20160805AVU to Clearwater 5 Attachment B.pdf

Clearwater_PR_05 Attachment B Page 1 of 14
Criteria I Corporates I Utilities:
Key Credit Factors: Business And
Financial Risks In The
Investor-Owned Utilities Industry
Primary Credit Analvst:
Todd A Shipman, CFA, New York I 1) 212-438-7676; [e-mail]
Table Of Contents
Relationship Between Business And Financial Ri ks
Part 1--Business Risk Analysis
Part 2-Financial Risk Analysis
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Criteria I Corporates I Utilities:
Key Credit Factors: Business And Financial
Risks In The Investor-Owned Utilities Industry
(Editor's Note: Table l in this article is no longer current. It has been superseded by the table found in " riteria
Methodology: Business Risk/Financial Risk Matrix Expanded • published May 27 2009 on RatingsDirect. For our
latest comments on regulated utility subsidiaries, please see "Methodology: Differentiating The Issuer red it Ratings
Of A Regulated Utility Subsidiary And Its Parent,· published March 11, 2010, on RatingsDirect.)
Standard & Poor' Raring Services' analytic framework for companies in all sectors, including inve tor-owned
urilitie , is divided inro two major egmenr : The fi rst part is the fundamental bu ine ri k analy i . Thi tep form
the ba i and provide the indu try and bu ine conrext for the econd egmenr of the analy i , an in-depth
financia l ri k analy i of the company.
An inregrated utility i often a part of a larger holding company tructure that also owns other bu ine e including
unregulated power generation. Thi fact doe nor alter how we analyze the regulated utility bur it may affect the
ultimate raring outcome becau e of any higher risk credit drag that the unregulated acri1•itie may have on the uriliry.
Such consideration include rhe freedom and practice of managemenr wirh re peer ro hifcing ca h re ource among
ub idiaries and rhe presence of ring-fencing mechanism that may prorecr rhe uriliry.
Relationship Between Business And Financial Risks
Prior co di cu ing rhe specific ri k factor we analyze within our framework, ir i important to under rand how we
view rhe relationship between bu ines and financial ri k . Table 1 di play thi relation hip and it implication for
a company's raring.
Table 1
Busineu And Fin1nclal Risk Proflle Mitri•
(AAA/AA) AAA AA A BBB BB
CAI AA A A-BBB-BB-
(BBB) A BBB+ BBB 88• 8•
(881 BBB BBB-BB• 811-8
(81 88 8+ 8+ 8 II-
Thao mng ouloomn 1A1 shown ro, ;uio.nc:e i,urposes ~ OIIM< qual-• -quon nglKtorsmayO\I 1110
ll'lfttltn ...
e Standard & Poor's 2008
Chart 1 summarize the rating proce .
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
Industry
Chart 1
Scoring And Rating Determination Process
BUSINESS RISK
Country and macroeconomic ris
Industry ris
Co!T1)etitive position
-Market posltlon
01Yefs11\ca1JOn
-Operating efficiency
Managernen growth and opera ·ng
sttategy, ns appetite; track record
o.vnersh p / governance
Profi1abtlrtyfpeer comparisons
FINANCIAL RISK
AC<:Ounllng
Ftn nciaJ govemanc:e and poliaes/
ns tolerance
Cash flow adequacy
Capilal strudureiasset proled10n
Liqu1d1ty/short· rm factors
C, Standard & Poor's 2008
Part 1--Business Risk Analysis
Bu51neu Risk
Score
Financial Risk
Score
Ra 'ng
Business risk is analyzed in four categoric : country ri k industry risk, competitive po irion and profitability. We
determine a core for the overall bu iness ri k ba ed on the scale hown in table 2.
Table 2
Business Risk Measures
Description Rating equivalent
Excellent AAA/AA
Strong A
Satisfactory BBB
Weak BB
Vulnerable B/CCC
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
Industry
Analy i of bu iness ri k factors is supported by factual data, including tatistics, but ultimately involves a fair
amount of ubjective judgment. Understanding business risk provide a context in which to judge financial risk,
which cover analy i of ca h flow generation, capitalization, and liquidity. In all ca e , the analy i u e hi torical
experience to make estimate of future performance and risk.
In the U.S., regulated utilitie and holding companie that are utility-focu ed virtually alway fall in the upper range
(Excellent or trong) of busine s risk profiles. The defining characteristics of most utilities--a legally defined service
territory generally free of significant competition, the provision of an essential or near-essential service, and the
pre ence of regulator that have an abiding interest in supporting a healthy utility financial profile--underpin the
business risk profiles of the electric, gas, and water utilities.
1. Country ri k and macroeconomic factors (economic, political, and ocial environments)
Country ri k play a critical role in determining all ratings on companie in a given national domicile.
Sovereign-related tre scan have an overwhelming effect on company credirworthine , both directly and indirectly.
overeign credit ratings suggest the general risk local entities face, bur the ratings may not fully capture the risk
applicable ro the private ector. A a resu lt, when rating a corporation, we look beyond the overeign raring ro
evaluate the specific economic or country risks that may affect the entity' creditworthine . uch ri ks pertain to the
effect of government policies and other country risk factor on the obliger's business and financial environments,
and an entity' ability to in ulate it elf from the e risk .
2. Industry business and credit risk characteristics
In establi hing a view of the degree of credit risk in a given industry for rating purpo e it i u eful to consider how
ir ri k profile compare to rhat of other indu rrie . Although the indu try ri k characreri tic caregorie are broadly
imilar aero s indu tries, the effect of these factors on credit ri k can vary markedly among indu tries. Chart 2
illu traces how the effect of the e credit-risk factor vary among ome major industries. The key industry factors are
scored as follows: High risk (H ), medium/high risk (M/H), medium risk (M), low/medium risk (UM), and low risk
(L).
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
Industry
Chart 2
Key Industry Chanicteristics And Drivers Of Credit Risk
Ut11Hlei Competitive Otl & gas
reigu111ed powar do·wns.Ue-t1m Autos. AlrllnM
Industry dynamics and compelithre anv ronme_n_, __ _
lnclul>lly qdlcallly
£• .. of .ntry
Procluctc~
IAffl of p,oduct qudty
Ollln-llOnlw!K­
Campaa_,,_,uzatton
Pilclng lnlealblllly
Bu-I IIIOIMI 1-ty
Oamog111p1Mc: ,.-.
Growth nd profitabilrty
Growtlt-
Pl'OIII ffllllgln l"HSU,_.OU_
um1ng1 vCMOMty
Operating con11cktra ons and costs
Tec:lln0109lcal rl111JchanOe
eo.t • aencylptnsu-
<>pe,a "' -""· A&Oc:oab
lne,vy coat sen11t1v11y
flaw ffiMlflal COii _,Mavtly
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COlb Cu•--•DOn
SUppllef -,,1raoon _ _,...._,
Aswttpi..1 q..-ry and agetupll­
Ev-rllk MMHIVlty
F,,,.noal ""'rloel va1aallryl,eft1nM1y
fnll-llg" ,en1Ulvl
Capital and financing characb!ristic~
Capllal in ... lllY
Botrowlng -·-· lnlltrHl •• MnMIIYlly
Gov mm411\I,, ubwry, and loll I onv ronmo<1ts
Aeoul_,.,.,eo.,._
GoYemlMlll ffllCIOeCOnOffl -MIClal pollcln
UOgioulneullegal .....
C Standatd & Pooc·s 2008
Industry strengths:
H H H H H
H H UM H H
UM UM UM H LIM
• Material barrier to entry because of government-granted franchi e , de pite deregularory trend ;
• Strategically important to national and regional economies; key pillar of the consumer and commercial economy;
• Improving management focu indu try-wide on operating efficiency in recent years; and
• Cross-border growth opportunities in Europe and industrializing emerging markets.
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
Industry
Industry challenges/risks:
• Maturity, with a weak growth outlook in developed countries;
• Highly politicized and burden ome regulatory (i .e., rate setting and investment recovery) process; and
• Risks of "legacy cost drag" as whole ale and retail markets move toward greater deregulation.
Major global risk is ues facing tbe utilities industry:
• lncrea ed volatility in the regulatory environment and competitive land cape leading to greater uncertainty
regarding adequacy of pricing and rerurn on capital;
• Longer-term impact of, and ability to absorb, significant secular upturn in fuel costs, which is the industry's
major operating expen e;
• Ability to recover mas ive investment costs that will likely be neces ary to replace aging indu try infrastructure in
a harsher cost and regulatory environment; and
• The debate over global warming will continue far beyond 2008. What the ultimate outcome will be is unclear,
but growing legi lation addre sing carbon emi ions and other greenhouse ga es i probable in the near future.
Utilities' ability to recover environmentally mandated costs in authorized rates and con umer ' willingness to pay
them could impact the indu try' fu ture credit strength.
Industry business model and risk profile in transition
Regulated utilitie are in ma ny developed countries transitioning away from qua i-monopolie toward more open
competitive environments.
The level of busine sand credit risk asso iaced with the investor-owned regulated ucilitie has historically proven in
mo t countries to be lower (ri k) than for many other industries. Thi ha been becau e of the exi tence of
government policy and related regulation that created significant barriers to entry limiting competition, and
regulatory rate erring de igned to provide an opportunity to achieve a pecific level of profitability. The credit
quality of most vertically integrated milicie in developed councrie ha hi corically been, and remains, olidly
investment grade. This, to reiterate, is primarily a function of the existence of protective regulation.
The risks of, and rationale for, deregulation
The traditional protected and privileged utilitie industry bu ine model with its marked monopoli tic
characteri tic i in many countrie undergoing tran ition to a more competitive and open framework. Thi
transition process, known as deregulation or liberalization, is weakening the business and credit risk profile of the
industry. While the impact of these changes may prove positive in the longer term for more efficient indu try
player , it i important ro bear in mind rhat economic hi tory i littered with the ve tige of indu trie and
enterprises that once flourished under the protection of government-created barriers and ocher protections. The shift
is being driven by introduction in many countries of policies to encourage the entrance of new competitors and co
reduce the traditional regulatory protections and privilege enjoyed by incumbent . Historically, the regulated
inve tor-owned urilitie were u ually granted exclu ive franchi e . Because of the ignificant ri k a ociated with the
capital-inten e nature of the utility investment, including ma ive unk/fixed co t and long-term break-even
horizon , government in many countrie created legal and regulatory framework char granted exclu ivity to one
operator in a given geographic area. To offset the monopolistic pricing power chi exclu ivicy created, a ystem of
heavy regulation was typically developed, which included the setting of pricing. The model often set pricing on a
"cost-plus-basi ", i.e., the margin over cost allowing for a perceived fair return to hareholder of investor-owned
urilirie . ne major weaknes of rhi y rem i rhar it created little incentive for urilirie ro efficiently manage co rs.
In recent year a many governments have adopted more liberal open market economic philo ophie and related
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
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policies focu ed on the creation of greater competition-in an effort to fo ter improved economic growth and
pricing efficiency throughout the economy-the traditional utility model in many councrie have come under
increa ing political crutiny and pre ure.
A major public policy and political ri k, a well a a credit ri k, a ociated with deregulation of protected indu tries,
is that existing incumbent often experience ignificant challenge in readju ting their management trategie ,
cultures, and expen e basis to be able to compete effectively in the new environment.
The turmoil and bankruptcie in the U.S. in the non regulated power marketing and trading arena between 2000 and
2002 arose ub equent to a major government initiative co deregulate the wholesale market. The e fai lures, as well
a other high-profile problems arising from deregulation elsewhere in the world, have given governments pause as to
the de irabilicy of a headlong ru h into deregulation. In the U.S., for example, there i currently little impetu to
carry deregulation any further.
Regulation and deregulation in the U.S.
While considerable arrenrion has been focused on companies in rates that deregulated in the late 1990s and the
early part of chis decade, and the related consequences of di aggregation and nonregulated generation, 27 race
(plus four that forma lly rever ed, uspended, or delayed restructuring) have retained the traditional regulated model.
For utilitie operating in those states, the quality of regulation and management loom considerably larger than
market , operation , and competitivenes in haping overall financial performance. Policie and practice among
srate and federal regulatory bodies will be key credit determinant . Likewise, the quality of management, defined by
its posture towards creditworthine s, strategic decisions, execution and con i tency, and its ability to sustain a good
working relationship with regulators, will be key. Importantly, however, it i virtually impo ible to completely
egregate each of the e characteristic from the others; to ome extent they are all interrelated.
Fragmentation of original model emerges in the U.S.
• Traditional regulated, vertically integrated utilities (generation, transmission, and distribution);
• Tran mi ion and di tribution;
• Diversified;
• Transmission; and
• Merchant generation.
We view a company that owns regulated generation, transmission, and distribution operations as positioned
between companies with relatively low-risk transmission and distribution operations and companies with higher-risk
diversified activitie on the bu ine profile pectrum. What typically di tingui he one vertically integrated utility'
business profile score from another is the quality of regulation and management, which are the nvo leading drivers
of credit quality.
Deregulation in the U.S. creates a new volatile industry subsector
The birth of large-cale, nonregulated power generator created the opportunity--and the need--for companie to
market and broker power. Power marketers, independent power producer , and unregulated ub idiarie of utility
companies offer power-supply alternatives to other utilities in the wholesale market as well as to large industrial
customer . Power marketing operation have been formed by energy companie (many with experience in marketing
natural ga ), utility ub idiarie , and independents. A with the gas i.ndu cry, electric power marketer expected to
develop an efficient market by traddling the gulf between electricity generators and their cu tomer , who have
become "free agents" in the newly competitive environment.
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
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Deregulation creates tiering of industry, business and credit risk profiles in Europe
The regional differences in marker liberalization across Western Europe result in material variation in indu try and
business risk profiles for the utilities industry at the national level. The U.K. and ordic markers, in particular, are
ubsranrially deregulated and open, and con equenrly present higher ri k than other marker char are les open,
including France and rhe Iberian marker. Raring therefore generally are lower in the e more deregulated markers.
The le -liberalized market may face more regulatory ri k going forward, particularly if effort by the EU ro
advance the internal marker by increasing the extent of marker liberalization aero the U continue.
Legal action again r companie that infringe on competition law should be expecred--particularly against rho e that
move to prevent new entry and limit customer choice (for example, thro ugh the tying of marker and capacity
hoarding) or coll ude with other incumbents to do so. The European ommission (E ) can fine companies rhat have
violated antitrust laws up to 10% of their global annual turnover and, under certain conditions, impose structural
remedie . Particular empha i would be placed on increa ing the effective unbundling of network and upply
acrivirie and on dimini hing marker concentration and barrier to entry.
The E ha publicly rated i intention to pur ue, a a priority, abu e of the dominant po ition of vertically
integrated companie (called vertical foreclosure). Behavioral remedie , such a energy release programs, are
expected to be imposed by the EC for which such abuses, or collusion, are proved. The commission could also
enforce tructural mea ures when behavioral remedies are deemed insufficient.
3. Company competitive position and keys to competitive succes
In analyzing a compa ny' competitive position, we consider the following:
• Regulation;
• Marker·
• Diversification;
• Operations;
• Management, including growth trategy;
• Governance; and
• Profitability.
We are mo t concerned about how the e elements contribute individually and in aggregate to the predictability and
sustainability of fi nancial performance, particularly cash flow generation relative to fixed obligations.
Regulation. Critical success factors include:
• onsi tency and predictability of decisions;
• Support for recovery of fuel and investment costs;
• History of timely and consi rent rare treatment, permitting sari factory profit margins and timely return on
inve rment; and
• Support for area onable ca h return on investment.
Regulation i the mo t critical a peer that underlie regu lated integrated urilitie ' credirworrhine . Regulatory
decisions can profoundly affect financial performance. Our assessment of the regulatory environments in which a
utility operates is guided by certain principles, most prominently consistency and predictability, as well as efficiency
and timelines . For a regulatory process to be considered supportive of credit quality, it mu r limit uncertainty in the
recovery of a utility's investment. They must also eliminate, or at least greatly red uce, the issue of rate-case lag,
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
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e pecially when a utility engage in a sizable capital expenditure program.
Our evaluation encompa e the administrative, judicial, and legislative proces es involved in state and national
government regulation, and includes the political environment in which commissions render decisions. Regulation is
a e ed in term of it ability to ari fy the particular need of individual utilities. Rare-erring action are reviewed
case by ca e with regard to the potential effect on credit quality.
Evaluation of regulation foc u cs on the ability of regulation ro provide urilirie with rhe opportunity ro generate
ca h flow and earning quality and stability adequate to:
• Meer inve rment needs;
• Service debt and maintain a satisfactory raring profile; and
• Generate a competitive rare of return ro inve tor .
To achieve this, regulation mu r allow for:
• Timely recognition of volatile co t component such as fuel and sati factory returns on inve ted capital and
equity;
• Ability to enter into long-term arrangements at negotiated rate without having to eek regulatory approval for
each contract; and
• Ability to recover costs in new investment over a reasonable time frame.
Because the bulk of a utility' operating expen es relate ro fuel and purcha ed power, of primary importance to
rating tability i the level of upport that rate regulators provide to utilitie for fuel co r recovery, particularly a
ga and coal co t have ri en. Utilitie that are operating under rare moratorium , or without acce to fuel and
purcha ed-power adju rment clau e , or face significant regulatory lag, al o are ubject to reduced operating
margin , increased cash flow volatility, and grea ter demand for working capital. Companies that are granted fuel
true-ups may be required to spread recovery over many years to ease the pain for the consumer. In addition to fuel
co t recovery filing , regulator will have to addre s ign ificant rate increa e reque t related to new generating
capacity additions, environmental modifications, and reliability upgrades. urrent cash recovery and/or return by
means of construction work in progress support what would otherwise sometimes be a significant cash flow drain
and reduces the utility's need to issue debt during construction.
Markets/market position. ritical ucces factors include:
• A healthy and growing economy;
• Growth in population and re idential and commercial cu tomer ba e;
• An attractive bu iness environment;
• An above-average re idential ba e; and
• Limited bypa s risk.
The importance of diversification and size. Critical ucce factors include:
• Regional and cro -border market diversification (mitigate economic, demographic, and political ri k
concentration);
• Industrial customer diversification;
• Fuel upplier diver ification;
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
Industry
• Retail, compared with wholesale;
• Regulatory regime diversification; and
• enerating facility diver ificarion.
Operations (operating strategy, capability, and perfonna11ce efficiency). ritical ucce factor include:
• Low cost structure;
• Well-maintained a set ;
• Solid plant performance;
• Adequate generating reserves, and compliance with environmenta l standards; and
• imited environmental exposures.
Manageme11t evaluation. Utilitie are complex pecialized businesse requiring experienced and succe ful
management reams ro have a rrong mix of rhe aforementioned disciplines. ritical elements of management succe s
include:
• ommitment to credit quality;
• Operating efficiency and co t control;
• Maintaining a competitive asset ba e, i.e., power plant construction project management, and plant upkeep and
renovation;
• Regulatory track record, process, and relationship management;
• M&A experience in ucce sfully identifying, executing, and integrating acquisition ;
• redibility and trong corporate governance;
• on ervative financial policie , e pecially regarding non-regulated activitie ; and
• Abiliry and crack record in repositioning and transforming business ro not just survive, bur prosper in a more
open market environment.
Management is asse sed for it ability to rnn and expand the busines efficiently, while mitigating inherent bu ines
and financial ri k . The evaluation al o focuses on the credibility of management' trategy and projection , it
operating and financial track record, and its appetite for assuming business and financial risk.
The management a e ment i ba ed on tenure, turnover, indu try experience, finan ial era k record, corporate
governance, a gra p of industry issues, and knowledge of regulation, the impact of deregulation, of customers, and
their needs. Management' ability and willingnes to develop workable trategies to address system needs, and to
execute rea onable and effective long-term plans are assessed. Management quality i al o indicated by thoughtful
balancing of multiple prioririe ; a record of credibility; and effective communication with the public, regulatory
bodie , and the financial communiry.
We al o focu on management' ability to achieve co £-effective operation and commitment co maintaining credit
quality. This can be assessed by evaluating accounting and financial practices, capitalization and common dividend
objective , and the company' philo ophy regarding growth and risk-raking.
4. Profitability/peer comparison
Regulated. Traditionally, the lower levels of ri k in utilities becau e of the highly regulated environment ha re ulted
in lower profitabiliry and rerurn on capital than in many other indu trial ector . In rhe regulared markerplace rhe
level and margin of profitability ha often primarily been a function of regulatory leeway, with the contribution of
operating efficiency and revenue growth taking more of a back eat.
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
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Deregulated/liberalized e11viro111ne11ts. In deregulated markets, cost efficiency and flexibility, and internal growth,
are the major profitability driver . The development of a robu t ri k management culture and infra tructure are al o
keys to creating rability of earning , becau e the company no longer has recour e to the regulator to cover co t or
losses-a recourse that usua lly protects from downside ea rnings surprises in rhe regulated sector.
Whether generated by the regulated or deregulated ide of the business, profitability i critical for utilirie becau e of
the need co fund inve tment-generating capacity, maintain acce to external debt and equity ca pica!, and make
acquisition . Profit potential and rabi lity i a critical determinant of credit protection. A company that generates
nigher o perating margin and return on capital al o ha a greater ability to fund growth internally am acr capital
externally, and with rand bu ines adver icy. Earnings power ultimately atte ts to the value of the company' a et ,
as well. Ln face, a company's profit performance offers a litmus test of its fundamental health and competitive
position. Accordingly, the conclu ion about profi rabiliry should confirm rhea e ment of bu ines ri k, including
the degree of advantage provided by the regulatory environment.
Part 2-Financial Risk Analysis
Havi ng evaluated a company' competitive po irion, operating environment, and earning q uality, our analy i
proceed to several financial categories. Financial ri k i portrayed largely through quantitative mean , particularly
by u ing financial ratio .
We ana lyze five ri k caregorie : accounting characteristic ; financial governance/policie and risk tolerance· ca h
flow adequacy; capital trucrure and leverage; and liquidiry/shorc-rerm factor . We then determine a core for overall
financial risk using the following scale:
Table 3
Financial Risk Measures
Description Rating equivalent
Minimal AAA/AA
Modest A
Intermediate BBB
Aggressive BB
Highly leveraged B
The major goal of financial risk analysis is ro determine the quality of cash resources from operations and ocher
major ources available ro ervice the debt and other financial liabilitie , including any new debt. An integral part of
this analysi is to form an understanding of rhe debt structure, including rhe mix of senior versu ubordinared, fixed
versu floating debt, as well as its maturity structure. Ir is also important ro ana lyze and form an opinion of
management' financial policy, accounting elections, and ri k appetite. Using ca h flow analy i a a building block,
it is further nece ary to establish the company's liquidity profile and flexibi lity. While closely interrelated, the
analysis of a company's liquidity differs from that of irs cash flow as ir also incorporates rhe evaluation of other
ource and u e of funds, such as committed undrawn bank facilities, a well a contingent liabilities (e.g.,
guarantees, trigger , regulatory is ue , and legal settlement ).
1. Accounting characteristics
Financial sraremenrs and related footnote are the primary ource of information about a company' financial
condition and performance. The analysis begins with a review of accounting characteristics to determine whether
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
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ratios and tatistic derived from the statements adequately measure a company' performance and position relative
to those of both it direct peer group and the universe of industrial companies. Thi asse sment is important in
providing a common frame of reference and in helping the analy t determine the quality of di clo ure and the
reliability of the reported numbers. We focu on the following area :
• Analytical adjustments and area of potential concern;
• ignificant tran action and notable event that have accounting implications.
• ignificant accounting and financial reporting policies and the underlying assumptions.
• Hi tory of nonoperating results and extraordinary charges or adju tments and underl ying accounting treatment,
disclosure, and explanation.
2. Financial governance/policie and ri k tolerance
The robu me s of management' financial and accounting strategies and related implementation proce e is a key
element in credit ri k evaluation. We attach great importance to management' philo ophie and policie involving
financial ri k.
Financial policie are al o important becau e companies with more conservative balance heet and the credit
capacity to pursue the nece ary inve tments or acquisitions gain an advantage. Overly aggre ive capital structures
can leave very little capacity to absorb unexpected negative developments and will certainly leave little capacity to
make future strategic inve tments. Companie with the credit capacity ro support trategic inve tments will be better
positioned to both evolve with industry change and to withstand inevitable downturns.
Under randing management' trategy for rai ing its hare price, including it financial performance objective , e.g.,
return on equity, can provide invaluable insight about the financial and bu ine ri k appetite.
3. Cash flow adequacy
ash-flow analysis is one of the mosr critical elements of all credit rating decisions. Although there usually is a
strong relationship between cash flow and profitability, many tran actions and accounting entries affect one and not
the other. Analy i of ca h-flow pattern can reveal a level of debt-ervicing capability that i either stronger or
weaker than might be apparent from earnings. Focu ing on the ource and quality/volati lity of ca h flow i also
important (e.g., regulated/deregulated; generation/transmi ion/trading}.
A review of ca h flow hi torically, as well as needs on a forward-looking basis, hould take inro account level of
capital expenditures for new generation plants. In periods where elevated new construction occurs in anticipation of
a ri e in power demand, ca h outflows will be high.
It is particularly important ro evaluate capital-intensive busines es, such as utility companie , on the basis of how
much cash they generate and ab orb. Debt ervice is an e pecially important u e of cash flow.
Cash-flow ratios. Ratios show the relationship of cash flow to debt and debt service, and also ro the company's
needs. Because there are call on ca h flow other than repaying debt, it i important to know the extent ro which
tho e requirement will allow cash to be u ed for debt service or, alternatively, lead to greater need for borrowing.
The most important ca h flow ratio we look at for the investor-owned utilities are:
• Fund from operation (FFO)/Toral debt;
• FFO/lncome;
• Funds from operations/Total debt (adjusted for off-balance-sheet liabilities};
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Criteria I Corporates I Utilities: Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities
Industry
• EBITDN!ntere t; and
• Nee ca h flow/Capital pending requi rements.
4. Capital structure and leverage
For utilitie , the long-term nature of capital commitments and extended breakeven period on investment, make the
type of financing required by the e companie to finance these need to be imilar in many way to the financing
need of other long-term asset-intensive businesses. Our analysts review projections of future CAPEX, debt, and
FFO levels to make a determination of the likely level of leverage and debt over the medium term, and the
companie ' ability to u rain them. The valuation of the debt amortization cheduled i tied into projection of
profitability breakeven, and the underlying assets becoming cash-flow-positive, are key components of the combined
cash flow and leverage analysis.
Capitalization ratios. When analyzing a utility' balance sheet, a key element is analysi of capitalization ratio . The
main factor influencing the level of debt are the level of capital expenditure , particularly con truction
expenditures, and the co t of debt. Companie with trong balance sheet will have more flexibility to further reduce
their debt, and/or increase their dividends. The following are useful indicators of leverage:
• Total debt*/total debt+ equity; and
• Total debt* + off-balance-sheet liabilitie /total debt+ off-balance-sheet liabilitie + equity.
"Power purcha e agreement-adju red total debt. Fully adju red, historically demonstrated, and expected to
consi tently continue.
Debt leverage, and intere t and amortization coverage ratio are the key driver of the financial ri k score.
5. Liquidity/working capital/short-term factors:
Our liquidity analysi tart with operating cash flow and cash on hand, and then looks forward at ocher actual and
contingent sources and uses of funds in the short term that could either provide or drain cash under given
circumstances.
A key ource of liquidity i bank line . Key factor reviewed are total amount of facilitie ; whether they are
contractually committed; facility expiration date(s); current and expected u age and e cimated availability; bank
group quality; evidence of upport/lack of upport of bank group; and covenant and trigger analy i . Financial
covenant analy i is critical for speculative-grade credits. We reque t copie of all bank loan agreement and bond
terms and conditions for rated enticie , and review supplemental information provided by issuers for Ii ting of
financial covenants and stipulated compliance level . We review covenant compliance as indicated in compliance
certificate , a well a expected future compliance and covenant headroom level . Entitie that have already tripped
or are expected to trip financia l covenants need to be subject to special crutiny and are reviewed for their ability to
obtain waiver or modification need to be subject to pecial crutiny and are reviewed for their ability to obtain
waiver or modification to covenants. Tripping covenants can have a double negative effect on a company's
liquidity. It may preclude it from borrowing further under it credit line, and may al o lead to a contractual
acceleration of repayment and increased interest rates.
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