Credit rating is a codified rating assigned to an issue by authorized credit rating agencies. These agencies have been promoted by well-established financial Institutions and reputed banks/finance companies. Credit rating is a relative ranking arrived at by a systematic analysis of the strengths and weaknesses of a company and debt instrument issued by the company, based on financial statements, project analysis, creditworthiness factors and future prospectus of the project and the company appraised at a point of time.
Objectives of Credit Rating
Credit rating aims to:
- Provide superior information to the investors at a low cost;
- Provide a sound basis for proper risk-return structure;
- Subject borrowers to a healthy discipline, and
- Assist in the framing of public policy guidelines on institutional investment.
Thus, credit rating in financial services represent an exercise in faith building for the development of a healthy financial system.
Approaches to Credit Rating
As a technique for independent examination of the investment worth of financial securities as an input to investment decision-making, the process of credit rating usually involves use of one or more of (i) implicit judgmental approach and (ii) explicit judgmental approaches and (iii) statistical approach. While implicit judgmental follows beauty-contest approach wherein a broad range of factors concerning promoter, project, environment and instrument characteristics are considered ‘generally’. Explicit judgmental approach involves identification and measurement of he factors critical to an objective assessment of the credit/investment worthier of an instrument with a view to arriving at a numerical credit score or index. Finally, statistical approach involves, assignment of weights to each of the factors and obtaining the overall credit rating score with a view to doing away with personal bias inherent in both-explicit and implicit judgment.
Significance of Credit Rating
Credit rating is always project/instrument specific. Credit rating for different financial instruments issued by the same company at the same time can be different. In the same way credit rating for similar instruments issued by the same company at different times can also be different. Credit rating is useful for investors, banks and other financial institutions and investments advisers as it helps them taking business decisions. Credit rating by an authorized competent authority gives a bird’s eye view of financial strength of an organisation and its instruments. It is of considerable help to an investor in deciding whether his investment is likely to be safe.
As financial markets have grown increasingly complex and global and borrowers base has become increasingly diversified, investors and regulators have increased their reliance on the opinions of credit rating agencies. Credit ratings attempt to provide a consistent and reasonable rank ordering of relative credit risks, with specific reference to the instrument being rated.
Credit rating can be applied in the following areas/instruments:
- Equity shares
- Rating for banking sector
- Individual credit rating
- Rating for insurance sector
- New instruments, floating rate notes, index based bonds, long-term deep discount bonds, etc.
- Rating of intermediaries in financial services
- Rating of companies raising funds overseas.
It is expected that credit rating will assume multi-dimensional role covering all sectors of the economy which would include rating of products, services, suppliers, customers, management schools, merchant bankers, banks, health services, schools, political parties and politicians and so on.
Methodology of Credit Rating
The process of credit rating begins with the prospective issuer approaching the rating agency for evaluation. The experts in analyzing banks should be given a free hand and they will collect data and informant and will investigate the business strength and weaknesses in detail. The entire process of rating stands on the for of confidentiality and hence even the most confidential business strategies, marketing plans, future outlook etc., are revealed to the steam of analysis.
The rating is based on the investigation analysis, study and interpretation of various factors. The world of investment is exposed to the continuous onslaught of political, economic, social and other forces which does not permit any one to understand sufficiently certainty. Hence a logical approach to systematic evaluation is compulsory and within the framework of certain common features the agencies employ different methodologies. The key factors generally considered are listed below:
1. Business Analysis or Company Analysis
This includes an analysis of industry risk, market position of the company, operating efficiency of the company and legal position of the company.
- Industry risk: Nature and basis of competition, key success factors; demand supply position; structure of industry; government policies, etc.
- Market position of the company within the Industry: Market share; competitive advantages, selling and distribution arrangements; product and customer diversity etc.
- Operating efficiency of the company: Locational advantages; labor relationships; cost structure and manufacturing as compared to those of competition.
- Legal Position: Terms of prospectus; trustees and then responsibilities; system for timely payment and for protection against forgery/fraud, etc.
2. Economic Analysis
In order to evaluate an instrument an analyst must spend a considerable time in investigating the various economic activities and also analyze the characteristics peculiar to the industry, whose issue the analyst is concerned with. It will be an error to ignore these factors as the individual companies are always exposed to changing environment and the economic activates affect corporate profits, attitudes and expectation of investors and the price of the instrument. hence the relevance of the economic variables such as growth rate, national income and expenditure cannot be ignored. The analysis, while doing the economic forecasting use surveys, various economic indicators and indices.
3. Financial Analysis
This includes an analysis of accounting, quality, earnings, protection adequacy of cash flows and financial flexibility.
- Accounting Quality: Overstatement/under statement of profits; auditors qualification; methods of income recognition’s inventory valuation and depreciation policies, off balance sheet liabilities etc.
- Earnings Protection: Sources of future earnings growth; profitability ratios; earnings in relation to fixed income changes.
- Adequacy of cash flows: In relation to dept and fixed and working capital needs; variability of future cash flows; capital spending flexibility working capital management etc.
- Financial Flexibility: Alternative financing plans in ties of stress; ability to raise funds asset redeployment.
4. Management Evaluation
- Track record of the management planning and control system, depth of managerial talent, succession plans.
- Evaluation of capacity to overcome adverse situations
- Goals, philosophy and strategies.
5. Geographical Analysis
- Location advantages and disadvantages
- Backward area benefit to the company/division/unit
6. Fundamental Analysis
Fundamental analysis is essential for the assessment of finance companies. This includes an analysis of liquidity management, profitability and financial position and interest and tax sensitivity of the company.
- Liquidity Management: Capital structure; term matching of assets and liabilities policy and liquid assets in relation to financing commitments and maturing deposits.
- Asset Quality: Quality of the company’s credit-risk management; system for monitoring credit; sector risk; exposure to individual borrower; management of problem credits etc.
- Profitability and financial position: Historic profits, spread on fund deployment revenue on non-fund based services accretion to reserves etc.
- Interest and Tax sensitivity: Exposure to interest rate changes, hedge against interest rate and tax low changes, etc.
Country’s Credit Rating
Country’s credit rating denotes its ability to source debt from the international market at a reasonable cost. Low rated nations will have discounts, offer high yield and are treated as risky investment. Risk relates to default. Country’s credit rating involves evaluation of external financial accounts and macro economic factors and is directed towards future trends. Credit rating of any country involves evaluation of:
- Economic growth and development : Gross national product and gross domestic product, population growth, Infrastructure development, good financial management, saving growth rate, industrial production, agricultural production, growth of services sector etc.
- Balance of trade and balance of payments : Export products, export prices, diversification of products and export market, global competition, import substitution, etc.
- Debt service ratio : This indicates the country’s external vulnerability. This is a ratio of external debt to total external earnings including export earning and earning from tourism, etc.
- Debt composition : Soft loans, commercial borrowings, interest rate structure, proportion of external debt.
- Liquidity : Level of reserves, foreign exchange reserves, import coverage ratio, currency backed by assets such as gold.
- Political and internal stability : Socio-religious conflicts, majority government strong opposition, unequal economic distribution, relations with neighboring countries, political factors are not predictable and is prone to unexpected events.
- Inflation and price stability.
Political challenges, economic transformation and policy consensus, fiscal imbalances and imposing public sector debt burdens are all factors which enhance or inhibit the credit rating of a country while political and economic forces are clearly a key determination of sovereign credit risk in emerging market countries, the financial pressures due to fiscal indiscipline pose threat to liquidity problems and default. Fiscal control is the key indicator of improving or deteriorating credit quality.
Drawbacks of Credit Rating
Following are some of the drawbacks of credit rating:
- The ratings process attempts to provide a guidance to investors/creditors in determining the risks associated with the instrument/credit obligation. It does not attempt to provide a recommendation and does not take into account factors like market prices, personal risk/reward preferences that might influence investment decisions.
- The ratings process is based on certain primitives. The agency, for instance, does not perform an audit. Instead, it has to rely solely on information provided by the user. Consequently, to the extent that the information provided is inaccurate and incomplete, the rating process is compromised.
- To the extent that a certain instrument of a specific company attracts a lower rating, the company has an incentive to shop around for the best possible rating, compromising the authenticity of the rating process itself.
Credit Rating Agencies in India
The concept of credit rating has been widely discussed and debated in India in recent times. Since the setting up of the first credit rating agency. Credit Rating and Information Services of India Ltd. (CRISIL) in India in 1987, there has been a rapid growth of credit rating agencies in India. The major players in the Indian market, apart from CRISIL include Investment Information and Credit Rating agency of India Ltd. (ICRA), promoted by IDBI in 1991 and Credit Analysis and Research Ltd. (CARE), promoted by IFCI in 1994. Duff and Phelps has tied up with two Indian NBFCs to set up Duff and Phelps Credit Rating India (P) Limited in 1996.
Major International Credit Rating Agencies
As capital flows have become increasingly global and turbulence in one economy has had contagion effects across the globe, credit ratings have spread outside the domain of the home country to overseas markets. Credit ratings are in use in the financial markets of most developed economies and several emerging market economies as well. The principal characteristics of the major internationally known rating agencies are as follows:
|Name of the agency||Home country||Ownership||Principle|
|Moody’s Investors Service||U.S.A||Dun and Bradstreet||Full Service|
|Fitch Investors Service||U.S.A||Independent||Full Service|
|Standard and Poor’s Corporation||U.S.A||Mcgraw Hill||Full Service|
|Canadian Bond Rating Service||Canada||Independent||Full Service (Canada)|
|Thomson Bank Rating||U.S.A||Thomson Company||Financial Institutions|
|Japan Bond Rating Institute||Japan||Japan Electronic Journal||Full Service (Japan)|
|Duff and Phelps Credit Rating||U.S.A||Duff and Phelps Corporation||Full Service|
|IBCA Ltd.||United Kingdom||Independent||Financial Institutions|
Over time, the agencies have expanded the depth and frequency of their coverage. The leading U.S. credit rating agencies rate not ply the long-term bonds issued by corporate in the U.S., but also wide variety of other debt instruments including, for example, municipal bonds, asset-backed securities, private placements, commercial paper programmes and bank certificates of deposit (CDs). In addition, the leading rating agencies also play a major role in evaluating sovereign ratings.
Most of the rating agencies have long had their own symbols. Some of them use alphabets; others use numbers; many use a combination of both for ranking the risk of default. The default risk varies from extremely safe to highly speculative. Gradually, major agencies has emerged to provide finer rating gradations to help investors distinguish more carefully among issuers. Standard & Poor Corporation in 1974 and Moody’s in 1982 started attaching plus and minus symbols to their ratings. Other modifications of the grading scheme-including the addition of a ‘credit watch’ category to denote that a rating is under review-have also become standard.