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100 business financing
small business accounting and finance



Business credit rating

Credit Rating

I. Introduction

Companies, financial institutions, public sector enterprises, local bodies and others raise funds from the domestic as well as international money or capital market by issuing debt instruments which are rated by the rating agencies. Investors also like to make their investment decisions based on business credit rating of instruments.

Credit rating plays a significant role in all credit as well as investment decisions. Credit signifies status of ability to pay or reputation about solvency and capacity to pay. Rating is nothing but estimated worth or value in terms of symbolic grade given to a persons or organizations ability to pay back the loans raised, with the help of financial position of the individual or organization. By combining business credit rating, these two words, one can find out the meaning of credit rating, which is concerned with an act of assigning symbolic grade of values of estimating financial position and thus disclosing solvency which indicates ability or capacity of the issuer about the repayment of loans raised.

II. Concept of credit rating

Credit rating may be defined as an expression, through use of symbols, of opinion about the quality of credit of the issuer of debt securities with reference to a particular instrument. As per the Securities and Exchange Board of India (SEBI) regulations, credit rating is nothing but an opinion regarding securities expressed in the form of standard symbol or in any other standardized form assigned by a credit rating agency. The symbol given by rating agency for credit rating indicates a credit character of that particular security and thus it only facilitates to take a view on credit risk pertaining to that security. However, it does not directly recommend whether to purchase, sale or hold that security. Thus, rating is a measure of credit risk only and hence it does not communicate anything about the degree of market risk.

Credit rating is considered predominantly in respect of debt instruments only. In addition to this, leaders like banks and non-banking finance companies use internally developed credit rating score models in assessing credit worthiness of their borrowers or depend on even rating agencies to get rating for the same. The companies which issue debt instruments cannot on their own rate instruments.

III. Benefits of credit rating

The rating of debt instruments offer benefits to the interested parties such as investors, issuers and intermediary agencies like brokers.

Benefits to Investors

i) Safeguards against Bankruptcy - Credit rating of an instrument given by the credit rating agency give an idea to the investors about the degree of financial strength of the issuer company which enables him to decide about investment. Highly rated instrument of a company gives an assurance to the investors of safety of their investment and in the interest in their investments with least risk of bankruptcy.

ii) Recognition of Risk - Business credit rating provides investors with rating symbols which carry information in easily recognizable manner for the benefit of investors to perceive risk involved in investment. It becomes easier for the investors by looking at the symbol to understand the worth of the issuer company because the instrument is rated by scientifically and professionally analyzing the financial position of the company. In view of this, there is no need for the investors to incur cost for collecting credit information and to carry out analysis. The investors without any knowledge of financial analysis can easily use rating symbols for investment decisions.

iii) Credibility of Issuer - Rating symbol assigned to a debt instrument gives an idea about the credibility of the issuer company. The rating agency is quite independent of the issuer company and has no business connections or otherwise any relationship with it or its Board of Directors. Due to absence of business links between the rating agency and the issuer company the confidence of investors is enhanced in such rating symbol.

iv) Rating Facilitates Quick Investment Decisions - Investor can take quick decisions about the investment to be made in various instruments with the help of credit rating assigned to various instruments. In view of this, there is no need for investors to undertake fundamental analysis of a company based on financial strength of the company, quality of management, as well as other parameters.

v) No Need to Depend on Investment Advisors or Professionals - For making investment decisions, investors with no knowledge of investment may have to seek advice of financial intermediaries such as, the stock brokers, the portfolio managers, or financial consultants while investing funds in debt instruments. However, investors need not depend upon the advice of these financial intermediaries as the rating symbol assigned to a particular instrument suggests the credit worthiness of the instrument and indicates the degree of risk involved in it. Thus, investors can make direct investment decisions.

vi) Choice of Investment - Several alternative credit rated instruments are available at a particular point of time for deploying investible funds. The investors can make choice of various instruments depending upon their own risk profile and diversification plan.

vii) Benefits of Rating Surveillance - Investors get the benefit of credit rating agencies on going surveillance of the rated instruments of different companies. The credit rating agency downgrades the rating of any instrument if subsequently the companys financial performance is not so good or financial position has suffered because of happening of internal or external events which necessitates consequent dissemination of information on its position to the investors.

To sum up, credit rating of debt instruments helps the investors in managing credit risk in investment decisions.

Benefits of Credit rating to Issuer Company

A company which has obtained business credit rating from rating agency for its issue of debt security enjoys various advantages. Few of these advantages are given below:

i) Lower cost of borrowing

ii) Wider audience for borrowing

iii) Rating as marketing tool

iv) Self discipline by companies

v) Reduction of cost in public issues

vi) Motivation for growth

Benefits to financial intermediaries

Highly credit card rated instruments put the brokers at an advantage to make less efforts in studying the companys credit position to convince their clients to select a

particular investment proposal. Rated instruments speak themselves about the financial soundness of the company and the strength of the instrument rated by the credit rating agency. This enables brokers and other financial intermediaries to save their time, cost, energy and manpower in convincing their clients about investments in any particular instruments. They utilize their resources in expanding their clientele and intensifying their business activities.

Other Benefits

The other benefits of credit rating in general are given below:

i) Identification of strength and weakness of the Issuer Company

ii) Liquidity and Marketability of Debt Securities

iii) Positive Impact on Capital Market

IV. Limitations of credit rating

While recognizing the benefits of credit rating, it is necessary to keep in mind certain limitations of the credit rating. Few of these are explained below:

1) Biased Rating and Misrepresentations

In the absence of quality rating based on objectivity analysis credit rating is a curse for the capital market. To avoid biased rating or subjectivity in the credit rating process, executives working with Credit Rating Agency, who are involved in the process of credit rating, should have no links with the company or the persons interested in the issuer company so that they can make their report impartial and judicious recommendations for rating committee. Again, rating committee members should also be impartial and judicious in their decision making.

The companies having lower grade rating do not advertise or use the rating while raising funds from the public. In such cases, the credit rating agencies should themselves in the public interest, advertise the rating symbols assigned to such companies for public information and make the public aware of the poor financial position of such companies.

2) Static study

Rating is done on the basis of present and past data of the company and this only a static study. Disclosure about the companys health through credit rating is one time exercise and any thing can happen after assignment of rating symbols to the company. Dependence for future results on the rating, therefore defeats the very purpose of risk indicativeness of rating. Subsequent to the allotment of credit rating many changes may take place in economic environment, political situation, government policy framework which may directly affect the working of a company. With such changes, the purpose for which credit rating was done gets defeated.

3) Concealment of material information

The company which has approached for credit rating may not provide all material information to the credit rating agency. In such cases, credit rating given by the credit rating agency may not reflect true picture of credit risk.

4) Rating is no guarantee for soundness of the company

Credit rating is done for a particular instrument to assess the credit risk. And therefore it cannot be construed as a rating for the quality of management of the company or its sound financial position.

5) Down grade

Once a company has been rated and if it is not able to maintain its satisfactory financial performance, credit rating agency would review the grade and down grade the rating resulting into impairing the image of the company.

Most of the limitations mentioned above can be overcome by taking precautions at every stage of credit rating process.


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