Tips From The Top – “Projection Modeling And Sensitivity Analysis” – Mr. Anoop Bhatia, V.P., I.C.R.A.
The seminar began on a light note, with Mr. Anoop offering Lao Tzu’s take on forecasting and quoting Laurence Peter’s witty remarks on economists. He explained how an economist actually is involved in presenting a result oriented outlook along with the forecast of industry demand, involved in financial planning, establishes goals and analyses the market to provide well-informed guidance on the possibilities. The projections are normally done with 5-7 years of data, which helps create a holistic outlook including up-cycle and down-cycle data, including those of the competitors in the industry. For vitality of project specific projections, the data utilised can even stretch up to 20 years. However, he professed from experience that the maintenance of a certain degree of accuracy of projections is difficult beyond 2-3 years.
He then walked us through the key steps in Projections, which included analysing various factors such as the turnover or revenue of the company, the capacity utilisation factors, operating profits, dividend trends, cash accruals, the fixed assets, the growth of capital expenditure of the company, if it hovers around the right amount of working capital, the state of its debts and inventory and so on. Something often overlooked in this process is a number of loans a company often provides to its sister concerns.
Mr. Anoop also mentioned how the equity and the method in which the creditors are repaid influences the projection. He spoke of the example of construction companies which start their loan payments after a certain period of time, whereas some other companies utilise balloon loans serviced through bullet repayments. The number of creditors also has a large impact on the bargaining power of the company.
He reflected on the various assumptions, such as the revenue space includes considerations for the constraints of capacity addition and utilisation, capacity for the service space referring to sales per unit space, the non-operating income of the company, brand value, segment wise revenue projections and the regulatory risks. A conservative approach would be ideal for considering trade-offs. The profit margins are looked at differently for the manufacturing and service sectors. Much of the manufacturing sector is dependent on the cost structure, scale benefits, anticipated industry trends and the approach used to write off debtors. The assets and liabilities of the company also play a major role in projections.
He then continued on to how sensitivity analysis is performed by the ratings’ industry, considering the elements of a 7-year performance period where the revenues, profits, balance sheets, the impact of foreign exchange and mergers/de-mergers play a major role in determining the various tendencies of the organisation. A conservative approach is often considered where sharp revenue rises are investigated and long-term stability often becomes the key deciding factor in this analysis. The requirement to ensure consistency is often a representation of the management’s plans and capabilities and the business risk management approach adopted by the company. Sensitivity variation may also depend on the tangible and intangible net worth of the company.
Mr. Anoop then walked us through a couple of examples of the credit rating process and simulated the assignment of ratings varying in between D and AAA where AAA to BBB represented the companies that fall under the investment grade and the ones below signify non-investment grade companies. He explained that the challenges in this process lie in the absolute prediction of the performance of companies that have unpredictable up-cycles and down-cycles and lapses in the financial audit processes of the company. He concluded by answering questions on the modern evolving role of the credit rating organizations and the future they represent.