Corporate Finance

Criteria Report
Corporate Rating Methodology

Analysts „ Summary
U.S. Corporates Fitch’s corporate ratings make use of both qualitative and quantitative
Timothy Greening analyses to assess the business and financial risks of fixed-income
+1 312 368-3205 issuers and of their individual debt issues.
[email protected]
An issuer default rating (IDR) is an assessment of the issuer’s ability to
European Corporates service debt in a timely manner and is intended to be comparable
Trevor Pitman across industry groups and countries. Because short- and long-term
+44 20 7417-4280
ratings are based on an issuer’s fundamental credit characteristics, a
[email protected]
correlation exists between them (see Fitch Rating Correlations chart,
Latin American Corporates
page 2). Fitch’s analysis typically covers at least five years of
Daniel R. Kastholm, CFA operating history and financial data, as well as forecasts of future
+1 312 368-2070 performance. A fundamental part of Fitch’s approach is based on
[email protected] comparative analysis, through which we assess the strength of each
issuer’s business and financial risk profile relative to that of others in
Asia-Pacific Corporates
its peer group. In addition, sensitivity analyses are performed through
Tony Stringer several “what if” scenarios to assess an issuer’s capacity to cope with
+852 2263-9559 changes in its operating environment. A key rating factor is financial
[email protected] flexibility, which depends, in large part, on the issuer’s ability to
generate free cash flow from its operating activities.

Ratings of individual debt issues incorporate additional information on

priority of payment and likely recovery in the event of default. The
rating of an individual debt security can be above, below or equal to
the IDR, depending on the security’s priority among claims, the
amount of collateral and other aspects of the capital structure. Fitch’s
criteria report, “Recovery Ratings: Exposing the Components of Credit
Risk,” dated July 26, 2005, provides a full explanation of the
methodology.

„ Qualitative Analysis

Industry Risk
Fitch determines an issuer’s rating within the context of each issuer’s
industry fundamentals. Industries that are in decline, highly
competitive, capital intensive, cyclical or volatile are inherently riskier
than stable industries with few competitors, high barriers to entry,
national rather than international competition and predictable demand
levels. Major industry developments are considered in relation to their
likely effect on future performance. The inherent riskiness and/or
cyclicality of an industry may result in an absolute ceiling for ratings
within that industry. Therefore, an issuer in such an industry is unlikely
to receive the highest rating possible (‘AAA’) despite having a
conservative financial profile, while not all issuers in low-risk
industries can expect high ratings. Instead, many credit issues are
weighed in conjunction with the risk characteristics of the industry to
arrive at a balanced evaluation of credit quality.
June 13, 2006
www.fitchratings.com
 Corporate Finance
Fitch Rating Correlations

Long-Term Ratings Short-Term Ratings

‘AAA’

‘AA+’
‘F1+’
‘AA’

‘AA–’

‘A+’
‘F1’
‘A’

‘A–’

‘BBB+’
‘F2’
‘BBB’
‘F3’
‘BBB–’

Operating Environment may be a factor if it confers major advantages in terms

Fitch explores the possible risks and opportunities in of operating efficiency, economies of scale, financial
an issuer’s operating environment resulting from flexibility and competitive position. In commodity
social, demographic, regulatory and technological industries, size is not as important as cost position, since
changes. Fitch considers the effects of geographical the ability of one participant to influence price in a
diversification and trends in industry expansion or global commodity is usually not significant.
consolidation required to maintain a competitive
position. Industry overcapacity is a key issue, Management
because it creates pricing pressure and, thus, can Fitch’s assessment of management quality focuses on
erode profitability. Also important are the stage of an corporate strategy, risk tolerance, funding policies
industry’s life cycle and the growth or maturity of and corporate governance. Corporate goals are
product segments, which determine the need for evaluated to determine if management has an
expansion and additional capital spending. aggressive style dedicated to rapid growth that
maximizes near-term earnings at the expense of
In rating cyclical companies, Fitch analyzes credit- future performance or a conservative style geared
protection measures and profitability through the cycle toward optimizing cash flow over the long term. A
to identify an issuer’s equilibrium or midcycle rating. policy of growth through acquisition is not
The primary challenge in rating a cyclical issuer is necessarily a negative credit factor, especially in a
deciding when a fundamental shift in financial policy or consolidating industry in which new projects would
a structural change in the operating environment has dampen prices for all participants. Key factors
occurred that would necessitate a rating change. considered are the mix of debt and equity in funding
growth, the issuer’s ability to support increased debt
Market Position and the strategic fit of new assets. The historical
Several factors determine an issuer’s ability to mode of financing acquisitions and internal
withstand competitive pressures, including its expansion provides insight into management’s risk
position in key markets, its level of product tolerance. Although any assessment of the quality of
dominance and its ability to influence price. management is subjective, financial performance
Maintaining a high level of operating performance over time provides a more objective measure. Fitch
often depends on product diversity, geographic assesses management’s track record in terms of its
spread of sales, diversification of major customers ability to create a healthy business mix, maintain
and suppliers and comparative cost position. Size operating efficiency and strengthen market position.

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 Corporate Finance
Fitch also gives management significant credit for protection measures is evaluated over a period of
delivering on past projections or maintaining time to determine the strength of an issuer’s
previously articulated strategies when evaluating operations, competitive position and funding ability.
future growth plans and related financial projections.
Cash Flow Focus
Finally, Fitch analyzes the quality of corporate In our financial analysis, Fitch emphasizes cash flow
governance (e.g., percentage of independent directors) measures of earnings, coverage and leverage. Cash flow
to evaluate the structural framework and context in from operations provides an issuer with more secure
which management operates. Fitch’s approach to credit protection than dependence on external sources of
evaluating corporate governance is described in the capital. In dealing with quantitative measures, Fitch
special report, “Evaluating Corporate Governance: The regards the analysis of trends in a number of ratios as
Bondholders’ Perspective,” dated April 12, 2004. more relevant than any individual ratio, which
represents only one performance measure at a single
Accounting point in time. Fitch’s approach attributes more weight to
While Fitch’s rating process does not include an audit of cash flow measures than equity-based ratios. The latter
an issuer’s financial statements, it examines accounting rely on book valuations, which do not always reflect
policies and the extent to which they accurately reflect current market values or the ability of the asset base to
an issuer’s financial performance. Relevant areas generate cash flows. Measures such as debt-to-equity
include consolidation principles, valuation policies, and debt-to-capital are less relevant to a credit analysis
inventory costing methods, depreciation methods, because they are based on formalized accounting
income recognition and reserving practices, pension standards, which are subject to interpretation. In
provisions, treatment of goodwill and off-balance-sheet addition, these measures do not reflect an issuer’s debt-
items. The overall aim is to judge the aggressiveness of servicing ability as transparently as those based on cash
the accounting practices and restate figures, where flow generation. Because the equity account is presented
necessary, to make the issuer’s financials comparable at book value, it does not provide the most accurate
with those of its peers. Fitch also analyzes the assessment of an issuer’s asset base to generate future
differences among national accounting standards and cash flows. Thus, asset values may be over- or
the effect these differences have on the financial results understated, while the issuer’s liabilities remain close to
of issuers within the same industry but domiciled in the cash obligation payable at maturity. However, use of
different locations. equity-based ratios is prevalent in many parts of the
world, and these ratios have relevance in helping
Because different accounting systems can affect an investors in those markets understand an issuer’s
issuer’s assets, liabilities and reported income, Fitch financial profile.
makes adjustments to ensure comparability with other
companies in the peer group. Such adjustments include Earnings and Cash Flow
those made for revenue recognition, asset values, leased Key elements in determining an issuer’s overall
property, contingency reserves, treatment of goodwill, financial health are earnings and cash flow, which
provision for deferred taxes and off-balance-sheet affect the maintenance of operating facilities, internal
liabilities. The general principal Fitch applies in its growth and expansion, access to capital and the
adjustments is to get back to cash. Fitch avoids using ability to withstand downturns in the business
fair value numbers shown increasingly in financial environment. While earnings form the basis for cash
statements unless these give an indication of what the flow, adjustments must be made for such items as
real cash inflow or outflow will be. noncash provisions and contingency reserves, asset
writedowns with no effect on cash and one-time
„ Quantitative Analysis charges. Fitch’s analysis focuses on the stability of
The quantitative aspect of Fitch’s corporate ratings earnings and continuing cash flows from the issuer’s
focuses on the issuer’s policies in relation to major business lines. Sustainable operating cash flow
operating strategies, acquisitions and divestitures, provides assurance of the issuer’s ability to service
financial leverage targets, dividend policy and debt and finance its operations and capital expansion
financial goals. Paramount to the analysis is the without the need to rely on external funding.
issuer’s ability to generate cash, which is reflected by
the ratios that measure profitability and coverage on a
cash flow basis. The sustainability of these credit-

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 Corporate Finance
Capital Structure must not constitute nonpayment or insufficient payment,
Fitch analyzes capital structure to determine an which would increase the risk of insolvency.
issuer’s level of dependence on external financing.
To assess the credit implications of an issuer’s Hybrid securities, which are financial instruments
financial leverage, several factors are considered, that combine attributes of debt and equity, may also
including the nature of its business environment and be considered as quasidebt depending on their terms.
the principal funds flows from operations (see the For details and statistical support for the current
Definitions of Cash Flow Measures table on page 5). policy, see the criteria report, “Hybrid Securities:
Because industries differ significantly in their need Evaluating the Credit Impact—Revisited,” dated
for capital and their capacity to support high debt April 20, 2005. Given the recent developments in this
levels, the financial leverage in an issuer’s capital market, the criteria for hybrids are subject to revision.
structure is assessed in the context of industry norms.
Financial Flexibility
As part of this process, an issuer’s debt level is Having financial flexibility provides an issuer with
adjusted from fair value to cash where applicable and the ability to meet its debt-service obligations and
for a range of off-balance-sheet liabilities by adding manage periods of volatility without eroding credit
these to the total on-balance-sheet debt level. Such quality. The more conservatively capitalized an issuer
items include the following: is, the greater its financial flexibility. In addition, a
commitment to maintaining debt within a certain
• Borrowings of partly owned companies or range allows an issuer to cope with the effect of
unconsolidated subsidiaries that may involve unexpected events on the balance sheet. Other factors
claims on the parent issuer. that contribute to financial flexibility are the ability to
• Debt associated with receivables securitizations, redeploy assets and revise plans for capital spending,
if there is recourse to the issuer. strong banking relationships and access to debt and
• In the event of debt that is nonrecourse to the equity markets. Committed, multiyear bank lines
rated entity, Fitch reviews each situation to provide additional strength. Factors that diminish
ascertain the relevance of including the debt as financial flexibility include a large proportion of
part of the total debt calculation. short-term debt in the capital structure, significant
• Operating lease obligations. unfunded pension obligations, contingent obligations
• Pension, health care and other post-retirement and unfunded other post employment benefits
obligations. (OPEB) other than pensions. Each of these can cause
substantial drains on cash flow, which can severely
In situations where specific liabilities are excluded reduce or even eliminate financial flexibility (e.g., the
from the debt calculation, the analyst will also numerous asbestos bankruptcies).
exclude any related cash flow, income or assets from
the equation. The issuer’s history in supporting off- „ Appendix: Guide to Credit Metrics
balance-sheet investments with additional funds will Fitch uses a variety of quantitative measures of cash
also be a factor in determining the appropriateness of flow, earnings, leverage and coverage to assess credit
including or excluding these amounts from total debt risk. The following sections summarize the key credit
in the absence of a formal guarantee or commitment. metrics used by Fitch to analyze credit default risk and
compare them to measures based on operating earnings
Preferred stock issues with fixed dividend payments before interest, taxes, depreciation and amortization
or redemption dates may be considered as quasidebt (EBITDA). EBITDA is still an important measure of
instruments. These securities offer issuers low-cost, unlevered earnings capacity and the most commonly
tax-deductible funds while providing equity that is used measure for going-concern valuations. As such,
available if needed. Structural features that Fitch EBITDA plays a key role in Fitch’s recovery analysis
deems as essential characteristics for partial for defaulted securities (see the criteria report,
consideration as equity include subordination to all “Recovery Ratings: Exposing the Components of Credit
other debt of the issuer, maturities of at least 30 years, Risk,” dated July 26, 2005). However, given the
a payment deferral option for multiple five-year periods, limitations of EBITDA as a pure measure of cash flow,
limited acceleration rights and weak creditor rights in Fitch utilizes a number of other measures for the
bankruptcy. Shortfalls of interest and principal purpose of assessing debt-servicing ability. These
payments may be rolled over to succeeding periods but include funds flow from operations (FFO), cash flow

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 Corporate Finance
from operations (CFO) and free cash flow (FCF),
together with leverage and coverage ratios based on Definitions of Cash Flow Measures
Revenues
those measures, which are more relevant to debt-
– Operating Expenditure
servicing ability and, therefore, to default risk than + Depreciation and Amortization
EBITDA-based ratios. + Long-Term Rentals
= Operating EBITDAR
The following definitions are only an introduction to the – Cash Interest Paid, Net of Interest Received
– Cash Tax Paid
cash flow measures and credit metrics used by Fitch in + Associate Dividends
our analysis. Detailed definitions and sample – Long-Term Rentals
calculations are provided in the criteria report, “Cash +/– Other Changes Before FFO
Flow Measures in Corporate Analysis,” dated Oct. 12, = Funds Flow from Operations (FFO)
+/– Working Capital
2005. Specific industries, such as media and
= Cash Flow from Operations (CFO)
telecommunications, may have industry-accepted +/– Nonoperational Cash Flow
definitions and practices that differ from the terms – Capital Expenditure
described below. – Dividends Paid
= Free Cash Flow (FCF)
+ Receipts from Asset Disposals
„ Cash Flow Measures – Business Acquisitions
+ Business Divestments
Funds Flow from Operations +/– Exceptional and Other Cash Flow Items
= Net Cash In/Outflow
+/– Equity Issuance/(Buyback)
Post-Interest and Tax, Pre-Working Capital +/– Foreign Exchange Movement
FFO is the fundamental measure of the firm’s cash +/– Other Items Affecting Cash Flow
= Change in Net Debt
flow after meeting operating expenses, including
Opening Net Debt
taxes and interest. FFO is measured after cash +/– Change in Net Debt
payments for taxes, interest and preferred dividends Closing Net Debt
but before inflows or outflows related to working
capital. Fitch’s computation also subtracts or adds operations, after capital expenditure, nonrecurring or
back an amount to exclude noncore or nonoperational nonoperational expenditure and dividends. It also
cash in- or outflow. FFO offers one measure of an measures the cash flow generated before account is
issuer’s operational cash-generating ability before taken of business acquisitions, business divestments
reinvestment and before the volatility of working and any decision to issue or buy back equity, or make
capital. When used in interest coverage ratios, a special dividend, by the issuer.
interest paid is added back to the numerator.
Operating EBITDA and EBITDAR
Cash Flow from Operations Operating EBITDA is a widely used measure of an
issuer’s unleveraged, untaxed cash-generating
Post-Interest, Tax and Working Capital capacity from operating activities. Fitch excludes
CFO represents the cash flow available from core extraordinary items, such as asset writedowns and
operations after all payments identified by the issuer restructurings, in calculating operating EBITDA
for ongoing operational requirements, interest, unless an issuer has recurring one-time charges,
preference dividends and tax. CFO is also measured which indicate the items are not unusual in nature.
before reinvestment in the business through capital Fitch also excludes stock-option expensing from
expenditure, before receipts from asset disposals, operating EBITDA calculations.
before any acquisitions or business divestment and
before the servicing of equity with dividends or the The use of operating EBITDA plus gross rental
buyback or issuance of equity. expense (EBITDAR, including operating lease
payments) improves comparability across industries
Free Cash Flow (e.g., retail and manufacturing) that exhibit different
average levels of lease financing and within
Post-Interest, Tax, Working Capital, Capital industries (e.g., airlines) where some companies use
Expenditures and Dividends lease financing more than others.
FCF is the third and final key cash flow measure in
the chain. It measures an issuer’s cash from

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 Corporate Finance
„ Coverage Ratios FCF Debt-Service Coverage

Debt and Net Debt FCF plus Gross Interest plus Preferred Dividends
Debt represents total debt or gross debt, while net debt divided by Gross Interest plus Preferred
is total debt minus cash and equivalents on the balance Dividends plus Prior-Year’s Debt Maturities due
sheet. Recognizing the cultural differences in the in one year or less
approach of analysts and investors worldwide, Fitch
evaluates all debt measures on both a gross and net This is a measure of the ability of an issuer to meet
debt basis. As previously discussed, distinctions are debt service obligations, both interest and principal,
also made between total interest and net interest from organic cash generation, after capital expenditure
expense. The following definitions include only gross and assuming the servicing of equity capital. This
interest and gross debt to illustrate the concepts. For a indicates the entity’s reliance upon either refinancing in
detailed explanation of net debt and net interest the debt or equity markets or upon conservation of cash
calculations, see the criteria report, “Cash Flow achieved through reducing common dividends or capital
Measures in Corporate Analysis,” dated Oct. 12, 2005. expenditure or by other means.

FFO Interest Coverage „ Leverage Measures

FFO plus Gross Interest Paid plus Preferred FFO Adjusted Leverage
Dividends divided by Gross Interest Paid plus
Preferred Dividends Gross Debt plus Lease Adjustment minus Equity
Credit for Hybrid Instruments plus Preferred
This is a central measure of the financial flexibility of Stock divided by FFO plus Gross Interest Paid
an entity. This measure compares the operational plus Preferred Dividends plus Rental Expense
cash-generating ability of an issuer (after tax) to its
financing costs. Many factors influence coverage, This ratio is a measure of the debt burden of an entity
including the relative levels of interest rates in relative to its cash-generating ability. This measure
different jurisdictions, the mix of fixed-rate versus uses a lease-adjusted debt equivalent and takes
floating-rate funding, the use of zero-coupon or account of equity credit deducted from hybrid debt
payment-in-kind (PIK) debt and so on. For this securities that may display equitylike features. Fitch
reason, the coverage ratios should be considered capitalizes operating leases as the net present value of
alongside the appropriate leverage ratios. future obligations where appropriate and when
sufficient information is available. Otherwise, leases
FFO Fixed-Charge Coverage are capitalized as a multiple of rents, with the
multiple depending on the industry.
FFO plus Gross Interest plus Preferred Dividends
plus Rental Expenditure divided by Gross Interest Total Adjusted Debt/Operating EBITDAR
plus Preferred Dividends plus Rental Expenditure
Total Balance Sheet Debt Adjusted for Equity
The above measure of financial flexibility is of
Credit and Off-Balance-Sheet Debt divided by
particular relevance for entities that have material
Operating EBITDAR
levels of lease financing. It is important to note that
this ratio inherently produces a more conservative
result than an interest cover calculation (i.e., Total Debt with Equity Credit/Operating
coverage ratios on debt-funded and lease-funded EBITDA
capital structure are not directly comparable), as the
entirety of the rental expenditure (i.e., the equivalent
of interest and principal amortization) is included in Total Balance Sheet Debt with Equity Credit for
both the numerator and denominator. Hybrid Securities divided by Operating EBITDA

These leverage measures help gauge financial

flexibility and solvency. They are conceptually

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 Corporate Finance
similar to the commonly used debt/EBITDA Total Debt/Total Capitalization
measures with adjustments for equity credit and lease As with gearing, this commonly used measure shows
financing. the portion of debt and equity in the issuer’s funding.
The inherent limitation of this ratio is that book
Pension-Adjusted Leverage equity does not give a true picture of the cash flow
Fitch believes the general increase in unfunded generating ability of the asset base. However, many
pension liabilities should be addressed in financial companies, especially those with fluctuating cash
analysis. In European ratings, this is done by adding flows, use this ratio to communicate the composition
pension fund deficits to financial indebtedness as a of their capital structure to third parties.
supplementary tool in our quantitative financial
analysis. The criteria reports, “European Pensions— „ Profitability Ratios
Implications for Contingent Funding of Pension
Schemes on Corporate Credit Ratings,” dated Feb. Operating Income/Revenues
22, 2006, and “The European Pensions Debate,”
Operating EBTIDAR/Revenues
dated March 26, 2003, discuss the topic in depth. In
Operating or profitability margins provide a useful
the United States, the shortcomings of current
measure of an issuer’s profitability from one period
accounting treatment for pension obligations and the
to the next, stripping away gains due entirely to
fact that pension accounting will be revised in the
revenue growth. These ratios are also quite helpful in
near term make an adjusted-debt figure less useful.
assessing relative profitability of companies within
As a result, Fitch focuses on cash claims in the near
the same industry facing similar competitive
term, represented by required contributions, and
pressures. However, a comparison of operating
assesses these obligations in the context of the
margins across industries as a measure of relative
issuer’s operating cash flow. Fitch also recognizes
creditworthiness is not relevant due to inherent
the long-term, and volatile, nature of the obligations
differences in cost structure and risk premiums.
represented by an underfunded position. The ability
of the issuer to meet these obligations is analyzed,
but the reported GAAP deficit is not included in the
U.S. ratio analysis since it is an inadequate measure
of the potential cash funding need.

Copyright © 2006 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.
Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the
information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the
truth or accuracy of any such information. As a result, the information in this report is provided “as is” without any representation or warranty of any kind. A Fitch rating is an opinion as to the
creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of
any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection
with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort.
Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-
exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees
generally vary from USD1,000 to USD750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured
or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from USD10,000 to USD1,500,000 (or the applicable currency equivalent). The
assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the
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publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.

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