A new report by Moody's Investors Service warns that the finances and governance of more than five dozen Chinese companies raise "red flags" including high concentrations of family ownership, frequent changes in auditors and too-aggressive business and financial strategies.
Moody's analysts have developed 20 criteria to assess the risks associated with emerging-market companies.
In a report released Monday, the ratings firm said increased scrutiny by the U.S. Securities and Exchange Commission and other agencies of Chinese companies prompted it to develop a layer of analysis beyond the usual ratings.
The SEC has recently looked into the quality of financial reporting from publicly listed Chinese companies.
"To address investors' concerns and provide transparency on our approach to ratings, this report identifies warning signs — so-called "red flags" — for our rated, high-yield, non-financial Chinese companies," Moody's said
Moody's said it plans to follow up soon with a report for other issuers in Asia.
The analysts looked at 61 rated companies in China.
Moody's red flags included corporate governance, riskier business models, poorer quality of earnings or cash flow, and concerns over auditors or financial statements.
One company — West China Cement Ltd., among China's largest cement producers — had 12 red flags. It carries a non-investment grade rating of "Ba3" and a "stable" outlook.
The company's chairman and his daughter own 44 percent of its stock, Moody's said. It has twice changed auditors and has had inadequate compliance with International Financial Reporting standards and a record of insufficient internal controls, Moody's said. Prior to its listing on Hong Kong's stock exchange in August 2010, the company changed had favorable reviews by independent auditors.
Moody's gave the second-highest number of red flags to Winsway Coking Coal Holdings Ltd., which also has a non-investment grade rating of "Ba3" and "stable" outlook.
Winsway has a short track record and a plan for rapid expansion. The company boosted its procurement of Mongolian coal from 1.3 million tons in 2008 to 6.5 million tons in 2010. That triggered several red flags because the required build-out of infrastructure pressured working capital and left Winsway with negative free cash flow.
Also, the company's chairman is the majority owner of Winsway and its commodities-trading businesses, which facilitated the debut and growth of Winsway's operations, but Moody's said the chairman has a non-compete agreement with Winsway.
The third-highest number of red flags went to China Lumena New Materials Corp. with a non-investment grade rating of "B2" and a "negative" outlook. The mining company's 10 red flags point to its rapid growth, short listing history, high concentration of customers and ownership and poorer quality of earnings and cash flow.
The red flag analysis does not change Moody's traditional review, which Moody's said already takes into account many of the issues highlighted by the red flag analysis.
"The red flags provide further clarity and detail but do not represent a change in our rating methodologies," the report said.