Factors considered while Rating Companies/Instruments and Process of Credit Ratings explained

Ratings are based on a comprehensive evaluation of the strengths and weaknesses of the company fundamentals including financials along with an in-depth study of the industry and macroeconomic, regulatory, and political environment. Some factors that may be considered for credit rating are the Issuer Company’s operational efficiency, level of technological development, financials, competence and effectiveness of management, record of debt servicing, etc.

Credit rating agencies employ unique terminologies within their credit rating scales to delineate the risk inherent to corporate entities. These credit rating systems are designed for this purpose.

Please see the following image of different credit rating agencies indicating their credit rating uniquely.

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Factors Considered while Rating Companies/Instruments and a Government.

Credit ratings apply to businesses and government. The following factors are considered while Rating Companies/Instruments.  Credit ratings of companies depend on various factors including payment history, amounts owed, types of credit, debt utilization ratio, length of credit history, outstanding debt, and overall financial behaviour. Further, the Current cash flows and income, the overall market or economic outlook, and any unique issues that might prevent timely repayment of debts are also considered.

Credit Rating of a company’s issue:

Credit ratings of companies depend on the issuer’s ability to service its debt. For this credit rating agencies calculate

a) Issuer Company’s past and future cash flows.

b) Assess how much money the company will have to pay as interest on borrowed funds and how much will be its earnings.

c) How much are the outstanding debts?

d) Company’s short-term solvency through calculation of current ratio.

e) Value of assets pledged as collateral security by the company.

f) Availability and quality of raw material used, favorable location, cost advantage.

g) Track record of promoters, directors, and expertise of the staff.

In addition to the above, CRAs view the legal position of the instrument to be issued, regulatory implications, the quality of management, the market positions of the company’s products, the reputation, and the market share of its products. Industry risks about the position for the products of that industry, international competition, etc.,

Rating a country:

 Investors use sovereign credit ratings as a way to assess the riskiness of a particular country’s bonds. While rating a country the factors considered are its industrial and agricultural production, gross domestic product, government policies, political situation, war, rate of inflation, etc.

For example: S&P Global ratings on India: On May 29, 2024, S&P Global Ratings revised its outlook on India to positive from stable. At the same time, we affirmed our ‘BBB-‘ long-term and ‘A-3’ short-term unsolicited foreign and local currency sovereign credit ratings. The transfer and convertibility assessment remains ‘BBB+’. Whereas, Standard & Poor’s credit rating for the war-torn country Ukraine stands at CC with a negative outlook. Moody’s credit rating for Ukraine was last set at Ca (Judged to be highly speculative and with the likelihood of being near or in default, but some possibility of recovering principal and interest.), with a stable outlook.

The Credit Rating Process:

A credit rating agency is generally done at the request of the borrowers or Issuer companies.

Step 1: The rating agency and issuer company enter into an agreement covering the terms and conditions for doing the ratings.

Step 2: The rating agency assigns the job to its team of experts who have experience in the relevant line of business.

Step 3: The analytical team collects information about the client company and studies the company’s financial position, cash flow, native and basic competition, market share, operating efficiency arrangement, management track, cost structure, selling and distribution record, power ( electricity) and labour situations, etc.

Step 4: The assessment team contacts responsible officials and executives of the client to get clarifications and understanding of the client’s business, the analytical team visits and interacts with the executives of the client.

Step 5:  The team discusses among its members and compiles the study of facts and their unbiased opinion of the client’s ability to discharge present and future liabilities.

Rating symbols may vary depending on the type of debt instrument and the tenure i.e. long-term or short-term. Each rating symbol is an alpha-numeric representation of the degree of repayment risk associated with debt instruments. The following image gives you an idea about the symbols given by the CRAs.

Plus and minus symbols are used to indicate finer distinctions within a rating category. The minus symbol associated with ratings has no negative connotations. For example, you may observe from the following image that the ratings in a higher rating category such as ‘AA-’ are stronger than ratings in a lower rating category such as ‘A+‘. Credit rating agencies are regulated by the Securities and Exchanges Board of India (SEBI). The SEBI (Credit Rating Agencies) Regulations, 1999 govern the credit rating agencies and provide for eligibility criteria for registration of credit rating agencies, monitoring and review of ratings, requirements for a proper rating process, avoidance of conflict of interest, and inspection of rating agencies by SEBI, amongst other things.

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