The Concept of Credit Rating

The Concept of Credit Rating
It is usually the effort of investors in financial instruments to minimise or eliminate default

risk. Credit rating (CR) service is useful to them in designing strategies for this purpose. It
can be defined as an act of assigning values to credit instruments by estimating or assessing
the solvency, i.e., the ability of the borrower to repay debt, and expressing them through pre-
determined symbols. It is an assessment of the credit quality or investment quality of a
particular credit instrument issued by a given business unit. The following definitions of CR
indicate towards the same meaning of CR:
 “Credit rating is designed exclusively for the purpose of grading bonds according to
their investment quality”.
 “Corporate or municipal debt rating is a current assessment of the credit worthiness of
the obligator with respect to a specific obligation”.
 “A corporate credit rating provides lenders with a simple system of gradation by
which the relative capacities of companies to make timely repayment of interest and
principal on a particular type of debt can be noted. The higher the rating, the greater
the likelihood that the borrower will fulfil his obligations towards the creditors”.
In order to know the meaning of CR, it is useful to know what it is not. CR is not a
recommendation to purchase or sell or hold security. It is not a general purpose evaluation of
the company. It does not create a fiduciary relationship between the credit rating agency
(CRA) and the rating users. It does not imply that the CRA performs an audit function or
attests the veracity of information provided by the borrowers. It is not a one-time evaluation
of risk which remains valid for the entire life of the security.
Features
Credit rating is done by specialised, expert, reputed and accredited institutions. It is mostly
confined to debt instruments, but efforts have been made to rate equity shares also. In CR,
although the whole organisation is not graded, it does reflect the issuer’s strength, soundness
of operations, quality of management, organisational behaviour, and composite performance.
CR may differ for different instruments issued by the same organisation because of the
different nature of obligations each instrument has. Usually, the Credit Rating Agency (CRA)
undertakes the job of rating an instrument on a request by the organisation issuing that
instrument. However, once it has rated an instrument, it becomes its obligation towards
investors to periodically announce the deterioration, improvement in the grade of that
instrument, whether the issuer wants it or not. Unsolicited CR also exists abroad. While
assigning ratings, CRAs take into account factors such as industry risk, market position,
operating efficiency, tract record, planning and control systems, accounting quality, financial
flexibility, profitability, liquidity, and asset quality of the borrower. CR is based on
information provided by the borrower and the one obtained by CRA independently. After
they are assigned, ratings are continuously monitored by CRA, and they can be changed,
suspended, and withdrawn by it at any time as a result of new information or other
circumstances.
The practice of “country rating” or “sovereign rating” as well as debt instruments rating has
become more common in the recent past. It is worth noting that while in the case of domestic
borrowers only the instruments are traded, in the case of country ratings, the whole country or
nation is rated which is against the basic tenet of CR.
Objectives
Although the basic objective of CR is to provide superior and low-cost information to

investors for taking a decision regarding risk-return trade-off, it helps other market
participants also in many ways:
a) It imposes a healthy discipline on borrowers.

b) It lends greater credence to financial and other representations.
c) It facilitates formulation of public guidelines on institutional investment.
d) It helps merchant bankers, brokers, regulatory authorities, etc. in discharging their
functions related to debt issues.
e) It encourages greater information disclosure, better accounting standards, and
improved financial information, which, in turn, help in investor protection.
f) It may reduce interest costs for highly rated companies.
g) As a marketing tool, it is of great help to the issuer.
Credit ratings guide the investors, but they may also serve to misguide them, which depends
on both the expertise and honesty of CRAs. Credit rating is a science as well as an art. It has
been rightly pointed out that rating is not and never will be a precise science; there are simply
too many variables or a tremendous variety and combination of business conditions to be
judged. Therefore, there is no magic formula for arriving at CR; it involves matters of
judgement, not merely an analysis of statistics. Subject to this, the usefulness of CR depends
upon the quality of CRA, its independence from industrial concerns, absence of its vested
interest in or linkages with the issuer of securities, its objectivity, the quality of its staff, and
so on.

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The Concept of Credit Rating

It is usually the effort of investors in financial instruments to minimise or eliminate default

Although the basic objective of CR is to provide superior and low-cost information to

a) It imposes a healthy discipline on borrowers.

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