Credit ratings help investors by providing an easily recognizable, simple tool that couples a possibly unknown issuer with an informative and meaningful symbol of credit quality.
Process of assigning a symbol with specific reference to the instrument being rated, that acts as an indicator of the current opinion on relative capability on the issuer to service its debt obligation in a timely fashion, is known as credit rating.
Factors that Determine the Credit Rating Profile
Following are the factors that affecting credit rating profile:
1. Nature of Industry
A key determinant of the level and volatility in the earnings of any business in the basic characteristic of the industry to which the firm belongs.
This is the most important factor in credit risk assessment.
2. Market Position
Factors that influence the relative competitive position is the issuer need to be examined in detail.
These include product positioning, perceived quality of products or brand equity, proximity to the markets, distribution network and relationship with the customers.
3. Efficiency of Operation
For any business unit in a competitive market, operational efficiency is most important, since it is critical to control costs at all levels.
Moreover, low-cost producers almost always have an edge.
4. Project Risk
The risk profile of an issuer is greatly influenced by the scale and the nature of new projects.
Assessment in greater detail needs to be made of unrelated diversifications into new projects.
5. Protective Factors
In addition to the above, protective factors are also assessed.
These include a track record of the management in project implementation, experience and quality of the project implementation team, experience and track record of the technology supplier, implementation schedule, the status of the project, project cost comparisons, financing arrangements, tie-ups with raw material sources, the composition of the operations team and market outlook.
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6. Quality of Management
Quality of management need hardly be overemphasized.
When the business conditions are adverse, it is the strength of the management that provides resilience.
Much wider insight into management is obtained by having a detailed discussion on its objectives, plans and strategies, competitive position, past performance and future outlook of the business.
7. Financing Policies
The level of financial risk is the determined byte type of funding policies follows by a firm.
These policies are generally focused on issues such as future funding requirements, level of leveraging, views on retaining shareholding control, target returns for shareholders, views on interest rates, currency exposures including policies to control the currency risk, and asset-liability tenure matching.
8. The Flexibility of Financial Structure
The financial flexibility factor generally helps to determine the relative strength within a rating category and has a greater bearing on short term ratings.
Although the primary source for servicing obligations is the cash generated from operations, an assessment is also made of the ability of the issuer to draw on other sources.
9. Past Track Record
Past financial performance of the issuer is assessed to determine the risk profile.
A detailed review of previous financial statements is made to determine the future cash flow adequacy for servicing debt obligations.
10. Quality of Accounting Policy
Quality of accounting policies followed is a clear indicator of management quality.
Consistent and fair accounting policies are a prerequisite for a fair financial evaluation and inter-firm comparison.
11. Financial Performance Indicators
Financial indicators of a firm spanning over a period of five years are analyzed for the purpose of comparison with its peers.
12. Credibility and Independence
Ratings are considered valuable only as long as they are credible.
Credibility arises primarily from objectivity, which results from the rating agency being independent of the issuer’s business.
The investor is willing to accept the judgement only where such credibility exists.
When an increasing number of investors are willing to accept the judgement of a particular rate then that rater gains recognition as a reputed credit rating agency.
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13. Capital Market Mechanism
Strong demand for investment-related information is generated due to the reliance on the capital market for resource allocation.
Credit Rating agencies provide this information.
Investors consider rating an important input for their investment decisions only when there is perceived default risk.
14. Disclosure Requirements
Rating agencies have assumed importance on account of their task of assigning grades to securities issued by companies.
Moreover, it is becoming incumbent for companies, due to regulatory guidelines, to have adequate corporate disclosure and to publish all the essential information required by the investors.
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15. Credit Education
Credit rating services as an effective indicator on the modalities of arriving at valid judgements about investing in securities.
It is to be noted that the information should not only reach the investor, but it must also enable them to make meaningful interpretations.
16. Creation of Debt Market
Credit rating is considered as an essential input for guiding investments in bonds.
This assumes significance in the context of substantial risks involved in their subscription fact, the continued growth and evolution of the credit rating business depend on the size and growth of the debt market.
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