Credit Rating: Meaning and Functions

Meaning and Defintion

Credit Rating is an assessment of the borrower it may an individual, group or company, that determines whether the borrower will be able to pay the loan back on time, as per the loan agreement.  Needless to say, a good credit rating depicts a good history of paying loans on time in the past. This credit rating influences the bank’s decision of approving your loan application at a considerate rate of interest.

It is usually expressed in alphabetical symbols. Although, it is a new concept in Indian financial market but slowly its popularity has increased. It helps investors to recognize the risk involved in lending the money and gives a fair assessment of the borrower’s creditability.

Importance of Credit Rating

For The Money Lenders

  1. Better Investment Decision: No bank or money lender companies would like to give money to a risky customer. With credit rating, they get an idea about the credit worthiness of an individual or company (who is borrowing the money) and the risk factor attached with them. By evaluating this, they can make a better investment decision.
  2. Safety Assured: High credit rating means an assurance about the safety of the money and that it will be paid back with interest on time.

For Borrowers

  1. Easy Loan Approval: With high credit rating, you will be seen as low/no risk customer. Therefore, banks will approve your loan application easily.
  2. Considerate Rate of Interest: You must be aware of the fact every bank offers loan at a particular range of interest rates. One of the major factors that determine the rate of interest on the loan you take is your credit history. Higher the credit rating, lower will the rate of interest.

Functions of Credit rating agencies

1. Business Analysis: A credit rating company will analyze the business condition of the borrowing company not merely by the profits the borrowing concern has made, but by the use of capital in a more productive purpose. The return on capital and the cost of capital will be analyzed.

2. Evaluation of industrial risks: Every industry will have its risks which are due to natural or market conditions such as competition or due to the substitutes that have arrived in the market. The extent of risks and measures to overcome them will be taken into account while judging the credit rating of the company.

3. Market position of the company within the industry: What is the share of the market of the company seeking credit rating? A higher percentage of market share will involve more risks as the company has to be vigilant to maintain its share. So, a credit rating agency will give due weight-age for the market share of the borrowing concern.

4. Operating efficiency: This is judged from the point of view of utilization of the capacity. When full capacity is utilized, the company has an advantage over others. This may be possible due to location advantage or better labor relations. These will be looked into by the credit rating agency.

5. Legal position in terms of prospectus: The statements made in the prospectus, should be true and factual. If tall claims are made, they will hamper the growth of the company and the credit rating agency will not rely on the prospectus of the company. It may also be construed as a willful fraud for attracting more funds. So, the contents of prospectus will also be a factor for credit rating considerations.

6. Financial analysis based on accounting quality: If accrued incomes are taken for making a window-dressing of balance sheet, it will not reflect well on the quality of accounting of the borrowing concern. Companies relying on realized income, will be in a better position to provide a realistic balance sheet. So, the true financial position of the company will be judged not merely on the books of accounts but also on their market conditions in meeting their debt commitments.

7. Management evaluation: What is the track record of management? How far they are successful in steering the company under difficult conditions? Evaluation of management is one of the important functions of credit rating agencies.