How are Credit metrics and credit migration risk use in financial analysis?

In this article, we’ll explain what credit migration risk and credit metrics are, and how to incorporate them into the financial analysis of companies by lenders and investors.

Credit Migration risks:

Credit ratings for public companies or Governments are similar to credit scores for individuals.  These ratings for the long-term and short-term are provided by established credit ratings firms such as Moody’s, Standard&Poor Global, CARE, CRISIL, FITCH India, ICRA, and INFOMERICS.

The higher the number or letter for credit ratings, the lower the company’s credit risk, and the lower ratings higher the credit risk. Accordingly,  lenders and investors might sometime split credit ratings into three categories for the purpose of monitoring viz. (1) Low risk, (2) Medium risk, and (3) High risk. The ratings of a company so awarded are subject to periodical change depending upon the credit risk condition of the company that improves or deteriorates. Over time, companies may move between these categories as their credit ratings change. This change in credit ratings is called credit migration because a company is moving or migrating from one level of rating to another. This method of measuring credit risk is known as credit migration or Credit Rating Migration Risk.

Monitoring credit migrations provide lenders with trends. If a company’s credit rating may have slowly degraded over several years. A quick glance at a credit migration table will reveal this information without the need for time-consuming analysis. When a company’s credit rating decreases and descends to a lower credit level, this is called negative credit migration. Positive credit migration is just the opposite.

Credit metrics:

The credit metrics approach is designed to evaluate credit risk or the risk of credit loss caused by changes in the creditworthiness of the borrowers. This methodology is used to quantify the credit risk across a broad range of instruments, including traditional loans, commitments, and letters of credit; fixed income instruments; commercial contracts like trade credits and receivables; and market-driven instruments such as swaps, forwards, and other derivatives. The relationships between exposure and the credit metrics framework develop a portfolio value due to credit risk. As and when a debtor’s (bond issuer’s) credit rating falls, the debtor’s bond cash flows become more deeply discounted and the total bond value drops accordingly. On the other hand, if a debtor’s rating improves, the cash flows are discounted less deeply, and the bond values will rise.

Credit Metrics are based on the analysis of credit migration, i.e., the probability of moving from one credit quality to another, including default, within a given time horizon. The most commonly used Credit Metric is the arrival of the debt-to-equity ratio from the balance sheet. Other common metrics include debt/EBITDA, interest coverage, and fixed charge coverage ratios. An analyst will look at all of these credit metrics in conjunction to assess a company’s debt capacity.

Originally posted on March 4, 2019, edited and reposted on February 13, 2023.

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