A Gentle Introduction to Credit Rating

The qualitative and quantitative characteristics of the subject entity are examined by a credit agency to determine the debtor's credit rating. The information may come from a variety of sources, including internal data that the company has supplied, such as audited financial statements and annual reports, as well as external data, including analyst reports, news stories that have been published, general industry analysis, and estimates.

 

An objective and an unbiased view of the credit risk borne by a specific business seeking to obtain capital through the issuing of loans or bonds are deemed to be provided by a credit agency because it is not a party to the transaction.

 

Currently, Moody's Investor Services, Standard and Poor's (S&P), and Fitch Group are the three leading credit agencies that hold 85% of the market for ratings. Each organization assigns credit ratings using a distinctive yet very comparable grading method.

 

A credit rating is an assessment by a specific credit agency of an institution's capacity and desire to meet its financial commitments in full and by the specified due dates, whether that entity is a government, corporation, or individual. A credit rating also represents a debtor's propensity to default. Additionally, it is an illustration of the credit risk associated with a financial instrument, such as a loan or a bond issuance.

 

The financial performance of a particular debt instrument or an individual debtor cannot be assured or guaranteed by a credit rating, however. The advice offered by a credit bureau does not take the place of that of a portfolio manager or financial advisor.

 

What Is a Credit Rating?

 

A quantitative evaluation of a borrower's creditworthiness, either generally or about a specific debt or financial obligation, is referred to as a credit rating. Any organization looking to borrow money, whether it be a person, a business, a state or local authority, or a sovereign nation, can be given a credit rating.

 

Credit bureaus like Experian, Equifax, and TransUnion compute each person's credit score using a three-digit numerical scale and a method called Fair Isaac Corporation (FICO) credit scoring. An organization that assigns credit ratings, such as S&P Global, Moody's, or Fitch Ratings, does so for both businesses and governments. The organization obtaining a credit rating for itself or one of its debt issues is the one paying these rating companies.

 

A credit rating is a numerical evaluation of a borrower's creditworthiness overall or about a particular financial obligation. Whether a borrower is given credit and the interest rate at which it will be repaid depends on their credit scores.

 

Any organization seeking to borrow money—whether it be a person, a business, a state or provincial authority, or a sovereign government—is given a credit rating or score. Credit bureaus use the FICO computation to score each consumer's credit on a numeric scale. Credit agencies provide ratings to bonds issued by corporations and governments using a letter-based system that ranges from AAA to D.

 

A loan is a debt and essentially a promise, frequently under a contract. A borrower's ability and willingness to repay a loan within the terms of the agreement without default are assessed using their credit score.

 

A borrower with a good credit rating is more likely to be able to return the loan in full and without any problems, but one with a low credit rating may find it difficult to make their payments. Businesses use credit ratings to prove their creditworthiness to potential lenders in the same way that an individual credit score is used to assess the creditworthiness of a single person.

 

Difference between Credit Ratings and Credit Scores:

 

Governments, corporations, and people all have credit ratings. For instance, although corporate credit ratings only apply to businesses, sovereign credit ratings apply to national governments as well. On the other hand, credit ratings only apply to certain people.

 

Credit histories are kept on file by credit reporting companies like Equifax, Experian, and TransUnion, from which credit scores are created. The reported figure for a person's credit score typically ranges from 300 to 850.

 

A borrower's chance of defaulting within a year is indicated by their short-term credit rating. In contrast to the past, where long-term credit ratings were given greater weight, this form of credit rating has recently become the standard. The borrower's chance of defaulting at any particular moment in an extended period is predicted by long-term credit ratings.

 

The chance of the borrower defaulting at any particular moment in the far future is predicted by long-term credit ratings.

 

Letter grades are frequently assigned by credit rating organizations to denote ratings. For instance, S&P Global offers credit ratings that range from AAA (outstanding) through C and D. A debt instrument is categorized as speculative-grade or junk bond if its rating is below BB, which indicates that it has a higher risk of loan default.

 

Also read | What is Credit Cycle?

 

Importance of Credit Ratings:

 

The rating organizations do extensive due diligence before assigning credit ratings to borrowers. Although a borrower will seek to maintain the best credit rating possible since it has a significant influence on the interest rates levied by lenders, rating agencies are required to take a fair and impartial assessment of the borrower's financial status and ability to service and repay the loan.

 

The approval of a borrower for a loan and the interest rate at which the loan must be repaid are both based on their credit rating. Being turned down for a loan might be disastrous because businesses depend on loans for many beginning and other costs, and a loan with a high-interest rate is considerably more difficult to repay.

 

Selecting which lenders to apply to for a loan should take into account the borrower's credit rating. The best lender for someone with excellent credit is probably going to be different from the best lender for someone with fair or even bad credit.

 

A potential investor's choice to buy bonds or not is heavily influenced by credit ratings. An investment with a bad credit rating is dangerous. The reason for this is that it suggests a higher likelihood that the corporation won't be able to pay its bond obligations.

 

Since credit scores are never fixed, borrowers must work hard to keep them at a high level. One bad debt will lower even the finest score, and they fluctuate often based on the most recent data.

 

Building credit also requires time. A company with excellent credit but little credit history is not seen as favorably as a company with excellent credit but a lengthy credit history. Debtors want to know whether a borrower can continuously retain good credit over time.

 

When grading a potential borrower, credit institutions take into account several characteristics. An agency takes the entity's prior borrowing and debt repayment history into account first. The rating may suffer from a history of late payments, defaults, or bankruptcies.

 

Along with the borrower's cash flows, the agency also considers the debt load at the moment. The credit rating will be better if the company has consistent revenue and a promising future. Their credit rating will decline if there are any concerns about the borrower's economic prospects.

 

The rating agencies, who are required to take a fair and unbiased perspective of the borrower's financial status and ability to service/repay the loan, base credit ratings or credit scores on extensive due diligence. This may have an effect on a borrower's eligibility for a loan as well as the interest rate at which the loan must be repaid.

 

The choice of whether or not to buy bonds is also heavily influenced by credit ratings, which are given to potential investors. An investment with a low credit rating is riskier since there is a greater chance that the firm will not be able to make its bond payments.

 

Also read | Credit Risk

 

Factors that affect Credit Rating:

 

A company's credit ratings can be impacted by a variety of things, such as:

 

The business's financial background:

 

• History of borrowing and lending

• old debt

• Financial history

• Financial records

• Debt levels and types at present

 

The future economic potential of the company:

 

• being able to pay back the loan

• anticipated earnings

• Right now's performance

 

A credit rating is a determination of an entity's creditworthiness for purposes of borrowing money. This includes businesses, non-profit organizations, local governments, or other governments. Verified credit rating companies evaluate the company's financial history and its capacity to pay back debts to issue these ratings.

 

It is crucial to have a strong credit rating since it is used by lenders and investors to determine whether or not to grant loans or participate in business ventures. A good credit rating may also help a firm obtain money, lower interest rates, and promote improved accounting standards.

 

Conclusion:

 

A credit rating is used to assess a business or company's creditworthiness rather than a person's, as was previously noted. The likelihood that they will stop making payments is essentially what this indicates. The rating is derived by employing corporate financial instruments and is often shown as a list of alphanumeric symbols.