argentina froze utility tariffs for

gas, electric, and local telephone services in
January 2002, which effectively cut the earnings power of those companies by 60%-75%
relative to their dollar debt, because of the
concurrent currency devaluation. In other
cases, sovereigns have more indirectly constrained price increases on politically sensitive
goods or services, or have moved to impose
even broader price controls (such as
Venezuela did in mid-1994).
Interest-rate risk
Does the country have a history of high real
interest rates, which can make local borrowing expensive? If local borrowings are
indexed to local reference (such as bank
deposit rates or inflation) or foreign exchange
rates, the company can be subject to sudden
and large rate hikes at times of sovereign
stress. Such borrowings may originally have
appeared cheaper, only in that the risk was
not fully recognized.
Restricted access to capital
Does the company have a large concentration of assets in a particular emerging market
country? The risk that access to cash flows
of foreign subsidiaries could be constrained
by potential transfer/convertibility risk
should be reviewed.
Access to capital
Is the company a top-tier name in the local
market, that would benefit from a flight to
quality from local bank lending during
crises? Does the company have committed
lines of credit from international banks that
are not subject to sovereign-related material
adverse change clauses? Does the company
have ample access to trade credit? Can the
company withstand the cuts in trade lines
and increase in costs that typically occur during periods of sovereign stress? (An example
was the sharp reduction in trade-line availability from foreign banks for Brazilian corporates during 2002). Where short-term debt
can be rolled over, it should be assumed that
substantially higher interest rates would be
incurred in a stress scenario. Limited access
to capital often is a key constraint for emerg-
40
ing-market issuers: it broadly penalizes their

credit quality relative to those of companies
in developed markets. Even the strongest
Latin American private-sector issuers had difficulties accessing local or international capital markets during periods of stress.
Companies are affected by volatile international investor confidence in emerging markets. While economic problems may originate
in a particular country or region, we have
seen many cases of regional or emerging market contagion. Thin domestic capital markets
also prevent companies from accessing local
markets at reasonable rates; in times of stress,
the local banking system would be suffering
illiquidity because of high capital flight. A
weak or poorly regulated local banking system can introduce additional volatility.
Moreover, many emerging-market-based
companies typically do not have access to
committed credit lines.
Debt maturity structure
For emerging-market issuers, concentration in
short-term debt, whether dollar- or local-currency denominated, exposes the company to
critical rollover risk. This risk is highest for
companies with large upcoming bullet maturities on capital market debt, although the
quality and likelihood of continued bank support also is analyzed. Emerging-market companies partially can mitigate this risk by
prefunding the refinancing of large bullet
maturities well in advance. It cannot be
assumed availability under uncommitted
linesor programs such as euro-denominated
commercial paper or medium-term notes
where pricing and availability always are subject to market sentiment.
Liquidity
Is the companys near-term financial flexibility supported by substantial liquidity? If so, is
the companys liquid asset position held in
local government bonds, local banks, or local
equities, and will the issuer have access to
these assets in times of stress on the sovereign? Local banks broadly are affected by
sovereign stress scenarios, with the extreme
case demonstrated by Argentinas bankdeposit freeze. Similarly, Ecuador froze
deposits in 1998 in an effort to halt a run on

its banks. Ideally, the company should have
liquidity positions that are well diversified
among top local and foreign financial institutions. Having liquidity outside the country of
domicile is also a significant enhancement
(although the risk that companies may be
required by the sovereign to repatriate
funds/export proceeds is also be considered).
Foreign-currency ratings
The local-currency credit rating, by definition, excludes the risk of direct sovereign
intervention that may constrain payment of
foreign currency debt. The foreign-currency
credit rating is a current opinion of an obligors overall capacity to meet its obligations in
foreign currency. In many cases, sovereign
default and sovereign intervention risk are
assumed to be roughly equivalent, and most
foreign-currency credit ratings in these jurisdictions are limited by that of the sovereign.
However, in some countries, we may determine that sovereign intervention risk is different than sovereign default risk. In these cases,
foreign-currency credit ratings for private-sector entities may be higher than that of the
sovereign. Examples include currency unions
Standard & Poors
such as the European Monetary Union

(EMU), where the AAA rating of the
European Central Bank indicates an AAA
ability to convert euros to foreign currency
and transfer foreign currency. Thus, no ratings of entities within the EMU are constrained by transfer and convertibility risk.
There are other company- or issue-specific
reasons why the entitys foreign-currency rating may be higher than that of the sovereign.
For example, companies domiciled in a given
country but with substantial offshore operations, or companies that are subsidiaries of
offshore parents, could have a rating higher
than the country of domicile. In addition,
transactions can be structured to reduce
transfer and convertibility (T&C) risk by capturing transaction flows off shore, through
insurance for T&C risk, or using other structural techniques, and therefore receive a rating higher than the foreign-currency
sovereign credit rating. (For additional comments, see Sovereign Risk and Ratings
Above the Sovereign, July 23, 2001, and
Rating Above The Sovereign: Criteria
Update, Nov. 3, 2005, both published on
RatingsDirect, Standard & Poors Web-based
research and credit analysis system.)
41
Ratings And Ratios:

Ratio Medians
he key ratio medians for U.S. corporates by rating category

and their definitions are displayed below. The ratio medians
are purely statistical, and are not intended as a guide to achieving

a given rating level. They are not hurdles or prerequisites that
should be achieved to attain a specific debt rating.
Caution should be exercised when using the ratio medians for
comparisons with specific company or industry data because of
differences in method of ratio computation, importance of industry or business risk, and the impact of mergers and acquisitions.
Because ratings are designed to be valid over the entire business
cycle, ratios of a particular company at any point in the cycle may
not appear to be in line with its assigned debt ratings. Particular
caution should be used when making cross-border comparisons,
because of differences in accounting principles, financial practices, and business environments.
Company data are adjusted
for the following:
Nonrecurring gains or losses are eliminated
from earnings. This includes gains on asset
sales, significant transitory income items,
unusual losses, losses on asset sales, and
charges because of asset writedowns, plant
shutdowns, and retirement programs. These
42
adjustments chiefly affect interest coverage,

return, and operating margin ratios.
Unusual cash-flow items similar in origin
to the nonrecurring gains or losses also
are reversed.
The operating lease adjustment is performed for all companies. Companies that
buy all plant and equipment are put on a
more comparable basis with those that lease
Table 1Key
Industrial Financial Ratios, Long-Term Debt
Three-year (2002 to 2004) medians

AAA
AA
BBB
BB
CCC
EBIT interest coverage (x)
23.8
19.5
8.0
4.7
2.5
1.2
0.4
EBITDA interest coverage (x)
25.5
24.6
10.2
6.5
3.5
1.9
0.9
FFO/total debt (%)
203.3
79.9
48.0
35.9
22.4
11.5
5.0
Free operating cash flow/total debt (%)
127.6
44.5
25.0
17.3
8.3
2.8
(2.1)
Total debt/EBITDA (x)
0.4
0.9
1.6
2.2
3.5
5.3
7.9
Return on capital (%)
27.6
27.0
17.5
13.4
11.3
8.7
3.2
Total debt/total debt + equity (%)
12.4
28.3
37.5
42.5
53.7
75.9
113.5
Table 2Key
Utility Financial Ratios, Long-Term Debt
Three-year (2002 to 2004) medians
EBIT interest coverage (x)

FFO interest coverage (x)
Net cash flow/capital expenditures (%)
AA
BBB
BB
4.4
3.1
2.5
1.5
1.3
5.4
4.0
3.8
2.6
1.6
86.9
76.2
100.2
80.3
32.5
FFO/average total debt (%)
30.6
18.2
18.1
11.5
21.6
Total debt/Total debt + equity (%)
47.4
53.8
58.1
70.6
47.2
Common dividend payout (%)
78.2
72.3
64.2
68.7
(4.8)
Return on common equity (%)
11.3
10.8
9.8
4.4
6.0
Table 3Key
Ratios
Formulas
1. EBIT interest coverage
Earnings from continuing operations* before interest and taxes/Gross interest

incurred before subtracting capitalized interest and interest income
2. EBITDA interest coverage
Adjusted earnings from continuing operations** before interest, taxes, depreciation, and amortization/Gross interest incurred before subtracting capitalized interest and interest income
3. Funds from operations (FFO)/total debt Net income from continuing operations, depreciation and amortization, deferred
income taxes, and other non-cash items/Long-term debt + current maturities +
commercial paper, and other short-term borrowings
4. Free operating cash flow/total debt
FFO capital expenditures (+) increase (decrease) in working capital (excluding

changes in cash, marketable securities, and short-term debt)/Long-term debt +
current maturities, commercial paper, and other short-term borrowings
5. Total debt/Total debt + equity
Long-term debt + current maturities, commercial paper, and other short-term

borrowings/Long-term debt + current maturities, commercial paper, and other
short-term borrowings + shareholders' equity (including preferred stock) +
minority interest
6. Return on capital
EBIT/Average of beginning of year and end of year capital, including short-term

debt, current maturities, long-term debt, non-current deferred taxes, minority
interest, and equity (common and preferred stock)
7. Total debt/EBITDA
Long-term debt + current maturities, commercial paper, and other short-term

borrowings/Adjusted earnings from continuing operations before interest, taxes,
and D&A
*Including interest income and equity earnings; excluding nonrecurring items. **Excludes interest income, equity earnings, and nonrecurring items; also
excludes rental expense that exceeds the interest component of capitalized operating leases. Including amounts for operating lease debt equivalent, and debt
associated with accounts receivable sales/securitization programs.
Standard & Poors
43
Ratings and Ratios
part or all of their operating assets. The lease

adjustment affects all ratios.
The net debt adjustment affects median
ratios largely for the AAA rating category,
composed almost entirely of cash-rich pharmaceutical companies.
The captive-finance adjustment has a great
effect, mainly on automobile, department
store, and some capital goods companies.
The adjusted ratio median universe for
industrials includes about 1,000 companies.
The data exclude transportation companies
that exhibit different financial-ratio profiles.
44
The medians themselves are affected by

economic and environmental factors, as well
as mergers and acquisitions. The universe of
rated companies constantly is changing, and
in certain rating categories, adding or deleting
a few companies also can affect the financialratio medians.
Strengths and weaknesses in different
areas have to be balanced and qualitative
factors evaluated. There are many nonnumeric distinguishing characteristics that
determine a companys creditworthiness (see
Tables 1, 2, and 3).
Rating Each Issue:

Distinguishing Issuers and Issues
tandard & Poors Ratings Services assigns two types of credit
ratingsone to corporate issuers and the other to individual
corporate debt issues (or other financial obligations). The first

type is called a Standard & Poors corporate credit rating. It is a
current opinion on an issuers overall capacity to pay its financial
obligationsi.e., its fundamental creditworthiness. This opinion
focuses on the issuers ability and willingness to meet its financial
commitments on a timely basis. It generally indicates the likelihood of default regarding all financial obligations of the company,
because, in most countries, companies that default on one debt
type or file under the Bankruptcy Code virtually always stop payment on all debt types. It does not reflect any priority or preference among obligations. In the past, we published the implied
senior-most rating of corporate obligorsa different term for
precisely the same concept. Default risk rating and natural
rating are additional ways of referring to this issuer rating.
Generally, a corporate credit rating is published for all companies that have issue ratingsin addition to those companies that
have no ratable issues, but request just an
issuer rating. Where it is germane, both a
local currency and foreign currency issuer rating are assigned.
Standard & Poors
Standard & Poors also assigns credit ratings to specific issues. In fact, the vast majority of credit ratings pertain to specific debt
issues. Issue ratings are a blend of default risk
(sometimes referred to as timeliness) and
the recovery prospects associated with the
specific debt being rated. Accordingly, junior
45
debt is rated below the corporate credit rating. Preferred stock is rated still lower (see
Preferred Stock). Well-secured debt can be
rated above the corporate credit rating.
Recovery ratings were added in 2003.
These ratings address only recovery
prospects, using a scale of one to five, rather
than the letter ratings.
Notching Down; Notching Up
The practice of differentiating issues in relation to the issuers fundamental creditworthiness is known as notching. Issues are
notched up or down from the corporate credit rating level.
Payment on time as promised obviously is
critical with respect to all debt issues. The
potential for recovery in the event of a
defaulti.e., ultimate recovery, albeit
delayedalso is important, but timeliness is
the primary consideration. That explains why
issue ratings are still anchored to the corporate credit rating. They are notchedup or
downfrom the corporate credit rating in
accordance with established guidelines
explained here.
As default risk increases, the concern over
what can be recovered takes on greater relevance and, therefore, greater rating significance. Accordingly, the loss-given-default
aspect of ratings is given more weight as one
moves down the rating spectrum. For example, subordinated debt can be rated up to two
notches below a noninvestment grade corporate credit rating, but one notch at most if
the corporate credit rating is investment
grade. In the same vein, the AAA rating category need not be notched at all, while at the
CCC level the gaps may widen.
There is also an important distinction
between notching up and notching down.
Whenever a financial obligation is judged to
have a materially worse recovery prospect
than other debt of that issuerby being unsecured, subordinated, or because of a holdingcompany structurethe issue rating is
notched down. Thus, priority in bankruptcy
is considered in broad, relative terms; there is
no full-blown attempt to quantify the potential severity of loss. And, because the focus is
relative to the various obligations of the
issuer, no comparison between unsecured
46
issues of different companies is warranted.

For example, the fact that a senior issue of
company A is not notched at all does not
imply anything about its recovery prospects
relative to the junior debt of company B
with the same corporate credit ratingwhich
is notched down.
In contrast, issue ratings are not enhanced
above the corporate credit rating unless a
comprehensive analysis indicates the likelihood of full recovery100% of principal
for that specific issue. The degree of
confidence of full recovery that results from
this more rigorous analysis is reflected in the
extent to which the issue is notched up. If the
analysis concludes that recovery prospects
may be less than 100%, the issue is not
deemed deserving of any rating enhancement,
even though it can be valuable indeed to realize, say, 80% or 90% of ones investment and
avoid a greater loss.
The entire notion of junior obligations
and the related difference it makes with
respect to recovery prospectsis specific to
the applicable legal system. Notching guidelines are, therefore, a function of the bankruptcy law and practice in the legal
jurisdiction that governs a specific instrument. For example, distinguishing between
senior and subordinated debt can be meaningless in India, where companies may be
allowed to continue paying even common
dividends at the same time they are in
default on debt obligations; accordingly,
notching is not applied in India. The majority of legal systems broadly follow the practices underlying Standard & Poors criteria
for notchingbut it always is important to
be aware of nuances of the law as they pertain to a specific issue.
Junior Debt: Notching Down

When a debt issue is judged to be junior to
other debt issues of the company, and,
therefore, to have relatively worse recovery
prospects, that issue is assigned a lower rating thani.e., it is notched down from
the corporate credit rating. As a matter of
rating policy, the differential is limited to
one rating designation in the investmentgrade categories. For example, when the
corporate credit rating is A, junior debt

may be rated A-. In the speculative-grade
categories, where the possibility of a default
is greater, the differential is up to two
rating designations.
Notching relationships are based on broad
guidelines that combine consideration of
asset protection and ranking. The guidelines
are designed to identify material disadvantage for a given issue by virtue of the existence of better-positioned obligations. The
analyst does not seek to predict specific
recovery levels, which would involve knowing the exact asset mix and values at a point
well into the future.
Notching relationships are subject to
review and change when actual developments
vary from expectations. Changes in notching
do not necessarily have to be accompanied by
changes in default risk.
Guidelines for Notching
To the extent that certain obligations have a
priority claim on the companys assets, lowerranking obligations are at a disadvantage
because a smaller pool of assets will be available to satisfy the remaining claims. One case
is when the issue is contractually subordinatedthat is, the terms of the issue specifically
provide that debt holders will receive recovery in a reorganization or liquidation only
after the claims of other creditors have been
satisfied. Another case is when the issue is
unsecured, while assets representing a significant portion of the companys value collateralize secured borrowings.
A third form of disadvantage can arise if a
company conducts its operations through an
operating subsidiary/holding-company structure. In this case, if the whole group declares
Table 1Investment-Grade
bankruptcy, creditors of the subsidiaries

including holders of even contractually subordinated debtwould have the first claim
to the subsidiaries assets, while creditors of
the parent would have only a junior claim,
limited to the residual value of the subsidiaries assets remaining after the subsidiaries direct liabilities have been satisfied.
The disadvantage of parent-company creditors owing to the parent/subsidiary legal
structure is known as structural subordination. Even if the groups operations are
splintered among many small subsidiaries,
the individual debt obligations of which
have only dubious recovery prospects, the
parent-company creditors may still be disadvantaged compared with a situation in
which all creditors would have an equal
claim on the assets (see table 1).
As a rough generic measure of asset availability, we look at the cumulative percentage
of priority debt and other liabilities relative
to all available assets. When this ratio reaches
certain threshold levels, the next, more junior,
debt is considered disadvantaged debt, and is
rated one or two notches below the corporate
credit rating. These threshold levels take into
account that it normally takes more than $1
of book assetsas valued todayto satisfy
$1 of priority debt. (In the case of secured
debtwhich limits the priority to the collateral pledgedthe remaining assets are still
less likely to be sufficient to repay the unsecured debt, inasmuch as the collateral ordinarily consists of the companys better assets
and often substantially exceeds the amount of
the debt.)
For investment-grade companies with a
typical asset mix, the threshold is 20%. That
is, if priority debt and liabilities equal 20%
Example
Corporate credit rating: A

Issue ratings
Assets $100
Priority debt $30
Lower-priority debt $10
A-
Equity $60
The lower-priority debt is rated one notch below the corporate credit rating of 'A', because the ratio of priority debt to assets (30 to 100) is greater than 20%.
Standard & Poors
47
or more of the companys assets, the lowerpriority debt (unsecured, subordinated, or

holding company) is rated one notch below
the corporate credit rating (see table 2).
If the corporate credit rating is speculative
grade, there are two threshold levels. If priority obligations equal even 15% of the assets,
the lower-priority debt is penalized one
notch. When priority debt and other liabilities amount to 30% of the assets, lower-priority debt is substantially disadvantaged and
is, therefore, differentiated by two notches.
The concept behind these thresholds is to
measure material disadvantage with respect
to the various layers of debt. At each level, as
long as the next layer of debt still enjoys
plenty of asset coverage, we do not consider
the priority of the top layers as constituting a
real disadvantage for the more junior issuers.
Accordingly, the nature of the individual
companys asset is important: If a company
has an atypical mix of assets, the thresholds
could be higher or lower to reflect the relative
amounts of better or worse assets.
The relative size of the next layer of debt
also is important. If the next layer is especially largein relation to the assets assumed to
remain after satisfying the more senior layersthen coverage is impaired. There are
numerous LBOs financed with outsized issues
just below the senior layers. Although the priority debt issues may be small (below the
threshold levels), they pose a real disadvantage for the junior issues, given the paucity of
coverage remainingso the junior debt
should be notched down.
Multiple Layers
A business entity can have many levels of
obligations, each ranking differently with
Table 2Speculative-Grade
respect to priority of claim in a bankruptcy.

For analytical purposes, debt levels are
ranked as follows, from highest priority
to lowest:
Debt secured with higher-quality operating
asset collateral;
Debt secured with lesser-quality operating
asset collateral;
Lease obligations/securitizations;
Senior debt of the operating company;
Senior liabilities (ranked pari passu with
senior debt);
Subordinated debt;
Junior subordinated debt;
All other operating company liabilities;
Senior debt of the holding company; and
Subordinated debt of the holding company.
Once a notching threshold level is
crossedaggregating successive layers of priority claimsnotching applies to the remaining, lower-ranking issues (see chart 1).
The reason notching is constrained to one
notch for investment-grade companies and
two notches for speculative-grade companies
is to maintain the important weighting of
timeliness in all ratings. Remember, notching
pertains only to differentiating recovery
prospects: it is presumed a default will interrupt payment on all of a companys debt
issues. The very highest-ranking issues receive
the corporate credit rating, or sometimes a
higher rating, if full recovery is confidently
expected; the lowest-ranking issues will never
be rated lower than one notch under the
investment-grade corporate credit rating, or
two notches in the case of noninvestmentgrade corporate credit ratings.
This rating convention often results in debt
issues of significantly different standing being
rated the same. If, for example, a two-notch
Example
Corporate credit rating: BB+

Issue ratings
Assets $100
Priority debt $35
BB+
BB-
Equity $45
The lower-priority debt is rated two notches below the corporate credit rating of BB+, because the ratio of priority debt to assets (35 to 100) is greater than 30%.
48
distinction is indicated for a senior subordinated issue, that issue and the worse-positioned issues at the holding company are all
rated at the same two-notch gap relative to
the corporate rating. No distinction is made
to highlight the differences between junior
issues (see table 3).
Senior Secured Debt
Not all senior secured debt of an issuer is
necessarily equally secured. Second-mortgage
debt, for example, has only a junior claim to
an asset also securing first-mortgage debt,
making it inferior to a first-mortgage issue
secured by the same asset. The second-mortgage debt issue would receive the corporate
credit rating only if the amount of first-mortgage debt outstanding was sufficiently small
relative to the assets.
In general, secured debt is notched according to the expected recovery associated with
its specific collateral (see Bank Loan
Methodology and Recovery Ratings). If
the collateral that secures a particular debt
issue is of dubious value, while the more
valuable collateral is pledged to another loan,
even secured debt may be notched down
from the corporate credit rating.
Application of Guidelines
Perspective. Notching takes into account
expected future developments. For example, a company may be in the process of
refinancing secured debt so that it would
Chart 1XYZ
Corp. and XYZ Holdings Inc.
Corporate credit ratings BB

Issue
ratings
Liabilities
$80
Assets
$100
<15% No notches
Secured debt $15
BB (or higher)
15% to 30% one notch
Senior debt $15
BB-
>30% two no
Subordinated debt $15
B+
Other liabilities $15
Not rated
Holding company debt $20
B+
tches
Equity
$20
Standard & Poors
have little or no secured debt within a year.

If there is confidence that the plan will be
carried out, a notching differential should
not be needed, even currently. Conversely,
if companies have open first-mortgage
indentures or the leeway to increase
secured borrowings under negative pledge
covenants (or if no negative pledge
covenants are in place), Standard & Poors
attempts to determine the likelihood that
the company will incur additional secured
borrowings. But the analyst would not
automatically base notching on the harshest assumptions.
If an issuer has a secured bank credit facility, such borrowings would be reflected in
notching to the extent that the issuer was
expected to draw on the facility. Typically, as
a company approaches a financial crisis, it
will need to tap its sources of financing. In
the absence of expectations to the contrary,
Standard & Poors takes a conservative
approach, assuming available bank borrowing capacity is fully utilized. Likewise, if a
company typically uses bank borrowings to
fund seasonal working capital requirements,
we focus on expected peak borrowing levels,
rather than the expected average amount.
Adjustments. Book values are used as a
starting point; analytic adjustments are
made if assets are considered significantly
overvalued or undervalued for financial
accounting purposes. This analysis focuses
on the varying potential of different types
of assets to retain value over time and in
the default context based on their liquidity
characteristics, special-purpose nature, and
dependence on the health of the companys
business. Goodwill especially is suspect,
considering its likely value in a default scenario. In applying the notching guidelines,
Standard & Poors generally eliminates
from total assets goodwill in excess of a
normal amount10% of total assets.
The particular characteristics of specific
intangibles, as distinct from goodwill, are
considered. (For example, some credit typically is given for the enduring value of
well-established brands in the consumer
products sector.) We do not, however, perform detailed asset appraisals or attempt to
postulate specifically about how market
49
values might fluctuate in a hypothetical

stress scenario (except in the case of
secured debt).
In applying the guidelines above, lease obligationswhether capitalized in the companys financial reporting or kept off balance
sheet as operating leases as priority debt
and the related assets are included on the
asset side. Similarly, sold trade receivables
and securitized assets are added back, along
with an equal amount of priority debt. Other
creditors are just as disadvantaged by such
financing arrangements as by secured debt. In
considering the surplus cash and marketable
securities of companies that presently are
financially healthy, Standard & Poors
assumes neither that the cash will remain
available in the default scenario, nor that it
will be totally dissipated, but rather that,
over time, this cash will be reinvested in operating assets that mirror the companys current
asset base, subject to erosion in value of the
same magnitude.
Local- and foreign-currency issue ratings.
In determining local-currency issue ratings,
the point of reference is the local-currency
corporate credit rating: local-currency issue
ratings may be notched down one notch
from the local-currency corporate credit
rating in the case of investment-grade
issuers, or one or two notches in the case
of speculative-grade issuers. A companys
Table 3Speculative-Grade
foreign-currency corporate credit rating is

often lower than its local-currency corporate credit rating, reflecting the risk that a
sovereign government could take actions
that would impinge on the companys ability to meet foreign-currency obligations. But
junior foreign-currency issues are not
notched down from the foreign-currency
corporate credit rating, because the government action would apply regardless of the
senior/junior character of the debt. Of
course, the issue would never be rated
higher than if it had been denominated in
local currency. For example, if a companys
local-currency corporate credit rating were
BB+ and its foreign-currency corporate
credit rating were BB-, subordinated foreign currency-denominated issues could be
rated BB-. But, if a companys local-currency corporate credit rating were BB+
and its foreign currency corporate credit
rating were BB, subordinated foreign-currency denominated issues would be rated
BB-, as would subordinated local-currency
denominated issues. (See chart 1).
Short-term ratings. All short-term ratings,
including commercial paper ratings, are
linked to the issuers corporate credit rating. Although commercial paper generally
is unsecured, commercial paper ratings
focus exclusively on default risk. For example, if an issuer has an A corporate credit
Example
Corporate credit rating: BB+

Issue ratings
Assets $100
Priority debt $25
BB+
BB
Equity $60
Here, assuming the issuer was speculative grade, the lower-priority debt might be rated one notch below the corporate credit rating,
rather than two notches, although the ratio of priority debt to assets (25 to 100) is close enough to the guideline threshold of 30% to make
this a borderline case.
Issue ratings
Assets $100
Priority debt $25
BB+
BB-
Equity $45
In this case, the lower-priority debt should be rated two notches below the corporate credit rating. Although the ratio of priority debt to
assets is still 25 to 100, the substantial amount of lower-priority debt would dilute recoveries for all lower-priority debtholders.
50
rating and secured debt issue rating, and an

A- unsecured rating, its commercial paper
rating would still be A-1the commercial
paper rating associated with the A issuer
default ratingnot A-2, the commercial
paper rating ordinarily appropriate at the
A- default risk rating level.
Parents and Subsidiaries:
Structural Subordination
At times, a parent and its affiliate group
have distinct default risks. The difference in
risk may arise from covenant restrictions,
regulatory oversight, or other considerations. This is the norm for holding companies of insurance operating companies and
banks. In such situations, there are no fixed
limits governing the gaps between corporate
credit ratings of the parent and its subsidiaries. The holding company has higher
default risk, apart from post-default recovery distinctions. If such a holding company
issued both senior and junior debt, its junior obligations would be notched relative to
the holding companys corporate credit rating by one or two notches.
Often, however, a parent holding company with one or more operating companies is
viewed as a single economic entity. When
the default risk is considered the same for
the parent and its principal subsidiaries,
they are assigned the same corporate credit
rating. Yet, in a liquidation, holding-company creditors are entitled only to the residual
net worth of the operating companies
remaining after all operating company obligations have been satisfied.
Parent-level debt issues are notched down
to reflect structural subordination when the
priority liabilities create a material disadvantage for the parents creditors, after taking into account all mitigating factors. In
considering the appropriate rating for a
specific issue of parent-level debt, priority
liabilities encompass all third-party liabilities (not just debt) of the subsidiaries
including trade payables, pension and
retiree medical liabilities, and environmental liabilitiesand any relatively betterpositioned parent-level liabilities. (For
example, parent-level borrowings collateralized by the stock of the subsidiaries would
Standard & Poors
be disadvantaged relative to subsidiary liabilities, but would rank ahead of unsecured

parent-level debt.)
Potential mitigating factors include:
Guarantees. Guarantees by the subsidiaries
of parent-level debt (i.e., upstream guarantees) may overcome structural subordination by putting the claims of parent
company creditors on a pari passu basis
with those of operating company creditors.
Such guarantees have to be enforceable
under the relevant national legal system(s),
and there most be no undue concern
regarding potential allegations of fraudulent conveyance (see Upstream
Guarantees). Although joint and several
guarantees from all subsidiaries provide the
most significant protection, several guarantees by subsidiaries accounting for a major
portion of total assets would be sufficient
to avoid notching of parent debt issues in
most cases.
Operating assets at the parent. If the parent is not a pure holding company, but
rather also directly owns certain operating
assets, this gives the parents creditors a
priority claim to the parent-level assets.
This offsets, at least partially, the disadvantage that pertains to being structurally subordinated with respect to the assets owned
by the subsidiaries.
Diversity. When the parent owns multiple
operating companies, more liberal notching guidelines may be applied to reflect the
benefit the diversity of assets might provide. The threshold guidelines are relaxed
(but not eliminated) to correspond with
the extent of business and/or geographic
diversification of the subsidiaries. For
bankrupt companies that own multiple,
separate business units, the prospects for
residual value remaining for holding company creditors improve as individual units
wind up with shortfalls and surpluses
Also, holding companies with diverse businessesin terms of product or geographyhave greater opportunities for
dispositions, asset transfers, or recapitalization of subsidiaries. If, however, the
subsidiaries are operationally integrated,
economically correlated, or regulated, the
51
companys flexibility to reconfigure is

more limited.
Concentration of debt. If a parent has a
number of subsidiaries, but the preponderance of subsidiary liabilities are concentrated in one or two of these, e.g., industrial
groups having finance or trading units, this
concentration of liabilities can limit the disadvantage for parent-company creditors.
Although the net worth of the leveraged
units could well be eliminated in the bankruptcy scenario, the parent might still
obtain recoveries from its relatively
unleveraged subsidiaries. In applying the
notching guideline in such cases, it may be
appropriate to eliminate the assets of the
leveraged subsidiary from total assets, and
its liabilities from priority liabilities. (The
analysis then focuses on the assets and lia-
Table 4Single
bilities that remain, but the standard notching guideline must be substituted by other
judgments regarding recovery prospects.)
However, to the extent the company is
viewed as one consolidated entity, the presumption that the healthier subsidiaries
would remain healthy is questionable. This
also would dilute the value of guarantees
from individual subsidiaries.
Downstream loans. If the parents investment in a subsidiary is not just an equity
interest, but also takes the form of downstream senior loans, this may enhance the
standing of parent-level creditors because
they would have not only a residual claim
on the subsidiarys net worth, but also a
debt claim that would generally be pari
passu with other debt claims. Standard &
Poors gives weight to formal, documented
Economic Entity Example
Parentcorporate credit rating: BB+

Debt type*
Issue rating
Senior secured
BB-
Senior unsecured
BB-
Subordinated
BB-
Subsidiarycorporate credit rating: BB+

Debt type*
Issue rating
Senior secured
BB+
Senior unsecured
BB
Subordinated
BB-
Different Default Risk Example

Parentcorporate credit rating: BB+
Debt type*
Issue rating
Senior secured
BB+
Senior unsecured
BB
Subordinated
BB-
Subsidiarycorporate credit rating: B+

Debt type*
Issue rating
Senior secured
B+
Senior unsecured
Subordinated
B-
*Debt types are used here merely as illustrative of typical results for different priority debt; notching actually depends on the guidelines explained above. In
the first example, because the parent and subsidiary are viewed as having the same default risk, the lowest rating at either is two notches below the single
corporate credit rating. If the parent is a holding company without assets other than its ownership interest in the subsidiary, the parents debt is viewed as
junior and notched down. In contrast, in the second example, the parent and subsidiary are viewed as having different default risks, so each has a different
corporate credit rating (assumed to be BB+ at the parent and B+ at the subsidiary), and the two-notch limit is relative to the corporate credit ratings at each
entity: there is no limit on the span of ratings that applies across the two legal entities.
52
loansnot to informal advances, which

are highly changeable. (On the other
hand, if the parent has borrowed funds
from its subsidiaries, the resulting intercompany parent-level liability could further dilute the recoveries of external
parent-level creditors.) As with guarantees, the assessment of downstream
advances must take into account the
applicable legal framework.
Adjustments. Additional adjustments are
necessary in assessing structural subordination. We eliminate from the notching
calculations subsidiaries deferred tax
assets and liabilities and other accounting
accruals and provisions that are not likely
to have clear economic meaning in a
default (see table 4).
Exceptions to the Rule

If the recovery prospects for a specific junior
issue equate to the level associated with senior debt generally, notching is dispensed with.
As long as recovery of 80 cents on the dollar
reasonably can be anticipated, the junior debt
is not notched below the senior debt.
Only a handful of rated junior issues provide for such good recovery prospects. In
each case, the junior debt is secured, and
the value of the assets that serve as collateral is independent of the fate of the issuer. As
in all cases of secured debt, the specific collateral is subjected to analysis of its recovery prospects.
With respect to these and similar cases,
we do not presume any specific level of
recovery for the senior creditors of the company in question. The senior debt could
still, in the end, fare better than the collateralized subordinated issue. The key: As long
as the subordinated debt should recover as
much as the vast majority of defaulted senior debt, it is not discernibly disadvantaged
and does not deserve to be notched down.
After all, recovery of 75%-85% would compare favorably with that experienced by
roughly three-quarters of senior creditors.
Note that it is not necessary to conclude
that holders will be made whole to eliminate the notching down of subordinated
obligations. Obligations that are likely to
provide full ultimate recovery are rated
Standard & Poors
above the corporate credit rating (see

Notching Up).
Upstream Guarantees
When a subsidiary guarantees the debt of its
parent, it commonly is referred to as an
upstream guarantee. The object of the exercise is to address the structural subordination that would otherwise apply to
parent-company debt if the debt, liabilities,
and preferred stock of the operating company are material. Upstream guarantees, if
valid, eliminate the rating distinction, since
the operating company becomes directly
responsible for the guaranteed parent debt.
However, the validity of the guarantee is
subject to legal risk. An upstream guarantee
may be voided in court, if it is deemed to
constitute a fraudulent conveyance. The
outcome depends on the specific fact pattern, not legal documentationso one cannot standardize the determination. But, if
either the guarantor company received value
or was solvent for a sufficiently long period
subsequent to issuing the guarantee, the
upstream guarantee should be valid.
Accordingly, we consider upstream guarantees valid if any of these conditions are met:
The proceeds of the guaranteed obligation
are provided to (downstreamed to) the
guarantor. It does not matter whether the
issuer downstreams the money as an equity
infusion or as a loan. Either way, the
financing benefits the operations of the
subsidiary, which justifies the guarantee;
The legal risk periodordinarily, one or
two years from entering into the guaranteehas passed;
There is a specific analytical conclusion
that there is little default risk during the
period that the guarantee validity is at
risk; or
The rating of the guarantor is at least BB-
in jurisdictions that involve a two-year risk,
or at least B+ in jurisdictions with oneyear risk.
Accordingly, there will be cases where we
decline to recognize the upstream guarantee
at the time of issuancebecause of legal
riskbut would upgrade the issue a year
(or two) later. Standard & Poors accepts
an upstream guarantee whenever the guar-
53
antor obtained value. As long as the guarantor is the recipient of the funds, it meets
this test.
Well-Secured Debt: Notching Up
In 1996, Standard & Poors first published its

framework for weighting both timeliness and
recovery prospects in a default or bankruptcy
scenario when assigning ratings to wellsecured debt. The extent of any rating
enhancement depends on the following
three considerations:
Economics
Will the second way out provide 100%
recovery? Of principal only, or interest, as
well? When the collateral value exceeds the
amount of the claim, the creditor could
receive postpetition interest. Managing the
legal nuances of bankruptcy would be an
important aspect of achieving postpetition
interest. Although accurately predicting this
outcome is extremely difficult, the criteria
recognize the potential for such payment. (If
all accrued interest, from before and after the
default, can be recovered, the length of any
delay in recovery is less consequential.)
There can be different degrees of confidence with respect to recovery. For example,
excess collateral translates into a greater likelihood that there will be enough value to
recover the entire obligationalthough obviously, the creditor will never get more than
the obligation amount. Subjective judgments
are critical in deciding how to stress collateral
values in hypothetical postdefault scenarios.
How long will the delay be?
The time it takes to realize ultimate recovery
of the loan obligation can be critical. At best,
the recovery would be highly valued because
of its nearly timely characteralmost like a
grace period. At worst, we would not give
any credit for a very delayed payment. In estimating the length of any delay in recovery,
the analysis would focus on:
How the legal system resolves bankruptcies
or provides access to collateral. This varies
by legal jurisdiction. In the U.S., 18 to 24
months typically is needed to resolve a
Chapter 11 filing. (The analysis would
54
identify and differentiate cases that might

take longer than usual because of perceived
complexities, such as litigation.) In jurisdictions that are more creditor-oriented, the
access to collateral may be expedited.
The structure of an obligation. The analysis
could distinguish between a bond, a lease
obligation, and certificates governed by
Section 1110 of the U.S. Bankruptcy Code,
which provides specific legal rights to
obtain certain transportation assets during
a bankruptcy proceeding.
The terms of an obligation. For example,
in the case of a guarantee that provided for
ultimatebut not necessarily timelypayment, it would be important to know within what period payment must be made.
Weighting
The higher the rating, the more weight one
should give to timeliness; the lower the rating,
the more it should incorporate a postdefault
perspective. (This principle is the basis for the
policy of rating junior debt of investment-grade
issuers one notch below the issuer credit rating,
but differentiating junior debt of speculativegrade borrowers by two notches.) Therefore,
the degree of rating enhancement generally
depends on the starting pointi.e., the level of
the issuer credit rating.
Guidelines for notching
To get even one notch above the corporate
rating, a debt issue must have at least reasonable prospects for full recovery. As the
prospects improve, based on the nature
and/or amount of the collateral, another
notch may be added. If the analysis indicates
great confidence in full recovery, three or four
notches are possible. This reflects the highest
expectations for full recovery, following more
rigorous stressing of collateral values in various scenarios. This level of strong collateral
protection ordinarily would imply decent
prospects for recovering post-petition interest,
as well.
These guidelines pertain to the speculativegrade portion of the rating spectrum. At the
upper end, notching generally is less generous. For example, in the case of first mortgage bonds of investment-grade companies, it
takes greater enhancement to achieve the

same notch or two.
With respect to short-term ratings, timeliness of payment is paramount. Accordingly,
there is no enhancement of short-term ratings
based on ultimate recovery.
To reiterate, the policy of enhancing issue
ratings based on ultimate recovery prospects
applies only if the expected recovery is
100%. Standard & Poors does not attempt
to differentiate unsecured debt, even though
some defaults will result in recovery of 80
cents on the dollar, and others will result in
only 30 cents.
Commercial Paper
Commercial paper (CP) consists of unsecured
promissory notes issued to raise short-term
funds. CP ratings pertain to the program
established to sell such notes. There is no
review of individual notes. Typically, only
companies of strong credit standing can sell
their paper in the money market, although
there periodically is some issuance of lesserquality, unrated paper (notably, prior to the
junk bond market collapse late in 1989).
Alternatively, companies sell commercial
paper backed by letters of credit (LOC) from
banks. Credit quality of such LOC-backed
paper rests entirely on the transactions legal
structure and the banks creditworthiness. As
long as the LOC is structured correctly, credit
quality of the direct obligor can be ignored.
To achieve an A-1+ CP rating, the companys credit quality must be at least the
equivalent of an A+ long-term corporate
credit rating. Similarly, for commercial paper
to be rated A-1, the long-term corporate
credit rating would need to be at least A-.
(In fact, the A+/A-1+ and A-/A-1 combinations are rare. Ordinarily, A-1 CP ratings are associated with A+ and A
long-term ratings.)
Conversely, knowing the long-term rating
will not fully determine a CP rating, considering the overlap in rating categories.
However, the range of possibilities is always
narrow. To the extent that one of two CP
ratings might be assigned at a given level of
long-term credit quality (e.g., if the longterm rating is A), overall strength of the
credit within the rating category is the main
Rating criteria
Evaluation of an issuers commercial paper
reflects Standard & Poors opinion of the
issuers fundamental credit quality. The analytical approach is virtually identical to the
one followed in assigning a long-term corporate credit rating, and there is a strong
link between the short-term and long-term
rating systems (see chart 2).
Indeed, the time horizon for CP ratings is
not a function of the typical 30-day life of a
commercial-paper note, the 270-day maximum maturity for the most common type of
commercial paper in the U.S., or even the
one-year tenor typically used to determine
which instrument gets a short-term rating in
the first place.
Standard & Poors
Chart 2Correlation
of CP Ratings
with Long-Term Corporate
Credit Ratings*
AAA
AA+
AA
A-1+
AA-
A+
A-1
A-
BBB+
A-2
BBB
BBB-
A-3
BB+
BB
*Dotted lines indicate combinations that are highly unusual.
55
consideration. For example, a marginal A

credit likely would have its commercial
paper rated A-2, whereas a solid A would
almost automatically receive an A-1.
Exceptional short-term credit quality
would be another factor that determines
which of two possible CP ratings are
assigned. For example, a company may possess substantial liquidityproviding protection in the near or intermediate termbut
suffer from less-than-stellar profitability, a
longer-term factor. Or, there could be a concern that, over time, the large cash holdings
may be used to fund acquisitions. (Having
different time horizons as the basis for longand short-term ratings implies either one or
the other rating is expected to change.)
Backup policies
Ever since the Penn Central bankruptcy
roiled the commercial-paper market and
some companies found themselves excluded
from issuing new commercial paper,
Standard & Poors has deemed it prudent
for companies that issue commercial paper
to make arrangements in advance for alternative sources of liquidity. This alternative,
backup liquidity protects companies from
defaulting if they are unable to roll over
their maturing paper with new notes,
because of a shrinkage in the overall commercial-paper market or some cloud over
the company that might make commercialpaper investors nervous. Many developments affecting a single company or group
of companiesincluding bad business conditions, a lawsuit, management changes, a rating changecould make commercial-paper
investors flee the credit.
Given the size of the commercial-paper
market, backup facilities could not be relied
on with a high degree of confidence in the
event of widespread disruption. A general
disruption of commercial-paper markets
could be a highly volatile scenario, under
which most bank lines would represent
unreliable claims on whatever cash would
be made available through the banking system to support the market. Standard &
Poors neither anticipates that such a scenario is likely to develop, nor assumes that
it never will.
56
Having inadequate backup liquidity

affects both the short- and long-term ratings
of the issuer because it could lead to
default, which would ultimately pertain to
all of the companys debt. Moreover, the
need for backup applies to all confidencesensitive obligations, not just rated commercial paper. Backup for 100% of rated
commercial paper is meaningless if other
debt maturitiesfor which there is no backupcoincide with those of the commercial
paper. Thus, the scope of backup must
extend to euro-denominated commercial
paper, master notes, and short-term
bank notes.
The standard for industrial and utility
issuers has long been 100% coverage of
confidence-sensitive paper for all but the
strongest credits. Backup is provided by
excess liquid assets or bank facilities
in an amount that equals all such paper
outstanding.
While the backup requirement relates
only to outstanding paperrather than the
entire program authorizationa company
should anticipate prospective needs. For
example, it may have upcoming maturities
of long-term debt that it may want to refinance with commercial paper, which would
then call for backup of greater amounts.
Available cash or marketable securities
are ideal to provide backup. (Of course, it
may be necessary to haircut their apparent value to account for potential fluctuation in value or tollgate taxes surrounding a
sale. And it is critical that they be immediately saleable.) Yet the vast majority of
commercial paper issuers rely on bank facilities for alternative liquidity.
This high standard for back-up liquidity
has provided a sense of security to the commercial-paper marketeven though backup
facilities are far from a guarantee that liquidity will, in the end, be available. For
example, a company could be denied funds
if its banks invoked material adverse
change clauses. Alternatively, a company
in trouble might draw down its credit line
to fund other cash needs, leaving less-thanfull coverage of paper outstanding, or
issue paper beyond the expiration date of
its lines.
Companies rated A-1+ can provide 50%75% coverage. The exact amount is determined by the issuers overall credit strength
and its access to capital markets. Current
credit quality is an important consideration in
two respects. It indicates:
The different likelihood of the issuers ever
losing access to funding in the commercialpaper market; and
The timeframe presumed necessary to
arrange funding should the company lose
access. A higher-rated entity is less likely to
encounter business reverses of significance
andin the event of a general contraction
of the commercial-paper marketthe higher-rated credit would be less likely to lose
investors. In fact, higher-rated companies
could actually be net beneficiaries of a
flight to quality.
In 1999, Standard & Poors introduced a
new approach that offers companies greater
flexibility regarding the amount of backup
they maintain, if they are prepared to match
their maturities carefully with available liquidity. The new approach differentiated
between companies that are rolling over all
their commercial paper in just a few days
and those that have a cushion by virtue of
having placed longer-dated paper. The basic
idea was that companiesif and when they
lose access to commercial papershould
have sufficient liquidity to cover any paper
coming due during the time they would
require to arrange additional funding.
However, companies encountered practical difficulties in implementing the new
approach. Moreover, changes in the banking
environment have since made us more leery
about a company arranging new facilities
when under stress. Still, notes that come
due only 11-12 months from now do not
Table 5Guidelines
require backup so far in advance.

Companies should begin to actively arrange
liquidity backup approximately six months
prior to maturity. Similarly, 12-month notes
that automatically extend their maturity
month by month do not require back-up
arrangements from day one. They will be
able to arrange backup when and if the
extensions stop, leaving a full 12 months to
do so (see table 5).
Extendible commercial notes (ECN) provide built-in backup by allowing the issuer
to extend for several months if there is difficulty in rolling over the notes; accordingly,
there is no need to provide backup for
themi.e., until the extension is effected.
However, there is no way to prevent the
issuer from tapping backup facilities intended for other debt and use the funds to repay
maturing ECNs, instead of extending. This
risk is known as leakage. Accordingly, for
issuers that provide 100% backup,
unbacked ECNs must not exceed 20% of
extant backup for outstanding conventional
commercial paper.
All issuerseven if they provide 100%
backupmust always ensure that the first
few days of upcoming maturities are backed
with excess cash or funding facilities that
provide for immediate availability.
For example, a bank backup facility that
requires two-day notification to draw down
will be of no use in repaying paper maturing in the interim. The same would hold
true if foreign exchange is needed, and the
facility requires a few days to provide it.
Moreover, if a company issuing commercial
paper in the U.S. were relying on a bank
facility in Europe, differences in time zones
or bank holidays could prevent availability
when needed. Obviously, a bank facility in
for U.S. Industrials and Utilities

% of total outstanding
A-1+/AAA
50
A-1+/AA
75
A-1
100
A-2
100
A-3
100
Standard & Poors
57
the U.S. would be equally lacking with

respect to maturing euro-denominated commercial paper. So-called swing lines typically equal 15%-20% of the program size
to deal with the maximum amount that will
mature in any three- to four-day period.
Quality of backup facilities
Banks offer various types of credit facilities
that differ widely regarding the degree of the
banks commitment to advance cash under all
circumstances. Weaker forms of commitment,
while less costly to issuers, provide banks
great flexibility to redirect credit at their own
discretion. Some lines are little more than an
invitation to do business at some future date.
Standard & Poors expects all backup lines
to be in place and confirmed in writing.
Preapproved lines or orally committed
lines are viewed as insufficient. Specific designation for commercial-paper backup is of
little significance.
Contractually committed facilities are
desirable. In the U.S., fully documented
revolving credits represent such contractual
commitments. The weaker the credit, the
greater the need for more reliable forms of
liquidity. As a general guideline, if contractually committed facilities cover 10-15 days
upcoming maturities of outstanding paper,
that should suffice.
Even contractual commitments often
include material adverse change clauses,
allowing the bank to withdraw under certain
circumstances. While inclusion of such an
escape clause weakens the commitment,
Standard & Poors does not consider it criticalor realisticfor most borrowers to
negotiate removal of material adverse
change clauses.
In the absence of a contractual commitment,
payment for the facilitywhether by fee or
balancesis important because it generally creates some degree of moral commitment on the
part of the bank. In fact, a solid business relationship is key to whether a bank will stand by
its client. Standardized criteria cannot capture
or assess the strength of such relationships. We
therefore are interested in any evidencesubjective as it may bethat might demonstrate
the strength of an issuers banking relationships. In this respect, the analyst is also mind-
58
ful of the business cultures in different parts of

the world and their impact on banking relationships and commitments.
Dependence on just one or a few banks
also is viewed as an unwarranted risk.
Apart from the potential that the bank will
not have adequate capacity to lend, there is
the chance it will not be willing to lend to
this issuer. Having several banking relationships diversifies the risk that any bank will
lose confidence in this borrower and hesitate to provide funds.
Concentration of banking facilities also
tends to increase the dollar amount of an
individual banks participation. As the dollar amount of the exposure becomes large,
the bank may be more reluctant to step up
to its commitment. In addition, the potential requirement of higher-level authorizations at the bank could create logistical
problems with respect to expeditious access
to funds for the issuer. On the other hand, a
company will not benefit if it spreads its
banking business so thinly that it lacks
a substantial relationship with any of
its banks.
There is no analytical distinction to be made
between a 364-day and a 365-day facility.
Even multiyear facilities will provide commitment for only a short time as they
approach the end of their terms. It obviously
is critical that the company arrange for the
continuation of its banking facilities well in
advance of their lapsing.
It is important to reiterate that even the
strongest form of backupa revolver with
no material adverse change clausedoes
not enhance the underlying credit and does
not lead to a higher rating than indicated by
the companys own creditworthiness. Credit
enhancement can be accomplished only
through an LOC or another instrument that
unconditionally transfers the debt obligation
to a higher-rated entity.
Banks providing issuers with facilities for
backup liquidity should themselves be
sound. Possession of an investment-grade
rating indicates sufficient financial strength
for the purpose of providing a commercialpaper issuer with a reliable source of funding. There is no requirement that the banks
credit rating equal the CP issuers rating.
Nonetheless, Standard & Poors would look

askance at situations where most of a companys banks were only marginally investment grade. That would indicate an
imprudent reliance on banks that
might deteriorate to weaker, non-investment-grade status.
Documentation for CommercialPaper Program ratings
Company letter requesting rating;
Copy of board authorization for program;
Indication of authorized amount;
Indication of program type (e.g., 3(A)3,
4(2), ECN, euro);
Description of use of proceeds;
Listing of dealers (unless company is a
direct issuer); and
Description of backup liquidity (including
list of bank lines, giving the terms of the
facilities, the name of each bank participating, the commitment amount, and the form
of the commitment).
Accordingly, we believe the tenor of any
backup facility with a hard maturity needs to
be at least 180 days. The rating level of the
company while it is still issuing commercial
paper is not a consideration.
Preferred Stock
Preferred stock carries greater credit risk than
debt in two important ways: The dividend is
at the discretion of the issuer, and the preferred represents a deeply subordinated claim
in the event of bankruptcy. Prior to 1999,
Standard & Poors used a separate preferred
stock scale. In February 1999, the debt and
preferred stock scales were integrated.
Accordingly, now, preferred stock generally is
rated below subordinated debt. When a companys corporate credit rating is investment
grade, its preferred stock is rated two notches
below the corporate credit rating. For example, if the corporate credit rating is A+, the
preferred stock would be rated A-. (In case
of a AAA corporate credit rating, the preferred stock would be rated AA+.) When the
corporate credit rating is non-investment
grade, the preferred stock is rated at least
three notches (one rating category) below the
corporate credit rating. Deferrable payment
Standard & Poors
debt is treated identically to preferred stock,

given subordination and the right to defer
payments of interest.
Financial instruments that have one of
these characteristics, but not both (for example, deferrable debt with a senior claim), generally are rated one notch below the
corporate credit rating for investment grade
credits, and two notches below for speculative grade credits.
There are situations in which the dividend
is especially jeopardized, so notching would
exceed the guidelines above. For example,
state charters restrict payment when there is a
deficit in the equity account. This can occur
following a write-off, even while the company is healthy and possesses ample cash to
continue paying. Similarly, covenants in debt
instruments can endanger payment of dividends, even while there is a capacity to pay.
Also when there is an unusually large dividend burden, there is greater risk to that dividend. If preferred issues total over 20% of
the companys capitalization, it normally
would call for greater differentiation of
the preferred rating from the corporate
credit rating.
On the other hand, the right to defer can in
some instances be constrained by virtue of
financial covenants. In others, the discretion
to defer is limited by the remedy that preferred holders possess to take over the issuing
entity and liquidate its assets. Note, however,
that such situations are exceptional and normally pertain to negotiated, privately placed
transactions. Yet there do exist a handful of
preferred issues that are rated pari passu with
the companys debt (in some cases, senior
debt). In all cases, the risk of deferral of payments is analyzed from a pragmatic, rather
than a legal, perspective.
If a company defers a payment or passes on
a preferred dividend, it is tantamount to
default on the preferred issues. The rating is
changed to D once the payment date has
passed. The rating usually would be lowered to
C in the interim, if nonpayment were predictablee.g., if the company were to
announce that its directors failed to declare the
preferred dividend. Whenever a company
resumes paying preferred dividends but
59
remains in arrears with respect to payments it

skipped, the rating is, by definition, C.
Convertible preferred
Securities such as PERCS and DECS/PRIDES
provide for mandatory conversion into common stock of a company. Such securities vary
with respect to the formula for sharing potential appreciation in share value. In the interim,
these securities represent a preferred stock
claim. Other offerings package a short-life preferred stock with a deferred common stock
purchase contract to achieve similar economics.
These issues are viewed very positively in
terms of equity creditassuming conversion
will take place in a relatively short time frame
and the imbedded floor price of the shares
makes it unlikely the company will regret and
reverse its decision to sell new common stock.
Ratings on the issue address only the likelihood of interim payments and the solvency
of the company at the time of conversion to
enable it to honor its obligation to deliver
the shares. These ratings do not address the
amount or value of the common stock
investors ultimately will receive. (We once
highlighted this risk by appending an r to
the ratings of these hybrid securities, but
now rely on the markets familiarity with
such instruments and their terms.)
Trust-Preferred stock
When using a trust preferred stock, a company
establishes a trust that is the legal issuing entity of the preferred stock. The sale proceeds of
the preferred stock are lent to the parent com-
60
pany, and the payments on this intercompany

loan are the source for servicing the preferred
obligation. In some cases, this financing structure can provide favorable equity treatment
for the company, even while the payments
enjoy tax-deductibility.
Standard & Poors rating of trust-preferred
securities is based on the creditworthiness of
the parent company and the terms of the intercompany loan. Any equity credit that might be
associated with these issues also is a function
of the terms of the intercompany loan, especially with respect to payment flexibility.
This variety of preferred was introduced in
1995 as trust originated preferred securities
(TOPrS). TOPrS represented a structural alternative for deferrable payment hybrids that had
been sold since late 1993 under the appellation
MIPSMonthly Income Preferred Securities.
The use of a trust neither enhances nor
detracts from the structure compared to the
alternative issuing entities. The legal form
of the issuing entity can be a business trust,
limited partnership, off-shore subsidiary in
a tax haven, or on-shore limited liability
corporation. What these structures have in
common is an intercompany loan with
deferral features (typically five years), no
cross-default provision, a long maturity, and
deep subordination. The preferred dividend
is similarly deferrable, as long as common
dividends are not being paid. After the
deferral period, the trust preferred holders
have legally enforceable creditors rightsin
contrast to conventional preferreds, which
provide only very limited rights.
Secured Debt/Recovery
Ratings, Overview
n 1996, Standard & Poors Ratings Services introduced criteria
that allowed for notching up certain debt obligations. If a par-
ticular obligation had reasonable prospects for full recovery, given

a default, it could be rated above the corporate credit rating.
This innovation coincided with the expansion of rating bank
loansan asset class rarely rated previously. The secured position
of many of these loans helped make it possible to analyze ultimate recovery prospects on an absolute basis. In some cases, the
collaterals value is independent of the companys business fortunes. In many others, the priority of the secured debt allows one
to conclude that there will be sufficient valueeven making harsh
assumptions about the bankruptcy scenarioto allow for full
recovery. Furthermore, the legal protection of the secured debt
removes much of the uncertainty associated with the bankruptcy
process itself (see table 1).
We apply the new framework to all secured
debtnot just bank loans. This includes first
mortgage debt issued by utilities. But, because
these issuers primarily are investment-grade
companies with more remote likelihood of
default, recovery is less relevant as an investment focus, so the weighting of recovery
prospects plays a lesser role in the rating. As
a corollary, the hurdles for justifying a notch-
Standard & Poors
up are higher as one rises in the credit-rating

spectrum. The table below shows how notching standards change as they pertain to first
mortgage bonds of companies in the various
investment-grade categories (see table 2).
In December 2003, Standard & Poors
launched its recovery ratings for secured debt.
Recovery ratings use a new scale1+
through 5. These ratings do not blend default
61
risk and recovery given default, as the conventional issue ratings do. Rather, they
express only our assessment of an issues
recovery prospects. Each rating category corresponds to a specific range of recovery values (see table 3).
Notice the correlation between the bank
loan rating and recovery rating scales. They
incorporate a crosswalk from the expected
recovery percentage to both the degree of
notching and the recovery rating level. There
are exceptions, however, including cases
where we would not notch down even
though recovery expectations are rated low,
such as poorly secured debt that is the most
senior obligation of the entity. Also, there are
cases where the notching is less generous
such as secured investment grade debt. It is
possible for the secured debt of a highly
rated company (i.e., investment grade) to
receive a recovery rating of 1 and still not
be notched above the corporate rating.
Finally, there is a maximum of two notches
that are subtracted to reflect the weak recovery prospects of junior debt. Therefore, debt
issues with recovery ratings of four and five
both get the same two notches when it comes
to the conventional rating.
Absolute trumps relative
Our more recent recovery analysis focuses on
the absolute values that may be expected in a
Table 1Notching
potential default scenario. This contrasts with

the long-standing convention in the assignment of issue ratings, which differentiated
senior and junior debt of a company merely
in relative terms. Junior issues were rated a
number of notches below the corporate rating
based on the relative position of the debt
issues of that particular company.
Now, notching up secured debt and notching down junior debt take absolute values
into account. For example, if the absolute
recovery prospect for a specific junior issue is
80 cents on the dollar or more, notching is
dispensed with. In recovery terms, if such
recovery can be reasonably anticipated, the
junior debt is not considered so disadvantaged that it should be notched below the
corporate rating. After all, this level compares
favorably with recovery associated with senior debt generally.
Note, however, that we still will not rate
the senior-most debtand particularly bank
loans collateralized with first liensbelow
the corporate ratings, based on low expected recovery. To do soand be consistent
about itStandard & Poors would have to
be prepared to rate all senior unsecured
debteven where there is no secured debt
lower than the corporate rating, according
to its recovery prospects. Analytically, that
is in most cases not feasible: Maybe some
day. (However, we would notch down even
Criteria
Secured, speculativegrade bank loan ratings
62
Ultimate recovery
of principal
Indicative recovery
expectation
Issue rating relative

to corporate rating
Highest expectation
of full recovery of principal
100% of principal
+ 3 or 4 notches
High expectation of full

recovery of principal
100% of principal
+ 1 or 2 notches
Substantial recovery
of principal
80-100% of principal
No notching
Meaningful recovery
of principal
50-80% of principal
-1 notchunless most senior
Marginal recovery
of principal
25-50% of principal
-2 notchesunless most senior
Negligible recovery
of principal
0-25% of principal
-2 notchesunless most senior
such bank debt when indicated, by the

threshold method. For example, if lease
assets and/or securitizations exceed the
15%/20% or 30% thresholds.)
or private debt markets. Because the probability of their defaulting is low, post-default recovery is of little relevance. For these reasons, it
would be unusual to find bank loans of investment-grade companies that deserved a rating
higher than the entitys corporate credit rating.
Bank Loan Rating Methodology

Both syndicated bank loans and privately
placed debt frequently provide collateral
designed to protect the lender against loss if
the borrower defaults. In assigning ratings to
bank loans and private placementsboth the
conventional debt ratings and the more recent
recovery ratingsStandard & Poors takes
loss-given-default into account when analyzing the recovery prospects of a specific loan.
To the extent a loan is well-secured or contains other loan-specific features that enhance
the likelihood of full recovery, the debt rating
on that loan can be higher than the borrowers corporate credit ratingand it will
receive a high recovery rating.
Globally, creditor rights vary greatly,
depending on legal jurisdiction. Wellsecured debt of borrowers subject to the
U.S. Bankruptcy Code generally receives a
rating one or two notches higher than the
corporate credit rating. Even greater weight
could be given to collateral elsewhere in the
world where legal jurisdictions may be more
favorable for secured creditors, allowing an
enhancement of three or four notches. On
the other hand, no consideration is given
for security in many countries such as
China, where the bankruptcy process is
virtually unpredictable.
Highly rated issuers generally are not expected to provide much collateral or other postdefault protection when raising funds in public
Table 2Notching
Determining ratings
The starting point for assigning a bank loan
rating is determining the borrowers default
risk, based on an analysis of the companys
business strength and financial risk. The
result is the corporate credit rating. The
analysis then proceeds to the recovery aspects
of a specific debt issue. Regarding recovery
ratings, which purely address the recovery
prospects, the likelihood of default is irrelevant. Still, the circumstances surrounding a
potential default are highly germane to the
recovery outcome. So comprehending the
default scenario is part of every analysis.
We analyze the issues legal structure and
the collateral that supports each issue. The
recovery risk profile is established by assessing the characteristics of various asset types
used as collateral and subjecting the collateral
values to stress analysis under different postdefault scenarios. High collateral coverage
levels can increase confidence that asset values will cover the secured debt, even under
adverse conditions, although greater levels of
collateral obviously do not entitle a creditor
to any more than the amount of the claim.
When the collateral value exceeds the
amount of the claim, the creditor could also
receive post-petition interest. This excess collateral value is referred to as an equity cushion.
The creditor must carefully manage his legal
posture to take advantage of this cushion and
Criteria
First mortgage bonds of investment-grade utilities

Corporate rating
Asset value/secured debt (x)
Notches above corporate rating
A and above
BBB
B and BB
Standard & Poors
1.5
1.5
63
receive interestwhile still asserting entitlement to the courts adequate protection of

the collateral. Accordingly, our rating criteria
recognize the advantage of a specific issue that
may be a candidate to be paid post-petition
interest, even though it is almost impossible to
accurately predict such an outcome.
Default scenarios
The analysis of recovery prospects for secured
debtwhich underpins the assignment of
both conventional issue ratings and recovery
ratingsfocuses exclusively on the value of
collateral in the post-default scenario. The
current value of the collateraleven if
stressed for various economic contingencies
is not relevant. The only meaningful stress
scenario is the one consistent with the
default. This is true whatever method is used
to appraise the collaterals value, be it discounted cash flow of the enterprise, transaction prices of discrete assets, market-multiple
conventions, capitalization rates, or some
other approach.
Comprehending the default scenario is perhaps the most challenging aspect of lossgiven-default analysis. In a limited number of
situations, the default may be imminent, so
the context is already set. But in most cases,
it is necessary to make certain assumptions.
The analyst must be creative, but avoid
engaging in excessive conjecture or speculation. The higher the companys corporate rating, the more remote its risk of defaultand
the more obscure the default scenario.
In the absence of a more specific view, we
use a generic model for default scenarios: the
companys projected cash flow (EBITDA) will
have fallen below its financial burden of proTable 3Recovery
jected interest and debt amortization. (When

a company engages in significant leasing of
assets, the appropriate measure is coverage of
interest and rental expense by EBITDAR.)
The model sets a base level for post-default
cash flow, while the risk of a still-lower level
must be taken into account, as well. The
validity of this tool is intuitive, and is also
supported by some empirical evidence.
However, the potential cause of such
decline in a companys current EBITDAto
the level of EBITDA associated with
defaultneeds to be understood. The implications for the collateral values will vary,
depending on the underlying reasons for the
companys decline. Figuring all this out
especially well in advance of a company
experiencing problemscan be analytically
challenging. Moreover, there often are several
factors, rather than a single factor, that
together cause a default. Accordingly, cashflow multiple valuations works best for companies that are presently highly leveraged.
Their default can be expected to result from
the high level of financial burden, even while
the companys business fundamentals are not
drastically impaired.
The model is less accurate where default
risk is associated with potential declines in
the business fundamentals. And the model
does not apply wherever the risk of default is
associated with vulnerabilities such as litigation, acquisition activity, or liquidity crisis. In
all such situations, the analysis must substitute other approaches to model a default scenario that is consistent with the thinking
behind the current rating. For example, many
companies have low ratings because of a perceived propensity to use debt for acquisitions
Ratings
Secured Debt
Ultimate recovery of principal
64
Indicative recovery expectation
Recovery rating
Highest expectation of full recovery of principal
100% of principal
High expectation of full recovery of principal
100% of principal
1+
1
Substantial recovery of principal
80%-100% of principal
Meaningful recovery of principal
Marginal recovery of principal
Negligible recovery of principal
0%-25% of principal
of other businessesor to buy the companys

common stock. In these instances, the companys ability to service its current debt is
greater than its rating would indicate. The
real concern is that the company will take on
more debt, and subsequently lack the cash
flow to service that increased corpus of debt.
Accordingly, the default scenario to be used
in loss-given-default analysisand the related
EBITDA/interest ratiomust focus on the
projected increased debt level, rather than the
current amounts.
Similarly, in the current low-interest-rate
environment, many companies risk of
defaultand, in turn, their credit ratingsis
based on the assumption that interest rates
will rise (unless they have locked in low rates
with fixed rate, long-tenor debt). Indeed, current coverage ratios for many companies
would otherwise seem out of line with their
low ratings. Default scenarios for loss-givendefault analysis relating to these companies
will, therefore, reflect an inability to service
the potentially higher interest amounts.
In these two examples, the enterprise value
in the default scenario would be appreciably
higher than if current debt or interest
amounts are used in the calculation.
In the same vein, a default could occur if
creditors accelerate their loans or force a
restructuring upon breach of covenantswell
before the company runs out of money, so
to speak. The creditors motivation would be
to preserve recovery values by precipitating
an early default, i.e., prior to potential further declines in the business cash-generating
capacity. Default would then be linked to
covenant levelsordinarily a multiple of
interest expenserather than actual interest
expense levels.
However, the reality is that bankers normally waive covenant breaches (although
they could well extract a payment or obtain
security for doing so). It is exceptionally difficult to predict in advance the minority of
companies that will find their bankers taking
the more radical position of pulling the plug.
Similarly, companies might default if they
cannot refinance a large maturityand,
indeed, such a risk does occasionally drive
the rating outcome. Yet, most companies
that generate enough EBITDA to service
Standard & Poors
their debt do mange to refinance. Especially

in the current flush financial markets, it is
rare to see companies that cannot attract
new debt financing.
Note, too, that if the default scenario were
based on presumed intervention upon breach
of covenants, the corporate rating would also
have to reflect this expectation. As pointed
out before, there must be consistency regarding the default scenario underlying the corporate rating and the recovery analysis. The
effect of this would be greater default risk
and lower corporate ratings. (Any notching
up would then be from a lower base.)
Collateral Value Analysis

Collateral can consist of discrete assets (such
as accounts receivable, real estate, or vehicles) that have value independent of the
business, discrete assets that are linked
directly or indirectlyto the business fortunes (inventory, production equipment), or
the business enterprise itself. Bank loans to
below-investment-grade issuers tend to have
a first-priority lien on substantially all of a
companys operating assets: receivables,
inventory, trademarks, patents, plants, property, equipment, and pledges of subsidiary
stock. In effect, they have the entire enterprise as collateral. Indeed, the whole is usually worth more than the sum of its parts, as
long as the business enterprise continues as a
going concern. (Private-placement debt
issues are more likely to be secured by one
or more discrete asset types.)
All types of collateral can enhance a creditors rights and help ensure loan recovery,
even though it is rare that a creditor will be
able to simply foreclose and seize the collateral to liquidate it. In the U.S. at least, a bankruptcy filing imposes a stay on a creditors
right to the collateral during what is often a
long and tortuous reorganization process.
Moreover, the bankruptcy judge often has
wide discretion (although seldom exercised)
to substitute collateral. Indeed, most large
company bankruptcies never result in liquidation: the company is usually reorganized.
(The decision of whether to reorganize is
influenced by a myriad of factors, including
the legal system, industry trends, perceived
65
long-term viability of the business, and regulatory or political considerations.) The form
the reorganization takes, including the resolution of creditors claims, is the result of a
negotiated process worked out before or after
an actual bankruptcy filing.
Nonetheless, the outcome for creditors ultimately is a function of the collaterals value
going into the reorganization process. For
example, bankruptcy judges can substitute
collateral, but they must adhere to the principle of adequate protection by providing
collateral of comparable value to that of the
original. So, knowing the value of the collateralrelative to the amount owedprovides
an approximation of just how well a creditor
is secured.
Consequently, the bank-loan analysis
focuses on determining the value of the various asset types. The valuation analysis that
produces the higher asset value should be
used in determining the bank loan rating.
Generally, if the business operating assets are
all part of the security package, thinking of
the collateral as a going-concern business
would yield the highest values. That explains
why the enterprise-value analysis is performed regularly. However, given the nature
of the enterprise-value methodology, this
appropriately is used only when the default
scenario can be reasonably visualized, e.g.,
for highly leveraged companies. In these
instances, the business presumably continues
without drastic changes, while the financial
overextension leads to default when the company can no longer service its entire fixedcharge burden. The enterprise value analysis
cannot usually be used for investment-grade
companies or for speculative-grade companies
with conservatively leveraged balance sheets
(and whose default risk is based on some serious business vulnerability). Instead, a liquidation analysis is conducted to determine the
projected value of the specific assets that constitute such companies collateral.
Enterprise-Value analysis
Enterprise value is established by using a discounted cash flow calculation, or, as a shortcut, a general market-multiple approach. The
companys EBITDA (or, where applicable,
EBITDAR) at the hypothetical point of
66
default is multiplied by a representative valuation multiple. (The value established

assumes investors would finance the unit with
a combination of debt, leasing, and equity).
Appropriate discounts are applied to stress
both cash flow and capitalization rates used
to determine the value of the business.
EBITDA is projected to reflect the decline
in cash flow at the time the company defaults.
For this analytical exercise, the analyst simulates default scenarios. First, a base case is
constructed that represents the minimum
decline in EBITDA associated with a potential
default. In this scenario, EBITDA falls short
of the companys periodic interest and debt
amortization payments. This scenario results
in maximum cash flow consistent with a
default and, therefore, equals the highest
potential value for the defaulted company.
Second, an alternative scenario is proposed,
under which normalized EBITDA is reduced
to a greater extentusually 50% or moreto
reflect other possible, more stressful default
scenarios. Additional scenarios, with different
reductions, can reflect company-specific
default factors, such as sector risk, political,
regulatory, or other factors. The more negative scenario is not automatically used in the
rating determination; analysts must judge
which scenario is appropriate based on the
companys individual circumstances.
As explained earlier, a borrower with a
respectable business position but a risky
financial profile would be more likely to
default (if a default occurs at all) because of
its leverage than because of a decline in its
business strength. Such an entity would be
viable over the long term if it were more
appropriately capitalized. The base-case scenario would be weighed more heavily. By
contrast, a borrower with a weak business is
more likely to default because of a decline in
its business (failure to keep up with competition, changes in technology, etc.). The impairment of its business associated with the
default scenario could more seriously affect
its cash flow and market value. Accordingly,
the weighting would lean toward the downside risksor we would decide to abandon
the enterprise-value approach altogether.
The cash-flow multiple used in the enterprise valuation model takes into account the
market multiple of the borrowers peer group.

(This market multiple would always have to
be adjusted to incorporate the negative effect
a bankruptcy filing.) Cash-flow multiples, of
course, change. If for no other reason, they
should fluctuate with prevailing interest rates.
For rating purposes, 5x has some empirical
validity over the long termand we cannot
predict interest rates at the unspecified time
of the simulated default. Actual experience
with sales of distressed companies shows the
5x multiple to be widely applicable.
A higher multiple might in some instances
be warrantedfor example, if an industry
has unusual growth potential. However, one
must be cautious about arguing for a higher
multiple for a company in a very troubled situationi.e., following a bankruptcy filing. It
is hard to be confident that the industry
would still have such positive characteristics
in that context. When the insolvency risk can
be attributed to a cyclical problem, there
might be some predictability of a post-default
rebound. That should warrant using a higher
multiple of the cash flow at a cyclical low
point, which presumably would coincide with
the point of default.
To be conservative, any priority claims
such as product or environmental liabilities
that are material would be deducted from the
enterprise value. Similarly, the value of other
existing secured debt, such as industrial revenue bonds or mortgage debt, is subtracted
from the enterprise value. In some instances,
trade creditors could have a perfected firstpriority interest in merchandise, and the bank
creditors would have a lower-priority claim
on inventory. Importantly, to the extent the
company relies on operating leases to generate its cash flow, an amount must be subtracted from the capitalization to represent
the ongoing lease obligation.
The enterprise value analysis also assumes
any revolving portion of a bank credit facility
is fully drawn at the time of default.
(However, this harsh assumption is not automatically made regarding notching down any
unsecured issues.) In some cases, assumed
borrowings under the rated facilities are earmarked for acquisitions. In these instances,
the default EBITDA levels would be adjusted
for the additional cash flow from these acqui-
Standard & Poors
sitions. The effect is adequately dealt with in

the base-case scenario, but adjustment is
called for in the downside case. Given the
likelihood that most acquisitions will not be
totally productive, the full amount of cash
flow normally attributable to the borrowings
is not added to EBITDA. The conservative
position is to add 50% of the new cash flow
to the EBITDA figure.
Standard & Poors default scenario is modeled on EBITDA being insufficient to cover
interest and amortization payments. As
noted, other scenarios may affect the timing
of a default. For example, a company may
not be able to meet its amortization schedule
or a bullet maturity, precipitating a default.
Other large required outlaysincluding
nondiscretionary capital expenditurecould
have a similar effect on a wobbly company.
In such cases, the cash flow associated with
the default scenario should be higher than the
usual base-case default assumptions.
However, (re)financing risk ultimately is
related to a companys prospects. As long as
prospects for a company suggest an ongoing
ability to service its debt, lenders should
make financing available. The distressedEBITDA default scenario generally reflects
conditions that preclude refinancing.
Discrete-Asset value analysis
Standard & Poors has rated loans backed by
a broad range of assets, from real estate and
drilling rigs to timberlands and oil and gas
reserves. Important considerations include the
type and amount of collateral, whether its
value can be objectively verified, and how
likely will it hold up under various postdefault scenarios, along with any legal issues
related to perfection and enforcement.
The analytical starting point is the assets
current value. Market value is key, and therefore appraisals often are required. Several
methods are used to determine the market
value, including recent sales of comparable
assets and the assets replacement cost, adjusted to reflect their age and technology. Other
valuation techniques include discounting cash
flow, industry norms and multiples of earnings
and cash flow, and replacement value and fixed
prices per unit of production (for natural
resources). Although all valuation methodolo-
67
gies rely on some subjective aspects, the more

objective the valuation, the better. (As noted,
however, the relevant value is the value of the
asset in a distressed scenario. To one degree or
another, the companys asset values normally
will be affected by the default scenario, when it
is not business as usual.)
Book values typically are irrelevant, but
may sometimes suffice to establish the starting pointif historical price and depreciation policies are standardized, and
depreciation schedules are adequate to keep
book value in line with market value. Two
examples of assets for which this approach
has been used are shipping containers and
autos. Appraisals usually are necessary when
the collateral is specialized, such as real
estate, plants, or equipment.
The assets potential to retain value over
time is critical. Even if not directly linked to
the companys fortunes, asset values fluctuate
and need to be stressed. Therefore, collateral
is judged according to volatility, liquidity,
special-purpose nature, and any correlation
of its value with the health of the issuers
industry. Even assets that have value independent of the specific owner may still be
correlated to industry or market factors.
Because the relevant context is the default of
the assets owner, the analyst must be mindful
that the circumstances leading to a default
might also affect the assets values. For example, if the borrower were a supermarket chain
and the collateral were its fleet of trucks, the
assets value would not be reduced by the
companys default. But, if the borrower were
an offshore contract driller and the collateral
were its fleet of vessels, there might well be a
strong correlation between the events leading
to the companys default and the market
value of its drilling ships.
Also, if proper upkeep is critical to the
assets value, there might be some doubt
about how much maintenance a failing company would provide. Any costs that would
have to be expended to realize asset values
also must be taken into account. These
include dismantling installation, transportation, foreclosure, and remarketing costs,
among others. On the other hand, the analysis would be based on an orderly liquidation
scenario, rather than a fire sale.
68
Springing liens.
Springing liens, as the name implies, are
liens that become effective once a companys
credit quality deteriorates to a predetermined
level. This level normally reflects the point at
which creditors would become concerned
about the possibility of default and bankruptcy.
Often, the trigger for springing the lien is tied
to a reduction in Standard & Poors rating.
As far as rating criteria for corporate ratings, these liens ordinarily are considered
identical to liens that already have been perfected, because they likely will be in effect
by the time that security is relevanti.e., in
bankruptcy. (In the case of structured entities and hybrids, the approach we take is
radically different because such entities
might well preemptively file for bankruptcy
protection to avoid an elevation in the status of claims against their assets by becoming secured.)
The corporate approach applies to both
notching up and notching down. Bank loans
containing springing liens can be notched
up immediately; unsecured issues are to be
notched down immediately to reflect their
ultimately disadvantaged position in bankruptcy to loans that contain springing liens.
However, one can never completely take
for granted the ability to perfect a lien. This
legal risk would force some distinction
between security that already has been perfected and security that still requires perfection. In practice, this factor could serve as a
damper against assigning a rating two or
more notches above the corporate credit
rating in cases that would otherwise deserve
such substantial enhancement.
A lien also cannot be perfected when a
company is in bankruptcy, and problems
regarding preference may apply if the lien
springs close to a filing. That makes it
important to have the trigger level correspond to a point in time that presumably
will come well before a default. If a rating
trigger for springing the lien is BB- or
higher, we would expect the lien to be legally enforceable, expecting such a rating to
apply well ahead of any bankruptcy filing.
Conversely, some liens are designed to fall
away. The effect of this potential removal of
the security feature should be reflected
immediately. A typical example would be a

five-year loan secured only for the first year
or two. In that instance, the rating should
ignore the security, given its temporary
nature (unless the corporate credit rating is
very low, in anticipation of imminent
default). Another arrangement allows the
lien to fall away when the corporate credit
rating is raised. In that case, the loan rating
can be enhanced at the outsetto the extent
that it would remain at that level even after
the security lapses, consistent with the higher corporate credit rating at that point.
Second liens
The bank loan rating for second-lien debt
can range from being notched above the
corporate credit rating, to the same as the
corporate credit rating, to below the corporate credit rating by one or two notches.
The key is to analyze the expected recovery following any potential default in
absolute terms. The methodology outlined
below supercedes our earlier approach,
which merely addressed the relative disadvantage of the second-lien debt by considering the amount of priority debt.
These steps are followed:
Analysts should compute coverage levels
for the first-lien debt.
Next, compute the coverage for the aggregate of first- and second-lien debt. The
coverage levels will indicateas a first
passhow confident we are about the
recovery for the second-lien debt.
However, the second-lien debt is not as
well protected as the aggregate numbers
would suggest, given the priority of the
first-lien debt. One way to think about it:
There is greater sensitivity to coming up
short for the second-lien debtwhich is
at the bottom rungthan would be the
case for one aggregate debt amount. Put
differently, even if the coverage levels for
the first- and second-lien debt are close
i.e., in the arithmetic sense, for this one
crude measurethe actual protection levels are very different in qualitative terms.
This leads to a simple rule, which can
serve as a reality check: We do not rate
the first- and second-lien debt the same,
for conventional ratings that are above
Standard & Poors
the corporate credit rating. (However, it is

acceptable to have the same recovery ratings, given the range of outcomes represented by those ratings. And it is also
acceptable to be notched down by the
same degree when taking into account
the maximum gapping allowed by
Standard & Poors for the various classes
of junior debt.)
Once the bank loan rating is assigned
based on the steps above, the recovery perspective carries over to the recovery ratings.
Some examples:
If the first-lien debt is two notches above
the corporate credit rating, the second-lien
debt can be as high as one notch above,
assuming we are confident they too would
recover 100%. The recovery ratings would be
1 for both.
If the first-lien debt is one notch above the
corporate credit rating, the second-lien debt
can be the same as the corporate credit ratingas long as we are confident of 80%
recovery. The recovery ratings would be 1 for
the first-lien debt, and 2 for the second-lien
debt. Even if the raw numbers indicate 100%
recovery for the second-lien debt, the best it
can be rated is equal to the corporate credit
rating, i.e., one notch lower than the first-lien
debt: therefore, a recovery rating of 2.
In cases where the first-lien debt is rated at
the same level as the corporate credit rating,
the second-lien debt can be rated at that
levelat least theoretically; it could also be
rated lower, depending on the fact pattern.
The best case would be one where the firstlien debt is relatively small in comparison to
the assets of the company, so that the disadvantage it poses to the second-lien debt is
below Standard & Poors typical threshold
levels. If the amount of the second-lien debt
also is small, relative to the corporate assets,
that could translate into recovery ratings of
2 for both the first- and second-lien debt
i.e., at least 80% recovery.
Normally, however, the second-lien debt
recovery prospects would be viewed as
worsethe result of coming behind the priority debt or the lack of valuable collateral in the
first place. They then could be rated one or
more notches behind the first-lien debt. If the
analysis indicates they can be expected to
69
recover 50% to 80%thus corresponding

with a recovery rating of 3then the bank
loan rating would presumably be at least one
notch down (from a noninvestment grade corporate credit rating). If the recovery prospects
were deemed still worseonly 25% to 50%
the recovery rating would be 4; the bank
loan rating normally would be two notches
below the corporate credit rating.
In some cases, the first-lien debt also may
be viewed as weak in terms of recovery
prospects, and so might have a recovery rating of 3 or 4. Nonetheless, the first-lien
debtas the senior-most debtwould not be
notched down, as noted above.
Borrowing bases
A borrowing base sets a limit on borrowing
based on a percentage of the assets outstanding at a given time. The borrowing-base definitions of eligible assets are used to exclude
impaired assets such as overdue receivables or
obsolete inventory. If the analyst is comfortable with the borrowing base formula at the
outset, its applicability can be relied on over
time. The amount of any new borrowings
would depend on the quality and value of
then-current assets, although risk remains for
what has already been borrowed. For example, the borrowing base may require an
amount of oil and gas reserves as collateral.
But once the advance is extended, the oil is
produced, and there can be no guarantee that
new oil will be found to replace it.
Ideally, as oil is produced or inventories are
sold and receivables are collected, the proceeds
must be used to repay bank borrowings, and
renewal of borrowing means once again meeting the tests. But often, this is not the case.
Nonetheless, the proximity of the valuation to
the time of the ultimate default, as well as
potential limitation of exposure to further
deterioration are advantages. Periodic monitoring allows the banker to exercise some control. It is therefore important to know how
frequently compliance with the borrowing
base is calculated and what remedies are available if the base is exceeded. The definition of
eligible assets obviously is critical.
The path to bankruptcy could involve a
major drop in asset values, even if the default
scenario incorporates an inventory buildup
70
resulting from a decline in sales. Unit value

may slip as inventory piles up. Accumulation
of aging, uncollectible receivables also is possible, but less common. Credit agreements often
have sublimits on inventory borrowings in relation to total borrowings, to guard against just
such unfavorable shifts in the collateral mix.
Stock as collateral
Being secured by a pledge of a business units
stock is not the same as being secured by the
assets of that unit. The stock represents only
the residual value after all claims directly
against the unit have been satisfiedand may
in the end be worthless.
The criteria, however, do not preclude
assigning value when shares are the collateral.
Shares of the borrowerwhich would be
bankrupt in the relevant scenariopresumably would have little value. The same would
apply to the shares of major subsidiaries of a
bankrupt borrower, especially if the companies are in the same general line of business.
However, shares of a subsidiary in a different
line of business, or of a subsidiary abroad
that has independent business prospects, may
retain value, even if that subsidiary is drawn
into the bankruptcy.
(Standard & Poors Ratings Services legal
team has researched the risk of substantive
consolidation, and concluded that it is remote
in nearly all cases.)
The key analytical issue would be the risk
the subsidiary is weakened financially by
actions of its parent as the parent struggles to
stave off its own default. Even if that unit has
few liabilities now, there must be legal or regulatory restrictions that prevent incurring
additional debtor the residual value of the
shares could be diminished.
Subsidiary stock has been an effective
way of providing valuable security in cases
when assets could not be pledged directly
e.g., certain licenses and contracts. The
licenses are set aside in dedicated subsidiaries, typically as their sole assetswhile
liabilities are strictly limited.
Tenor/amortization
Long-term concerns that could constrain a
corporate credit rating may extend beyond
the time horizon of an issue or bank loan
facility. Therefore, a short final maturity may

be favorable. (Unsecured debt issues do not
benefit similarly from shorter maturities,
because they normally are repaid by refinancing. The issues long-term risk profile would
affect the refinancing risk.)
In addition, because confidence in asset
valuations diminishes over a longer time
span, the ratings benefit that could be given
for asset-based recovery potential is greatest
for short-term loans. For example, at a given
time, the outlook for energy markets may
cause little concern for the value of oil rigs
for the next two or three years, but great
concern about potential loss of value over a
12-year period. Also, the risk of obsolescence
or regulatory restrictions increases over time
for certain types of assets such as aircraft.
Similarly, when assessing a potential bankruptcy scenario, doubts about how operating
assets might be affected would be greater if
bankruptcy proceedings are anticipated to be
lengthier than normal.
Amortization reduces the amount of debt
that must be covered by the value of the assets,
and thereby improves loan-to-value coverage
(unless the security is reduced in tandem via a
borrowing-base formula). Accordingly, if one
tranche of a loan facility amortizes more quickly or is significantly shorter than another, the
two tranches could be rated differently.
Legal considerations
For collateral to be given weight in the rating
process, lenders should have a perfected security interest in the collateral. Perfection can
be accomplished in a number of ways, including Uniform Commercial Code filings in the
U.S., possession, title, and regulatory filings.
Not all collateral types (e.g., patents and
trademarks) readily lend themselves to perfection. And some assets, such as cargo containers, may be easy to perfect but hard to locate
and recover if they are in foreign countries at
the time of a bankruptcy filing. Uncertainty
about gaining possession of part of the collateral can sometimes be offset by providing
greater overcollateralization.
Tight covenants
Covenants alonein the absence of collateralseldom result in a higher debt rating,
Standard & Poors
although there could be a boost for the

recovery rating.
As far as default risk, if the covenant
breach were to arise from deterioration in the
business, the banks enforcement will only
compound the problem. If the bank refuses to
provide more fundsand especially if it
requires immediate repaymentthe companys liquidity will suffer and the risk of default
increases. The best-case scenario would be
one in which the bank waives or renegotiates
the covenant without penalizing the company
by way of compensation or tougher terms.
If the potential covenant breach is linked to
a proposed credit-harming transaction that is
discretionary, the bank could force the company to abandon the transaction. But, if the
bank waives the covenant, or if the company
manages to refinance the bank loan as part of
its deal, the covenant will not have benefited
the companys default-risk profile.
Accordingly, tight covenants theoretically
could benefit the corporate credit rating, but
more often do not. Rating enhancement
would apply only when:
Concern over a deliberate credit-harming
event is the specific rating factor that prevents a higher rating (situations in which the
rating explicitly takes into account such an
expectation or event risk are uncommon
except in the context of a parent tapping the
financial potential of a subsidiary); and
The covenants would have to be tight
enough to prevent any transaction inconsistent with the higher rating level; and
We could be confident in advance that the
bank would not waive the covenant, and
could not (easily) be replaced. In reality,
the banks waiver or alternative financing
should be available for reasonable credits
i.e., wherever the rating outcome following
the transaction is BB- or better.
Enforcement of the covenants and precipitating a bankruptcy might indeed benefit the
bank in terms of ultimate recovery of principal from a deteriorating situation. The bank
would be seeking repayment early on, while
the business retained greater value. However,
the rating outcome for the bank loan would
not necessarily be higher than it would be
without the tight covenantsand might even
be lower: Increased notching would presum-
71
ably be from a lower corporate credit rating,

given the increased risk of default.
If the covenant breach arises from a discretionary transaction, the bank could avoid
riskif not by preventing that transactionby
insisting that it be taken out by other financing. The rating benefit to the bank loan itself
would still depend on the extent to which such
a potential credit-harming transaction plays a
role as a rating factor in the first place. The
more prominent the transactions role in the
ratingi.e., to the exclusion of concern for
ordinary, fundamental risksthe more the
potential that tight covenants could mitigate
risk and enhance the assigned rating.
Debtor-In-Possession
(DIP) Financing
Because adequate funding is key to a companys potential for reorganization and emergence from bankruptcy as a viable entity, the
U.S. Bankruptcy Code provides incentives for
lenders to finance companies operating under
the protection of Chapter 11. Such post petition financing is known as debtor-in-possession (DIP) financing.
Our criteria for rating DIP loans extended
to companies in bankruptcy employs the conceptual framework developed for bank loan
ratings. The analysis for these DIP loans consists of two parts:
The first focuses on timely repayment; and
The second focuses on the particulars of
the specific loan and the potential for
recovery on that loan in the event
liquidation (a shift to Chapter 7)
becomes necessary.
Timely payment
In the case of DIP loans, timely payment of
principal occurs through the debtor-in-possessions reorganization, its emergence from
Chapter 11, and repayment of the DIP loan.
Such payment is considered timely and in
accordance with the terms of the agreement
not withstanding the possibility of a stated
earlier maturityin keeping with the normal
expectations. DIP lenders generally are tied in
for the duration of the reorganization process.
This part of the analysis considers the likelihood of reorganization. A favorable assess-
72
ment is likely for viable companies, particularly for large, established entities. If the
operation is fundamentally healthy, but the
company is saddled with debt because of a
leveraged buyout (LBO), a recapitalization,
or an overpriced acquisition, its ability to
service a more appropriate debt load via reorganization might be quite strong.
However, if there were any significant
doubt about the companys viability, the
result probably would be a speculative-grade
outcome. A failed company in an industry
with poor fundamentals or with a seriously
flawed business model would be a lesser candidate for rehabilitation and refinancing.
Accordingly, much of the analysis is identical to the fundamental corporate credit analysis relating to a company in the context of its
particular industry. This analysis focuses on
the supply-and-demand forecasts for the companys products, its market position, operating history, current cash flow, and ability to
operate profitably once it has a manageable
capital structure. These factors are much the
same as would be considered in assigning a
credit rating to a non-bankrupt company. Of
course, the impact of the bankruptcy itself
on the companys business relationships with
its customers, its vendors, and its employeesis critical in the case of a DIP loan.
One important difference from other rated
instruments is the relatively short time horizon for a DIP loan (often six months to two
years), which obviates some of the longerterm considerations factored into traditional
ratings. In rating a DIP loan, we focus on
longer-range factors only to the extent they
affect the companys ability to reorganize.
Once the company has filed for Chapter 11
protection, pre-petition debt service usually is
suspended. Obviously, there will be debt service on the rated loan and there may be other
obligations the court has approved for continuing payment. If there is secured debt, the
company generally will accrue post-petition
interesteven if no cash payments are being
madeto the extent the value of the security
exceeds the amount of the debt. It is imperative to be aware of any motions that may be
filed on behalf of pre-petition creditors to
receive payment of their claims, adequate protection for their position, or otherwise contest
the DIP loan. The company may be planning

asset sales, store closings, or lease cancellations, all of which could have a bearing on the
level of cash flow the company can generate
and its attractiveness as a viable candidate for
fresh financing to take out the DIP lenders.
Collateral and ultimate recovery
The second part of the rating analysis looks at
the particulars of the specific loan and its
recovery potential in the event of liquidation.
As with collateralized loans to non-bankrupt
companies, the rating may be enhanced by
one or several notches, if there is a reliable,
second way out.
Strong legal protection is a hallmark of
DIP lending, and so it would be normal to
expect some enhancement of the DIP loan
rating: Thus, the rating is anchored by the
perceived likelihood of reorganization, and
supplemented by the potential for recovery
through asset liquidation.
We analyze collateral with a focus on its
ability to retain value through a liquidation
process. A conservative valuation of the collateral should cover the loan by a safe margin (see
Bank Loan and Private Placement Rating
Criteria). This would be the case if a company entered Chapter 7. Receivables and inventory often are the collateral supporting typical
industrial DIP loans. This collateral is among
the most liquid types, and typically governed
by conservative borrowing bases.
Legal status
Section 364 of the U.S. Bankruptcy Code provides for superpriority status to be given to a
claim for payments on the DIP loan if that is
the only way to induce lenders to provide credit. Superpriority statusi.e., the right to be
repaid from the unencumbered assets of the
companygives the DIP lender substantially
the same recovery rights as a direct security
interest in the otherwise unencumbered assets
of the company would have. In addition, the
bankruptcy court may authorize security for
the loan through a lien on the companys unencumbered property. While a debtor-in-possession may obtain unsecured financing in its
ordinary course of business without a court
Standard & Poors
order, the bankruptcy court must approve any

loan agreement that puts payments ahead of
other administrative expenses.
By providing clarity on the status of the
lenders claim to be repaid, court orders
authorizing application of these provisions of
the bankruptcy code give substantial comfort.
Analysis of the loan agreement and court
orders can determine the priority of the
lenders claim on the companys payments. It
is important to review any other claims, either
on par with or prior to the loan. In addition,
there may be liens that can affect the lenders
claim: Taxes and ERISA claims may be of
such a priority. Pension Benefit Guaranty
Corp. (PBGC) claims normally are treated as
junior in priority to any DIP claim. To understand the nature of any significant liens
against a company, Standard & Poors views a
Uniform Commercial Code (UCC) search as
important. We will discuss the results of any
significant findings with the company, as well
as whether new liens have been filed.
A DIP loan with superpriority claim status,
and a tight loan agreement and court order,
can get the full measure of rating enhancement. A strong court order would state that
no other claim having priority over or being
on par with the DIP loan should be granted
while the DIP loan is outstanding. This is
important because the lender may have a
security interest in unencumbered collateral.
In addition, the court order should explicitly
established the superpriority status of the DIP
lenders claim and assure that the automatic
stay provisions will not be lifted of modified
to the detriment of the DIP loan.
Key DIP documents
The following are the key documents needed
for rating a DIP loan:
Loan agreement, with all modifications
and amendments;
Updated financial information;
Interim orders and final order;
Evidence of a UCC search, with e-mail
confirmation of new prior claims, and
Opinion that the order has become final
and is unappealable.
73
Equity Credit: What It Is And

How You Get It
(Editors note: This article
updates a Corporate Criteria
article originally published on
Oct. 28, 2004.)
tandard & Poors Ratings Services often is asked, Will the
issuer of this hybrid security receive equity credit? In other
words, has the issuers credit quality improved and has its debt
capacity expanded, as is ordinarily the case when equity is added
to the balance sheet?
The question of equity credit is not a yes-or-no proposition. The
notion of partial credit is very appropriate.
What is equity?
What constitutes equity in the first place?
Traditional common stockthe paradigm
equitysets the standard. But equity is not a
monolithic concept; rather, it has several
dimensions. We look for the following positive characteristics in equity:
It requires no ongoing payments that could
lead to default;
It has no maturity or repayment requirement;
It provides a cushion for creditors in the
case of a bankruptcy; and
It is expected to remain as a permanent
feature of the enterprises capital structure.
If equity has these distinct defining attributes, it should be apparent that a specific
security can have a mixed impact. Hybrid
securities, by their very nature, will be equitylike in some respects and debt-like in others.
We analyze the specific features of any
financing to determine the extent of financial
risks and benefits that apply to an issuer.
In any event, the securitys economic
impact is relevant: its nomenclature is not. A
74
transaction labeled debt for accounting, tax,

or regulatory purposes may still be viewed as
equity for rating purposes, and vice versa.
Attributes of equity
Equity provides value for the enterprise.
When a company sells equity, it receives
money to invest in its business. It is able to
do research, buy equipment, or support
inventory and receivables growthall to generate cash flow and keep the enterprise
healthy. If issuing a security allows the company to avoid a cash outflow that would
have been incurred in the course of business,
the beneficial impact is identical. When
shares are issued in lieu of employee benefits
that otherwise would be paid in cashfor
example, as part of an ESOPthis aspect of
equity is fulfilled. However, if shares are
issued as a newperhaps unnecessaryform
of compensation, the benefit is dubious: the
question is whether the enterprise has
received anything of value. Soft capitala
commitment from a nonaffiliated provider of
capital to inject equity capital at a later
dateoffers another example of a transaction

that falls short in terms of this basic attribute
of equity. However valuable it may be to
have a call on funds in the future, the business does not have the funds now. And, by
making the funds available at the companys
discretion, there is the risk that a delay in
exercising that option may lead to a situation
of too little, too late.
Equity requires no ongoing payments that
could lead to default. Equity pays dividends, but has no fixed requirements that
could lead to default and bankruptcy if
these dividends are not paid. Moreover,
there are no fixed charges that might, over
time, drain the company of funds that may
be needed to bolster operations. A company is under pressure to pay both preferred
and common dividends, but ultimately
retains the discretion to eliminate or defer
payment when it faces a shortage of funds.
Of course, a companys reluctance to pass
on a preferred dividend is not identical to
its reticence to altering its common payout.
Accordingly, there is a difference in equity
credit afforded to common equity relative
to preferred equity. Similarly, common
equity issued in conjunction with so-called
income depository securities (IDSs) is
viewed as possessing less discretion over
dividends: They are marketed with an
expected yield, and investors are promised
a payout of virtually all cash flow.
The longer a company can defer dividends,
the better. An open-ended ability to defer
until financial health is restored is best. As a
practical matter, the ability to defer dividend
payments for five or six years is most critical
in helping to prevent default. If the company
cannot restore financial health in five years, it
probably never will. The ability to defer payments for shorter periods also is valuable, but
equity content diminishes quickly as constraints on the companys discretion increase.
Debt instruments can be devised to provide
flexibility with regard to debt service.
Deferrable payment debt issued directly to
investorsi.e., without a trust structure
legally affords the company flexibility regarding the timing of payments that is analogous
to trust preferreds. Yet, by being identified as
a debt security, the companys practical dis-
Standard & Poors
cretion to defer payments may be constrained, which diminishes the equity credit
attributed to such hybrids compared with
deferrable payment preferred stock.
By removing the discretionary element, certain trigger mechanisms can increase comfort
that deferral actually will occur when the circumstances of the issuer make this desirable
from the creditors perspective. Income
bondsi.e., where the payment of interest is
contingent on achieving a certain level of
earningswere designed with this in mind.
However, to the extent that cash flow
diverges from earnings measures, income
bonds tend to be imperfect instruments. A
recent variation on the theme pegs the level
of interest payments to the companys cash
flow. The equity content of such instruments
is a function of the threshold levels used to
determine when payments are diminished. If
the level of cash flow that triggers payment
curtailment is relatively low, that instrument
is not supportive of high ratings. Another
straightforward concept entails linking interest payments to the companys common dividend, creating an equity-mimicking bond. A
number of international financial institutions
issued such bonds in the late 1980s. Of
course, if a company had an inordinate
amount of dividend-linked issues outstanding, this ultimately could increase its reluctance to curtail its common dividend.
Equity has no maturity or repayment
requirement. Obviously, the ability to
retain the funds in perpetuity offers the
company the greatest flexibility. Extremely
long maturities are next best. Accordingly,
100-year bonds possess an equity feature
in this respect (and only in this respect)
until they get much nearer their maturity.
To illustrate the point, consider how
much, or how little, the company would
have to set aside today to defease or handle the eventual maturity. However, crossdefault provisions would lead to these
bonds being accelerated.
Preferred equity often comes with a maturityas a limited-life or sinking-fund preferredwhich would constitute a clear
shortcoming in terms of this aspect of equity.
Limited credit would be given for this type of
preferred, even if the security had a 10-year
75
Equity Credit: What It Is, and How You Get It
life or more. Even if it could be assumed the

issue successfully is refinanced at maturity,
the potential for using debt in the refinancing
would be a concern (see the following discussion on the permanence of equity).
Equity provides a cushion for creditors in
the event of default. What happens in
bankruptcy also pertains to the risk of
default, albeit indirectly. Companies can
continue to raise debt capital only as long
as the providers feel secure about the ultimate recovery of their loans in the event of
a default. Debtholders claims have priority
in bankruptcy, while equity holders are relegated to a residual claim on the assets.
The protective cushion created by such
equity subordination allows the company
access to capital, enabling it to stave off a
default in the first place.
Subordination typically is a secondary consideration compared with other beneficial
aspects of equity. Thus, if an instrument is
senior, but ongoing payments are deferrable
and it has a long-dated maturity, we could
well view it as having substantial equity content. On the other hand, if an instrument is
subordinated, but lacks the other equity-like
traits, it would be viewed as predominantly
debt-like. The distinction between subordination and deep subordination generally is not
significant in our analysis, although deep subordination incrementally is more supportive.
Equity is expected to remain a permanent
feature of the enterprises capital structure.
At any time, a company can choose either
to repurchase equity or to issue additional
shares. However, some securities are more
prone to being temporary than others. Our
analysis tries to be pragmatic, looking for
insights as to what may ultimately occur.
The ability to call always should give reason for pause; however, we have not placed
much emphasis on this feature if the instrument is truly low-costsuch as taxdeductible preferredand, therefore,
should not pressure the company to refinance. Calls exercisable after five years are
very common to long-dated hybrids. (We
would question the rationale for a call date
only two to three years after issuance.)
Sometimes the issuer has the right to call
the instrument not just on the initial call
76
date, but on each subsequent coupon date:

this weakens equity credit, because it
increases the likelihood the issuer ultimately will find conditions attractive for refinancing the instrument with debt. Preferred
stock, in particular, likely will have provisions for redemption or exchange, if not an
outright stated maturity. Coupon step-ups
are designed to motivate calling the issue.
Auction or remarketed preferred stock is
designed for easy redemption. Even though
the terms of this type of preferred provide
for its being perpetual, failed auctions or
lowered ratings typically prompt the issuer
to repurchase the shares.
Our discussions with management regarding a companys financial policies provide
insights into its plans for the securities:
whether a company will call or repurchase
an issue and what is likely to replace it.
Replacement language in the issue that
restricts refinancing to issues of similar equity content can provide additional comfort
regarding management intent, even though
companies financial policies can vary over
time, future capital market conditions could
limit the ability to issue specific types of
securities, and legal enforcement is dubious.
Another important consideration is the
issuers tax-paying posture. It is difficult for
a nontaxpaying issuer to make the case that
the company will continue to finance with
nontaxdeductible preferred stock once it
becomes a taxpayer and can lower its cost of
capital by replacing the preferred with debt.
Other clues can come from the nature of
investors in the issue (e.g., money market, as
opposed to long-term fixed-income investors)
and the mode of financing that is typical of
the companys peer group. For example, utilities traditionally finance with preferred
stock, and industry regulators are comfortable with it. Therefore, the usual concern
that limited-life preferred stock will be refinanced with debt does not generally apply in
the case of utilities.
In the case of so-called tax-deductible
equity, risk exists that their favorable tax
status is overturned, andespecially with
new hybridsthat risk may be substantial.
This concern can be mitigated by provisions
in the transaction to convert into another
equity-like security in the event of loss of

tax-deductibility.
Rating methodology
While many focus on the leverage ratio in
thinking about equity credit, a companys
leverage is just one of many components of a
rating assessment. (In fact, cash flow adequacy and financial flexibility have long surpassed balance-sheet considerations as
important rating factors.)
Standard & Poors methodology of breaking all the analyses into categories allows each
of the several attributes of hybrid securities to
be considered separately and in the appropriate analytical category. The aspect of ongoing
payments is considered in fixed-charge coverage and cash-flow adequacy; equity cushion
in leverage and asset protection; need to refinance upon maturity in financial flexibility;
and potential for conversion in financial policy. The before- and after-tax cost of paying
for the funds also is a component of both
earnings and cash flow analysis.
In practice, the analyst often takes a shortcut approach to reflecting hybrids in credit
ratios. In general, the analyst calculates alternative sets of ratios, reflecting that the truth
lies in a gray area between two perspectives.
(Please see the Hierarchy section at the end
of this piece.)
But we do not simply haircut hybrid
securities or assign fractional equity credit
when calculating financial ratios.
In any event, the relative importance of
each equity attribute can vary. The critical
issues for companies can differ. Moreover, the
factors that delineate A ratings from AA
ratings tend to differ from those that determine whether a rating will be B or BB. So,
the impact of a hybrid may depend on the
specific needs of a given issuer or its place in
the rating spectrum. Aspects affecting nearterm flexibility usually are of prime importance for low-rated, troubled credits, while
long-term considerations are more germane
when an already highly rated credit is being
reviewed for an upgrade. To illustrate the
point: Replacing 20-year debt with 100-year
debt is a nonevent for a company facing
insolvency in the next several quarters.
Standard & Poors
There are no specific limitations with

respect to the amount of hybrid preferred
that receives equity treatment. However, at
some point, one would question a companys creating a capital structure with an
unusually large proportion of newfangled
securities. The analytical comfort range
depends on the seasoning of the type of
instrument, peer group comparisons, and
any potential negatives (in terms of reputation) for the company that might prompt it
to reevaluate and restructure.
Factoring Future Equity Into

Ratings
There are many ways to arrange for the creation of equity in the future. These methods
range from issuing traditional convertible
securities to entering forward purchase contracts to establishing grantor trusts for future
issuance. The key considerations for receiving
credit today for the promise of a positive
development in the future are:
How predictable the outcome is, and
How soon it will occur.
If the analyst is reasonably assured that an
equity infusion will occur over the next two
to three years, then that event can be incorporated into the financial analysis on a pro
forma basis. On the other hand, analyzing an
equity infusion in the distant future, even if
one could be certain about this eventuality,
requires a different approach. It is not meaningful to overlay such an event on current
financial measures. To do so would be to isolate just one transaction from the full picture
of the companys future, in effect, taking it
out of context. Yet a program of equity
issuance can be a powerful statement about
the issuers financial policyan important
rating consideration.
Predicting the outcome
The first dimension of the analysis is assessing the potential for issuance of, or conversion to, equity, and the likelihood of the
companys retaining that equity as permanent capital. The risks vary by the type of
instrument and any unique characteristics.
The following discussion is arranged in
77
ascending order, based on the likelihood of

a positive outcome.
Convertible debt usually turns into equity
at the option of the investor. The issuer can
force conversion, but only if the security is
in the money.
The odds of any specific issue converting
is a function of the conversion premium and
the likelihood of the companys stock price
achieving that level. Standard & Poors has
been extremely conservative about relying
on anticipated stock price movements. Even
when the stock is trading very near the
strike price and the companys future seems
bright, the risk exists that the stock will fall
out of favor or that the market as a whole
may turn bearish. There are mechanisms
that can increase the odds of conversion. For
example, periodic adjustment of the conversion premium is one means. However, the
difficulties in statistically assessing the outcomes still would limit any equity credit
given for these issues. Conversely, discount
bonds, such as LYONs, have a built-in
mechanism for always raising the bar as the
debt value accretes, thereby making the odds
of conversion ever more remote.
In some securities, the issuer holds the
option to convert into equity. For example,
there may be a provision to pay with cash or
stock. This provides a modicum of flexibility; however, no equity credit is given. The
analyst is still concerned the issuer might not
exercise its prerogative except under dire circumstances. After all, any company can
issue equityif it so choosesat the prevailing market price. The reality is that companies rarely are satisfied with the market
price and are reluctant to add such an
expensive form of capital. Even if the share
settlement is mandatory, a company disinclined to issue at the market price would
merely repurchase those shares.
There is an analogous problem with soft
capital from a ratings perspective. The company has a contractual right to demand at
any time an equity infusion from some outside provider of capital: The question is at
what point the company makes this demand.
Moreover, in the interim, the company does
not enjoy the use of these funds to invest in
maintaining the health of its business.
78
Covenants offer another way to influence

the outcome. One popular method is to
require that the repayment of principal upon
maturity must be made with funds raised
through the issuance of equity. From our perspective, this method of providing equity is
flawed. For one thing, enforceability is dubious. Second, as discussed earlier, if the company is not inclined to add equity at the
market price, it still can meet the legal
requirement of issuing equity while simultaneously repurchasing its shares. (Banks have
used this structure to raise Tier 1 regulatory
capital. Indeed, considering the regulatory
impetus behind the issuance, it is unlikely a
bank would cavalierly reverse such an equity
issuance. But it would be wrong to generalize
for all corporate issuers.)
A different covenant calls for automatic
conversion when a trigger event occurs
typically, a rating downgrade or a defined
financial setback. The debt would be eliminated at a time when the company might
find it difficult to service it. This represents
an equity feature and helps to place a floor
under the companys rating if the threshold
for conversion is set high enough (e.g., at
the investment-grade level).
The most favorable rating consideration is
given to issues that are mandatorily convertible in the near term and at a fixed price.
Conversion is a certainty. At the end of a very
short period, the investor receives one share
of common stock, or a fractional share, if the
price of the common stock has appreciated
beyond a certain point. The companys decision to issue the equity is based on the
locked-in floor price for the common stock.
Regardless of the movement in the stock
price, there is little reason for the company to
reconsider its decision.
Synthetic mandatory equity securities can
be created by using forward purchase contracts and related options contracts; the
impact would be equally positive from a ratings viewpoint. (However, if there is a substantial mismatch between the issuance of the
equity and the maturity of the debt, there is
no assumption the debt will be cancelled by
the equity proceeds. The burden of proof is
on the company regarding the use of the
equity sums for debt reduction.)
Grantor trusts, ESOPs

Apart from convertibles, grantor trusts and
ESOPs offer avenues for future equity
issuance. Many companies have established
programs that commit them to issuing
shares periodically as a means of dealing
with large, unfunded, employee benefit liabilities. The company places shares in a
grantor trust or ESOP to be used over a
period of time for employee benefits that
otherwise would be paid in cash.
The vehicles for these programs differ with
respect to the range of benefits that can be
covered, the scheduling of issuance and
releases of shares, the degree of exposure to
changes in share price, and tax treatment.
The creation of new equity via such programs
is highly predictable. However, the major
drawback is the extended period over which
this will occurseven years to 10 years for
many ESOPs, and 10 years to 15 years in the
case of rabbi trusts, such as Flexitrusts.
This limits the positive impact on current
credit quality, as explained below.
Timing the issuance
As important as knowing what will occur is
knowing its context. Events anticipated in
the short term are handled differently in the
analytical process than those further out.
Anything expected to occur in the next two
to three years is factored into the projected
financial statements and credit ratios that
form a basis for rating assessments. The
analysts projections cover this period, taking into account all known aspects of an
issuers business environment, strategy, and
financial plans. (Historical financials are
relevant only as a guide to what may occur
in the future, because ratings address the
risks of the future.) Therefore, if equity is
expected within two to three years, the
transaction can be fully analyzed and incorporated in the current ratings.
The rating review of a company making a
large, debt-financed acquisition offers a common example. The analysis would not focus
on a snapshot view of the issuers financial
condition; rather, the rating would take into
account the companys plan to restore financial health, if such a plan exists. New equity
usually is part of such plans. The company
Standard & Poors
might issue convertible securities or it might

commit to issuing specific amounts of common equity over the short term.
When a positive or negative development
is expected farther out in the future, its ratings impact is diminished. As a dynamic
entity, the issuer will be affected in many
offsetting ways in the interim. To single out
one expected event is to take it out of context. To reflect its impact in pro forma
financial ratios would be a distortion.
Still, the willingness to issue equity over
time to maintain credit quality can be an
important element of financial policy.
Establishing a program to do so represents
tangible evidence that adds credence to a stated commitment. From a ratings perspective,
the beneficial impact still can be significant,
even if the equity program is not reflected in
financial ratios. Indeed, when focusing on the
longer term, rating analysis emphasizes a
companys fundamentalsits competitive
position and financial policies.
In this light, consider the case of a prominent utility that decided to establish a rabbi
trust to fund a very substantial amount of
employee benefits over a 15-year period.
Historically, the company had issued a combination of debt and equity to maintain its
leverage at 50% and its debt rating at A.
Standard & Poors, relying on the companys
financial policies, was confident the future
held more of the same. Based on the legal
commitment to add more than $1 billion of
equity via the trust, the company lobbied for
a rating upgrade.
However, we concluded that the future
equity added little in this instance. The company still plans to issue debt alongside the
new equity issued by the trust. The dividend
reinvestment plan that was used to issue equity in the past would now be discontinued. In
fact, leverage at all times will continue to be
50%. In short, nothing has changed. In this
case, the equity program enhances confidence
in the A rating, rather than suggesting that
the rating be upgraded.
Often, companies combine share issuance
programs with share repurchase transactions.
A company may incur debt to purchase
shares already outstanding that will be reissued through a trust or an ESOP. Another
79
option is for the ESOP to borrow to buy

shares in the market, with the corporate
sponsor guaranteeing the debt. This is known
as a leveraged ESOP. Or, a company may
repurchase shares and issue convertible debt
to limit the credit impact.
The analyst separates the dual aspects of
these actions. The negative impact is identical
to any debt-financed share repurchase.
Separately, the promise of future equity is
taken into account, along the lines previously
discussed. The positive impact of future equity issuance usually is sufficient to partially
offset the credit-harming effects of the share
repurchase. The net result can be an affirmation or a smaller downgrade than otherwise
would have occurred.
Tax-Deductible Preferred And

Other Hybrids
Texaco Capital LLC issued the first of the socalled tax-deductible preferred stocks in
1993. This hybrid equity security was a
major innovation in corporate finance, creating a modern-day version of the long-existing
preferred stock.
Tax-deductible preferred has since enjoyed
tremendous issuance volume. The total is well
over $300 billion. The product has been especially popular with utilities and banks, but
has attracted issuers of all stripes.
Equity credit
The essence of the new financing vehicles success is achieving simultaneous treatment as
equity for credit-rating purposes, and treatment as debt for the issuers tax purposes.
While the new type of preferred sacrifices
some of the equity features of conventional
preferred stocks, it retains sufficient equity
content to warrant partial equity credit in
terms of our rating criteria. Importantly, it is
effectively tax deductible, which benefits the
companys after-tax profitability and cash
flow. This low cost, in turn, enhances the
equity content by increasing the expectations
for longevity of the instrument.
The financing structure calls for issuance of
the preferred by a subsidiary entity that pays
no taxes. The funds are then lent to the parent, with the loan terms closely mirroring the
80
terms of the preferred. The interest payments

on the intercompany loan are tax deductible.
The Texaco deal used a subsidiary located
in the Caribbean tax haven of Turks and
Caicos to issue the preferred. Subsequently,
Delaware LLCs, partnerships, and trusts
were used to accomplish the same tax treatment. Since 1995, the trust structure has
emerged as the vehicle of choice, hence the
term trust preferred coming into use to
describe the genre.
The essential equity features that have
become standard are:
Deferral of payments for up to 60
monthsas long as no common dividends
are being paid. (Conventional preferreds
have unlimited potential for nondeclaration
of dividends, subject only to board representation by preferred holders after six
quarters of nonpayment.)
Deep subordination.
30-year life. (Conventional preferreds are
perpetual, although many have call provisions. The new-genre preferreds also are
nominally perpetual, but terminate when
the intercompany loan matures, normally
in 30 years.)
We view preferreds that meet these standards as having intermediate equity content.
As the remaining life of the specific issue
dwindles over time, the equity attribution is
reduced. Conventional preferreds, by way of
comparison, typically possess equity content
that does not diminish over time, given their
perpetual tenor.
Some history
As this financing instrument became very
popular, the U.S. Treasury moved to deny its
tax-deductible status. In particular, there were
attempts to define long-tenor instruments as
equity, limiting the life of debt to 15
years. This would have discouraged issuance
of precisely that type of preferred that warrants credit in the rating process, while the
short-life versions would get no rating benefit, eliminating the key motivation for companies to issue such hybrids.
It also put at risk the treatment of many
extant issues that provided for unwinding in
the event of a change in tax treatment. The
continuation of equity treatment then
depended on expectations the tax treatment

of outstanding issues would be grandfathered. (Other deals would result in a parent
preferred were a change in tax treatment to
occur, and were not a problem.)
In the end, however, Congress did not
adopt the proposals, and the tax treatment
is now viewed as safe. The tax rules are
left with extremely broad and very vague
definitions of debt/equityincluding
how an instrument is viewed by credit rating agencies.
Another issue confronting the new preferreds has been accounting treatment.
Initially, these preferreds were displayed on
the balance sheet as minority interest. As
of 2003, however, they must appear as a liability, and the dividend payments show up in
the same category as interest expense.
This change probably dampens the enthusiasm of companies for issuing these securities.
However, the change in accounting does not
drastically affect the equity treatment we
afford the preferreds.
Nomenclature and accounting can influence the general perception of the instrument,
thereby subtly affecting the companys discretion regarding payment deferral. Still, these
factors are secondary to the terms of the
instrument and the companys economic
incentives, so the equity content is only
slightly reduced because of debt accounting.
(Banks and financial institutions face additional issues regarding the acceptance of these
preferreds as regulatory capital. Regulators
were first reluctant in this respect, but did
eventually allow them, with some modifications, to be treated as Tier 1 capital. In light
of changes in accounting, changes to the
structure may now be needed to continue to
get such capital credit in the future.)
Adding features
Some trust preferreds add convertibility features to make them more equity-like.
Investors can convert to common equity, subject to the stock price appreciating by a certain percentage. Indeed, under Standard &
Poors criteria, convertible preferreds are typically viewed as having 60% equity content.
To broaden investor appeal, preferreds
with variable rates were introduced. This
Standard & Poors
does not, in our view, alter the equity content, although the exposure to floating rates,
if material, can pose a risk that is considered
in other aspects of the analysis.
A further innovation called for resetting rates after an initial 5- or 10-year period. The idea was to create an incentive for
the company to call the issue at that point,
to avoid a penalty rate. We regard issues
with step-up rates as having an effective
maturity at that point, thereby largely
undermining their equity content.
A reset that merely captures any change in
the issuers credit spreads is less troublesome, because the company presumably
would have little incentive to refinance the
issue. That still could be problematic, if, for
example, the issuer dropped to non-investment grade: its cost for long-term funds
might be expected to widen to the point that
only shorter-term alternatives would be
palatable. Alternatively, the reset could be a
fixed spread over a floating rate that is higher than the current credit spread. Arguably,
the extra spread could be justified as compensation for potential credit deterioration
over a long term. Moreover, it cannot be
presumed to be higher than the companys
credit spread will be at the reset date.
A miniscule rate resetsay, 25 basis
pointsis not problematic, nor is moving
from a fixed to a floating rate, by itself, a
problem. However, adding 50 or more basis
points to the fixed rate or the reference rate
produces a penalty rate. Similarly, if the rate
is the higher of two or more reference rates,
there is an effective penalty to the issuer.
(There can be exceptions, however, depending on the specific rates involved. For example, there is no concern if one is a 30-day
rate and the other a 30-year rate, since one
can expect the longer-term rate will apply
almost all of the time.)
To mitigate the impact of stepped-up rates
on the equity credit afforded to that financing, some issues proffer replacement language, promising that any refinancing of
the instrument will come from proceeds of
an equity issuance or a new instrument of
equivalent equity content. The legal enforceability of such terms is highly dubious.
Nonetheless, Standard & Poors does put
81
stock in such provisions, as long as the company involved has a decent record of credibility, and the language is highly specific
regarding the definition of instruments that
would qualify as replacements.
Global variations
The new genre of preferreds has local variations, reflecting differing capital market preferences and tax considerations.
In the U.K., for example, Inland Revenue
allows a tax deduction even if the debt is
perpetual and dividends can be deferred
without limitation. A handful of deals
(notably, from Grand Met PLC and Cadbury
PLC) did incorporate those equity enhancementsand the equity content, from our
perspective, was boosted.
On the other hand, European investors are
less inclined to make very long-term investments. European deals, therefore, are more
likely to incorporate reset provisionsmaking replacement language critical.
Some European deals introduced greater
restrictions on the ability to defer dividends.
The issuer can defer only after curtailing its
common dividend for some period of time.
This translated into seriously lower equity
credit afforded to those issues. In the case
of companies that do not pay a quarterly
common dividendnot unusual in
Europethe problem is compounded,
because there might be an even longer period between when the company experiences
financial distress and when it can defer preferred dividend payments. Similarly, the
value of deferability is diminished if the
deferral can only occur following a period
when the company has reported a net loss,
but where the company reports results on a
semiannual, rather than quarterly, basis.
In some European instruments, payments
are noncumulative. This is incrementally
more beneficial than when payments are
cumulative, because the need to make up
payments previously deferred can otherwise
hinder a companys turnaround. We are
wary of cases where foregone cash distributions must be replaced by the issuance of
common stock, given the potential that the
company would be loathe to accept the
ensuing dilution.
82
The Japanese put a toe in the water in

2001 with a version of trust preferred securities. NEC Corp. sold a deal that was perpetual, but, after the first five years, had a rate
reset that would reflect changes in credit
spreads. Standard & Poors expressed its
reservations about the value of such instruments in the Japanese context. Local business
culture involves great reticence with respect
to altering dividend payments. Indeed, the
whole notion of preferred stock of any type is
a novelty in Japan. Accordingly, the equity
content of Japanese preferreds will evolve
over time as local practices may come to
resemble those of Western markets.
Recent innovations
The quest for enhancing preferreds equity
content continues. One idea is making payment deferral automatic upon reaching certain triggers or occurrence of certain events.
Indeed, replacing issuer discretion with a formulaic approach to deferral adds significantly
to the equity contentif the threshold for
stopping payments is set high. Each issuers
situation would require a unique analysis,
making standardization impossible.
Triggers could be based on financial data
or ratios or rating levels. Alternatively, the
payments could be linked to the companys
common dividend. Additionally, it is possible to offer non-cumulative versions that
would not require the company to make up
for payments skipped because of financial
distress. Beyond that, forgiveness of part of
the principal in cases of company stress
could theoretically be offered.
The rub is that investors would be leery
about accepting the risks associated with
nonpayment associated with high thresholds.
The key is to find the right balance that
would be meaningful for the issuer and still
acceptable to investors at a reasonable rate.
Some other hybrids
Mandatory exchangeable debt or preferred (e.g., DECs): If the issue must be
settled with the stock of another entity
(currently owned by the issuer), the analytical treatment is that of a deferred asset
sale. All assets may be positive or negative to credit quality; there is no stan-
dardized impact. The factors that determine the credit impact include price
achieved and use of after-tax proceeds.
Will the proceeds be distributed to shareholders? Or used to pay down debt on a
permanent basis? Or be reinvested? If
reinvested, is the new asset more or less
risky that that which was sold?
Mismatched mandatory conversion debt
(e.g., FELINE PRIDES): Given the mismatch, the equity issuance is not ordinarily
netted against the debt obligation. It is
equivalent to a company simultaneously
issuing deferred equity plus a like amount
of debt. The net impact of these two issues
would depend on whether leverage is
increased or decreased, which, in turn,
depends on the companys financial leverage prior to these two issuances.
Step-up preferred: If an instrument provides for adjustment of terms, the analyst
may consider the adjustment date as the
expected maturity, with the related
diminution of equity credit. If the adjustment is to above-market rates, it is presumed the instrument will be
refinancedand not necessarily with
another equity-like security.
Remarketed convertible trust preferred (e.g.,
HIGH TIDES): On balance, this hybrid is
viewed negatively, despite the potential for
conversion to common stock and the rate
savings created by the remarketing feature.
The need to remarket at a level above par
could lead to terms that are unpalatable to
the issuer, prompting a refinancing.
Auction preferred: These frequently remarketed preferreds virtually are treated as
debt. They are sold as commercial paper
equivalents, which leads to failed auctions
if credit quality ever falls to A-3or even
A-2levels. While the company has no
legal obligation to repurchase the paper
i.e., the last holder could be left with this
perpetual securitythe issuer invariably
bows to market pressures, and chooses to
repurchase the preferred.
Standard & Poors
Streamlining Hierarchy Of
Hybrid Securities
Standard & Poors Ratings Services introduced the equity hybrid hierarchy in 1999,
pioneering a quantitative approach to the
partial credit associated with equity hybrids
issued by corporates. (Given different analytic
considerations, another framework applies
for financial institutions.) The hierarchy was
expressed using a scale of 0% to 100%.
Ordinary common equity represented the
paradigmatic 100%.
This scale was created to provide greater
transparency, as companies and their advisers probed the relative benefits associated
with alternative financial products. At the
same time, we cautioned users to avoid
exaggeration of the differences suggested by
the various gradations.
In 2005, we modified the scale by collapsing the hierarchy into three categories, and
changing the terminology. This rebalancing of
specificity with simplicity was to communicate our views more effectivelynot to
change the underlying analytical methodology.
Three categories
The different levels of equity content are
grouped into three categories. Hybrids that
had been 10/20/30 on the previous scale are
classified as possessing minimal equity content. Those that were 40/50/60 are classified
as possessing intermediate equity content;
those that were 70/80/90 are classified as
having high equity content.
Modified Hybrid Hierarchy
Minimal Equity Content: This group

includes instruments with little or questionable permanence; terms or nomenclature that restrict or discourage discretion
over payments; after-tax costs or conversion terms that may become unattractive
to the issuer.
Intermediate Equity Content: This group
encompasses most of preferred stock
genre, from 30-year trust preferred with
five-year cumulative deferral rights to perpetual, tax-deductible preferred (as in the
U.K.), with unlimited and/or noncumulative deferral rights.
83
High Equity Content: This group includes

instruments with a mandatory component,
either regarding deferral of ongoing payments (at appropriately high trigger levels),
or near-term conversion into a fixed number of common equity shares (on a basis
that would not be deemed unpalatable to
the issuer at the time of conversion).
(See: Hybrids High Equity Content
Category Held to High Standards; published
Sept. 7, 2005, and CreditFAQ: Sundry
Equity Hybrid Features, published Dec. 9,
2005, on RatingsDirect, Standard & Poors
Web-based research and credit analysis system, for additional criteria.)
Rating methodology
The numerical gradations never implied fractional treatment for the purpose of ratio calculation (a point repeatedly stressed). This
continues to be the case. (We have never split
the amounts of an issue for ratio calculations
because the results can be distortive.) Rather,
hybrids with minimal equity content are
treated as debt for ratio purposes; hybrids
84
with high equity content are treated as equity

for calculating ratios.
For hybrids with intermediate equity content, financial ratios are computed both
waysviewed alternatively as debt and as
equity. That is, two sets of coverage ratios are
calculatedto display deferrable ongoing
payments (whether technically dividends or
interest) entirely as ordinary interest and
alternatively as an equity dividend. Similarly,
two sets of balance-sheet ratios are calculated
for the principal amount of the hybrid instruments, displaying those amounts entirely as
debt and entirely as equity.
For these hybrids in the middle category,
analytical truth lies somewhere between
these two perspectives. Analysts must interpolate between the two sets of ratios to arrive
at the most meaningful depiction of an
issuers financial profilenormally, by splitting the difference.
Analysts can still note and give effect to
each more-equity-like/less-equity-like feature
of various hybrids in the same category; however, such nuances play, at most, a very subtle
role in the overall rating analysis.
ffiliation between a stronger and a weaker entity will almost
always affect the credit quality of both, unless the relative
size of one is insignificant. The question rather is how close

together the two ratings should be pulled on the basis of affiliation.
General Principles
In general, economic incentive is the most
important factor on which to base judgments
about the degree of linkage that exists
between a parent and subsidiary. This matters
more than covenants, support agreements,
management assertions, or legal opinions.
Business managers have a primary obligation
to serve the interest of their shareholders, and
it should generally be assumed they will act
to satisfy this responsibility. If this means
infusing cash into a unit previously termed a
stand-alone subsidiary, or finding a way
around covenants to get cash out of a protected subsidiary, then management can be
expected to follow these courses of action to
the extent possible. It is important to think
ahead to various stress scenarios and consider
how management would likely act under
those circumstances. If a parent supports a
subsidiary only as long as the subsidiary does
not need it, such support is meaningless.
A weak entity owned by a strong parent
usuallyalthough not alwayswill enjoy a
stronger rating than it would on a standalone basis. Assuming the parent has the ability to support its subsidiary during a period
of financial stress, the spectrum of possibilities still ranges from ratings equalization at
one extreme to very little or no help from the
parents credit strength at the other. The
Standard & Poors
greater the gap to be bridged, the more evidence of support is necessary.

The parents rating is, of course, assigned
when it guarantees or assumes subsidiary
debt. Guarantees and assumption of debt are
different legal mechanisms that are equivalent
from a rating perspective. Cross-default and
cross-acceleration provisions in bond indentures also can be important rating considerations. They can provide a powerful incentive
for a stronger entity to support debt of a
weaker affiliate, because they trigger default
of the stronger unit in the event of a default
by the weaker affiliate. Bear in mind, however, that cross-default provisions can disappear
if the debt that contains the provisions is
retired or renegotiated.
A strong subsidiary owned by a weak parent generally is rated no higher than the parent. The key reasons:
The ability of and incentive for a weak parent to take assets from the subsidiary or
burden it with liabilities during financial
stress; and
The likelihood that a parents bankruptcy
would cause the subsidiarys bankruptcy,
regardless of its stand-alone strength.
Both factors argue that, in most cases, a
strong subsidiary is no further from
bankruptcy than its parent, and thus cannot
have a higher rating. Experience has shown
85
that bankrupt industrial companies file with

their subsidiaries more often than not.
For rating purposes, the risk of substantive consolidation is a side issue.
Consolidation in bankruptcy, sometimes
referred to as substantive consolidation,
occurs when assets of a parent and its subsidiaries are thrown together by the bankruptcy court into a single pool and their
value allocated to all creditors without
regard for any distinction between the two
legal entities. In such cases, creditors of a
subsidiary may lose all claim to the value
associated with that particular subsidiary.
Much more often, a parent and its subsidiaries will all file, but each legal entity
will be kept separate in the bankruptcy proceeding. Creditors keep their claim to the
assets of the specific legal entity to which
they extended credit. Because corporate ratings address default risk, the key issue is not
consolidation, but rather whether a bankruptcy filing will occur. Nonconsolidation
opinions are, therefore, of more value with
respect to recovery ratings and issue ratings
of subsidiary debt, because those opinions
address the likelihood of substantive consolidation, rather than the likelihood of simultaneous bankruptcies for parent and
subsidiary. Perhaps the willingness to obtain
such an opinion might also serve as some
evidence of management intent regarding a
subsidiarys independence.
Protective covenants apparently protect a
subsidiary from its parent by restricting dividends or asset transfers. In general, this
type of covenant is given very limited
weight in a rating determination. Reasons
for limited value of protective covenants:
The Parent/Operating Unit Relationship

Investment
No analytical
consolidation.
Dividend income.
Analyze riskiness
and liquidity of
investments value.
86
Integrated Business
No consolidation.
Anticipate additional
investment.
Pro rata
consolidation.
investment.
Full consolidation.
investment.
They do not affect the parents ability to

file the subsidiary into bankruptcy;
It is very difficult to structure provisions
that cannot be evaded; and
Ultimately, courts usually cannot force a
company to obey the covenant. During
severe financial stress, especially prior to a
bankruptcy, a weak parent may have a
powerful incentive to strip a stronger subsidiary. The court can, at best, only award
monetary damages after the fact to a creditor who has incurred a loss (when the issue
defaults) and chooses to sue.
Subsidiaries/Joint Ventures/
Nonrecourse Projects
With respect to the parents credit rating,
affiliated businesses operations and their
debt may be treated analytically in several
different ways, depending on the perceived
relationship between the parent and the
operating unit. These alternatives are illustrated by the spectrum below.
The same alternatives may apply when
companies invest in joint ventures that issue
debt in their own name, and when companies choose to finance various projects with
nonrecourse debt. These analytical issues
also may apply when companies take pains
to finance some of their wholly owned subsidiaries on a stand-alone, nonrecourse
basis, especially in the case of noncore or
foreign operations.
Sometimes, the relationship may be characterized as an investment. In that case, the
operational results are carved out; the parent gets credit for dividends received;
the parent is not burdened with the
operations debt obligations; and the
value, volatility, and liquidity of the
investment are analyzed on a case-specific
basis. The quality of the investment dictates
how much leverage at the parent company
it can support.
At the other end of the spectrum, operations may be characterized as an integrated
business. Then, the analysis would fully
consolidate the operations income sheet
and balance sheet; and the risk profile of
the operations is integrated with the overall
business risk analysis. Or, the business may
not fall neatly into either category; it may

lie somewhere in the middle of the spectrum. In such cases, the analytical technique
calls for partial or pro rata consolidation
and usually the presumption of additional
investment, that is, the money the company
likely would spend to bail out the unit in
which it has invested.
This characterization of the relationship
also governs the approach to rating the debt
of the subsidiary or the project. The size of
the gap between the stand-alone credit quality of the project or unit and that of the
group, sponsor, or parent is a function of
the perceived relationship: the greater the
integration, the greater the potential for
parent or sponsor support. The reciprocal
of burdening the parent with the nonrecourse debt is the attribution of support to
that debt. The notion of support extends
beyond formal or legal aspectsand can
narrow, and sometimes even close, the gap
between the rating level of the parent and
that of the issuing unit.
If the credit quality of a subsidiary is
higher than that of the parent, the ability of
the parent to control the unit typically caps
the rating at the parent level. Exceptions are
made in the case of bankruptcy-remote special purpose vehicles for securitization, regulated entities, independent finance
subsidiaries, and the rare instances that
have extremely tight covenant protection.
The measure of control the parent can exercise is very much a function of ownership,
so the percent of ownership of a joint venture or project and the nature of the other
owner are critical rating criteria in such situations. Where two owners can prevent
each other from harming the credit quality
of a joint venture, the debt of the venture
can be rated higher than eithers rating, if
justified on a stand-alone basis.
Formal supportsuch as a guarantee (not
merely a comfort letter)by one parent or
sponsor ensures that the debt will be rated
at the level of the support provider. Support
from more than one party, such as a joint
and several guarantee, can lead to a rating
higher than that of either support provider.
(See Public Finance CriteriaJointly
Supported Debt.)
Standard & Poors
Determining Factors
No single factor determines the analytical
view of the relationship with the business
venture in question. Rather, these are several factors that, taken together, will lead to
one characterization or another. These
factors include:
Strategic importanceintegrated lines of
business or critical supplier;
Percentage ownership (current and
prospective);
Management control;
Shared name;
Domicile in same country;
Common sources of capital;
Financial capacity for providing support;
Significance of amount of investment;
Investment relative to amount of debt at
the venture or project;
Nature of other owners (strategic or financial; financial capacity);
Managements stated posture;
Track record of parent company in similar
circumstances; and
The nature of potential risks.
Some factors indicate an economic rationale for a close relationship or debt support.
Others, such as management control or
shared name, pertain also to a moral obligation, with respect to the venture and its liabilities. Accordingly, it can be crucial to
distinguish between cases where the risk of
default is related to commercial or economic factors, and where it arises from litigation
or political factors. (No parent company or
sponsor can be expected to feel a moral
obligation if its unit is expropriated.)
Percentage ownership is an important
indication of control, but it is not viewed in
the same absolute fashion that dictates the
accounting treatment of the relationship.
Standard & Poors also tries to be pragmatic in its analysis. For example, awareness of
a handshake agreement to support an ostensibly nonrecourse loan would overshadow
other indicative factors.
Clearly, there is an element of subjectivity
in assessing most of these factors, as well as
the overall conclusion regarding the relationship. There is no magic formula for the
combination of these factors that would
lead to one analytical approach or another.
87
Regulated Companies
Normal criteria against rating a subsidiary
higher than a parent do not necessarily
apply to a regulated subsidiary. A regulated
subsidiary is indeed rated higher than the
parent if its stand-alone strength so warrants and regulatory protection is sufficiently strong. However, the nature of regulation
has been changingand creditors can rely
on regulators to a much smaller extent that
in the past. For one thing, deregulation is
spreading. As competition enters markets,
the providers are no longer monopolies
and the basis of regulation is completely
different. Most of all, regulators are
more concerned with service quality than
credit quality.
For example, some regulated utilities are
strong credits on a stand-alone basis, but
often are owned by companies that finance
their holding in the utility with debt at the
parent company (known as double leveraging), or that own other, weaker business
units. To achieve a rating differential from
that of the consolidated group requires evidencebased on the specific regulatory circumstancesthat regulators will act to
protect the utilitys credit profile.
The analyst makes this determination on
a case-by-case basis, because regulatory
jurisdictions vary. Implications of regulation
are different for companies in Wisconsin
and those in Florida or those subject to the
scrutiny of the Securities and Exchange
Commission under the 1935 Public Utilities
Act. Also, regulators might react differently
depending on whether funds that would be
withdrawn from the utility were destined to
support an out-of-state affiliate or another
in-state entity. Finally, while regulators may
be inclined to support investment-grade
credit quality, there is little basis to believe
regulators would insist that a utility maintain an A profile. Their mandate is to protect provision of serviceswhich is not a
direct function of the providers financial
health. In fact, if a utility has little debt, the
overall cost of capital, and therefore the
cost of service, can be higher.
There is a corollary that negatively affects
the parent and weaker units whenever a
utility subsidiary is rated on its stand-alone
88
strength. If the regulated utility is indeed

insulated from the other units in its group,
its cash flow is less available to support
them. To the extent, then, that a utility is
rated higher than the consolidated groups
credit quality, the parent and weaker units
are correspondingly rated lower than the
group rating level.
Foreign Ownership
Parent/subsidiary considerations are somewhat different when a company is owned by
a foreign parent or group. The foreign parent is not subject to the same bankruptcy
code, so a bankruptcy of the parent would
not, in and of itself, prompt a bankruptcy
of the subsidiary. In most jurisdictions,
insolvency is treated differently from the
way it is treated in the U.S., and various
legal and regulatory constraints and incentives need to be considered. Still, in all circumstances, it is important to evaluate the
parents credit quality. The foreign parents
creditworthiness is a crucial factor in the
subsidiarys rating to the extent the parent
might be willing and able either to infuse
the subsidiary with cash or draw cash from
it. A separate parent or group rating will be
assigned (on a confidential basis) to facilitate this analysis.
Even when subsidiaries are rated higher
than foreign parents, the gap usually does
not exceed one full rating category. It is difficult to justify a larger gap, because it would
entail a clear-cut demonstration that, even
under a stress scenario, the parents interest
would be best served by keeping the subsidiary financially strong, rather than using it
as a source of cash.
In the opposite case of weak subsidiaries
and strong foreign parents, the ratings gap
tends to be larger than if both were domestic entities. Sovereign boundaries impede
integration and make it easier for a foreign
parent to distance itself in the event of
problems at the subsidiary.
Smoke-and-Mirrors Subsidiaries
Some multibusiness enterprises controlled by
a single investor or family are characterized by:
Unusually complex organizational
structures;
Opportunistic buying and selling of

operations, with little or no strategic
justification;
Cash or assets moved between units to
achieve some advantage for the controlling
party; and
Aggressive use of financial leverage.
By their nature, these types of companies
tend to be highly speculative credits, and it is
inadvisable to base credit judgments on the
profile of any specific unit at any particular
point in time.
The approach to rating a unit of such an
organization still begins with some assessment of the entire group. Some of the affiliated units may be private companies;
nonetheless, at least some rough assessment
must be developed. In general, no unit in the
group is rated higher than the consolidated
group would be rated. Neither indenture
covenants nor nonconsolidation opinions can
be relied on to support a higher rating for a
particular subsidiary.
At the same time, there is no reason for all
entities in a smoke-and-mirrors family to
receive the identical rating. Any individual
unit can be notched down as far as needed
from the consolidated rating to reflect standalone weakness. This reflects the probability
that a weak unit will be allowed to fail if the
controlling party determines no value can be
salvaged from it. Complex structures are
developed in order to maximize such flexibility for the controlling party.
Finance Subsidiaries
Rating Link to Parent
Finance units are unlike other subsidiaries
from a criteria perspective. In turn, there are
two types of finance subsidiariesindependent and captivethat are very distinct in
terms of the analytical approach employed by
Standard & Poors Ratings Services.
Independent Finance Subsidiaries
Independent finance subsidiaries can receive
ratings higher than those of the parent,
because of the high degree of separation
between these subsidiaries and the parent. A
finance companys continuous need for capital at a competitive cost creates a powerful
Standard & Poors
incentive to maintain its creditworthiness.

Therefore, it can be argued that the parent
would be better served, in a stress scenario,
by divesting the still-healthy subsidiary than
by weakening it or risking drawing it into
bankruptcy. In addition, there must be evidence of the parent companys willingness to
leave the subsidiary alone, including a history
of reasonable dividend and management fee
payouts to the parent.
Nonetheless, a finance company subsidiary
rating still is linked to the credit quality of
the company to which it belongs. If the
finance companys credit fundamentals are
stronger than those of the consolidated entity,
one cannot rule out the risk that this strength
could be siphoned off to support weaker
affiliates or service the debt burden of the
parent. Whatever the rating would be on a
stand-alone assessment, it is unlikely an independent finance subsidiary would ever be
rated more than one full rating category
above the parent rating level. To the extent
that part of the receivables portfolio were
related to parent company sales, there would
be an additional tie to the parent risk profile.
Conversely, if the consolidated entitys rating is higher than the subsidiarys, because of
the stronger creditworthiness of the other
affiliates, the analysis would attribute some
of that strength to the finance company, making possible a higher rating than it could
receive on its own. Assessing the degree of
credit support includes the usual subjective
factors, such as management intentions and
shared names of the parent and subsidiary. In
the case of a subsidiary that has been formed
or acquired only recently, a demonstrable
record of support is lacking and questions
might remain concerning the long-term strategy for the subsidiary. Some formal support
likely will be required. The most frequently
used support agreement commits the parent
to maintain some minimum level of net
worth at its subsidiary. Frequently, the parent
also will agree to assume problem assets and
to maintain minimum fixed-charge coverage.
Captive Finance Companies
A captive finance companyi.e., a finance
subsidiary with over 70% of its portfolio
consisting of receivables generated by sales of
89
the parents or groups goods or servicesis

always assigned the same rating as the parent. Captive finance companies and their
operating company parents are viewed as a
single business enterprise. The finance company is a marketing tool of the parent, facilitating the sale of goods or services by
providing financing to the dealer organization
(wholesale financing) and/or the final customer (retail financing).
The business link between an operatingcompany parent and captive is the key consideration supporting the subsidiarys rating
at the parent company level, apart from any
support arrangements between the two. The
parents investment in the captive (in the
form of equity and advances) may also provide economic incentive to maintain the captives financial health.
Conversely, a captive that appears strong
on a stand-alone basis is not rated higher
than its operating company. Because of the
operational tie-in, the parent does not have
the same options for divesting a healthy captive as in the case of an independent finance
subsidiary. Eventually, then, the captives
bankruptcy risk is closely linked to that of its
parent. This viewpoint is based in part on
case history. A parent-company bankruptcy
filing usually will result in a filing by its captive, either simultaneously or soon thereafter.
Captive finance company debtholders may be
better off than the parent debtholders with
respect to ultimate recovery in a liquidation
or reorganization, but bankruptcy would
impair the timeliness of payments.
Methodology
While the captive and parent ratings are
equalized, the two are not analyzed on a consolidated basis. Rather, the analysis segregates
financing activities from manufacturing activities and analyzes each separately, reflecting
the different type of assets they possess. No
matter how a company accounts for its
financing activity in its financial statements,
the analysis creates a pro forma captive unit
to apply finance-company analytical techniques to the captive-finance activity, and
correspondingly appropriate analytical techniques to the operating company. Finance
assets and related debt liabilities are included
90
in the pro forma finance company; all other

assets and liabilities are included with the
parent company. Similarly, only finance-related revenues and expenses are included in the
pro forma finance company.
The debt and equity of parents and captives are apportioned and reapportioned so
that both entities will reflect similar credit
quality. A tentative rating for the two companies is assumed as a starting point. Next, a
leverage factor is determined that is appropriate for the captive at the tentative rating
level, based on the quality of the captives
wholesale and retail receivables. With the
appropriate leverage determined, the analyst
calculates the amount of equity required to
support credit quality at the assumed level,
and the proper amounts of debt or equity can
be transferred either to the parent from the
captive or to the captive from the parent. No
new debt or equity is created.
Next, the analyst determines levels of revenues and expenses reflective of the captives receivables and debt. The higher the
tentative rating, the greater the level of
imputed fixed-charge coverage and return
on assets. For purposes of this analysis, any
earnings support payments are transferred
back to the parent.
The analyst eliminates the parents investment in the captive to avoid double leveraging. The captive is an integral part of the
enterprise, not an investment to be sold.
While its assets can be more highly leveraged
than those of the parent, the methodology
takes that into account when determining an
amount of equity that is apportioned to support its debt.
Following the segregation of the finance
activity, the operating company profile may
not be consistent with the tentative rating.
The methodology is repeated, using parameters of a higher or lower rating level.
Several iterations may be needed to determine a rating level that reflects the credit
quality of both operating and financing
aspects of the company.
Leverage Guidelines
The receivables portfolio of the pro forma
captive entity is analyzed, as for any finance
company. Both quantitative and qualitative
assessments are made. Portfolios deemed to

be of average quality include consumer credit
card, commercial working capital, and agricultural wholesale. Auto retail paper is of
higher quality, all other things being equal,
while portfolios of commercial real estate and
oil credit-card assets are generally less leverageable. Adjustments are made to reflect the
performance of a given subportfolio. In addition, factors such as underwriting, charge-off
policy, and portfolio concentration or diversity are considered.
Securitization of Finance Receivables
An increasingly common funding mechanism for finance companies is the sale or
securitization of finance receivables through
structured transactions. Where companies
sell finance receivables that are regenerative
in nature (such as the operating assets
financed by a captive for its parent), Our
analytical approach in assessing leverage is
to uniformly add back the sold receivables
outstanding and a like amount of debt (the
same treatment as the sale of regenerating
trade receivables of operating companies, as
explained in Rating Methodology:
Industrials and Utilities).
When the level of assets being financed is
truly at the discretion of the finance company, there may be no need to add back
receivables sold. The question then is one of
Standard & Poors
permanence of the level of financial activity.

No adjustment is made to add back the sold
receivables, if the analyst has concluded the
unit will continue to operate at a lower
asset level. In those cases, the analysis
focuses on the actual economic risks
remaining with the company relative to the
sold receivables.
Depending on the type of transaction, the
residual risks take the form of capitalized
excess servicing, spread accounts, deposits
due from trusts, and retained subordinated
interests. If a company retains the subordinated piece of a securitization, or retains a level
of recourse close to the expected level of loss,
essentially all of the economic risk remains
with the seller. There is no rating benefit
deserved because there is no significant transfer of riskand there is no point in analyzing
such a company differently from the way it
would be analyzed had it kept the receivables
on its balance sheet.
Another serious concern is moral recourse,
i.e., the reality that companies believe they
must bail out a troubled securitization,
although there is no legal requirement for
them to do so. Companies that depend on
securitization as a funding source may be
especially prone to taking such actions. In
many situations, this expectation undermines the notion of securitization as a risktransfer mechanism.
91

o improve financial ratio analysis, Standard & Poors Ratings
Services uses a financial model that capitalizes off-balance-
sheet operating lease commitments and allocates minimum lease

payments to interest and depreciation expenses. Not only are
debt-to-capital ratios affected: so are interest coverage, funds
from operations to debt, total debt to EBITDA, operating margins,
and return on capital. This technique is, on balance, superior to
the alternative factor method, which multiplies annual lease
expense by a factor reflecting the average life of leased assets.
The operating lease model is intended to
make companies financial ratios more accurate and comparable by taking into consideration all assets and liabilities, whether on or
off the balance sheet. In other words, all
rated companies are put on a more level playing field, no matter how many assets are
leased and how the leases are classified for
financial reporting purposes. (We view the
distinction between operating leases and capital leases as artificial. In both cases, the lessee
contracts for the use of an asset, entering into
a debt-like obligation to make periodic rental
payments.) The model also helps improve
analysis of how profitably a company
employs both its leased and owned assets. By
adjusting the capital base for the present
value of lease commitments, the return on
capital better reflects actual asset profitability.
Also, leased assets are not available to corporate creditors in the event of a bankruptcy.
92
The resulting junior position of creditors relative to lessors may affect our ratings on specific debt issues. (Note, however, that
recovery of lessors claims beyond the value
of the leased assets themselves also is limited.) If warranted, the debt may be lowered a
notch or two from the corporate rating to
reflect differences in loss-given-default
prospects. Our lease methodology helps highlight the extent of a companys leasing activity and, therefore, its materiality with respect
to such recovery analysis.
Using The Methodology

Lease commitment data for a company are
gathered from the notes to its financial statements. Annual data for the coming five years
is required for accounts prepared under US
GAAPplus the aggregate amount for subsequent years. Under IFRS, all years need not
be individually displayed; the analyst must

decide how to best allocate the lump sum to
individual years. For the remaining lease
years, our model assumes the annual lease
payments approximate the minimum payment due in year five. The number of years
remaining under the lease is simply the
amount thereafter divided by the minimum
fifth-year payment.
The required lease payments generally are
taken gross, rather than netting out sublease
income; but, when the head-lease and sublease
are matched and the counterparty is sufficiently creditworthy, we would use net payments.
For the present value calculation, we generally use as the discount rate the issuers average interest rate (that is, interest
expense/average debt outstanding) from the
most recent annual statements, which is
reflective of the issuers cost of borrowed
funds. (For example, to derive the discount
rate for adjusting 2004 financials, we will use
2004 interest expense divided by the average
of year-end 2003 and year-end 2004 total
debt.) Interest cost is adjusted to eliminate
any distorting effects of capitalized interest,
interest income, or derivatives-related
gains/losses. (Also, if a companys borrowing
cost has soared because of financial distress,
we avoid the perverse result of a seemingly
shrinking lease obligation. In such a case, we
will use the average of several years borrowing rates or a market B rate, instead of the
companys average borrowing rate from the
previous year.)
Ideally, we could use an even better alternative for the discount factor: the interest
rates, or money factors, imputed in the
Table 1Lease
Model Calculation*
Reporting year
Payment period
2004
2003
Year 1
61.0
65.8
Year 2
54.0
53.3
Year 3
46.1
46.5
Year 4
42.6
41.9
Year 5
38.7
39.6
Thereafter
177.9
177.9
Total payments
420.3
425.0
* Reported figures: Future minimum lease commitments (mil. $)
Standard & Poors
companys actual leases, upon inception.

Another alternative might be the companys
average cost of secured debt. Where sufficient
information is available and operating lease
obligations are material, it is appropriate to
use one of these bases instead. However, it is
important for the sake of consistency that all
companies in an industry peer group be
adjusted in a consistent manner.
The resulting present-value figure is added
to reported debt to calculate the total-debtto-capital ratio. The figure also is added to
assets to account for the right to use leased
property over the lease term. Although less
than the cost of the property, this adjustment
recognizes that control of the property creates
an economic asset.
The implicit interest is calculated by multiplying the average net present value at the
end of the current and previous years by the
rate used as the discount rate. This figure is
then added to the companys total interest
expense. The SG&A adjustment is calculated
by taking the average of the first-year minimum lease payments in the current and previous years. SG&A is then reduced by this
amount. Depreciation expense is calculated
by subtracting the implicit interest from the
SG&A adjustment. The lease depreciation is
then added to reported depreciation expense.
The interest and depreciation adjustments
attempt to allocate the annual rental cost of
the operating leases. There is ultimately no
change to reported net income as a result of
applying the lease analytical methodology.
Financial ratio effect
EBIT: The implicit lease depreciation
adjustment is added to D&A expense; the
adjustment to SG&A expense reduces
SG&A expense. The result is to increase
EBIT by the difference between the
implicit lease depreciation and SG&A
adjustments, or $17.9 million as shown in
Table 2, which also is the amount of the
implicit interest.
EBITDA: In this case, only the implicit
interest is added to EBITDA. The result is
that EBITDA is increased $17.9 million.
The rationale for not including implicit
depreciation is that EBITDA is often used
as a proxy for cash flow. However, rental
93
expense is a cash expense, and it seems

inappropriate to consider the entire rental
expense as being available to pay interest.
Moreover, EBITDA interest coverage, a key
credit ratio, can be quite distorted by
adding both implicit interest and depreciation to the numerator while adding only
implicit interest to the denominator.
Interest expense: The implicit interest
figure, $17.9 million, is added to total
interest expense.
Total debt: The net present value of lease
payments, $336.5 million, is added to
total debt.
Operating income before D&A: Standard &
Poors typical calculation for the operating
margin adds D&A back to operating
income. When the operating lease adjustment is made, operating income is increased
by the adjustment to SG&A expense,
$63.4 million.
Funds from operations: Funds from operations is increased by the implicit lease
depreciation expense, $45.5 million
which is recharacterized as an increase in
capital expenditures.
Capital expenditures: The portion of the
lease payment that represents the actual use
of the asset$45.5 million in our examTable 2Calculation
pleis added to capital expenditures,

which reduces free cashflow by a like
amount. Also, the increase in the net present value of lease payments from year to
year is shown as an increase in capital
spendingalbeit without any effect on net
cash. This adjustment highlights situations
where a company is increasing its level of
asset leasingpresumably in lieu of conventional spending. Without such an
adjustment, we might mistakenly conclude,
for example, that the company was underspending for its capital equipment needs.
(Since factors other than new lease take-up
can lead to that increasesuch as changes
in foreign exchange rates or the implicit
rate used in calculating the net present
valuewe would try to be mindful of what
was actually occurring.)
Limitations Of The Model

Analysts and investors need to be aware of
the limitations of our model. In many cases,
our computed lease-related debt is significantly understated. We base our capitalization of the lease obligation on the disclosed
stream of minimum future rental payments,
even when we expect contingent payments
Of Operating Lease Adjustments For 2004

2004
2003
2002
659.4
664.9
766.8
36.2
40.2
5.5
5.6
61
65.8
2006
54
53.3
2007
46.1
46.5
2008
42.6
41.9
2009
38.7
39.6
2010 - 2014
38.7
Total debt (reported)

Total interest (incl. capitalized interest)
Implied interest rate
Future minimum lease commitments (mil. $)
2005
2009 - 2012
Net present value (NPV)
2004 implicit interest
318.7
Avg. NPV ($327.6) x interest rate (5.5%) = $17.9
Lease depreciation expense
Adjustment to SG&A* - implicit interest = $63.4 - $17.9 = $45.5
Adjustment to SG&Arent
Avg. first-year min. payments ($61.0 + $65.8)/2 = $63.4
*SG&ASelling, general, and administrative expenses.
94
39.6
336.5
Table 3Sample
Calculation Results
Without
capitalization
With
capitalization
Oper. income/
sales (%)
18.6
21.2
EBIT interest
coverage (x)
8.7
6.2
EBITDA interest
coverage (x)
12.3
8.6
Return on capital (%)
18.9
15.6
Funds from oper./

total debt (%)
54.1
40.4
Total debt/EBITDA (x)
1.5
2.1
Total debt/capital (%)
37.6
41.0
to increase actual rental expense significantly above the minimums. Also, by basing our
calculation of the liability on the minimum
future lease payments, we effectively carve
out any consideration of indirect residual
risk because, under FAS 13, if the present
value of the minimum lease payments is
90% or more of the fair value of the asset,
the lease is not classified as an operating
leasebut as a capital lease. So at least 10%
of the asset value gets overlooked. (If, however, a company extends a residual guarantee for assets under operating leases, this
should be reflected in our analysis as a debt
equivalent.) IFRS accounting poses similar
issues of understatement.
More broadly, our adjustment model does
NOT seek to replicate a scenario in which
a company acquired an asset and financed
it with debt; rather, our adjustment is narrower in scope: it attempts to capture only
the debt-equivalent of a companys lease
Standard & Poors
contracts in place. Whenever a company

leases for five years an asset with a 20-year
productive life, the adjustment picks up
only the lease period, ignoring the cost of
the entire asset that would have been purchasedand depreciatedby a company
that chose to buy instead of lease.
Alternate methodologies (known as factor
methods) attempt to replicate a debt-financed
purchase of the operating asset. The conceptual advantages of these methodologies
especially in terms of comparing
companiesare limited by other analytical
shortcomings and considerations. The factor
methods use multiples of annual expense to
estimate the asset valuetypically in a crude
or arbitrary fashion. Also, while incorporating the equivalent of owning the entire asset,
these methodologies lack the ability to differentiate between the first year of the assets
life, the last year, and all points in between.
(An asset actually purchased would be depreciated over its life.) And, by putting leasing
and ownership on a supposed apples-toapples basis, they gloss over the potential
flexibility associated with leasing only part of
an assets economic life.
Given the alternatives, we prefer our current, present-value methodology. However,
there could be merit in using more than one
method to capture leasing activityespecially
if some of the problems with the factor methods can be addressed. We intend to explore
the possibility of introducing a methodology
that is more comprehensive (i.e., which would
replicate a full asset purchase) to supplement
the current methodology.
95
tandard & Poors Ratings Services views unfunded liabilities
relating to defined benefit pension plans and retiree medical
plans as debt-like in nature. This also is the case with deferred

lump-sum payment schemes, such as termination programs for
employees in Italy. By accepting a portion of their compensation
on a deferred basis, the employees essentially become creditors
of the company. As with conventional debt, these liabilities pose
risks to their corporate sponsors from the call on future cash flow
they represent. (Defined contribution plans generally are not
problematic because they must be funded on a current basis, and
the corporate sponsor does not bear ongoing investment
performance risk.)
A companys postretirement obligations
affect its financial position, and also may be
germane to its competitive position. Most
problematic is when peers face different
retiree costs. Companies that have been relatively generous, have an older workforce, or
have a comparatively large number of
retirees, cannot raise their own selling prices
more than those of their competitors.
Likewise, competitors in different countries
often are not saddled with similar costs
because of differences in pension and health
care systems in their respective countries.
Any company more burdened with such
retiree costs than its competitors will be
96
penalized in the assessment of its overall

cost position. The implications for its competitiveness are no less than if it had older,
less efficient manufacturing facilities. Such a
competitive advantageor disadvantageis
an important rating consideration.
Distinguishing characteristics
Various characteristics distinguish unfunded
postretirement liabilities from debt obligations. One is the difficulty of measuring their
value. Because of the prospective and variable
nature of postretirement obligations, their
quantification relies on numerous assumptions, including:
Employee turnover rates and length of

service, whereby the length of time the
worker is employed by the company determines eligibility for and the size of the
retiree benefit;
Mortality rates, given that the employees
lifespan determines how long he or she
receives the benefit;
Dependency status, if the plan covers surviving dependents;
Compensation levels, if the employees wages
or salary prior to retirement is a factor in
determining the amount of the benefit;
Discount rate, which is required to calculate a present value of the future required
cash outflows; and
Return on benefit plan investments. To the
extent that the benefit is prefunded with
investment assets, if positive, the returns
realized on those assets will help defray the
cost of the benefit.
Because retiree medical benefits are not
monetary in nature, but rather are in-kind
benefitsi.e., the employee is promised
future health care servicesthere is additional uncertainty. Assumptions must be made
about future changes in health care inflation
and in health care use and delivery patterns.
Not simple matters.
Because of these difficulties, the analytical
exercise does not try to quantify a precise
amount to represent the postretirement obligation. As discussed below, sensitivity analysis is a better way to capture a companys
exposure than by focusing on a single figure.
Further, managements actions to modify
plan benefits or regulatory changes could
alter the value of the liability over time.
Standard & Poors pays close attention to
managements strategies for reducing the
cost of the burden and assesses these strategies in the context of the companys labor
relations; however, we naturally are reluctant to prejudge the success of any such
strategies, particularly if the workforce is
tightly unionized, and determined to resist
such cost-cutting efforts. Similarly, in theory, there always is the potential that some
significant change in the regulatory framework could enable a corporation to shift
some portion of its postretirement benefits,
burden to the government, but it hardly is
Standard & Poors
prudent to assume such a solution would

emerge. Indeed, there also is the risk governments could tighten funding requirements, as recently did Spain and
the Netherlands.
National/regulatory differences
Analysis of postretirement benefit obligations must take into account the differences
among countries regulatory systems. In
some countries (e.g., France, Italy, and
Spain), corporations do not bear such obligations directly to any material extent; pension and other postretirement benefits are
provided largely under governmental, rather
than corporate, schemes. Corporations generally must support these schemes indirectly
through taxes. Obviously, a companys overall tax burden must be considered in the
analysis of its cash flow.
In other cases, the benefit is provided
directly by corporations. Furthermore, strict
regulations require the company to prefund
the benefit by making contributions to dedicated trusts well in advance of the ultimate
disbursal of funds to retirees or third-party
insurers. This insulates retirees from the risk
that the company might become unable to
honor its commitments. Under such regulations, however, the company typically
retains some discretion to decide how much
to contribute in a given year. This is the
case with defined-benefit plans in the U.S.,
governed by the Employee Retirement and
Income Security Act (ERISA) of 1974 and
by the tax code, and with such plans in the
U.K. and the Netherlands.
In still other cases (e.g., defined-benefit
pensions in Germany and retiree medical
benefits in the U.S.), the benefit is provided
directly by companies, but there is no regulatory requirement to prefund and, typically,
no tax incentive for doing so. In such payas-you-go systems, the cash burden on the
company may be light for many years if the
company has a young workforce and few
retirees. On the other hand, if the company
has a high ratio of retirees to active employees, the ongoing cash outlays may be onerous. Moreover, under this system, there is
virtually no flexibility in the timing of payments: the retirees are owed their benefits.
97
If a company does business in more than

one country, Standard & Poors pays close
attention to the geographic profile of its
postretirement benefits obligations and the
relevant regulatory requirements.
Assessing the liability
As a practical matter, the companys financial
reporting is the best starting point because of
the accessible, timely, and comprehensive
nature of financial reporting information
compared with other sources. Analysts must
be wary, however, of the relatively uncertain
nature of accounting for postretirement obligations, given all the assumptions necessary
for their measurement, discussed above.
Moreover, in virtually all national accounting systems, as well as under International
Accounting Standards (IAS), those setting the
accounting standards have sought to avoid
volatile swings in earnings and liability values; hence, the extensive use of various
smoothing techniques, in which underlying
net liability changes and variations in actual
performancerather than assumptionsare
recognized on a deferred basis over an
extended period. (See Pitfalls of U.S.
Pension Accounting and Disclosure.)
The first step in analyzing postretirement
obligations is to examine key assumptions
used to quantify the obligations and determine expense accrual for financial reporting
purposes. The discount rate, wage appreciation, expected investment return, and medical
inflation rate are all disclosed under U.S.
GAAP. The use of actuarial assumptions
regarding mortality, dependency status, and
turnover can lead to more or less conservative estimations, but these assumptions are
not disclosed directly in financial reporting;
however, unrecognized losses or gains relating
to changes in actuarial assumptions indicate
further investigation is warranted.
When assessing assumptions, we focus on
differences among companies. Assumptions
are considered in light of an issuers individual characteristics, but also are compared
with those of industry peers and general
industrial norms. In addition, assumptions
are assessed in terms of their internal consistency. For example, both the discount rate
and rate of future compensation increases
98
should be closely linked to the rate of inflation. If the discount rate assumption significantly exceeds the assumed rate of
compensation increases, this may reflect
overoptimism by management about its ability to contain wage and salary increases.
Quantitative adjustments may be made to
normalize assumptions. For example, one
rough rule of thumb is that for each percentage point increase or decrease in the
discount rate, the liability decreases or
increases by 10% to 15%. At the very least,
any liberal or conservative bias is taken into
account when looking at the reported plan
obligations and assets.
The next step is to compare the current
value of a companys plan assets to the projected benefit obligation (PBO) for pensions,
or to the accumulated postretirement benefit
obligations (APBO) for retiree medical benefit
obligations. In the case of flat-benefit pension
plans (i.e., the pension benefit is a fixed
amount per year of service, rather than payrelated plans, in which the benefit for each
retiree is derived from a formula tied to compensation over a specified period), the PBO
likely understates the true economic liability.
This is because the PBO does not take
account of future benefit improvements for
these plans, even if probable, unless provided
for in the current labor agreement. In such
cases, the analyst estimates the additional
economic liability based on the companys
pattern of granting benefit improvements and
managements current strategies with respect
to compensation.
A companys plan assets as a percentage of
the PBO or APBO is a simple, basic measure
of plan solvency, referred to here as the funding ratio. Companies with the same funding
ratios in their benefit plans do not, however,
necessarily bear the same risks related to their
plans. The size of the gross liability is also
important because, where the gross liability is
large relative to the companys assets, any
given percentage change in the liability or
related plan assets will have a much more significant effect than if the gross liability had
been less substantial.
To bring the depiction of postretirementrelated items in the financial statements
more in line with its own analytical perspec-
tive, Standard & Poors has devised certain

ratio adjustments (see Adjusting Financials
for Postretirement Liabilities). These
adjustments are intended to undo the
smoothing of the accounting treatment and
reallocate certain accounting effects in the
statements while integrating the analysis of
postretirement obligations with other aspects
of the financial analysis. This last point is
particularly important because of the different funding approaches and regulations that
pertain to different plans. For example, as
noted earlier, pension plans in Germany
largely are unfunded; however, major
German industrial companies commonly
hold large cash balances and long-term
financial assets on the balance sheet to provide for future pension-related cash requirements. Analytically, as long as Standard &
Poors is comfortable that these assets will
be retained over the long term to satisfy the
pension-related obligations, the arrangement
might well be viewed as if the pension plan
had been funded. If, however, such a companys capitalization were analyzed without
factoring in the pension liability, one could
make the mistake of netting the surplus cash
against debt, thereby double-counting the
cash position and underestimating the companys financial leverage.
Beyond determining the plans current level
of funding, the analyst must also consider the
likelihood of significant changes made in the
liability or assets in the future. As an example, workforce downsizing through early
retirement programs is a major issue in the
current economic environment. The potential
for changes in benefits largely is a function of
the labor climate and the level of benefits relative to those of direct competitors and other
regional employers. Similarly, to take a
prospective view of plan assets requires the
sponsors input regarding its funding strategies and asset allocation guidelines.
Regarding the latter, we do not have a preferred strategy: heavy weighting toward equities heightens near-term volatility, butif
experience holds trueshould enhance longrange returns. Conversely, heavy weighting
toward fixed-income holdings should minimize near-term volatility, but may well limit
long-range returns.
Standard & Poors
Although Standard & Poors views unfunded

postretirement obligations as debt-like, the
surplus relating to overfunded plans generally
cannot be viewed as a cash equivalent. Having
a significantly overfunded postretirement benefit plan is, of course, a positive from a credit
perspective. If nothing else, it generally means
the company can curtail future contributions
to the plan, barring changes in asset or liability levels. Companies can use the surplus to
enrich the retiree benefits (possibly in lieu of
raising wages) or sometimes to fund special
workforce reduction programs. In the U.S., a
portion of the surplus can also be used to fund
retiree medical benefits in some circumstances.
But in the U.S.as in most other countries
companies with overfunded pension plans may
have little practical ability to revert the surplus: In the U.S., there are harsh tax consequences for doing so. (Amounts recaptured are
subject to ordinary income tax, plus a punitive
excise tax.)
Cash-Flow implications
The level of necessary future cash outlays has
the most immediate effect on a companys
financial health. Standard & Poors focuses on
prospective outlays. Information about the regulatory funding status of the plan, a companys
workforce, the makeup of its retiree population, its benefit plan characteristics, and managements cost-cutting and funding strategies
helps the analyst understand the likely direction of future cash outlays.
For plans in which prefunding is mandated by regulations, the degree of discretion
over payments is critical. The cash requirements for U.S. corporate sponsors are significantly shorter term than the underlying
disbursals to retirees, but ERISA usually
grants considerable flexibility in the year-toyear timing of contributions, except when
the plan is severely underfunded. Near-term
minimum funding requirements often are
low enough that companies can sharply curtail contributions temporarily if needed to
maintain liquidity. (In Japan, pension regulations grant companies significantly greater
flexibility to defer contributions over an
extended period than the U.S.) When funding is required in the near term to comply
with ERISA guidelines, the amounts
99
involved are viewed in a different, more

severe, light.
The calculation of minimum pension plan
contributions under ERISA is a highly complex
matter. Although the ERISA framework has
some similarities to the financial reporting
framework, ERISA uses its own distinct
methodologies and assumptions for valuing the
assets and liabilities of the plan. Funding
requirements are not just a function of the current funded status of the plan, but also take
into account the past funded status, the level of
past contributions relative to requirements, and
the nature of the events that gave rise to any
underfunding, among other factors.
In theory, it is possible to arrive at a rough
estimate of the companys minimum future
contribution levels by using the publicly
available Annual Return/Report of Employee
Benefit Plan on Form 5500, filed by the corporate plan sponsor; however, one such form
is filed for each qualified U.S. plan of a company, and large companies may have dozens
of separate plans. Moreover, the timeliness of
Form 5500 is problematic: it must be filed
210 days after the end of the plan year or
after the sponsor has filed its federal income
tax form, whichever is later. As a practical
matter, then, Standard & Poors relies on
management for information regarding the
companys future minimum pension contributions to meet regulatory requirements.
Other factors besides funding regulations
can influence funding decisions. For example,
in the U.S., benefits provided under qualified,
defined-benefit pension plans are guaranteed
by a quasi-governmental entity, the Pension
Benefit Guaranty Corp. (PBGC), which, in
turn, charges plan sponsors an annual premium, currently $19 per plan participant. If a
plans assets are less than the vested portion
of the liability (as measured under the very
conservative methodology stipulated by the
PBGC, which is different from the ERISA
approach), an additional, variable annual
premium is assessed of $9 for each $1,000 of
unfunded liability. Moreover, the plan sponsor must notify plan participants of the plans
underfunded status. Companies often make
sufficient contributions to their pension plans
to avoid these consequences, even if they are
not required to do so under ERISA.
100
Perversely, perhaps, financial reporting can

also drive funding decisions. For example,
under U.S. GAAP, if the value of plan assets
falls below that of the APBO, a large charge
to equity can result (Pitfalls of U.S. Pension
Accounting and Disclosure, again).
Companies sometimes make contributions to
avoid this reporting effect, particularly if
financial covenants might thereby be violated.
In the U.S., there are some tax-effective
means of prefunding retiree medical benefits.
One funding vehicle is the so-called
Voluntary Employees Beneficiary Association
(VEBA) trust. As with pensions, contributions
to a VEBA trust generally are tax-deductible
up to a certain limit, and earnings on trust
investments are tax-exempt. VEBA trusts are
more flexible than pension trusts: Although
VEBA funds cannot be reverted directly by
the corporate sponsor, they can be used to
pay for a variety of current benefits-related
expenses, thereby freeing up other cash. For
this reason, though, if a company is at all
inclined to use its VEBA assets in this way,
Standard & Poors tends to view the asset as
an extension of the companys ready liquidity
position, rather than as offsetting a portion
of the retiree medical liability.
In some cases, companies issue debt to
finance their benefit plan contributions. In
assessing the effect on credit quality,
Standard & Poors considers:
Any loss of payment-timing flexibility.
For example, if the company issues debt
with a five-year term to satisfy funding
contributions that could otherwise be
spread over up to 10 years, this could
well be viewed negatively;
The maturity of the new obligation compared with the terms of the obligations it
replaces. For example, if the company is
able to eliminate looming, near-term funding requirements with a long-term
debt issue, this could be a positive
development;
Tax consequences, such as the cash flow
benefit of accelerating a tax-deductible
contribution; and
The implications for the companys debt
issuance capacity, to the extent the
company might have other borrowing
requirements.
In most countries, companies are permitted

to contribute limited amounts of their own
stock to their benefit plans, substituting for
or supplementing cash contributions.
Standard & Poors views such transactions as
similarin their beneficial effectto the
companys issuing common stock and using
the proceeds to reduce financial obligations.
One difference, however, is the correlation
risk that results: If the company encounters
significant setbacks, this would presumably
be reflected in a weaker share price, which
could cause deterioration in benefit-funding
levels and precipitate accelerated funding
requirements. (For this reason, funding regulations generally set some limit on contributions of so-called employer securities. For
example, under ERISA, such contributions
cannot exceed 10% of the fair value of plan
assets, as determined through a closely scrutinized valuation process.)
Ultimate recovery considerations
For companies with significant unfunded
postretirement benefit obligations, the standing of such obligations in bankruptcy can be
an important consideration for creditors. It
may affect their willingness to lend, as it
obviously has a bearing on ultimate recovery
in a reorganization or liquidation. Analysis
of this matter is highly specific to the legal
system and type of benefit in question, as
well as to the legal structure of the corporation. In the U.S., unfunded pension liabilities
typically have the standing of general unsecured claims. (The PBGC or the company
generally terminates the plan, and then the
PBGC pursues a claim against the company
for the funding shortfall.) Companies in
financial distress could have been granted
funding waivers by government regulators in
return for liens on assets in advance of a
bankruptcy filing, but this is rare among
rated companies.
The standing of retiree medical liabilities in
the U.S. is less clear-cut because these do not
enjoy the same degree of protection under
ERISA. If, however, the benefits are owed
under the terms of a labor contract, the companys voiding of the contract in bankruptcy
would give rise to a general unsecured claim
by employees and retirees. If the company
Standard & Poors
were to reorganize rather than liquidate, this

claim would most likely be settled through
the continuation of the benefit, albeit perhaps
in a reduced form, rather than a monetary
payout. This wouldat least, in theorystill
dilute the recovery of other senior unsecured
claims, because the liability in its new capital
structure would limit the reorganized companys debt capacity.
Pitfalls of U.S. pension
accounting and disclosure
All areas of financial reporting require management to make estimates and judgments,
but this is particularly true of accounting for
defined-benefit pension plans. Given the
prospective and variable nature of the promise companies make to provide pension benefits to retirees, pension accounting relies on
numerous subjective assumptions (e.g.,
employee turnover, mortality rates, compensation levels, discount rates, and investment
returns). Moreover, the standards that currently govern pension accounting under U.S.
GAAPStatement of Financial Accounting
Standards No. 87, Employers Accounting
for Pensions (SFAS 87)were issued in
1985, despite intense opposition from many
companies. The Financial Accounting
Standards Board (FASB) responded with various compromise provisions to smooth the
effect on earnings and on the balance sheet
of pension-related factors. Consequently,
some aspects of the financial reporting
for pensions are incongruent with the
analytical perspective.
Aspects of the current accounting framework that represent potential pitfalls for analysts include the following.
Balance-sheet aspects
SFAS 87 defines the pension liability
two ways:
The accumulated benefit obligation (ABO)
is a measure of the present value of all benefits earned to date and includes nonvested
and vested benefits attributable to services
rendered through the balance sheet date. It
approximates the value of benefits that
would be payable if the company were to
terminate the plan, so it represents a shutdown perspective.
101
The projected benefit obligation (PBO)

also is a measure of the liability for accumulated service, but, unlike the ABO, it
also accounts for the effect of salary and
wage increases on benefit payouts that are
linked to future compensation levels by
some formula (for example, where the
benefits are based on a fixed percentage of
the average annual compensation over the
five years prior to the employees retirement). The PBO thus values the pension
promise at the amount for which it will
ultimately be settled as the company continues as a going concern.
Measurement of the ABO and PBO
requires the company to make many assumptions. Most important, because the liability is
calculated as the present value of estimated
future payments to plan beneficiaries, the liability valuation is highly sensitive to the discount rate used. (The lower the discount rate,
the higher the liability, and vice versa.) SFAS
87 directs companies to ...look to available
information about rates implicit in current
prices of annuity contracts that could be used
to effect settlement of the obligation [and]
also...to rates of return on high-quality fixedincome instruments currently available and
expected to be available during the period to
maturity of the pension benefits.
The discount rate therefore should differ
among companies, to the extent they operate
in regions with different prevailing interest
rates and have different workforce demographics. In actuality, though, as many
observers have noted, discount rate assumptions vary significantly more widely among
companies than underlying differences in
these variables would justify. If the ultimate
pension benefit payout is linked to compensation levels, the assumption regarding salary
or wage increases also is crucial. In theory,
this assumption should bear a close correlation to the discount rate because both reflect,
at least partly, the expected inflation rate. If
the discount rate is significantly higher than
the rate of compensation increases, this may
well reflect an overly optimistic view by management about its ability to contain salary
and wage cost increases.
Under the framework of SFAS 87, the PBO
is the basis for expense recognitioni.e., the
102
accounting seeks to spread the total cost

reflected in the PBO over the working careers
of the employees earning pension benefits. In
the pension footnote, the PBO is compared
with the fair value of plan assets to derive the
funded status of the plan. (Note: companies
can use a measurement date up to 90 days
earlier than the balance sheet date to facilitate preparation of the financial statements.
This can distort comparisons between the
funded status of different companies.) This
PBO-related funded status is the best measure
of a companys pension-related liability or
surplus, and therefore is the one upon which
Standard & Poors focuses.
However, the ABO, not the PBO, serves as
the basis for balance-sheet recognition of any
unfunded liability. Under the rules of SFAS
87, the relationship of different balance-sheet
accounts to the underlying economic reality
of the plan is sometimes tenuous. In the normal course of affairs, a company records a
liability on the balance sheet to the extent
that its pension expense exceeds its plan contributions. To the extent that a companys
plan contributions exceed its accrued
expense, the company records a prepaid pension asset on the balance sheet.
Strangely, an asset also can be created as a
result of benefits enhancements that increase
the value of the liability: This intangible asset
reflects the presumed economic benefit the
employer derives from the plan improvementfor example, better labor productivity
from a happier workforce. From an analysts
perspective, the increase in the amount of the
liability is more prudently interpreted as a
sunk cost. However, if at the end of a fiscal
year the fair value of plan assets is less than
the ABO, the company must record a socalled minimum liability by increasing any
existing balance sheet liability to the level of
the unfunded ABO and eliminating any existing asset accounts, with the offset being an
after-tax charge to equity (which flows
through other comprehensive earnings,
rather than net income). In other words, the
additional liability is ABO less (the market
value of plan assets plus already accrued liabilities less already accrued assets).
As Table 1 illustrates, this requirement
means a nominal change in the funding status
Table 1Quirks
of Liability and Asset Recognition
Under SFAS 87*

Example 1
Year ended Dec. 31
(Mil. $)
2001
2002
Accumulated benefit obligation (ABO)
80
100
Plan assets
80
80
15
Pension-related assets
Prepaid pension assets
Intangible assets
15
Pension-related liability
20
Change in net worth
(5)
Unamortized prior service cost
At year-end 2001, the company's pension plan was fully funded relative to the ABO. During 2002, the ABO increased by $20 million: $15
million because of plan amendments and $5 million because of variances from actuarial assumptions. Thus, at year-end 2002, the company
recorded a liability of $20 million. Offsets: the $15 million of the $20 million increase in the ABO resulting from plan amendments gives
rise to a $15 million intangible asset, and the balance reduces net worth.
Example 2
Year ended Dec. 31
(Mil. $)
Plan assets
2001
2002
100
80
80
Intangible assets
20
Change in net worth
(20)
In this example, there also was a $20 million increase in the ABO. The entire increase results from actuarial losses, however. Thus, net
worth is reduced by the entire $20 million.
Example 3
Year ended Dec. 31
(Mil. $)
2001
2002
80
100
Plan assets
80
80
Intangible assets
15
20
(5)
Change in net worth
In this example, the facts are exactly the same as in Example 2, except that the company already had accrued expense on the balance
sheet of $15 million. Thus, it is necessary to record only another $5 million to increase the balance sheet liability to a total of $20 million.
Standard & Poors
103
Table 1Quirks
of Liability and Asset Recognition
(continued)
Example 4
Year ended Dec. 31
(Mil. $)
2001
2002
80
100
100
100
30
30
Intangible assets
Change in net worth
Plan assets
In this example, the company had a $20 million pension funding surplus at Dec. 31, 2001, and a $30 million prepaid pension asset account
because, historically, its plan contributions had exceeded its accrued expense. (Under SFAS 87, there is no direct connection between the
actual size of the surplus and the amount of the prepaid asset account.) During 2002, the ABO increased to $100 million (because of
actuarial losses), eliminating the funding surplus. Because the plan was still fully funded at Dec. 31, 2002, however, there was no writedown of the prepaid asset account. A $30 million prepaid asset account remains, even though there is no pension funding surplus. (Had
this been a $30 million intangible asset, the treatment would have been the same.)
Example 5
Year ended Dec. 31
(Mil. $)
Plan assets
2001
2002
80
100
100
99
30
30
Intangible assets
31
Change in net worth
(31)
In this example, the facts are same as in Example 4. However, apart from the increase in the ABO, there was a $1 million decrease in the
value of plan assets. Thus, the plan was underfunded by $1 million at Dec. 31, 2002, relative to the ABO. The company's balance sheet
must now show a $1 million net liability, the shortfall of plan assets compared with the ABO. Thus, the company must record a $31 million
liability to offset the $30 million prepayment. Had the $30 million prepaid asset been an intangible asset instead, this would have been
written off against equity, and only a $1 million liability would have been recorded. *All examples ignore tax effects.
could result in a huge reduction in equity.

Analysts must be especially alert to the potential for a charge to equity in cases where
companies have financial covenants tied to
book equity levels. Yet, although the ABO is
the crucial benchmark for triggering such a
charge, companies are not required to disclose the ABO (except, indirectly, if a company has already had to book a minimum
liability)only the PBO.
Income-statement aspects
Although the PBO and ABO are subject to
volatile year-to-year fluctuations, SFAS 87
104
was structured to minimize earnings volatility. Pension expense consists of a number of

components, which can be grouped into
four categories:
Service cost. This is the value of benefits
earned by active employees during the period. From an analytical perspective, this is
akin to a normal operating expense;
Interest cost. This results from the aging
of the liability within the present-value
framework. The discount rate is applied to
the PBO at the beginning of the period.
From an analytical perspective, this is akin
to a financing charge;
Expected return on plan assets. This is

managements long-range expectation
about the performance of the investment
portfolio, rather than the actual return generated during the reporting period, based
on planned asset allocations. Companies
are given little guidance in the accounting
literature for setting this assumption, and
the assumptions used vary widely. From an
analytical perspective, this is a dubious
proposition at best. (Imagine if plain vanilla operating earnings were reported based
on managements long-range expectations.)
Moreover, as an alternative to being based
on the fair value of assets at the beginning
of the period, the assumed return rate can
be applied instead to the market-related
value of plan assetsi.e., on a basis that
smoothes out market fluctuations over a
period of up to five years; and
Amortization cost. Any changes in the liability resulting from plan amendments are generally amortized over the expected average
future service of employees who are active at
the date of the amendment. In addition, any
changes in the liability resulting from actual
experience that is different from the assumptionbeyond a threshold (i.e., 10% of either
the PBO or the market-related value of plan
assets, whichever is larger)also are amortized over an extended period. Examples
include shortfalls in investment performance,
the effect of unanticipated early retirement
programs, variances in mortality, and
changes in the discount rate. From an analytical perspective, these all represent items
without economic substance: all are losses or
gains that have already been realized in economicif not accountingterms.
The reliance on expected investment
returns is the element of SFAS 87 that has
drawn the harshest criticism of late, as companies have clung to return assumptions that
seem aggressive after three years of negative
actual returns. For one thing, although these
assumptions may be justifiable based on a
very long-range view, minimum funding
requirements under the Employee Retirement
Income Security Act (ERISA) will in some
instances necessitate substantial funding over
much a shorter timeframe, barring a dramatic
rebound in the stock market.
Standard & Poors
Separately, even without making aggressive

investment return assumptions, some companies are reporting sizable net pension credits
(that is, the expected return on plan assets
more than offsets the other cost components),
generally reflecting the significant overfunding of their pension plans. Overfunded benefits plans are a positive factor from a credit
perspective. Yet, the advantages this provides
may well be overstated by the credits (given,
for example, the practical inability of most
companies to directly revert the surplus), and
Standard & Poors takes this into account
when arriving at a rating.
Under SFAS 87, all the cost components
are aggregated, although from an analytical
perspective, as mentioned above, the interest
cost and investment returns are more appropriately viewed as financing items. In addition, the accounting literature contains no
definitive guidance on how to display the
pension cost on the income statement, so it is
variously classified with cost of goods sold,
SG&A, R&D, etc. Companies are not
required to disclose how they have allocated
pension cost among these accounts.
Cash-flow aspects
The elements of accrual accounting that
make the balance sheet and income statement aspects of SFAS 87 problematic do not
have the same effect on the statement of
cash flows, which reverses noncash accruals
and reflects only the cash flows related to
the pension plan. There is no standardization regarding where pension plan contributions should be presented on the statement
of cash flows, however, nor any requirement
that these be identified separately. As discussed in the related article mentioned
above, funding that significantly exceeds or
falls short of the normal period pension cost
(net of financing costs) is most appropriately
viewed from an analytical perspective as a
financing item, but adjusting for the distortions that otherwise can result is greatly
complicated by the lack of better disclosure.
Ultimately, if a company has a significant
unfunded pension liability and faces material
required pension fund contributions, its
funding position as defined under ERISA
rather than SFAS 87is the most relevant
105
analytical consideration. Yet, companies are

not specifically required by the SEC to disclose their ERISA funding positions or their
expected future minimum contributions as
determined under ERISA. Likewise, the contributions necessary to avoid Pension Benefit
Guaranty Corp. (PBGC) variable-rate premiums, even though avoiding these can also be
a powerful incentive for companies to make
plan contributions.
Adjusting financials for
postretirement liabilities
Standard & Poors uses certain financial
adjustments and ratio definitions to help
ensure that ratings on industrial companies
fully reflect unfunded, defined benefit pension and other postretirement obligations,
including health care obligations, retiree
lump-sum payment schemes, and other
forms of deferred compensation, whether
partially funded or completely unfunded. If
benefits-related matters are material,
Standard & Poors we will calculate capitalization and cash flow protection measures
that fully reflect such unfunded benefits
obligations. Also, in its analysis of profitability, Standard & Poors will undo certain distortions that result from current
accounting standards and their application.
Given the intricacies of benefits-related regulations and financial reporting, Standard &
Poors must strike a balance between what,
on one hand, might seem like the most correct approach and, on the other hand, what
is feasible in light of the practical limitations
of the analytic process.
In any event, if benefits obligations constitute a major rating consideration, ratio analysis will not substitute for a close
consideration of the issuers particular circumstances and its benefits plans. Note:
Funding and liquidity considerations may
well be much more important than the financial-statement analysis matters covered here.
In approaching benefits-related adjustments
and ratio calculations, the following guiding
assumptions are made:
Standard & Poors treats unfunded pension
liabilities, health care obligations, and all
other forms of deferred compensation as
debt-like;
106
To simplify the analysis, Standard & Poors

combines all benefits plan assets and liabilities, netting a companys overfunded plans
against its underfunded plans. In theory,
companies with multiple plans can curtail
over the long term funding of overfunded
plans and direct contributions to underfunded plans. In actuality, there is often little tax incentive to fund certain plans.
Also, companies have very limited practical
ability to tap funding surpluses; it is even
possible for companies to face onerous
near-term cash contribution requirements
related to certain plans while other plans
are overfunded. When near-term cash
requirements are the central focus, though,
ratio analysis is likely to be of secondary
importance; and
Standard & Poors emphasizes the fullest
measure of the unfunded liability available.
Generally, for pensions, this is the so-called
projected benefit obligation (PBO) under
U.S. GAAP, which takes account of the
value at which the liability ultimately will
be settled (including the effect of expected
wage increases if the benefit is tied to
employee compensation according to some
formula) and views the company as a going
concern. It should be noted, however, that
for collectively bargained labor contracts,
the PBO does not take account of expected
wage increases beyond the term of the
existing contract. The PBO is a broader
measure than the accumulated benefit obligation (ABO) or vested benefit obligation,
which instead reflects a shutdown value
perspective. For postretirement medical liabilities, the measure equivalent to the pension PBO under U.S. GAAP is the
accumulated postretirement benefit obligation (APBO).
Capital structure analysis

Standard & Poors emphasizes the following
as an important measure of capitalization:
(total debt + unfunded benefits obligations)
(total debt + unfunded benefits obligations + adjusted equity)
Unfunded benefits obligations are factored
in as debt equivalents.
Given the point made above, our benefitsadjusted capitalization ratio is based on the
unfunded PBO rather than on the amount recognized on the balance sheet. There often is a
substantial gap between the two, given the
accounting approach of amortizing the effects
of variances in investment or actuarial performance compared with assumptions, or of
changes in plan benefits, over an extended period. For companies with net underfunded plans,
Standard & Poors increases or reduces the balance sheet liability to equal the unfunded PBO,
with the offsets to the incremental change in
the liability being to deferred tax assets (where
applicable) and equity (see table 2). Any transition assets, intangible assets stemming from
benefits enhancements, or prepaid asset
amounts are deducted from equity because
Standard & Poors believes such assets lack
economic substance.
We factor benefits liabilities in on an

after-tax basis, using the marginal tax rate,
in countries where plan contributionsor
direct payments to retirees or third-party
insurersare tax-deductible. This distinguishes benefits liabilities from debt, repayment of which does not generate tax credits.
Again, the emphasis assumes the company is
a going concern and can pay its taxes.
If a company is experiencing financial distress, the tax benefits related to required
plan contributions are unlikely to be realized, and the analyst may then choose to
exclude a tax benefit from the calculations.
(In such cases, liquidityrather than
capitalizationnormally would be the
main area of emphasis in Standard &
Poors analysis.)
Table 2Capitalization Adjustments
XYZ Co.*
Debt totals $1.0 billion and equity $600 million at Dec. 31, 200X. Tax rate: 33%-1/3%. Projected benefits obligation (PBO) exceeds fair
value of plan assets by $1.1 billion at year-end 200X, up from $700 million at the previous year-end.
Change in benefits obligation (Mil. $)
PBO, beginning of year
2,000.0
Current service cost
60.0
Interest cost (7% x 2,000)
140.0
Actuarial adjustments
100.0
Benefits paid
(300.0)
PBO, end of year
2,000.0
Change in plan assets

Fair value of plan assets, beginning of year
1,300.0
Actual return on plan assets
(100.0)
Benefits paid
(300.0)
Fair value of plan assets, end of year
900.0
Unfunded PBO
1,100.0
Assuming only $800 million of the $1.1 billion unfunded accumulated benefits obligation was recognized on the balance sheet at Dec. 31,
200X, adjusted debt leverage is computed as follows:
Adjusted debt and
debt-like liabilities =
Total debt + [(1 - tax rate) x

(unfunded PBO)]
$1.0 bil. + (66-2/3% x $1.1 bil.)

= $1.733 bil.
Adjusted equity =
Book equity - [(1 - tax rate) x (unfunded PBO liability already recognized on balance sheet)]
$600 mil. - [66-2/3% x

($1.1 bil. - $800 mil.)] = $400 mil.
Adjusted debt and debt-like

liabilities/total capitalization =
$1.733 bil./($1.733 bil. +

$400 mil.) = 81.2%
This compares with unadjusted

total debt to capitalization of:
$1.0 bil./($1.0 bil. + $600 mil.) = 62.5%
*XYZ Co. operates in a country where benefits plans are prefunded and plan contributions are tax-deductible. Any intangible pension asset account relating to
previous service cost would be eliminated against equity. This would also be tax-effected.
Standard & Poors
107
Note: Given the latitude companies have

under some accounting systems to choose the
discount rate, and the significant sensitivity of
the liability measurement to the rate used, it
would in theory be desirable to normalize for
different discount rate assumptions, putting
all companies in the same region, with the
same workforce demographics, on the same
basis. This is, however, as a practical matter
extremely difficult to do with any accuracy,
without knowing the underlying cash flow
assumptions on which the companys liability
measurement are based. Standard & Poors
periodically will survey companies disclosures to help ascertain which discount rate
constitutes the norm. Where companies vary
materially from the norm, Standard & Poors
Table 3Cash
will seek sensitivity information from management to facilitate the analysis.

Cash-flow analysis
Where benefits obligations are material,
Standard & Poors calculates the following
ratio:
Funds from operations (Total debt +
unfunded benefits obligations)
The denominator is adjusted as described
above. Funds from operations (FFO) is
defined as net income from continuing operations plus D&A, deferred income taxes, and
other non-cash items.
Standard & Poors makes an additional
adjustment to FFO for companies with
unfunded benefits obligations that make
Flow Adjustment
ABC Co.*
The company makes catch-up plan contributions that significantly exceed period expense. Tax rate: 33-1/3%. The company had a
sizable unfunded PBO at the previous year-end and contributes $400 million to benefits plan during 200X. The actual return on plan assets
is $30 million.
Pension expense for 200X
(Mil. $)
Service cost
50
Interest cost
150
Expected return on plan assets
(140)
Amortization of previous service cost, other unrecognized gains or losses

Net periodic benefits cost
40
100
By contributing more than the combined service cost and net interest cost ($50 million + $150 million - $30 million), ABC Co. is viewed as
retiring a portion of its unfunded benefits obligation. The amount of cash needed to satisfy the combined service and net interest cost is
treated as a normal cash operating expense. The balance of the cash flow effect of the $400 million contribution is reclassified as a
financing item.
Reported 200X statement of cash flows
Net income
100
Adjustments for items not affecting cash from operating activities

Depreciation
200
Deferred income taxes
50
Other
100
Funds from operations
450
Adjustments: The $400 million contribution depressed reported FFO by $266 million: $400 million - (33-1/3% x $400 million). The taxeffected overage: [($400 million - ($50 million + $150 million - $30 million)] x (1 - 33-1/3%) = $153 million, is added back to FFO and subtracted from financing sources/uses:
Reported FFO
450
Adjustment
153
Adjusted FFO
603
*ABC Co. operates in a country where benefits plans are prefunded and plan contributions are tax-deductible. Includes ($266 million) after-tax effect of $400
million contribution. Management input may be required to differentiate FFO effects of the contribution from the working capital effects.
108
would otherwise be the distorting effect of net

positive cash inflows.)
Conversely, if the company is funding its
postretirement obligations at a level substantially below its accrued expense, this
may be interpreted as a form of borrowing
that artificially bolsters reported cash flow
from operations. Standard & Poors also
adjusts cash flow to normalize for investment return performance viewed as nonrecurring in nature, whether abnormally high
or low (see table 3).
catch-up contributions to reduce their

unfunded liabilities. Otherwise, FFO would
appear depressed as a result of a cash outflow
that Standard & Poors would view as a
finance item (akin to debt amortization) rather
than a cash operating expense. Specifically, as
shown below, plan contributions that are
materially greater than benefits-related service
and net interest cost accrued during the period
(that is, net of actual pension investment
returns) are added back to FFO. (Note that
this adjustment is capped at zero, given what
Table 4Application/Expansion
of Core Earnings Framework
UVW Co.
The company used 10% in 200X as its expected return on plan assets assumption. Plan assets totaled $3.5 billion at the beginning of the
year. Actual return was 2% ($70 million).
200X income statement
Net sales
(Mil. $)
2,000
Operating expenses
Pension expense
200
D&A
1,000
All other operating expenses
600
Oper. income (after D&A)
200
Interest expense
120
Pretax income
80

50
Interest cost
300
Expected return on plan assets (10% x $3.5 bil.)
(350)
Amortization of unrecognized gains or losses
200
Net pension expense
200
The income statement would be adjusted as follows:

As reported
Net sales
Adjustments
2,000
Adjusted
2,000
Operating expenses
Pension expense*
200
D&A
(150)
1,000
50
1,000
600
600
EBIT
200
350
Interest expense
120
Pretax income
EBIT fixed-charge interest coverage (x)
230
350
80
200/120 = 1.7
350/350 = 1.0
*All but the current service cost ($50 million) are eliminated from benefits expense. Benefits-related interest cost, less the actual return on plan assets ($300
million - $70 million) is combined with other interest expense.
Standard & Poors
109
earned by employees for services rendered

during the periodis viewed as an operating expense, and treated as such.
The components that represent accounting
artifacts and stem from the smoothing
approach of the accounting rulese.g.,
amortization of variations from previous
expectations regarding plan benefits, investment performance, and actuarial experienceare eliminated (consistent with the
Profitability Analysis
In analyzing profitability (including EBITDA), as illustrated below, it is appropriate
to disaggregate the benefits cost components that are combined in financial reporting and eliminate those with no economic
substance, in accordance with the approach
of Standard & Poors Core Earnings framework. The so-called service costreflecting the present value of future benefits
Table 5Profitability Adjustment
for Overly Optimistic Expected Return on Plan Assets
UVW Co.
The company used 10% in 200X as its expected return on plan assets assumption. Standard & Poors views 8% as a more realistic longrange expected annual return. Plan assets totaled $3.5 billion at the previous year-end.
200X income statement
(Mil. $)
Net sales
2,000
Operating expenses
Pension expense
200
D&A
1,000
600
Oper. income (after D&A)
200
Interest expense
120
Pretax income
80

50
Interest cost
300
Expected return on plan assets

(10% x $3.5 billion)*
(350)
Amortization of unrecognized gains and losses
200
Net pension expense
200
The income statement would be adjusted as follows:

As reported
Net sales
Adjustments
2,000
Adjusted
2,000
Operating expenses
Pension expense
200
D&A
70
270
1,000
1,000
600
600
EBIT
200
130
Interest expense
120
120
Pretax income
EBIT fixed-charge interest coverage (x)
80
10
200/120 = 1.7
130/120 = 1.1
*Under U.S. GAAP, the expected return on plan assets may not be based on the fair value of plan assets at the previous year-end, but on a "market-based
value," i.e., a smoothed value averaging values of several previous years. The adjustment should always be based on the fair value of plan assets at the
previous year-end. The expected return on plan assets is reduced by (10% - 8%) x $3.5 billion = $70 million, thereby increasing pension expense by $70 million.
110
immediate recognition of these unamortized

amounts in the treatment of capitalization
discussed above).
Any increase or decrease in the plan liability resulting from plan benefit changes is recognized immediately as an operating
expense/credit. Interest expense, which is the
result of the application of the discount rate
to the PBO to age the liability with the
passage of time, is essentially a finance charge
and is reclassified as such. (As discussed
above, sensitivity analysis taking account of
different discount rates is appropriate.)
The expected return on plan assets also is
eliminated and replaced by a much more
meaningful amount: the actual return on plan
assets during the reporting period. The actual
return on plan assets is netted against interest
expense up to the amount of the interest
expense reported, but not beyond in the case
of fully funded plans, as the economic benefits to be derived from such overage are limited. If the actual return is negative, though,
the full amount in excess of interest expense
is treated as an addition to interest expense
because, unfortunately, the resulting economic detriment to the company is quite tangible
(see table 4).
In practice, however, the profitability
measures that result from the use of this
Standard & Poors
approach can be extremely volatile, with

benefits-related effects often obscuring operating results. For this reason, we view such
measures as supplementary. Just as in other
aspects of its analysis, we look beyond
changes considered temporary in nature. In
approaching its conventional profitability
ratios, we adjust for the effects of expected
investment return assumptions that are significantly higher than the norm, where this
has a material effect on reported earnings
(see table 5).
Moreover, we are alert to cases where companies have net pension credits that are a
material source of overall earnings. Net pension credits generally reflect a healthy benefits
funding picture, but such credits exaggerate
the economic advantage to the company of
this overfunding status and can distort
period-to-period and peer comparisons.
At this time, we do not intend to recalculate its published key industrial and utility
financial ratios as described here. Because
most U.S. companies pension plans were
fully funded through the latter half of the
1990s, we believe such adjustments would
not make a substantial difference to the published medians. If, however, current, broadly
depleted funding levels persist, we will
reassess the basis for statistical data.
111
Corporate Asset-Retirement
Obligations
sset-retirement obligations (AROs) have for some time been
viewed as debt-like liabilities in Standard & Poors Ratings
Services analysis. Recent changes to accounting and disclosure

standards under IFRS and U.S. GAAP have yielded more reliable
information on the value, nature, and timing of these obligations,
allowing for a more systematic analysis.
Asset Retirement Obligations
AROs are legal commitments to incur restoration and removal costs while disposing of, dismantling, or decommissioning long-lived
assets. They are legal obligations that have a
call on future cash flows of an enterprise,
much like debt and similar obligations.
Examples include the costs of plugging and
dismantling on- and off-shore oil and gas facilities; decommissioning nuclear power plants;
and capping mining and waste disposal sites.
AROs typically also meet accounting criteria to be reflected as liabilities in a companys
financial statements. Yet, several characteristics distinguish AROs from conventional
debt, including timing and measurement
uncertainties; tax implications; and the standing of claimants in bankruptcy. The measurement of AROs involves a high degree of
subjectivity and measurement imprecision.
For example, the amounts that will be paid
ultimately to settle an ARO often depend on
future legislation.
In certain cases, ARO costs are reimbursed
to the entity or assumed by other parties.
This occurs when an asset operator costs are
reimbursed by a local government, oras for
112
many regulated entitiesthe costs are recovered via the rate-setting process. In such
instances, the entity does not bear all of the
economic risks. (Please see Asset-Retirement
Obligations: How SFAS 143 Affects U.S.
Utilities Owning Nuclear Plants, published
on RatingsDirect on March 31, 2004).
How Standard & Poors views
AROs in its analysis
Because we consider AROs to be debt-like,
the after-tax amount of AROs is added to our
debt-based measures. Our analysis begins
with the reported liability amount, which is
adjusted for anticipated reimbursements and
tax reductions, and for any assumptions we
view as unrealistic.
To a large degree, Standard & Poors
agrees with the accounting view that retirement costs are encompassed in the value of
the fixed asset to which they relate. From
managements perspective, the return on the
asset is expected to be satisfactory, inclusive
of ARO costs. We believe economic reality to
be best depicted by including all the relevant
costs in the assets carrying value. However,
adjustments to the asset value may be war-
ranted in our analysis, in cases where we

believe future recoverability is in doubt.
Conversely, salvage asset values can somewhat mitigate the ARO burden (e.g., oil-producing assets, which may have a significant
residual value when sold, as they often are).
Measurement and timing
uncertainties of AROs
Because most AROs involve obligations to
incur costs that may extend well into the
future, uncertainties are inherent in their estimation. These include the estimated amount
of the ultimate cost; timing of asset retirement; and the discount rate to be used in the
present value calculation.
The actual cost of abandonment will
depend, notably, on the relevant countrys
laws, and asset-specific environmental regulations at retirement; the condition of the
markets for the specific assets retirement
services; possible economies of scale for the
operator; and whether the activities ultimately are performed by the operator or by
a third party (the accounting measure
assumes a third party would perform, and
accordingly incorporates a profit element).
The timing of asset retirement also is subject to assumptions that can change materially. In extractive industries, for
example, retirement timing also depends
on expectations for hydrocarbon or minerals prices, which are volatile. During
periods of depressed pricing, the value of
the abandonment obligation likely would
increase, because the retirement of the
asset could be accelerated. For power generators, asset-retirement timing depends
notably on local legislation, which may
either result in an impact that is favorable
(i.e., in the case of an operating license
extension) or unfavorable (i.e., in the case
of an early mandated closure).
The requirement to use an entity-specific
discount rate under U.S. GAAP also hinders comparability across companies
using U.S. GAAP, as opposed to IFRSreporting companies, which use marketrelated rates adjusted to risk-specific
factors attributable to the liability. As an
example, for two companies reporting
under U.S. GAAP, with different credit
Standard & Poors
quality and equal interests in the same

oil-field, the present value of the AROs
could be higher for the stronger company,
merely because that company uses a
lower discount rate. (Ultimately, however,
both companies should incur the same
costs at retirement.) Conversely, the periodic accretion expense would be higher
for the weaker company. Information is
not available to allow for adjusting for
these differences, nor would it be practical. Standard & Poors Ratings Services is
sensitive to the potential for understatement of the obligations for weaker companies, but in most cases, we do not
expect it to be a material rating factor.
AROs are recorded on a pretax basis under
most accounting standards. Any expected tax
benefits generally are reflected as a separate
deferred tax asset on the balance sheet
(because the ARO-related asset is depreciated).
In most cases, tax-related cash flows (or tax
savings) substantially coincide with the ARO
payments, thereby mitigating part of the cash
costs. In considering the ultimate cash flows
associated with AROs, these tax effects must
be considered. We analyze the companys profitability prospects and its tax position otherwise, in considering the adjustment related to
taxation effects. (Occasionally, governments
may provide benefits to companiessuch as
reduced royalty or income tax ratesto
extend the useful life of a field, to avoid writing a refund check.)
Basic numerical adjustments to derive
complementary ratios
Our analysis includes debt-like obligations
(such as for operating leases and postretirement benefits) when calculating credit ratios.
For AROs, and subject to data availability
and materiality, our approachwhich to a
significant extent mirrors that on postretirement benefitsis as follows:
The obligation, net of any dedicated retirement-fund assets, salvage value, and anticipated tax savings, is added to debt. We
evaluate the estimates and assumptions
underlying the obligation over time for reasonableness. In those cases where we feel
the balance-sheet recognition misrepresents
the obligation, we would make correspon-
113
Corporate Asset-Retirement Obligations
114
ding adjustments. Adjustments are made

on a tax-effected basis in cases where it is
probable that the company will be able to
utilize the deductions. We further consider
the investment risk associated with any
investment portfolio specifically set aside
against the obligation (such as a decommissioning trust) when netting such amounts
against the liability.
The accretion of the obligation reflects the
time value of money and is akin to noncash
interest. Thus, if the accretion amount is
reported as an operating charge in reported
statements, we reclassify it as interest
expense for both income-statement and
cash-flow statement analysis.
Because the liability is considered net of
tax, the ARO-related deferred tax asset is
reduced (or the ARO-related asset, if there
are insufficient related tax assets).
Cash expenses for abandonment and contributions into dedicated funds that exceed the
obligations newly incurred during the period are reclassified as principal repayment of
a debt-like obligation, thus increasing operating cash flow and funds from operations.
If dedicated funding is in place and the
related returns are not entirely reflected in
reported earnings and cash flows, the unrecognized portion of the return on these assets
is credited to earnings.
AROs affect a companys debt-service

coverage ratios (e.g., funds from operations
or operating cash flows to total debt and
interest-cover ratios) as well as leverage
ratios (e.g., total debt to total capital).
Liquidity implications typically are secondary to the analysis, as long as these obligations remain long term, and entail only
limited prefunding requirements.
A Post-Default Perspective: AROs

As Priority Obligations, Rather
Than Senior Unsecured Lenders
The laws that govern the status of AROs in
bankruptcy are diverse, asset- and jurisdiction-specific, andoccasionallyevolving
and uncertain. In some cases, it is clear
AROs cannot be rejected through the bankruptcy process and likely will rank senior to
unsecured creditors. In such cases, AROs
are viewed as priority obligations in the
calculation of ratios used for notching the
companys individual obligations up or
down to reflect their relative position (and
relative recovery prospects) in a companys
capital structure. (For a more detailed discussion on notching, see Standard & Poors
Corporate Ratings Criteria, on
RatingsDirect.)
The Role of Corporate

Governance in Credit
Rating Analysis
he linkages between credit quality and corporate gover-
nanceor, more correctly, certain elements of corporate gov-
ernancecan be extensive. Governance issues that are

germanesuch as ownership structure, management practices,
and financial disclosure policiesare regularly examined as part
of the credit ratings methodology, although they have not traditionally been labeled with corporate governance nomenclature.
Credit rating analysis has focused on many specific corporate
governance elements but has not aggregated these into one
category or attempted to arrive at an overall assessment of
corporate governance.
Until recently, greater emphasis has been
placed on corporate governance factors in the
rating analysis in countries with less-developed capital markets. However, given the
recent spate of management scandals in the
U.S. and Europe, Standard & Poors Ratings
Services is subjecting these issues to greater
scrutiny globally.
It is clear that weak corporate governance
can undermine creditworthiness in several
ways and should serve as a red flag or warning indicator to credit analysts. Alternatively,
strong corporate governance, demonstrated in
part by the presence of an active, independent
board that participates in determining and
monitoring the control environment, while
not an enhancement to creditworthiness, can
Standard & Poors
serve to support the credibility of financial

disclosure and, more broadly, management.
Recent examples of poor corporate governance, which contributed to impaired creditworthiness, include:
Uncontrolled dominant ownership influence that applied company resources to
personal or unrelated use.
Uncontrolled executive compensation
programs.
Management incentives that compromised
long-term stability for short-term gain.
Inadequate oversight of the integrity of
financial disclosure, which resulted in
heightened funding and liquidity risk.
Standard & Poors Governance Services
group offers full-scope corporate governance
115
The Evolving Role of Corporate Governance in Credit Rating Analysis
analysis and scores. These services are geared

largely to the equity investors perspective. In
addition, the credit ratings and governance
groups at Standard & Poors may collaborate
in the analysis of specific companies.
Moreover, to ensure a methodological consistency of approach relating to broad corporate
governance issues, collaboration at a technical level between credit and governance analysts does occur to review points of general
analytical criteria.
The following elements of corporate governance traditionally have formed part of ratings analysis. The significance of each
element as a rating factor can vary greatly.
Ownership
Identification of the owners is an obvious
requirement. It is a fundamental rating criterion that entities are never rated on a standalone basis; links to parent companies or
affiliates are important considerations.
Ownership by stronger or weaker parents
substantially affects the credit quality of the
rated entity. The nature of the ownergovernment, family, holding company, or strategically linked businessalso can hold
significant implications for both business and
financial aspects of the rated entity.
Control
The existence of more than one owner introduces additional issues regarding potential
conflicts over control. Joint owners might
disagree on how to operate the business.
Even minority owners can sometimes exercise effective control or at least frustrate the
will of the majority owners. Whenever control is disproportionate to the underlying
economic interest, the incentives for the
stakeholders could diverge. This could result
from existence of classes of shares with
super voting rights or from owning 51% in
each of multiple layers of holding companies. In either example, control might rest
with a party that holds only a relatively
small economic stake. Cross-shareholding of
industrial groupings and family-controlled
networks are commonplace in certain parts
of the world. Such group affiliations can
have positive or negative implications,
depending on the specific situation.
116
Conventional, equity-oriented corporate

governance analysis is very sensitive to share
structure (asking, for example, whether each
type of share provides representational voting), out of concern that actions will be
undertaken to the detriment of minority
shareholders. Although this concern is not the
direct focus of credit analysis, there is a
penalty for companies considered abusive to
minority holders. Perception of such conduct
would, obviously, impair the companys
access to investment capital. Furthermore, if a
company mistreated one set of its stakeholders, there would be serious concern that the
company could later try to shortchange other
stakeholders, including creditors.
Management and Organization
Assessment of management is an especially significant determinant of credit-rating assignments. Rating analysis considers many factors
that pertain to management, including:
Track record and competence;
Management background and reputation;
Management depth and turnover;
Professional or entrepreneurial style of
management; and
Any tensions among operating functions, the
finance function, or shareholder interests.
Policies and Strategies
Financial policies are assessed for aggressiveness or conservatism, sophistication, and consistency with business objectives. Policies
should optimize for the typically divergent
interests of the companys stakeholders
shareholders, creditors, customers, and
employees, among others. Specifically, the
companys goals with respect to its credit rating need to be consistent with the balancing
of those interests.
Business strategies are evaluated for realism, comprehension of competitive risks, and
contingency planning. Comparisons of policies and projections with a companys track
record form the basis for judging management credibility.
Information Disclosure
and Financial Transparency
Ratings are based on audited financial data
plus supplemental data (including detailed
financial projections) that might be provided confidentially. Ratings agencies enjoy

unique access to data given their status
under disclosure regulations in many jurisdictions and their impeccable track record
regarding confidentiality.
In judging the reliability of data, we consider the accounting standards used as the
basis of the financial statements, the reputation of the auditor, and the degree of openness of the local business practice. Qualms
about data quality (dubbed information
risk) would translate into a lower rating and
preclude a rating in the upper part of the rating spectrum.
A review of accounting quality is a critical
prerequisite of the financial analysis.
Comparisons of financial measures need a
common frame of reference. Consolidation
standards, revenue recognition methods, and
depreciation methods are all scrutinized, as
is off-balance sheet financing, such as leasing, securitizations, trust vehicles, and contingent liabilities. Adjustments are regularly
made to recast the financial statementsand
the credit ratios based thereonto better
reflect economic risks and to allow better
benchmark comparisons.
However, Standard & Poors does not conduct audits, and there are limitations to analytical methods. A company bent on
deception might succeed in misleading both
its auditors and the rating analysts.
Apart from disclosure to Standard &
Poors analysts, though, public disclosure and
transparency can be important. If a company
maintains an aura of secrecy, investors will be
suspicious and skittish. In addition, the company is more prone to so-called headline risk,
the consequences of which can be very damaging, especially in the current environment.
Intercompany and
Affiliated Party Transactions
These activities pose special challenges,
because it is difficult to ascertain that they
Standard & Poors
are done on a truly arms-length basis. A

propensity to engage in deals with inside parties would give rise to skepticism about the
companys conduct of its affairs, even if they
were fully disclosed.
A component of corporate governance that
historically has not figured prominently in the
rating process is board structure and involvement. Of course, if it is evident a companys
board of directors is passive and does not
exercise the normal oversight, it weakens the
checks and balances of the organization and
represents a negative credit factor. But considerations such as the proportion of independent members on the board of directors,
presence of independent directors in boardlevel audit committee, and direct reporting of
internal auditor to board or independent
internal audit committee at board level have
not been systematically examined.
Similarly, relatively little attention has been
paid to the compensation of directors and senior management teams. It can be difficult to
determine objectively if a given level of compensation is excessive or will result in a company strategy that is overly aggressive or mainly
focused on short-term performance.
As business practices change in the wake of
management and accounting abusesand
directors take on a more active role in the company direction and oversightmore weight to
the role of the board of directors could be warranted from the perspective of credit rating.
Quite obviously, strong corporate governance does not, by itself, indicate strong
credit worthinessjust as a company being
open and fair does not equate with the company being well managed. In addition, companies with high credit ratings could have
governance standards that are problematic,
particularly from the perspective of minority
shareholders. In the end, weak corporate
governance practices can undermine creditworthiness, but it would depend on the specific aspects of governance that led to the
poor assessment.
117
Securitizations Effect On
Corporate Credit Quality
he focus of this article is on securitizations undertaken by
industrial companiesnot by financial institutions, which use
securitization extensively to fund mortgage and credit card loans,

as well as other types of finance assets. Nevertheless, Standard &
Poors Ratings Services fundamental approach to analyzing securitization is the same in both the industrial and banking sectors.
Asset securitization is a form of financing
that has been widely used across industries
and across the rating spectrum.
Securitizations are important financing
sources for many companies, often providing both lower cost and more diverse
sources of funding and liquidity than available to the company otherwise. The ability
to securitize assets provides additional
financial flexibility and is regarded as a positive credit factor. Apart from this, though,
securitizations do not ordinarily transform
the risks or the underlying economic reality
of the business activitythat is, provide
what is commonly referred to as equity
relief. Equity relief is rarely achieved when
a company has a recurring financing
requirement, in contrast to one that uses
securitization only as a means to monetize a
non-core asset on a one-time basis. If securitization is used to supplant other debt, its
effect on credit quality is likely to be close
to neutral. Because the accounting treatment
of securitization frequently is not congruent
with Standard & Poors analytical perspective, adjustments to the reported financials
are necessary.
118
In the event of a bankruptcy, an issuers

reliance on securitization can be detrimental
to the ultimate recovery prospects of unsecured creditorsand so may well warrant
notching down of unsecured debt issue ratings from the issuer credit rating.
What Is Securitization?
A securitization is a means of obtaining
financing, but it is not accomplished through
a borrowing arrangement in the traditional
sense. In a securitization, an asset or pool of
assets is sold in a true sale to a bankruptcy-remote entity, variously referred to as a
securitization trust, special-purpose vehicle
(SPV), special-purpose entity (SPE), or variable-interest entity (VIE). This entity funds
the transaction by issuing debt, equity, or
other forms of beneficial interests.
Subsequently, the debt is serviced exclusively
with cash flow generated from the trusts
assets. Because the trust is bankruptcyremote, its debtholders are insulated from the
default risk of the issuer. (Securitizations are
often effected using a series of trusts to
achieve the desired legal isolation.)
Further protection is afforded to trust

debtholders through enhancement in the
form of overcolleralization. That is, the
debt issued by the securitization trust is less
than the value of the assets, and the difference between the two is the so-called firstloss exposure. This exposure can take
different forms, including subordinated
interests in trusts, cash reserves, and
deposits due from trusts.
Another form of enhancement can be the
accumulation by the trust of excess cash
flow, also referred to as excess spread or
interest-only strips. This is the difference
between cash inflows from the securitized
assets and cash outflows related to debt
service, servicing fees, and other expenses.
Some securitizations trap a portion of
this cash within the deal structure to further
protect debtholders.
Securitizations also frequently incorporate
enhancements provided through third parties, including bond insurance, liquidity
facilities, and credit derivatives.
Furthermore, securitizations commonly
include performance-based early amortization and reserve funding triggers.
Securitizations can be amortizing, in
which one asset or pool of assets is sold at
the initiation of the transaction and then is
liquidated over a stipulated period. Or, they
may be revolving in the sense that liquidating assets are replaced by new assets sold
by the issuer into the trust. Securitization
trusts may be associated with a single corporate seller of assets (single-seller conduits) or
incorporate several corporate sellers (multiseller conduits).
Corporations commonly securitize a wide
range of assets, including-to give just a few
examplesfinance and lease receivables, trade
receivables (including existing and future
export receivables), inventory, transportation
equipment, timberlands, trademark licenses,
royalties, receivables from tax authorities, and
stranded costs of electric utilities.
Benefits Afforded By Securitization

Securitizations are important financing
sources for many issuers, adding to the range
of other secured and unsecured funding alter-
Standard & Poors
natives. For some marginal or distressed companies, securitization may be the only accessible form of obtaining financing; investors
may be too wary of the companys poor
prospects to lend directly, but might still be
willing to lend against the companys discrete
assets when coupled with all the structural
protections afforded by securitization.
In addition, securitization may facilitate
match-funding, as the term of securitized
debt generally mirrors the life of the underlying assets.
Securitization also provides access to relatively low-cost financing in many instances.
However, the cost of the securitization transaction encompasses more than just the
coupon rate of the securitized debt: the costs
related to all the different forms of credit
enhancement must also be weighed, as well
as incremental administrative costs.
Moreover, securitization may weigh on the
cost of other financings because the overcollateralization enjoyed by securitized debtholders can put unsecured creditors at a
disadvantage, as discussed below.
In thinking about the financial flexibility
benefits provided by securitization, one
must also be sensitive to the risks posed by
financial covenants or other credit triggers
included in the securitization. In revolving
securitizations, triggers are commonly tied
to the performance of the underlying assets,
which, when triggered, stop the sale of
additional assets and cause all cash flow of
the securitization to be used for debt amortization. This can result in liquidity challenges and cause a credit cliff situation
for the company.
Does Securitization Bring

Equity Relief?
Many market participants think of securitizations effect on an issuers credit quality
almost exclusively in terms of equity relief,
that is, the notion that by having completed a
securitization, the issuer is able to retain less
equity, or incur more debt, than would otherwise have been the case, without any change
in its credit quality.
For Standard & Poors, equity relief is one
potential aspect of the analysis of a securiti-
119
Securitizations Effect On Corporate Credit Quality
zations effect on an issuers credit quality. We

gauge equity relief in terms of risk transfer:
equity relief is achieved only to the extent the
risk related to securitized assets is transferred
to the securitization debtholders. We do not
approach this matter in black-and-white
terms, but instead view the potential outcomes along a spectrum. To the extent that
the securitization accomplishes true risk
transference, the transaction is interpreted as
resembling an asset sale, whereas in the much
more common case where the issuer retains
the bulk of risks related to the asset, the
transaction is akin to a secured financing.
Key considerations include the following:
The riskiness of the securitized assets. The
only risk that can be transferred is that
which existed in the first place. If, as is
often the case, an issuer securitizes its highest-quality or most liquid assets, that limits
the extent of any meaningful equity relief.
First-loss exposure. The issuer commonly
retains the first-loss exposure, thereby
enhancing credit for the securitized debt.
For the securitized debt to be highly rated,
the extent of enhancement must be a multiple of the expected losses associated with
the assets. The first-loss layer thus encompasses the preponderance of risk associated
with the securitized assets, and the issuers
total realizations from the securitization
will vary depending on the performance of
the assets. Often, only the risk of catastrophic loss is transferred to third-party
investors-risk that is generally of little relevance in the corporate rating analysis.
Moral recourse. This refers to how the company would behave if losses did reach catastrophic levels. Empirical evidence suggests
that companies often feel they must bail out
troubled financings (for example, by repurchasing problematic assets or replacing them
with other assets) to preserve access to this
funding source and, more broadly, to preserve their good name in the capital markets, even though they have no legal
requirement to do so. Moral recourse is
magnified when securitizations represent a
significant part of a companys financing
activity or when a company remains linked
to the securitized assets by continuing in the
role of servicer or operator.
120
Ongoing funding needs. Even if it were certain that the risks related to a given pool of
assets had been fully transferred and the
issuer would not support failing securitizations, equity relief still would not necessarily have been achieved. If, for whatever
reason, losses related to the securitized
assets rose dramatically higher than initially anticipated, and if the issuer has a recurring need to finance similar assets, future
access to the securitization market would
be dubious-at least economically. Future
funding needs would then have to be met
by other means, with the requisite equity to
support them. Thus, even if a company
separately sells the first-loss exposures, or
sells the entire asset without retaining any
first-loss exposure, it may achieve little
equity relief. (See Auto Whole Loan Sales
Bolster Automakers Funding Flexibility,
published March 15, 2004, on
RatingsDirect, Standard & Poors Webbased research and credit analysis system.)
Our experience has been that expectations
regarding equity relief are often exaggerated.
The fact is, minimizing funding costs for the
issuer while transferring significant risk to the
investor tend to be mutually exclusive.
Accounting Aspects
Convoluted and form-driven accounting rules
under U.S. GAAP complicate the task of
assessing companies uses of securitizations.
Under SFAS 140 (Accounting for Transfers
and Servicing of Financial Assets and
Extinguishments of Liabilities), certain
specifically defined securitizations effected
through securitization trusts termed qualifying special-purpose entities (QSPEs) are
treated as asset sales, with the securitized
assets and related debt being off-balancesheet. Yet, QSPEs, which are passive in
nature and narrow in scope of activities,
include securitizations of recurring finance
receivables-a securitization type where there
is typically little basis for supposing risk
transfer has occurred, based on the factors
enumerated above.
Otherwise, under FASB Interpretation
Number 46-Revised (FIN 46R;
Consolidation of Variable Interest Entities),
a company must consolidate a securitization

trusthere termed a VIEif the company is
deemed to be the primary beneficiary of
the VIE trust (unless the VIE is a QSPE under
SFAS 140). Under FIN 46R, a company is
considered the primary beneficiary if it holds
a variable interest(s) in the VIE, which will
absorb most of its expected losses, receive
most of the expected residual returns, or
both. Variable interests are defined in terms
of the rights and obligations that convey economic gains or losses from changes in the values of the VIEs assets and liabilities.
According to FIN 46R, a company with the
majority of the risks or rewards associated
with a VIEs activities is essentially in the
same position as the parent in a parent/subsidiary relationship.
Applying the rules for tallying variable
interests is highly subject to judgment and
estimates. In addition, some companies tailor
the terms of securitizations specifically to fail
the tests for off-balance-sheet treatment
which can be achieved without substantially
modifying the underlying economics of the
transactionfeeling their financial statements
are thereby more transparent. Other companies prefer the minimization of apparent
financial leverage that can result from off-balance-sheet treatment.
Managements accounting objective may
also be influenced by income statement-related considerations: some companies prefer to
avoid the volatility associated with upfront
gain recognition, preferring the more
smoothed earnings recognition pattern generally afforded by on-balance-sheet accounting
for securitizations. (Note: FASB has recently
proposed an amendment to SFAS 140 that
would require companies to record upfront
gains on sales and mark-to-market all securitized assets and liabilities [including any
retained portions], as well as affording
optional fair-value or amortized cost accounting for servicing rights.)
Further muddying the waters: the IFRS
framework is very different from that of U.S.
GAAP. Thus, even when transactions have
the same economic substance, the accounting
treatment can vary.
Standard & Poors
Analytical Adjustments
Our analytical treatment of securitizations is
not dictated by the accounting treatment.
Rather, we seek to understand the economic
substance of the transactions. In calculating
financial ratios that assist us in assessing debt
leverage, profitability, and cash flow, we
adjust financial statements as necessary to be
in accordance with our analytical perspective
and to enhance comparability among issuers.
Capital structure
For capital structure ratio calculations, the
analytical treatment will vary depending on
the degree to which risks are transferred. For
transactions in which a company retains the
preponderance of risks (including those related to ongoing funding needs), we calculate
ratios where the outstanding amount of securitized assets are consolidated, along with the
related securitized debtregardless of the
accounting treatment. If securitization is used
essentially to transfer risk in full and there
are no contingent or indirect liabilities, we
view the transaction as the equivalent of an
asset sale. When necessary, then, we recast
the assets, debt, and shareholders equity
accordingly, including adjusting for deferred
tax effects. (In some cases, the securitization
gives rise to a deferred tax liability that
accrues over the life of the transaction and is
ultimately payable when the transaction
matures. Given the visibility of this liability
and the high likelihood that it will ultimately
become payable, in contrast to deferred tax
liabilities in general, it may be appropriate to
treat this as a form of debt.)
Profitability
When securitizations are accounted for as
sales, they commonly give rise to upfront
gain-on-sale effects, which represent the
present value of the estimated difference
between the asset yield and the securitization
funding rate and other securitization-related
costs. For securitizations in which a company
retains the preponderance of risks, it is
appropriate to back out such gains and
spread them out over the life of the securitizations, given the uncertainty about whether
the earnings will ultimately be realized as
121
Securitizations Effect On Corporate Credit Quality
expected and to give a clearer picture of the

companys recurring earnings.
In theory, it may be desirable to fully recast
the income statementfor example, consolidating off-balance-sheet securitization transactions not involving risk transference. As a
practical matter, though, this is difficult to
accomplish without the detailed assistance of
management. Some companies have voluntarily included such pro forma schedules in their
public disclosures.
Cash flow
In accordance with SFAS 95 (Statement of
Cash Flows), any cash inflows/outflows
related to working capital assets or liabilities,
or finance receivables, are classified as operating in nature on the statement of cash
flows. Hence, inflows/outflows from related
securitizations affect operating cash flow,
with particularly significant effects possible in
reporting periods when securitizations are initiated or mature. The reporting convention
varies, though, in line with the balance sheet
classification. If the securitization is consolidated, the related borrowings are treated as a
financing activity. If the securitization is
not consolidated, it is as if the assets self-liquidated on an accelerated basis: no debt
incurrence is identified separately, either as an
operating or financing source of cash.
When our analytic view is that securitizations should be consolidated (or, in rare situations, when those that are consolidated
should not be), it would be desirable to
recast the statement of cash flow accordinglyto smooth out the variations in operating cash flow that can result from the sale
treatment of the securitization, which can
give a distorted picture of recurring cash
flow. Again, though, as a practical matter,
this can be difficult to accomplish without
the companys assistance.
Ultimate Recovery Aspects

Use of securitization may pose concerns
regarding ultimate recovery prospects for
unsecured debt in the same way that securing
122
some debt with valuable assets relegates the

unsecured debt to junior status. Thus, where
sufficiently material, this may warrant notching down of unsecured debt issue ratings and
needs to be taken into account in assigning
recovery ratings to other debt issues.
Like secured debtholders, securitization
debtholders have a priority claim to a designated pool of assets. If the issuer becomes
insolvent, unsecured debtholders would
receive a direct benefit from the encumbered
assets only if the value of those assets was
more than sufficient to meet the secured/securitized debtholders claims. This implies subordination of unsecured debt and of debt
secured by lower-quality assets, which
becomes potentially more threatening the
greater the percentage of assets that are securitized. In the case of securitization, however,
if the value of the encumbered assets is insufficient to satisfy the claims of the securitized
debtholders, those debtholders have no claim
on the issuers unencumbered assets (that is,
as long as the company does not extend any
guarantee to the securitization). (Note:
Whether the securitization has been consolidated or deconsolidated for financial reporting purposes has no bearing on the legal
treatment in bankruptcy.) Therefore, as long
as the securitized and unsecuritized assets are
of roughly uniform quality, i.e., equally subject to erosion in value, the securitization
transactions should not be detrimental to the
ultimate recovery prospects of unsecured
creditors, particularly if the securitization
proceeds are used to repay unsecured debt.
If the securitization transactions are more
highly leveraged than those of the rest of the
issuer, securitization creates a potential relative benefit for the unsecured debtholders.
Obviously, though, if better-quality assets are
securitized while inferior ones are left unencumbered on the balance sheetwhich is
most often the casethe result is that unsecured debtholders are disadvantaged.
Particularly in view of the increasing use
of securitizations by corporates, we invite
comments from any market participants
regarding this article.
Short-Term Speculative-Grade
Rating Criteria
hort-term speculative-grade ratings represent Standard &
Poors Ratings Services opinion of the relative creditworthi-
ness of an obligor with specific reference to a short-term time

horizon, generally the following 12 months (on a rolling basis).
For issuers with long-term ratings of BB+ or lower, their shortterm ratings fall in a range, including A-3, B-1, B-2, B-3, C,
and D. For corporate issuers (industrial and utility sectors), the
emphasis for short-term speculative-grade ratings is cash flow
analytics, liquidity (including loan covenant analysis), and relevant near-term business factors.
Near-term credit factors are often similar to
longer-term credit factors, and Standard &
Poors always considers credit issues over a
variety of time horizons in assigning long-term
ratings. However, for speculative-grade issuers,
the short-term horizon can be particularly critical, in terms of liquidity, event risk, and susceptibility to changes in business conditions.
Standard & Poors short-term speculativegrade ratings are intended to give market participants an additional indicator of
creditworthiness. Short-term ratings for speculative-grade issuers focus first and foremost
on liquidity, which is the leading driver of
creditworthiness over the short term for the
majority of corporate issuers in the speculative-grade category. In addition to liquidity,
Standard & Poors considers various other
factors in determining the short-term rating.
Standard & Poors
The business factors will vary by industry

and, for example, might address the following: cyclical factors such as commodity pricing environment, potential regulatory changes
or rate reviews, potential legal issues, potential new products, or potential sources of
delay in introducing products, such as regulatory approvals, potential entry into new business line or exit from existing lines,
significant potential competitive developments, near-term country risk factors faced
by material emerging market subsidiaries, or
other potential event risk.
Short-term speculative-grade ratings are
assigned as an issuer rating, i.e., one that
addresses relevant short-term credit factors
for a particular company. Standard &
Poors would also assign ratings to specific
123
short-term notes or loans (i.e., issue ratings)

upon request.
All else being equal, companies with exceptional liquidity characteristics are those most
likely to have short-term ratings at the upper
end of the scale, since they can rely on their
liquidity cushion to shelter them from nearterm risks. Companies with corporate credit
ratings of BB+ may even achieve an A-3
short-term rating, which is equivalent to the
A-3 rating assigned to investment-grade
issuers. Despite strong liquidity and what may
be favorable near-term industry conditions,
these companies speculative-grade long-term
ratings indicate exposure to significant risks
over time, for example: vulnerability to a
downturn in the domestic economic cycle,
product obsolescence risk, expected mediumterm competitive developments, regulatory
risk, legal risk, or other types of event risk.
Liquidity analysis is naturally a key focus
for both short- and long-term speculative
grade ratings. The sections below will review
the cash flow and liquidity analytics focus for
the short-term rating.
Internal Sources Of Liquidity

Cash, marketable securities
A companys cash position is of course the
most reliable source of liquidity. However,
not all of the cash position can be viewed as
surplus: virtually every company has some
base amount of cash that must be retained
for day-to-day operating purposes. In addition, balance-sheet figures cannot be taken at
face value: information on published balance
sheets may be stale; cash may be held at
operating subsidiaries and not available to
the holding company, due to covenant restrictions, cross-border tax inefficiencies, or foreign-exchange restrictions for emerging
market subsidiaries; or cash may be pledged
to a certain facility. What companies classify
as marketable securities may in fact be
more or less liquid, may be subject to significant swings in value, and depending on the
accounting jurisdiction, may or may not be
marked to market on a regular basis.
Marketable securities also need to be scrutinized for risk concentrations (credit risk;
124
country risk; and currency risk). For weaker

credits, signs of a deliberate strategy to build
a cash-cushion prior to a filing for reorganization (such as Chapter 11 in the U.S.) need
to be considered.
Therefore, in analyzing a companys cash
position as a source of liquidity, Standard &
Poors evaluates the quality and availability
of the cash position, taking into account the
factors previously mentioned. Careful
review of the notes to financial statements,
other regulatory disclosures, understanding
managements liquidity investment policy,
and questioning management directly are
sources utilized.
Cash flow
A companys ability to generate free cash
flow (cash flow after working capital needs
and capital expenditures) is a key source of
liquidity. Building blocks for the cash flow
analysis include:
Funds from operations. This basic cash flow
indicator (cash flow before working capital
adjustments and capital expenditures) is scrutinized for historical and projected annual
level and relative volatility, including seasonal
or commodity price-related fluctuations.
Working capital/operating cash flow.
Working capital can be a critical use or
potential source of cash flow, depending on
the nature of the company and its operating
cycle. Standard & Poors reviews companies
with a high degree of seasonality and working capital variation, such as retailers, for
peak and trough levels of working capital
usage and related liquidity needs and sources.
A company may also be able to extract cash
from working capital at least temporarily, for
example, by monetizing receivables through
factoring or securitization, liquidating
unneeded inventories, or stretching out payments to suppliers. Each of these techniques
has potential drawbacks, however, in terms of
time needed to execute, orin the case of
stretching out paymentssending potentially
alarming signals to suppliers.
Capital expenditures/free cash flow.
Standard & Poors expectations about a
companys required maintenance capital
expenditures, as well as likely growth-related capital expenditures, are factored into
the cash flow analysis to arrive at projected
free cash flow. The relative flexibility the
company may have to cut back on capital

expenditures, if needed, is also analyzed.
External/Other Sources
Of Liquidity
Bank lines of credit
Key factors reviewed are total amount of
facilities; whether they are contractually committed; facility expiration date(s); current and
expected usage and estimated availability;
bank group quality; evidence of support/lack
of support of bank group; and covenant and
trigger analysis.
Financial covenant analysis is critical for
speculative-grade credits. Standard & Poors
requests copies of all bank loan agreements
and bond terms and conditions for rated entities, and reviews supplemental information
provided by issuers for listings of financial
covenants and stipulated compliance levels.
Standard & Poors reviews historical covenant
compliance as indicated in compliance certificates, as well as expected future compliance
and covenant headroom levels. Entities that
have already tripped or are expected to trip
financial covenants will be reviewed for their
ability to obtain waivers or modifications to
covenants. Penalties for violating financial
covenants are also reviewed as to whether
they trigger an event of default (most severe)
or a debt incurrence limitation. Material
adverse change clauses are also reviewed for
potential ability to affect bank group behavior
during a liquidity or other crisis.
Ratings triggers are less common for speculative-grade issuers than for investment-grade
issuers. Nevertheless, rating triggers are
sometimes found at the BB or B level (i.e.,
a downgrade from BB- to B+ may trigger a
put option or immediate unavailability of a
bank facility for future borrowings).
Market access
Although market access cannot be taken for
granted, companies are reviewed for their
track record in ability to access debt and
equity markets. Particularly outside the U.S.,
a companys role in the national economy can
enhance its access to bank and capital markets. Near-term, well-defined, highly executable bank or capital market financings are
Standard & Poors
included in Standard & Poors near-term cash

flow projections, while potential execution
risks are also considered.
Ability to access securitization markets on
an ongoing basis should also be considered.
This assessment should take into account the
current and anticipated liquidity in securitization markets, as well as the nature of assets
available to be securitized (amount, quality,
and salability). Committed multi-seller and
single-seller bank conduit facilities should be
considered where applicable.
Ability to sell nonstrategic assets
Identified, marketable nonstrategic assets may
be considered as a form of backup liquidity
support. However, execution risks may be
considerable; timing of the closing of such
transactions (i.e., receipt of funds) can be
notoriously unpredictable.
Parent support
Parent support may be considered as a potential source of liquidity, albeit with a healthy
dose of skepticism. The track record of the
parent in supporting the subsidiary or other
similar subsidiaries, the strategic nature of the
subsidiary, or the presence of cross defaults
related to the subsidiary in parent debt agreements all may lead Standard & Poors to conclude that temporary liquidity support from a
more highly rated parent is likely. However,
parents often change their views with regard
to the relative importance of keeping a subsidiary out of default or bankruptcy, as the
parent companys own business and financial
strategies evolve.
Uses Of Cash
In addition to working capital and capital
expenditures, expected near-term uses of cash
may include the following:
Debt maturities
A companys debt maturity schedule is carefully reviewed, with particular scrutiny of
short-term debt (debt with original maturity
within one year) and the current portion of
long-term debt (the portion of bond or longterm bank debt maturing within one year).
For most speculative-grade companies, market
125
access is not guaranteed. Periods of market

illiquidity or temporary spikes in credit
spreads may make market access difficult,
expensive, or both. Short-term bank debt
rollovers also cannot always be taken for
granted. Companies with the highest shortterm ratings will have sufficient cash to cover
near-term maturities or a refinancing plan that
we view as having little execution risk (such
as planned market access with committed
credit facilities as a backup). While the focus
is 12 months forward on a rolling basis, this
does not mean debt maturities just beyond
this horizon are ignored in the short-term rating analysis. Standard & Poors would want
to see that the company has a credible strategy for repaying or refinancing debt maturing
up to 18 months for companies to achieve the
highest short-term ratings. As maturities move
into the forward 12-month time horizon,
Standard & Poors will start placing more
weight within the short-term rating analysis
on the materiality of upcoming maturities and
the companys refinancing strategy and execution ability. Debt maturing within six months,
depending on materiality relative to liquidity
sources, would be weighted quite significantly
in the short-term rating, with proportionally
less credit given to refinancing strategies not
yet executed.
Particularly for companies in the weaker
short-term rating categories, the specific timing of debt maturities can be critical.
Maturities are scrutinized by month, and for
companies with severe liquidity problems,
constructing a day-by-day schedule of material maturities may be needed.
Besides bank and bond debt, other financial obligations are considered, including leases and contingent obligations.
Dividends
Expected common and preferred dividends
are factored into projected use of cash.
Standard & Poors will also consider a companys flexibility to reduce dividends if needed. Companies may find it difficult to reduce
dividends if they have maintained a long track
record of maintaining or increasing dividends
per share, which in turn is considered critical
to maintaining access to equity markets.
126
Acquisitions.
Expected near-term acquisitions (and funding
strategy) are factored into cash flow projections. For particularly acquisitive companies,
Standard & Poors may make a base-case
assumption about acquisitions in our forecast, although no specific acquisition target
may have been identified.
Other projected uses of cash may include:
Pension funding
Obligations arising from derivatives (margin calls)
Take or pay obligations
Debt buybacks
Litigation
Environmental obligations
Guidelines For Speculative-Grade

Short-Term Issuer Ratings
Standard & Poors considers the various
factors listed below for each rating category.
The final rating incorporates a qualitative
weighting of these and other industry risk
factors; therefore, the guidelines are not
meant to be definitive.
A-3
A small portion of speculative-grade credits,
those with outstanding short-term creditworthiness, may obtain an A-3 short-term
rating (i.e., cross-over to investment grade
for their short-term rating). These issuers
should have relatively low default risk over
the near term, despite speculative-grade
characteristics over the medium to long
term. They must have a combination of outstanding liquidity and lack of near-term
event risk. In particular, the issuer should
exhibit a combination of most of the following characteristics:
Free cash flow positive for prior (rolling)
12 months and per Standard & Poors projections for next (rolling) 12 months;
Cash and easily liquidated short-term
investments more than cover short-term
debt maturities (i.e., no refinancing risk in
the near term);
Has ample backup liquidity from unutilized
lines of credit and no chance of covenant
breech or rating trigger activation;
Enjoys very good access to external financing, including debt (bank, securitization,
and other debt markets), and equity.
Event risk over the short term (acquisitions, industry downturn, adverse regulatory/legal rulings, adverse competitive
developments) should be minimal.
B-1
Issuers with a B-1 short-term rating have
above-average creditworthiness over the short
term compared to other speculative-grade
issuers, despite credit concerns over the medium to long term. They should have a combination of very strong liquidity and limited
near-term event risk. In particular, such
issuers should exhibit the following:
Should be free cash flow positive for
prior (rolling) 12 months and per
Standard & Poors projections for next
(rolling) 12 months;
investments should nearly cover shortterm debt maturities (i.e., limited refinancing risk). Alternatively, backup liquidity
from unutilized lines of credit may help
cover short-term debt maturities, if there
is virtually no chance of covenant breach
or rating trigger activation;
Have ample backup liquidity from unutilized lines of credit and little chance of
covenant breech or rating trigger activation;
Total liquidity (cash, marketable securities, unutilized bank lines, projected 12month funds from operations) should
well exceed total near-term uses (working
capital requirements, capital expenditures,
dividends, pension funding requirements,
debt maturities);
Typically enjoy good access to external
financing (debt-including securitization
facilities), equity, or both); and
There may be some event risk over the
short term (acquisitions, industry downturn, adverse regulatory/legal rulings,
adverse competitive developments), but
assessed potential impact should be minimal. There may be more significant event
risk identified over the medium term.
Standard & Poors
B-2
average speculative-grade creditworthiness
over the short term. They should have adequate to good liquidity and may have limited
near-term event risk. In particular, these
issuers should have the following traits:
May be neutral to slightly free-cash-flownegative (for prior [rolling] 12 months and
per Standard & Poors projections for next
[rolling] 12 months);
investments, plus backup liquidity from
unutilized lines of credit, should nearly
cover short-term debt maturities (i.e., may
have some refinancing risk);
Have some backup liquidity from unutilized lines of credit. There may be some
chance of covenant breach, although limited impact is expected (i.e., either lines of
credit are not critical liquidity sources, or
banks are expected to waive);
Total liquidity (cash, marketable securities,
unutilized bank lines, projected 12-month
funds from operations) should cover total
near-term uses (working capital requirements, capital expenditures, dividends, pension funding requirements, debt
maturities). Some reliance on rollovers
(particularly for bank lines where covenant
coverage is ample) may be factored in;
Typically enjoy access to external financing
(debt, equity, or both), but disruptions can
be anticipated; and
There may be some event risk over the
short term (acquisitions, industry downturn, adverse regulatory/legal rulings,
adverse competitive developments), but
assessed potential impact should be moderate. There may be more significant event
B-3
weak speculative-grade creditworthiness over
the short term (next 12 months). They may
have poor to merely adequate liquidity and
have significant near-term event risk. In particular, the issuers should exhibit the following:
May be neutral to significantly free cash
flow negative (for prior [rolling] 12 months
127
and per Standard & Poors projections for

next [rolling] 12 months);
investments, plus backup liquidity from
unutilized lines of credit cover only a fraction of short-term debt maturities (i.e., may
have significant refinancing risk);
Have some backup liquidity from unutilized lines of credit. There may be a significant chance of covenant breach, although
such a breach should not lead to an immediate liquidity crisis;
Total liquidity (cash, marketable securities,
unutilized bank lines, projected 12-month
funds from operations) should nearly cover
total near-term uses (working capital
requirements, capital expenditures, dividends, pension funding requirements, debt
maturities). Some reliance on rollovers
Chart 1Short-Term
Speculative-Grade
Ratings: Correlation With
Long-Term Ratings
BBB-
BB+
BB
A-3
B-1
BB-
B+
B-2
B-
B-3
CCC+
C
CCC
CCCCC
128
SD
SD
(particularly for bank lines where financial

covenant compliance is comfortable) may
be factored in;
Typically have only sporadic access to external financing (debt, equity, or both); and
Typically there is some identified event risk
over the short term (acquisitions, industry
downturn, adverse regulatory/legal rulings,
adverse competitive developments);
assessed impact would be significantly negative. There may be more significant event
C
Issuers with a C short-term rating have very
weak creditworthiness over the short term.
They have a combination of poor liquidity
and/or significant event risk, suggesting a
high near-term default risk. In particular,
these issuers should have the following:
Be typically free-cash-flow-negative;
Have no capital market access and limited
bank line availability. They also have
large near-term maturities. Covenant
breach may be expected in the near term,
with a high level of uncertainty by
Standard & Poors over the issuers ability
to obtain bank waivers;
Have high near-term event risk (such as
materially adverse litigation result expected); and
Default is highly probable in the near term,
unless a significantly positive development
materializes that is not in our base case
(i.e., external sources of liquidity found
through asset sales, cash injection from
parent, acquisition by a stronger company,
event risk is reversed).
Note: Speculative-grade short-term ratings
have a certain natural correlation with longterm ratings. However, with certain exceptions, several short-term rating outcomes are
possible for an issuer with a given long-term
rating. Issuers with long-term ratings of BB
and lower are not expected to achieve a
short-term rating of A-3 or higher; issuers
with long-term ratings of CCC+ and lower
are not expected to achieve a short-term rating higher than B-3.

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