ICRA Rating Methodology

Indian Gems & Jewellery Industry Cut & Polished Diamonds

Rating Methodology for Indian Gems & Jewellery Industry Cut & Polished
Diamonds
The following note identifies the key factors considered by ICRA in assessing credit risk in the Indian Gems
& Jewellery industry Cut & Polished Diamonds (CPD). The objective of this note is to help investors,
issuers and other market participants to understand how ICRA analyses creditworthiness of entities in the
Indian CPD industry. ICRAs analysis focuses on the following key rating factors that are common to
assigning ratings in the sector. The key rating factors are:
Business Risk Analysis
o Scale & Market Position
o Supply Arrangements
o Diversification Geographic, Customer base, Product diversity and Sales Channels
o Grading systems, Internal Controls, Systems and Processes; technology adoption
o Government Policies

Financial Risk Analysis

o Revenue Growth
o Profitability
o Working Capital Management
o Foreign Exchange Risk
o Tenure mismatches, and risks relating to interest rates and refinancing
o Debt servicing track record
o Contingent liabilities/Off-balance sheet exposures
o Consolidated Financial Analysis
o Financial Policies and Capital Structure

Promoters/Management Quality

Business Risk Analysis

o Scale & Market Position
ICRA believes assessment of a companys scale of operations and market position are important factors in
determining the Companys competitive strength as well as its bargaining power with suppliers and
customers reflecting its overall business strength and operating flexibility. The assessment of these factors
becomes essential considering that the Indian CPD industry remains highly fragmented in nature with
several established as well as smaller players operating primarily out of Surat and Mumbai. While
analysing market position, ICRA considers market reputation, technical ability, sourcing relationships and
distribution & marketing reach of the Company as the same aid in assessing business stability and
sustainability of earnings and cash flow generation. Additionally, large scale and strong market position
generally also reflects large volumes, enabling economies of scale, cost absorption and ability to offer
competitive pricing.
o Supply Arrangements
Rough diamonds is the sole raw material which is used in the manufacture of cut and polished diamonds.
Supply of rough diamonds globally remains concentrated with few miners. The miners sell roughs to sight
holders who in turn sell it to CPD manufacturers. Given the nature of supply dynamics, the final supply to
the market remains limited given the high bargaining power of the suppliers in this industry. Evaluation of
supply side arrangements helps ascertain the risk associated with consistent availability of roughs at
appropriate prices. The key factors considered while assessing the input related risks include the past track
record of procurement, diversity of suppliers, length of association with the suppliers and nature of supply
contracts. For instance, a CPD player enjoying Supplier of Choice status from its main rough supplier may
have the right to reject the rough parcels which do not meet its own requirements as against other CPD
players who may have to necessarily buy the contracted rough parcels in a given year. CPD players who
are also sight holders usually enjoy uninterrupted supply of roughs at a relatively attractive pricing as the
miners sell the roughs through auction route only to its sight holders, providing a competitive edge.
Traditionally, DTC was the primary source of rough diamonds for the industry and hence the DTC sight
holder status of a CPD player assumed significant importance. However, the importance of the same has
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ICRA Rating Methodology

Indian Gems & Jewellery Industry Cut & Polished Diamonds

reduced to some extent in recent years, with emergence of other miners like Alrosa, Rio Tinto, Dominion
Diamond Corporation, etc.

o Diversification Geographic, Customers, Product diversity, Sales Channels

The Indian CPD industry is export focused, given that the key markets for the diamond jewellery are largely
the developed economies. The key consuming markets for CPDs are USA, Middle East and Hong Kong
(HK), with most of the exports to the Middle East and HK being finally resold to USA and Europe in the
ready jewellery form. Antwerp, in Europe has emerged as a hub for trade of rough as well as polished
diamonds. Meaningful geographic diversification is achieved when a CPD player is able to reach clients
across different regions of the world. Maintaining geographic balance is an important consideration for any
CPD player in order to achieve business stability given that jewellery buying falls in the discretionary
spending category and remains closely linked to the economic health of the consuming market. A CPD
player which has well diversified presence across multiple regions or geographies is more likely to perform
consistently across demand cycles prevalent in different consuming markets.
For a CPD player, customer mix mainly comprises of wholesale traders and jewellery retailers who can
come under liquidity pressures during periods of demand slow down exposing the CPD players to risks of
bad debts. In light of this, ICRA believes an entity with well diversified customer base is relatively better
positioned to protect its revenues and future cash flows in the event of weak demand conditions. In addition
to customer concentration risk, the qualitative aspects of customers like the past track record, length of
association with the entity and industry feedback are also considered to ascertain the quality of customer
profile and hence the sustainability of future cash flows.
Further, several CPD players forward integrate into jewellery manufacturing by venturing into retail or
wholesale jewellery, thereby creating a brand of its own; hence selling branded diamonds to retail clients.
CPD players with a product portfolio comprising of wide range of shapes, colors, sizes and carats of
diamonds are in a better position to cater to the demands of a large customer base. Consumer preferences
are driven by innumerable exogenous factors including fads, fashion, prices and quality perceptions. Thus a
firm which has a strong product mix with a reputation of timely supply of quality diamonds in various colors,
sizes and grades is a credit positive. ICRA believes a CPD player with high product diversity is also likely to
have a diversified customer base and in turn lower volatility of earnings. ICRA also believes that ability of
the CPD player to adopt multiple sales channels (e.g., marketing affiliates, brokers, online etc., besides
direct sales) and maintain a healthy sales mix across channels is a reflection of its market reach, brand
acceptance and credibility of its internal grading systems.
Typically, a well diversified operation is more likely to generate sustainable cash flows and thus the diversity
in terms of geographic coverage, customer base, product mix and sales channels are key rating factors.
o Grading systems, Internal Controls, Systems and Processes; technology adoption
With the Indian CPD industry being characterized by high competitive intensity owing to its fragmented
nature with several established as well as smaller players; the skill involved in grading, assortment, cutting
and final polishing so as to maximize yield, differentiates a player from the other. Investment in technology
(primarily in laser cutting machines and automated yield indicating equipments) leads to lower wastage and
more value per carat and in turn support profitability. Further robust internal grading practices also aids in
pushing internet sales, which is expected to grow exponentially in the coming years. Ability to accurately
value (grade) its diamonds within a narrow price range is hence a key business strength.
A polished diamond typically goes through a certification process for the 4 Cs, viz. Carat, Cut, Colour and
Clarity by renowned bodies like Gemological Institute of America (GIA), International Gemological Institute
(IGI), The American Gem Society (AGS), The European Gemological laboratory (EGL) and few others.
Loose diamonds are accompanied by a grading report that includes a detailed explanation of the diamonds
characteristics, which makes it more valuable than an uncertified stone. The certificate verifies a diamonds
identity and value, and hence is recognized by various gemologists across the world. Strong grading
systems, internal controls and processes as well as higher technology adoption is likely to aid a CPD player
in obtaining the certificates for the polished stones.

o Government Policies
The industrys sensitivity to the government policies remains moderate to high. Being a significant foreign
currency earner for the government, the CPD industry enjoys zero duty in terms of rough procurement.
However in terms of sourcing of polished diamonds through the import route, a 2% import duty was levied in
January 2012. The levy of 2% duty on the polished diamond aims at protecting the interest of the smaller
domestic players, who suffer from any disproportionate rise of rough prices compared to polished
diamonds. The Indian CPD industry is impacted indirectly from regulations related to import of gold
jewellery, given gold being the most sought after metal for diamond studded jewellery. Given that the final
price of the jewellery includes price of the diamond as well as the gold content, change in duty structure for
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ICRA Rating Methodology

Indian Gems & Jewellery Industry Cut & Polished Diamonds

gold imports (which at present stands at 10%), has a direct impact on the final price of the studded
jewellery. ICRA evaluates the impact of any major changes in the said policies to gauge any adverse impact
on credit profile of the CPD players on a regular basis.

Financial Risk Analysis

The rated entitys financial strength, like in other industries, is an important rating consideration. While
assessing the financial position of a CPD player, ICRA reviews the Accounting Policies followed by the
company; this is a critical input for most CPD players, with most of them largely being traditional family
owned businesses, operating as partnerships or privately owned entities. Any deviation from the Generally
Accepted Accounting Practices is noted and the financial statements of the issuer are adjusted to reflect
the impact of such deviations and also to compare more meaningfully against peers in the industry. Apart
from balance sheet strength, ICRA also evaluates the profitability and cash generating ability of the
business as well as other sources of financial flexibility available to an entity while evaluating its overall
financial risk profile.

o Revenue Growth and Profitability

Considering that jewellery buying falls under the discretionary spending category, economic health of the
consuming markets remains a direct reflection of the demand conditions. ICRA believes healthy revenue
growth without compromising on profitability is essential to establish sustainable accruals necessary to
meet future repayment obligations. The profitability of any CPD player is primarily a function of raw material
prices and given the strong control of miners on managing input prices, any disproportionate rise compared
to the market determined polished diamond prices can hurt profitability of the CPD players. In light of this,
efficient inventory management and tight controls on other overheads would be key to maintaining healthy
profitability levels. Higher technology adoption for certain higher caratage product categories could also
support profitability with lower wastage and more value per carat.
The two primary measures of profitability are: (i) Operating profit before interest, depreciation and taxes
margin (OPBDIT margin) and (ii) Return on capital employed (RoCE (%)). In absence of adequate profits, a
companys cash flow generation is likely to fall short of the levels needed to support the working capital
needs that are associated with maintaining high levels of inventory and capital expenditure needs if any
towards future business expansion.

o Working Capital Management

Inventory management plays a vital role in the financial health of any CPD player. Owing to the long
conversion cycle (from procurement of rough diamonds to sale of polished stock) inherent to the CPD
industry, a CPD player is required to maintain high levels of inventory at all points in time to service its
clients orders in a timely manner. High inventory levels however increases holding cost and also pricing
risks. Working capital intensity remains a good proxy of quality of working capital management by a
company. Deterioration in market position of a CPD player often leads to inventory pile-up in quest of
growth, significantly increasing price risks and liquidity concerns. Inventory valuations remains an area of
concern for the industry and rising trend in inventory levels could be a potential red flag.
The Indian CPD industry is largely export oriented and is characterized by high competitive intensity which
necessitates extension of relatively long credit periods to customers. In the event of demand slow down,
these collection cycles may get stretched further. Hence, ICRA also pays due attention to the receivable
position of a CPD player as any elongation of collection cycle would lead to debtor build up and in turn
strain the liquidity position of the Company. In this light, wider geographical reach and diversified customer
base would reduce the impact and support stability of cash flows. Overall, in order to assess the liquidity
profile of a CPD player, ICRA also assesses month-wise adequacy of un-drawn credit facilities from banks
for meeting peak working capital requirements.

o Tenure mismatches, and risks relating to interest rates and refinancing

Large dependence on short-term borrowings to fund long-term investments can expose an issuer to
significant re-financing risks, especially during periods of tight liquidity. The existence of adequate buffers
of liquid assets/bank lines to meet short-term obligations is viewed positively. Similarly, the extent to which
an issuer could be impacted by movements in interest rates is also evaluated.
o Debt servicing track record
The debt servicing track record of a company is an important input for any credit rating exercise. Any
delays or defaults in the past in the repayment of principal or interest payments reduce the comfort level
with respect to the CPD players future debt servicing capability and willingness.
o Contingent liabilities/Off-balance sheet exposures
In this case, the likelihood of devolvement of contingent liabilities/off-balance sheet exposures and the
financial implications of the same are evaluated.
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ICRA Rating Methodology

Indian Gems & Jewellery Industry Cut & Polished Diamonds

o Consolidated Financial Analysis

In case of groups consisting of companies with strong financial and operational linkages, various
parameters such as capital structure, debt coverage indicators, and future funding requirements are
assessed at the consolidated/group level.
o Financial Policy & Capital Structure
Companies that pursue an aggressive financial policy, including heavy reliance on debt financing, are likely
to be more vulnerable to cyclical downturns than companies that employ a lesser degree of financial
leverage in their business. ICRA takes into account the financing pattern of long term and short term assets
with reference to the firms long term and short term debt. Usually, working capital debt constitutes major
share of CPD players debt followed by unsecured loans from promoters and term loans availed for capital
expenditure, if any. ICRA however draws comfort on capital structure in case of adequate contribution by
promoters in form of unsecured loans which are subordinated to bank debt. Since the extent of term loans
is less, ICRA pays special attention to interest coverage indicators, vis--vis DSCR, while evaluating the
financial health of a CPD player.
ICRA is particularly concerned with a companys capability to honour its contractual obligations under
stress conditions. The more robust a companys performance is likely to be under a range of reasonable
projections, the better it is from a credit evaluation perspective. ICRA also critically looks at other sources
of financial flexibility available to an issuer, which could be in the form of, among others, availability of a
portfolio of liquid financial assets, strategic importance of the entity to the group to which it belongs along
with the financial strength of group entities.
Some of the key indicators observed by ICRA include
o Leverage (i.e. Total Debt/Tangible Net Worth)
o Interest Coverage (i.e OPBDITA / Interest and Finance Charges)
o Total Debt/OPBDITA
o Debt Service Coverage Metric (DSCR)
o Net Cash Accruals/Total Debt
o Current Ratio
o Total Outside Liabilities/Tangible Net Worth
Further, ICRA also gives due attention to the constitution of the CPD entity considering majority of them
operate as a partnership or a proprietorship firm accentuating the risk of capital withdrawals and in turn
increasing the vulnerability of the capitalization and coverage metrics.

o Foreign currency related risks

Foreign exchange risk for CPD players originate from import of raw materials and export of finished
products. The extent of exchange risk that a company faces depends on its net imports/ exports position.
ICRA also evaluates hedging policy of the company to assess the foreign exchange risks.

Promoters/ Management Quality

Management quality, though an intangible parameter and thus difficult to quantify, is one of the most
important factors in determining the credit quality of the company being rated. Periodic interactions with the
management provide insights into the operations of the company and ongoing developments and further
help understand the managements commitment to the business and strategies, growth plans as well as
risk appetite which may have an impact on the future performance of the company. The other factors
assessed are management policies on leveraging, interest risks, inventory risks and ability and willingness
of the promoter group to support the company for growth plans as well as during stress. The interactions
with the management also help ICRA estimate the probability of the managements tendency to deviate
from its business philosophy in times of stress.

Summing Up
ICRAs credit ratings are a symbolic representation of its opinion on the relative credit risk associated with
the instrument being rated. This opinion is arrived at following a detailed evaluation of the issuers business
and financial risks, its competitive strengths, its likely cash flows over the life of the instrument being rated
and the adequacy of such cash flows vis--vis its debt servicing obligations. As the note has highlighted, for
a CPD player, special attention is also paid on the market position, companys scale of operation, supply
arrangements, pricing flexibility, product quality, technological absorption, revenue diversity and
management strategies for managing cyclical downturns and an overall approach towards investment and
growth.

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ICRA Rating Methodology

Indian Gems & Jewellery Industry Cut & Polished Diamonds

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