Credit Rating

Credit rating is done for debt instruments such as debentures, fixed deposits, commercial papers, bonds, etc.
The company which issues debt instruments is called an issuer or issuing company. The issuer, issues these instruments to collect finance from the investors.
The investor looks at the credit rating of the instrument and the issuer before investing. If the credit rating is a high, investor will invest in the company. That is, he will purchase the debentures, etc. issued by that company. If the credit rating is low, he will not purchase the debentures, etc. of that company. So, credit rating guides the investor while investing.
Credit rating is an opinion about a debt instrument and its issuer. It tells the investor, whether the debt instrument is safe or risky. That is, it tells whether the company will be able to pay the interest and repay the principal amount in time. Credit rating is only an opinion. It is not a recommendation. It does not ask an investor to buy, hold or sell an instrument.
So, credit rating is an opinion about the future ability and legal obligation of the issuer to make timely payments of principal amount and interest on their debt instruments. Credit rating is done by independent credit-rating agencies like S & P, which is based in USA, while CRISIL, CARE and ICRA Ltd., which are based in India. Credit rating is done by experts after examining various factors. The rating is expressed in alphabetical or alphanumeric symbols. For e.g. if the rating of debenture is AAA (Triple A), then it is considered to have the highest safety for the investor. However, if the credit rating is D, then the debenture is considered to be very risky for the investor. The issuing company asks the credit-rating agency to rate its instrument. This is done before issuing the instrument. The agency collects and studies information about the issuing company. Then it gives a rating for the instrument. This rating is not permanent. It is reviewed periodically.

Benefits of Credit Rating to Investors

The advantages, importance or benefits of credit rating to the investors are:

1. Helps in Investment Decision : Credit rating gives an idea to the investors about the credibility of the issuer company, and the risk factor attached to a particular instrument. So the investors can decide whether to invest in such companies or not. Higher the rating, the more will be the willingness to invest in these instruments and vise-versa.
2. Benefits of Rating Reviews : The rating agency regularly reviews the rating given to a particular instrument. So, the present investors can decide whether to keep the instrument or to sell it. For e.g. if the instrument is downgraded, then the investor may decide to sell it and if the rating is maintained or upgraded, he may decide to keep the instrument until the next rating or maturity.
3. Assurance of Safety : High credit rating gives assurance to the investors about the safety of the instrument and minimum risk of bankruptcy. The companies which get a high rating for their instruments, will try to maintain healthy financial discipline. This will protect them from bankruptcy. So the investors will be safe.
4. Easy Understandability of Investment Proposal : The rating agencies gives rating symbols to the instrument, which can be easily understood by investors. This helps them to understand the investment proposal of an issuer company. For e.g. AAA (Triple A), given by CRISIL for debentures ensures highest safety, whereas debentures rated D are in default or expect to default on maturity.
5. Choice of Instruments : Credit rating enables an investor to select a particular instrument from many alternatives available. This choice depends upon the safety or risk of the instrument.
6. Saves Investor's Time and Effort : Credit ratings enable an investor to his save time and effort in analyzing the financial strength of an issuer company. This is because the investor can depend on the rating done by professional rating agency, in order to take an investment decision. He need not waste his time and effort to collect and analyse the financial information about the credit standing of the issuer company.

Benefits of Credit Rating to Company

The merits, advantages, benefits of credit rating to the issuing company are:

1. Improves Corporate Image : Credit rating helps to improve the corporate image of a company. High credit rating creates confidence and trust in the minds of the investors about the company. Therefore, the company enjoys a good corporate image in the market.
2. Lowers Cost of Borrowing : Companies that have high credit rating for their debt instruments will get funds at lower costs from the market. High rating will enable the company to offer low interest rates on fixed deposits, debentures and other debt securities. The investors will accept low interest rates because they prefer low risk instruments. A company with high rating for its instruments can reduce the cost of public issue to raise funds, because it need not spend heavily on advertising for attracting investors.
3. Wider Audience for Borrowing : A company with high rating for its instruments can get a wider audience for borrowing. It can approach financial institutions, banks, investing companies. This is because the credit ratings are easily understood not only by the financial institutions and banks, but also by the general public.
4. Good for Non-Popular Companies : Credit rating is beneficial to the non-popular companies, such as closely-held companies. If the credit rating is good, the public will invest in these companies, even if they do not know these companies.
5. Act as a Marketing Tool : Credit rating not only helps to develop a good image of the company among the investors, but also among the customers, dealers, suppliers, etc. High credit rating can act as a marketing tool to develop confidence in the minds of customers, dealer, suppliers, etc.
6. Helps in Growth and Expansion : Credit rating enables a company to grow and expand. This is because better credit rating will enable a company to get finance easily for growth and expansion.

Demerits of Credit Rating

The disadvantages, limitations or demerits of credit rating are listed below.

1. Possibility of Bias Exist : The information collected by the rating agency may be subject to personal bias of the rating team. However, rating agencies try their best to provide an unbiased opinion of the credit quality of the company and/or instrument. If not, they will not be trusted.
2. Improper Disclosure May Happen : The company being rated may not disclose certain material facts to the investigating team of the rating agency. This can affect the quality of credit rating.
3. Impact of Changing Environment : Rating is done based on present and past data of the company. So, it will be difficult to predict the future financial position of the company. Many changes take place due to changes in economic, political, social, technological, legal and other environments. All this will affect the working of the company being rated. Therefore, rating is not a guarantee for financial soundness of the company.
4. Problems for New Companies : There may be problems for new companies to collect funds from the market. This is because, a new company may not be in a position to prove its financial soundness. Therefore, it may receive lower credit ratings. This will make it difficult to collect funds from the market.
5. Downgrading by Rating Agency : The credit-rating agencies periodically review the ratings given to a particular instrument. If the performance of a company is not as expected, then the rating agency will downgrade the instrument. This will affect the image of the company.
6. Difference in Rating : There are cases, where different ratings are provided by various rating agencies for the same instrument. These differences may be due to many reasons. This will create confusion in the minds of the investor.