A credit rating is a judgment given by a recognized rating agency, regarding the current financial status of a company and its ability to fulfill its financial obligations. It also represents the likelihood of the debtor default. Investors and other market participants consider these ratings while deciding whether or not to invest in them. Credit risk rating mainly shows how likely a borrower is to default on their obligations to repay a loan.
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How do they work?
Credit ratings are assigned by credit rating agencies to the credit risk of different securities such as bonds and loans. For example, an AAA rating is the highest rating, followed by AA, A, BBB, and so on. Ratings of BB and below generally indicate a higher credit risk or risk of default.
Who evaluates Credit Ratings?
After analyzing the overall financial information such as financial reports, industry perspectives, articles, and reports of the entity, a credit rating agency allocates an opinion on the current financial situation of the entity. Thus, in the end, after a thorough overall analysis, they provide a credit rating. The big three credit rating agencies are Moody’s Investor Services, Standard and Poor’s (S&P), and Fitch Group. Every agency operates using unique rating styles to indicate credit ratings.
Credit rating agencies normally appoint analysts who recommend a rating, and then a committee finally votes on the recommendation. Analysts use external and internal data to make an accurate forecast regarding the credit risk.
Importance of Credit Ratings:
Credit ratings help improve a capital marketplace. They issue transparent third-party information that’s standardized for consistency. Thus, this creates clear and fair judgment criteria for all entities across the financial markets. Every institution, body, or unit gets a trusted idea of the ongoing position of the entity they are looking to invest in. At the customer level, banks base the terms of a loan as a function of a credit rating or credit score; this typically means that the higher one’s credit rating is, the better the terms of the loan are. Thus, this can impact their ability to obtain a mortgage or a credit card.
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Final thoughts/Key Takeaways:
- A credit rating is not an assurance or guarantee of a kind of financial performance by a certain instrument of debt or a specific debtor. It’s simply an opinion from a recognized and trusted credit rating company to help investors make an educated and well-informed decision.
- For emerging economies, a positive credit rating is extremely important while demonstrating their creditworthiness to foreign investors. A higher credit rate also means there is typically a lower interest rate, thus reducing the chances of defaulting.
- There has been a lot of controversies around genuine credit ratings for the past few years and the 2008 financial crisis is the perfect example of this.
Author: Nishtha Bahal
About the Author: I’m an go-getter at life with the aim to collect small bits of knowledge from every part of the world.I see the world as a playground, full of swings and slides of different colors just waiting to be enjoyed upon. I believe that opportunities can be created rather than waited for, and I thus I dedicate every step of mine in the direction of constructing never-ending posssibilites for myself.