Any form of debt has to be repaid. But what’s the guarantee that the person or the entity to whom you are lending your hard-earned money will certainly return it back timely or even just return it.
So, before you lend money, you would like to perform a background check on the borrower’s repayment capacity, i.e., ability and willingness to repay the debt. In simple words, this background check is used to determine the creditworthiness of the borrower.
Based on the result of the background check, a credit rating is used to access the creditworthiness of the borrower or issuer of debt. This kind of credit rating is assigned by a credit rating agency.
Credit Rating Agencies
Globally, there are three famous credit rating agencies: Standard & Poor’s (S&P), Moody’s, and Fitch. ICRA, CRISIL, and CARE are some of the credit rating agencies in India.
Basis of assigning Credit Rating
These agencies assign ratings to issuer of debt, such as companies and governments. To arrive at a credit rating, the agencies evaluate not only current and historical information but also assess the potential impact of foreseeable future events on the borrower’s repayment capacity.
While assigning a credit rating to a country, the focus is on political stability, monetary stability, impact of global events on the country’s economic and political stability, and overall debt burden.
When it comes to rating a company for its creditworthiness, the factors taken into consideration are: company’s past and current performance, industry profile, company’s position in the industry and how it stands in the competition in the industry, revenue model and cash flow, projected earnings, current debt load, corporate governance, and accounting practices.
‘AAA’ : Extremely strong capacity to meet financial commitments.
‘AA’ : Very strong capacity to meet financial commitments.
‘A’ : Strong capacity to meet financial commitments, but somewhat susceptible to adverse
economic conditions and changes in circumstances.
‘BBB’ : Adequate capacity to meet financial commitments, but more subject to adverse
economic conditions. Considered lowest investment grade.
‘BB+’ : Considered highest speculative grade.
‘BB’ : Less vulnerable in the near-term but faces major ongoing uncertainties to adverse
business, financial and economic conditions.
‘B’ : More vulnerable to adverse business, financial and economic conditions but
currently has the capacity to meet financial commitments.
‘CCC’ : Currently vulnerable and dependent on favourable business. financial and economic
conditions to meet financial commitments.
‘CC’ : Currently highly vulnerable.
‘C’ : A bankruptcy petition has been filed or similar action taken, but payments of
financial commitments are continued.
‘D’ : Payment default on financial commitments.
Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.
Meaning of AAA rating
The AAA rating is the highest possible rating that can be given to a country or company. AAA rating in the words of S&P is an “extremely strong capacity to meet financial commitments ” and is least likely to default on its debt payments.
The major benefit of AAA rating is that it helps a country or company borrow at low interest. The reason is that since the risk of lending is very less thus the lender and afford a to offer a low interest rate.
Credit ratings reflect relative opinions about the creditworthiness of a borrower, from the strongest (AAA) the weakest (D).
But it is important to remember that credit rating only reflects relative risk of return. For example, a company that is rated ‘A’ is only less likely to default on a debt payment than a company with a ‘BBB’ – rating. It us not that it will not default, but only that the possibility of a default is less likely than those rated below it.
Also, different credit rating agencies may assign different credit rating depending on its analysis of the company or country’s situation.