Wondering what a credit rating is all about? If so, stay tuned to this guide to learn what the term means and why it is important to investors and entities.
Definition first! A credit rating can be defined as an assessment of a government’s or company’s creditworthiness with respect to a certain financial or debt obligation. Many use credit scores and credit ratings interchangeably. However, the two differ in some ways. For instance, credit scores are usually assigned to individuals, while credit ratings are associated with entities and issued by organizations like Fitch Ratings, S&P Global, and Moody’s.
Understanding Credit Rating
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A credit rating represents an estimate of the risk level involved in lending funds or investing in a particular company or government entity. When a firm is determined to have a high credit rating, it means that it has the capacity to repay its debts without any difficulty. On the other hand, a poor credit rating indicates that a company may struggle to make repayments or even abandon its debt obligations completely.
Lenders and investors use credit ratings to gauge whether doing business with a particular company is ideal. It also helps set the interest rate that would compensate them for the related risk. For instance, a loan issued to a firm with a high credit rating is likely to attract less interest than a company with a low rating.
Credit ratings also reflect time horizons. A long-term credit rating indicates the likelihood of a borrower defaulting in the extended future, while a short-term credit rating reflects the borrower’s likelihood of abandoning their loan obligations within 12 months.
The History of Credit Ratings
Credit ratings were introduced in the early 1900s. They became popular in 1936 when financial regulators implemented new rules blocking banks from injecting funds into speculative bonds, that is, bonds with relatively low credit ratings.
The rules were intended to minimize the default risk, which could result in bank failures and financial losses.
Top Credit Rating Organizations
There are several credit rating agencies across the world, but these three control the market:
Fitch Ratings
This company was founded in 1913 by John Knowles Fitch. It provides financial statistics for the United States’ investment industry. According to data on the Fitch Ratings website, the company employs over 1,600 financial analysts.
Moody’s Investors Services
Before becoming a credit rating company, Moody’s Investors Services offered basic statistics about bonds and stocks of companies in various industries. In 1909, however, the founder of the firm, John Moody, started offering credit ratings for companies in different sectors. As of February 2024, Moody’s Investors Service has a presence in over 40 countries, researching and providing ratings on governments and companies.
S&P Global
This company was launched in 1860 by Henry Varnum Poor. At the time, Poor only provides critical information regarding the railway industry. In 1906, he published his first credit ratings. According to data on the S&P Global website, the firm has a presence in 35 nations and runs over 80 offices.
Significance of Credit Ratings
Credit ratings are vital for both investors and entities. A high credit rating shows that a company is capable of paying investors and fulfilling its debt obligations. Also, when an entity has a high rating, securing loans at fair interest rates becomes easy.
Credit Rating Scale
Credit rating agencies use varying scales. However, the most common rating scale involves grading with letters. For instance, a high credit rating is represented as AAA, while CCC signals a low rating.
Factors Considered When Rating a Company’s Creditworthiness
These are the factors that credit rating agencies take into account when rating a particular government or company:
- The entity’s history of payments, including past defaults and missed payments.
- The current loan amount and the type of the loan.
- The income generated by the company at the moment.
Conclusion
All lenders and investors must always consider the credit ratings of entities before doing business with them to gauge the potential risk.