A credit rating represents the rating agency opinion of whether the debt obligation will be fully paid and on time. A credit rating can be assigned to any entity that seeks to borrow money. This can be an individual, corporate, state, sovereign government.
There is a difference between credit rating agency and credit bureau. A credit rating agency gives an opinion on the future debt repayment by a borrower and a credit bureau provides an opinion on the past debt repayment by borrowers.
Reason to do credit rating
A rating is just a parameter that an investor should take care of while making an investment decision. It doesn’t speaks about whether an investor should really buy, sell or hold a debt instrument. A rating does not give an assurance of the repayment of the debt. A rating is just an opinion on the risk associated with the repayment of debt. In other words it gives an estimate of the likelihood of the default.
Credit ratings are assigned based on certain expectations and assumptions about variable that impact the issuer’s performance. This variable can change causing the change in the rating given to the issuer, these changes gets reflected in the changed credit ratings
Regulator of credit rating agencies
The capital market regulator regulates rating agencies in most regions. In India, the rating agencies are regulated by the capital markets regulator, the Securities and Exchange Board of India (SEBI)
Credit Rating Process
The credit rating process is similarly followed by major credit rating agency in the country. It includes the following steps:-
- Receipt of the request : – This is the first step to begin with the rating process. The rating agency receives a formal request for rating from a company desirous to issue obligations. An agreement is entered into between the rating agency and the issuer company. The agreement covers the following aspect: –
- It requires the CRA (Credit Rating Agency) to keep the information confidential.
- It gives right to the issuer company to accept or not to accept the rating.
- It requires the issuer company to provide all material information to the CRA for rating and subsequent surveillance.
- Assignment to analytic team: – After request has been received the rating agency assigns the job to the analytical team which usually comprises of people who have expertise in the relevant business area. They are responsible for carrying out the rating assignments
- Obtaining information: – The analytic team collects the information that is required from the client company and analyses the information relating to its financial statements, cash flow projections and other relevant information.
- Plant visits and meeting with management:- To have a better understanding of the clients operations, the team visits and interacts with the company’s executives. Plants visit helps in understanding the production process, evaluate the quality of technical personnel, evaluates the quality and cost of production.
- Presentation of findings:- Once the analysis is done the findings are discussed with the internal committee which comprises of the senior analyst of the credit rating agency. An opinion on the rating is formed which is finally resented to rating committee
- Rating committee meeting:- This is the final step of assigning the rating. The rating committee meeting is the only meeting where the issuer does not participate directly. After looking and analyzing all the factors and key issues getting a greater attention a rating is assigned to the company.
- Communication of decision:- This rating is finally communicated to the issuer with the reasons and rationale supporting the rating.The ratings which are not accepted are either rejected or reviewed in the light of additional facts provided by the issuer. The rejected ratings are not disclosed and complete confidentiality is maintained.
- Dissemination to the public:- Once the issuer accepts the rating, the credit rating agencies disseminate it through printed reports to the public.
- Monitoring for possible change:- Ratings are based on many assumptions so constant review is required wherein different factors affecting the rating is reviewed and if any changes are there it gets refelected in the changed ratings.
Credit Rating Methodology
In order to provide a rating to the issuer there are different financial and non-financial parameters on which a rating agency looks at and analyses in detail. These include
- Business Risk Analysis – These include a detailed analysis of the industry analysis, market position of the company, operating efficiency, legal position of the company etc.
- Financial / Fundamental Analysis – This parameter checks the financial strength of the company. This is done by understanding and analyzing the financials of the issuer company by musing different ratios. There are four important parameters that one sees in analyzing the financials of the company i.e. Accounting quality, Earnings potential/profitability, Cash flows analysis, Financial flexibility
- Management Evaluation – A company’s performance is significantly affected by the company management experience, skill sets, decisions, etc.
- Geographical Analysis – If Issuer Company is located across country enjoys the benefit of diversification as in comparison with the company which is located in one country. Even this has a significant impact on the company’s performance
- Regulatory and Competitive Environment – Different rules and regulations also has a significant impact on the financials of the company.
What does a credit rating indicate ?
As per SEBI, Rating Symbols for Long Term Debt Instruments is
Long term debt instrument is an instrument with original maturity exceeding one year
Rating symbols should have CRA’s first name as prefix
|Symbol||Instruments with the respective rating indicates level of safety with respect to timely servicing of financial obligations|
|AAA||The highest degree of safety|
|AA||High degree of safety|
|A||Adequate degree of safety|
|BBB||Moderate degree of safety|
|BB||Moderate risk of default|
|B||High risk of default|
|C||High risk of default|
|D||In default or are expected to be in default soon.|
Credit research v/s equity research
Credit ratings are assigned to debt instruments, while equity research relates to equity shares.A credit rating is focused on the risk of non-payment of the debt whereas equity research is focused on the growth possibilities of the company’s equity for which equity valuation is done.
A person can become a credit analyst where his major role will be to gather and analyse the financial and non-financial data about clients, and recommends a course of action for the customer.
The skills sets required to become a credit analyst is
- Analytical and Reasoning skills
- Good communication skills
- Developing a credit model
- A good understanding about the financials of the company
- Writing skills
- A good knowledge about the industry