What Is Credit Rating?

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A credit rating is a grade that is attributed to a person, an institution or a state in order to measure their ability to repay their debt at a specific point in time. This grade can improve or deteriorate depending on the financial health of the borrower. Because credit rating is a way to assess the riskiness of a borrower, it affects several factors like the minimum interest rate lenders will demand. To help you better understand this concept, consider three cases where you might have heard about what is credit rating; I will explain each of these scenarios:

1.       You applied for a new credit card and your bank asked you to provide personal information in order to obtain your credit score:

When you apply for credit, lenders like financial institutions and retailers need to assess your ability to repay the debt. For that, they reach out to credit reporting agencies. Those agencies have tracked your credit history since your first transaction and have calculated your credit score. Different agencies can develop different scoring models in the same country. A common model used in North America is the FICO score, which ranges from 300 to 900. The higher your credit score the higher your chances of getting approved for a loan. The factors that determine your score include the number of credit products you have, your payment history and the amounts you owe compared to your income.

2.       Your employer tells you the company has been downgraded by Fitch and it may impact this year’s financial results:

Similar to individuals, publicly traded companies get rated, but by corporate rating agencies. More exactly, it is the debt instruments those companies issue (bonds) that are rated. Common credit agencies include Moody’s, Fitch and Standard & Poor’s. Their rating system ranges from AAA (the best) to D (the worst), with varying intermediate grades. Ratings are derived from a thorough analysis of financial statements to determine the ability of a company to pay back its creditors (bondholders). Information on the leverage, coverage, liquidity, profitability and management of a company are all important factors in assessing credit risk. Credit ratings have become a powerful tool because a slight improvement (upgrade) or deterioration (downgrade) in credit rating can dramatically affect investors’ perception of a company. This in turn influences the price at which traders are willing to buy and sell the company’s bond and stock. The rationale behind this is that if a company relies heavily on debt to operate, a downgrade in its credit rating may incentivise lenders to ask for their money back and the company would rapidly run out of cash, running the risk of going bankrupt. So despite the fact that a credit rating provides only a partial and reversible opinion about a company’s credit risk, downgrades are generally NOT well perceived by financial markets.

3.       You hear in the news that The United States and France lost their Tripe A rating in the aftermath of the financial crisis:

Similar to companies and individuals, Countries and governmental institutions get evaluated by rating agencies in order to communicate to their current and potential business partners their ability to repay the funds they have borrowed. The better a country’s credit rating, the more willing are financial institutions, foreign countries and investors to do business with it, either through the purchase of sovereign bonds or foreign direct investment. Criteria that determine a high credit rating for a country are economic development, political environment, financial transparency, and macroeconomic metrics like GDP, inflation, fiscal balance, external debt and default history. When a country gets downgraded, it sends a bad signal to lenders and investors and it can affect the cost of raising funds, making it more expensive for the government to borrow money in order to realize necessary infrastructure and social projects. This in turn can impact the whole economy and citizens like you and I.

 

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