Understanding credit ratings

You may have often noticed the debt funds’ discussions hovering around credit ratings and credit risks. We are going to detail it here for you to understand what these are and how they work. Are you ready? Let us begin!

Credit ratings denote the ability of an entity to repay the loan they are undertaking. In other words, they help you assess the risk associated with bodies like Corporates, the Government, and so on when you decide to lend them money via fixed-income instruments. This risk is called the credit risk, which is often one of the deciding factors when choosing the suitable debt funds for investment. These ratings are ascertained by the various credit rating agencies. The ratings vary from AAA to D, on the basis of the creditworthiness, with AAA being the highest rating. Needless to say, higher the credit rating, better are the chances of the entity repaying the loan.

The credit rating of an entity is not permanent. The assessment is continuous in nature. Hence, when the agencies upgrade a company’s credit rating, it implies that the company now has a better chance of repaying the loan than before. Alternatively, a reduced credit rating implies that the repayment capability has reduced.

Knowing the credit rating of these instruments can help you in many ways

1. It tells you about the creditworthiness of the borrower

2. It can help you determine a suitable debt fund for investment, given your goals, risk appetite, etc.

3. The borrowers are continuously thriving to improve their credit rating because it increases their borrowing capacity.

The process of determining credit ratings involves a thorough qualitative and quantitative analysis of the organisation/entity. Each agency may have its own method of calculating the rating, and hence, the results need to be looked at collectively. They take into account the lending and borrowing history of the entity, financial statements, the type of debt undertaken, nature of the business, revenue/costs, and many such other factors when determining the ratings.

These ratings, however, are not to advise the investors. They mean to be data and information that can be employed by the investors to make more sound decisions. A credit rating can be of two types- short-term, or long-term. A short-term credit rating tells you the possibility of the entity to default within 1 year of borrowing and the long-term rating indicates the same possibility in the extended future.

Source: https://scripbox.com/mf/credit-rating/

The foremost difference between the two is that the former is given to an organisation/entity, while the latter is assigned to individuals. Credit ratings determine the creditworthiness of companies/businesses and range from AAA to D, as seen in the above table. The credit score is a number, usually in the range of 300-700, assigned to individuals.

The thing in common between both is that they both measure the possibility of an individual being able to repay a loan.

Now that you know about credit ratings, you can read here to know more about the credit risk.

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