What Is A Corporate Credit Rating? And How Does It Work?

What Is A Corporate Credit Rating? And How Does It Work?What Is A Corporate Credit Rating? And How Does It Work?

“Corporate Credit Rating” is a rating on the ability of a business or a company to payback its debt and the likelihood of its default. It is the evaluation of a business’s credit worthiness by some credit agency based on some qualitative and quantitative information.

A poor credit rating indicates the rating agency’s opinion that a particular business has high risk of default. Although the investors use these ratings before investment and it is used by companies as well while inviting investment, many credit rating agencies issue disclaimers that their ratings are simple forward looking opinions that express the agency’s opinion about the ability and willingness of a subject or company to meet its financial obligations in full and on time and it speaks simply about the credit quality of a company and likelihood of default. They do not indicate any investment merit or any suitability of an investment like buy, sale or hold recommendations. They only speak on one aspect on investment decision—“Credit Quality.”

Credit Ratings are not solely based on mathematical formulas instead the agencies use their experience and judgment. They analyze the entity’s history and long term economic prospects. Since the 2008 financial crisis, there had been a lot of controversies on corporate credit rating system. The systems of corporate credit ratings by some credit rating agencies were widely questioned. Consumer Protection Act and Dodd-Frank Wall Street Reform mandated credit rating agencies have to publicly disclose how their ratings have been performed. In 2013, Moody, Standard & Poor’s and Fitch Ratings were sued for assigning artificially high credit ratings to Bear Stearn’s Hedge Fund.

The following table gives an idea of Bond Credit Rating Grades by Moody and Standard & Poor’s:

Grade Risk Moody’s Standard & poor’s Remarks
Investment Lowest Risk Aaa AAA Highest Rating. Extremely strong capacity to meet financial commitments
Investment Low Risk Aa AA Very strong capacity to meet financial commitments
Investment Low Risk A A Strong capacity to meet financial commitments, but somewhat susceptible to changes in circumstances and adverse economic conditions
Investment Medium Risk Baa BBB Sufficient capacity to meet financial commitments but subject to changes in circumstances
Junk High Risk Ba, B BB, B Highest speculative grade
Junk Highest Risk Caa / Ca/ C CCC/ CC/ C Presently vulnerable and dependent on favorable financial and business conditions
Junk In Default C D Highly vulnerable and payment default on financial commitments

How Corporate Credit Rating Works?

The credit rating agencies receive payment for their service either from the borrower that requests the rating or from the subscriber who receives the published ratings and related credit reports. Lower credit ratings result in higher borrowing costs because the borrower is deemed to carry a higher risk of default. Before you decide to invest in a company you should look whether the entity is able to meet its obligation. To a great extent it helps investors to decide how risky an investment is. Sometime the lenders like financial institutions or banks do not understand the technology-driven work and opt for credit rating certificates from rating agencies. The agencies assess the firm’s viability and capability to honor business obligations, give insight into its operational, sales and financial activities and assess its overall health and risk element. A good rating helps the firm to get faster and comparative cheap finance. So credit rating is like a report card to the corporate enterprises.

Thus, the benefits of corporate credit rating can be summarized as:

  • It helps investment decision
  • Assurance of safety
  • Constant review gives updated information to the investors
  • Easy to understand investment proposal
  • Better choice of instruments
  • Saves investor’s time and effort
  • It allows borrowers to easily borrow money from financial institutions or public debt markets.

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