RATING METHODOLOGY – SUGAR SECTOR

Rating Methodology - Sugar Sector

[Issued in December 2020]

Industry Overview

Globally, sugar is produced either from sugar beet or sugarcane. In India, sugarcane is the prime
source of sugar, which is cultivated in almost all parts of India due to favorable climatic conditions
of the country, with Uttar Pradesh, Maharashtra, Karnataka, Tamil Nadu and Punjab being the
major producing states. The sugar industry is an agro-based industry which impacts rural
livelihood of about 50 million sugarcane farmers and also a large number of workers who are
either directly employed in the sugar mills or in various ancillary activities relating to transport,
trade, servicing of machinery and supply of agriculture inputs. India is the second-largest
producer of sugar across the globe, after Brazil, and the largest consumer of sugar as well. The
production of sugar is seasonal as it is crushed from November to April; however, the demand
for sugar lasts through the entire year. The supply of sugar is dependent on a number of factors
including sugarcane production, sugarcane utilization for sugar production, duration of the sugar
season, sugar recovery rates and cane pricing. The sugar industry is cyclical in nature and is
susceptible to price fluctuations and it is also highly regulated in India ranging from allocation of
sugarcane to cane pricing and by-product pricing. The sugarcane prices are regulated by the
government while sugar prices are market-driven. In the process of manufacturing sugar, various
by-products are derived, viz, press mud, bagasse and molasses. Bagasse and molasses are the
two primary by-products of the sugar industry.

Bagasse
Bagasse is the dry pulpy fibrous residue which is left after sugarcane is crushed to extract its juice.
Sugar mills generally use it as a captive raw material source of generating power and steam
required during the process of manufacturing sugar. The surplus bagasse available after meeting
the captive power and steam requirement is either sold to the paper manufacturers, as bagasse
can also be used for manufacturing paper and particle boards or utilized for generating electricity.
The bagasse-based co-generation projects help the sugar mills in arresting the cyclicality of the
sugar industry by generating a stable source of revenue. Power is insulated from the price
fluctuations and is not cyclical in nature. This helps the sugar mills to protect their overall margins
during the down cycle of the sugar business.

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Molasses
Molasses is also derived during the process of manufacturing sugar and is a by-product of
sugarcane. Molasses is used to manufacture potable alcohol, industrial alcohol and ethanol.
Ethanol can be used as an automotive fuel and it can also be mixed with the petrol to make it
relatively environment-friendly fuel. Thus, to promote use of environment-friendly fuel and
reduce the dependence on imported fuel, Government of India (GoI) first introduced compulsory
blending of ethanol and petrol programme in the country in January 2003. However, with
renewed focus of the government on the ethanol, changes have made in the Ethanol blending
programme (EBP) from time to time.

Rating Methodology
CARE Ratings has a detailed methodology for rating of the companies belonging to the
manufacturing sector. CARE’s rating process begins with the evaluation of the economy/industry
in which the company operates, followed by the assessment of the business risk factors specific
to the company. This is followed by an assessment of the financial and project-related risk factors
as well as the quality of the management. This methodology is followed while analyzing all the
industries that come under the purview of the manufacturing sector. However, considering the
size and diversity of the manufacturing sector, CARE Ratings has developed methodologies
specific to various industries within the sector. These methodologies attempt to bring out factors,
over and above those mentioned in the broad methodology, which are considered while
analyzing companies belonging to a particular industry. CARE Ratings considers the following
factors as important determinants of credit risk associated with Indian sugar companies.

1. Industry risk
CARE ratings’ analysis of the industry risk for the sugar sector focuses on the following factors-

Climatic risk
Sugarcane crop is vulnerable to the climate change directly through changes in temperature
and/or precipitation/monsoon & indirectly through pest-related attacks. The sugar industry is
directly dependent on the sugarcane crop and its yield and is hence prone to the climatic risks.
The optimum productivity or the yield of the sugarcane basically depends on the climatic
conditions (availability of abundant rainfall) and soil quality which leads to fluctuating trends in
sugar production in different regions.

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Thus, CARE evaluates a sugar entity’s extent of exposure to these climatic risks and also examines
the geographical dispersion of their capacities which could help them to mitigate the negative
impacts of climate change in a particular area.

Demand – Supply cycle

The sugar industry is cyclical in nature. It is a typical cycle which is affected by cane supply and
sugar demand though largely driven by the supply side dynamics. Higher production leads to
increased availability of sugar, thereby resulting in the declined sugar prices. This leads to
lower profitability for the companies and consequently delayed payment to the farmers. Due
to higher sugarcane arrears, the farmers switch to other crops which lead to a fall in the area
under cultivation for sugar. This further leads to lower production and lower sugar availability,
followed by higher sugar prices, higher profitability and lower arrears and thus the cycle
continues. In India, sugar production usually follows a three to five-year cycle. The Indian sugar
industry is fully supply-driven, as steady growth is observed in the sugar consumption. For
determining the sugar supply situation for a given sugar season along with the sugar prices,
CARE tracks and assesses factors like opening sugar stock levels, expected domestic sugar
production for the upcoming sugar season, the demand-supply scenario globally along with
the prevalent global sugar prices. Furthermore, government’s policies on export & import
to/from India are also assessed.

Regulatory risk
The sugar industry in India is extensively regulated by the government starting from the
procurement of sugarcane to the sale of sugar. The industry is subject to the government policies
which influence cost through cane availability through the command area concept, cane price
(SAP/FRP), imports & export of sugar to/from India, monthly quotas, minimum support prices
(MSP), by-product pricing, etc. In India, sugar mills are not allowed to own sugarcane fields. They
have to mandatorily procure the entire sugarcane production from the specific area assigned to
them, known as the command area which leads to considerable variability in their inventory-
holding patterns and management of working capital for a sugar mill. Furthermore, cane prices
are controlled by the government. Currently, there are two cane-pricing regimes in the country-
the state-advised price (SAP) regime, announced by state governments and the fair and
remunerative price (FRP) regime, suggested by the Commission for Agricultural Costs and Prices
(CACP) and announced by the central government. Among the major sugar-producing states,
Uttar Pradesh, Tamil Nadu, Uttarakhand, Punjab and Haryana follow the SAP regime, while

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Maharashtra, Karnataka, Gujarat and Andhra Pradesh follow the FRP regime. With no linkage
between the sugar realizations & FRP/SAP, the profitability of the sugar mills remains vulnerable
to supply-demand dynamics.
The government also controls import/export of sugar through imposition of duty as & when
required through export ban, duty-free import quota in scenario of sugar shortage, levy of import
duties & export incentives for sugar exports in years of surplus sugar production. The government
also regulates the pricing of the by-product, ethanol. Government has notified administered price
of ethanol since 2014. However, renewed focus of the Government of India on EBP through
various incentive & schemes and also by offering better pricing policies have resulted in increased
participation by the industry players in the EBP programme. Government has also resorted to
measures like setting up of minimum support prices & monthly release quotas, etc. The extents
of these measures vary with the demand and supply situation in the domestic market & are
generally to support the sugar mills.
Sugar companies do not have much control over all these factors which significantly affect the
economics of their operations. CARE closely monitors the key policy decisions taken by the
Government. Hence, CARE believes a sugar company's credit risk profile is vulnerable to
change in the government policies.

2. Business & Operating Risk

Market position & Size
In the highly fragmented sugar industry with organized and unorganized players, size is an
important determinant of a company’s market position. The size of an entity is measured in terms
of its crushing capacity & also the level of forward integration. Large companies, if not highly
leveraged, typically have greater ability to withstand external shocks, better access to capital
markets and consequently tend to have strong credit risk profile vis-à-vis small unorganized
players. Entities which have dominant market position & larger capacities are considered
favorably by CARE.

Level of forward integration

The sugar industry is forward integrated into ethanol/alcohol production from molasses & power
co-generation through bagasse. The integrated sugar mills generally exhibit higher degree of
sustainability in cash flows and hence are viewed more favorably as they are in a stronger position
to handle the volatility of the sector. Optimal utilization of by-products such as molasses and
bagasse enables companies to capture value across the production chain. The revenues from by-

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products on an average ranges from 15% to 25% of the total revenues for the large sugar mills,
however, the percentage contribution from by-products to total operating profits is much higher.
The average revenue contribution from the by-products may however change for the sugar mills
that are diverting B-grade heavy molasses and direct sugarcane juice to produce ethanol after
the introduction of the National bio-fuel policy, as such diversion would result in lower recovery
rates from sugarcane and consequently lower sugar production.
Fully-integrated players are viewed more favorably from the credit perspective by CARE, as fully-
integrated model helps the mills to generate additional revenue and to partially mitigate the risk
of fall in profitability margins arising from the downturn of the sugar business. Furthermore, in
cases of integrated mills which sell power to state-owned discoms, CARE also evaluates timely
receipt of receivables from them by taking into account their past payment track record, credit
rating of the state discoms, their financial profile, etc.

Sugarcane (raw material) availability & operating efficiency

Sugarcane is the basic raw material for producing sugar. For the optimum operations of a sugar
mill, its access to sugarcane is considered critical. Adequate cane availability also aids in optimally
utilizing the co-gen and distillery plants for the integrated sugar mills which results in better
profitability. Sugar mills in collaboration with farmers undertake various cane developmental
activities to ensure quality raw material availability.
Operating efficiency of a sugar entity is primarily determined by the recovery rate which is also
crucial for the credit profile of a sugar company. The recovery rate is the proportion of sugar
extracted per tonne of sugarcane crushed & is determined by the factors such as sucrose content
of the sugarcane which depend on the variety of cane, climatic conditions, conditions of soil, etc.
The sucrose content of sugarcane tends to reduce if the sugarcane is kept for a longer duration
after harvesting (sugarcane has to be crushed within 24 hours of harvesting to get optimum
recovery).
CARE evaluates the above risks by looking at the past history of timeliness of cane payments, the
area under cane development, and trends in cane diversion for other uses. From the credit
perspective, sugar companies with healthy capacity utilization of the sugar mill and better cost
structure through consistently high recovery rates are better placed compared with others.

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Working capital management

The demand for sugar lasts throughout the year; however, the production is concentrated
between September and April. Given the seasonality involved in the industry, most of the sugar
companies hold sugar inventory varying from 4 to 6 months as on March-end. Sugar companies
have large working capital requirements during the peak season compared to their average
requirements.
Sugar companies need to have sufficient liquidity cushion at any point in time to meet both- their
operational expenses and debt obligations. In years of surplus production, sugar companies have
to resort to additional working capital borrowings in order to fund the high level of inventory (which
sugar entities are carrying if they are unable to dispose the excess stock due to stock holding
limits/monthly sales quota imposed by the government) which leads to increase in its working capital
intensity. High repayment obligations especially at the time when companies are holding excess
inventory can be a cause of concern. Hence, efficiently managing of the seasonal working capital
requirements amidst fluctuating prices in a regulated environment is a critical factor for all sugar
companies which CARE analyzes.

3. Financial Risk
CARE Ratings follows its standard ratio analysis methodology for manufacturing companies as
per CARE’s criteria on Financial Ratios-Nonfinancial Sector (Refer to Financial Ratios –
Nonfinancial Sector for this section on our website www.careratings.com) in order to assess the
financial risk of companies in the sugar sector apart from the following ratios which are looked
into for some sector-specific points.

Revenue & Profitability

In a sugar company, degree of stability to revenue & profits is of high importance. The sales &
profitability varies depending on location, demand & supply scenario, operating efficiency & even
the government measures. Furthermore, higher proportion of revenue from the integrated
segments also improves the profitability & smoothens out revenue volatility. Healthy profitability
reflects ability to generate cash accruals to support business operations and fund ongoing
expansion/capex requirements, if any. Profitability margins also vary across sugar mills,
depending on the level of forward integration.
Furthermore, the recovery rate also plays as a key factor in the overall profitability of a sugar mill.
High recovery rates result in lower cane cost in comparison to sugar mills with lower recovery
rates within the similar region/territory. The recovery rate apart from the cane variety would also

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depend on the extent of cane diversion towards B-heavy molasses for ethanol production (after
the introduction of Bio-fuel policy by GoI in 2018). While the contribution margin from sugar
could be lower in cases of an entity which diverts more sugar towards ethanol, the contribution
margin from ethanol would be higher given the higher yields of ethanol (from B-heavy molasses
or direct sugarcane juice). Hence, the profitability margins for a sugar entity shall be assessed in
relation to overall margin contribution by sugar and its by-products segments like Co-gen,
Ethanol/distillery, molasses, bagasse, etc.

Leverage & Debt Servicing

Sugar industry is characterized as a capital intensive industry and also has high working capital
requirements. High leverage reduces financial flexibility of a sugar company due to possible level
of stress on operational cash flows, particularly in cyclical downturns. Furthermore, owing to
capex-related incentives and low-cost funding to support cane payments; the leverage is high for
the players in the sector. CARE evaluates a sugar company’s total debt position vis-à-vis gross
cash accruals to ascertain the adequacy of its cash flows to service debt repayment obligations.
Furthermore, total outside liabilities to tangible net worth is also a key indicator observed by
CARE. The entities with low leverage have a greater financial flexibility due to relatively lower
debt servicing requirement especially during any downturns & are hence viewed more positively
by CARE.

Liquidity & Inventory Valuation

CARE, while evaluating the liquidity of a sugar entity, analyses the available cash balances, ability
of an entity to generate consistent levels of internal accruals, debt repayment obligations, un-
utilized working capital limits (by drawing a comparison between working capital utilized against
lower of the sanctioned limits or drawing power). Sugar companies have high working capital
requirements owing to seasonality in its nature of operations & also at times on account of
government’s regulations (like stock holding limits, maintenance of buffer stock, etc); hence, its
working capital intensity level is examined to understand the company’s efficiency in managing
its overall liquidity. CARE keeps in view that drawing power in the respective periods is a function
of the inventory valuation and hence it is imperative that it should be seen in relation to the value
that can be realized more importantly in situations when the sugar prices are falling. Since the
prices of sugar are fluctuating & they depend on a lot of factors, the carrying cost of sugar
inventory is to be analyzed for any given period in relation to the realizable value and possibility
of inventory losses & unrealized gains is to be ascertained.

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Conclusion
The rating process is ultimately an assessment of the fundamentals and the probabilities of
change in the fundamentals. The rating determination is a matter of experienced and holistic
judgment, based on the relevant quantitative and qualitative factors affecting the credit quality
of the issuer.
Overall credit risk profile of the companies in sugar sector is driven by its relative position in the
market as reflected by their scale of operations, level of forward integration, operating
efficiencies and the ability to handle the regulatory challenges and effectively manage their
working capital requirements. CARE Ratings analyses each of the above factors to arrive at the
overall assessment of credit quality of the Issuer. Credit rating is a futuristic assessment and the
rating outcome is ultimately an assessment of the fundamentals and the probabilities of change
in the fundamentals in future. Moreover, for arriving at the rating outcome, CARE Ratings also
considers future estimation of the company’s financials based on past trends and future
strategies, competition, industry trends, economic condition and other considerations.

[For previous version please refer ‘Rating Methodology – Sugar Sector’ issued in November 2019]

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