Credit Rating: Meaning, Importance & How it Works?

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Credit rating is a valuable tool for evaluating the creditworthiness of diverse entities, including individuals, groups, businesses, non-profit organisations, governments, and even nations. These

specialised rating agencies meticulously assess the financial risk of these borrowers, determining their capability to repay loans promptly.

Essential features of credit rating are that these agencies compile comprehensive reports encompassing various factors to establish a credit rating. These factors include the borrower's borrowing and lending history, capacity to honour debt obligations, previous indebtedness, future economic potential, and more.

Types of Credit Ratings in India

Credit rating agencies utilise different terms within their credit rating scales to assess the risk associated with corporate entities. What is credit rating can be classified into two categories.

Investment Grade

Credit ratings classified as investment grade signify that the corporate entity has demonstrated prudent investment practices and can repay debts promptly. Companies under this category enjoy more accessible loans, often at lower interest rates.

Speculative Grade

Credit ratings falling within the speculative-grade category indicate that a corporate borrower has engaged in high-risk investment activities and may face challenges in repaying the loan. Entities receiving ratings in this category are typically granted loans at higher interest rates, reflecting the increased risk involved.

Importance of Credit Rating

Credit ratings are essential for lenders, borrowing companies, and entities considering investments in equity shares or bonds of borrowing firms. Lenders rely on credit ratings to evaluate a company's creditworthiness and make informed decisions regarding loan approvals or denials.

For borrowing companies, credit ratings determine their eligibility for obtaining loans to support operational or expansionary endeavours. Moreover, individual and institutional investors analyse credit rating terms to assess the risks before investing in a company's shares or bonds.

What are the Factors that affect Credit Rating?

Lending and borrowing history: The company's record of borrowing and repaying debts, including any defaults or late payments.
Past debt: The amount and type of previous debt the company has taken on.
Payment history: The company's history of making timely payments on loans and other financial obligations.
Financial statements: The analysis of the company's financial statements, including balance sheets, income statements, and cash flow statements.
Level and type of current debt: The company's existing debt levels and the nature of the debt, such as short-term or long-term liabilities.

These factors, among others, are considered the importance of credit rating when determining a company's creditworthiness and assigning credit ratings. Companies must maintain a solid financial history and demonstrate promising future economic potential to achieve and maintain favourable credit ratings.

Impact of Credit Ratings on Borrowers & Lenders

Impact on Lenders:

Credit ratings enable lenders and investors to make informed investment decisions by assessing the risk profile of potential borrowers. By considering an entity's credit rating, lenders can have confidence that their funds will be repaid promptly, along with the appropriate interest.

Impact on Borrowers:

Companies with higher credit ratings enjoy several advantages. They are perceived as lower-risk borrowers, making it easier for them to obtain loan approvals. Lenders, such as banks and financial institutions, are more likely to offer loans to entities with higher credit ratings at lower interest rates. These benefits of credit card rating help facilitate access to funds for business expansion and reduce borrowing costs.

How do Credit Rating Agencies Work in India?

Credit rating agencies are vital in assigning ratings to various organisations and entities. These entities include companies, state governments, non-profit organisations, countries, securities, unique purpose entities, and local governmental bodies. When determining an entity's credit rating, agencies consider financial statements, debt levels and types, borrowing and lending history, repayment ability, and past debt obligations.

Once the credit rating agency assigns a rating to an entity, it provides valuable insights to investors, who then analyse this information to make informed investment decisions. A poor credit rating indicates a higher risk of default for the entity in question.

Top Credit Rating Agencies in India – 2023

Several credit ratings in financial services in India are responsible for assigning credit ratings to corporate entities. These agencies include:

ICRA
CRISIL
InRating and Research Private Limited
Brickworks Ratings India Private Limited
Credit Analysis and Research Limited (CARE)
Acuite Ratings and Research
Infometrics Valuation and Rating Private Limited

Also Read: What is Credit Card Interchange Fees?

Credit Ratings and Financial Markets

A favourable credit card rating enhances credibility and signifies a positive track record of timely loan repayment in the past. It assists banks and investors in evaluating loan applications and determining the interest rates to be offered.

FAQs

Q1. How do credit ratings contribute to financial market stability?

A higher credit rating grants borrowers the advantage of securing loans at lower interest rates. Credit ratings also facilitate trading fixed-income securities on the secondary market, providing traders with valuable information for making informed investment decisions.

Q2. Can credit rating agencies influence market perceptions through their ratings?

Yes. Market perceptions of companies and countries can be significantly shaped by credit rating agencies' rating decisions and outlook changes.

Q3. What are some criticisms and controversies surrounding credit ratings?

Rating agencies have faced criticism for failing to identify risks associated with certain types of debts, like mortgage-backed securities, which could have alerted investors to potential pitfalls. Additionally, concerns have been raised about possible conflicts of interest between rating agencies and the issuers of securities.

Q4. Have there been any regulatory measures or reforms addressing credit ratings?

The Securities and Exchange Board of India (SEBI) regulates credit rating agencies in India through the SEBI (Credit Rating Agencies) Regulations, 1999, and subsequent circulars issued under these regulations to follow the credit rating process.

Q5. Do credit ratings influence capital requirements for banks and other institutions?

Yes, Loan terms offered by banks are determined based on the internal rating assigned to the borrower, taking into consideration both internal factors and external constraints. Banks assess the creditworthiness of borrowers using their internal rating systems, which consider various factors such as the borrower's financial health, repayment history, and collateral.