What is a Credit Rating?
A credit rating represents a measurement of a borrower’s creditworthiness. It comes from a credit agency that shows their opinion of an entity’s ability and willingness to fulfill its financial obligations. Usually, credit rating agencies look at various factors to determine an entity’s credit rating. It includes looking at their historical loans and repayments.
There are various scales that credit rating agencies may use as there is no standard for credit rating measurement. However, the most common one is the S&P scale. S&P ranks borrowers from a scale of AAA up to D. The AAA scale is for credits with the best credit ratings. After that, entities may get an AA, A, BBB, BB, B, CCC, CC, and C rating. Lastly, they can also get a D rating, which is the worst credit rating and means Default.
While credit ratings are prevalent across various fields, they do not represent an assurance or guarantee. Since these ratings come after evaluating an entity’s historical records, they cannot predict future performance. However, that does not imply that credit ratings are not important. Credit rating has various uses in practical financial transactions.
Why is Credit Rating important?
As mentioned, credit ratings are relevant in various fields, especially those associated with finance. Similarly, in debt transactions, credit ratings can be crucial for both borrowers and lenders. Given below are some of the ways in which credit ratings can impact transactions.
Risk evaluation and management
Most lenders use credit ratings as a risk evaluation and management tool. Once lenders determine a borrower’s credit rating, they can decide whether to provide them with a loan. Similarly, based on the credit rating, lenders can evaluate how much risk they are taking with a transaction. Credit ratings are also crucial for institutional and individual investors in risk evaluation and management.
Cost of borrowing
Credit rating is also important in determining the cost of borrowing of a debit transaction. For entities with a higher credit rating, the borrowing cost will be lower. It is because the lender takes lower risks and, hence, provides borrowers with better terms. On the other hand, the borrowing costs for entities with a low credit rating can be significantly higher.
Required by lenders
Most institutional lenders require borrowers to have a high credit rating. In case they fail to meet this requirement, they cannot secure a loan from the issuer. Similarly, non-institutional lenders may also look at the borrower’s credit rating to assess their investment risk. For example, investors may look at a bond-issuing company’s credit rating before investing in its bonds.
Source of finance
While credit ratings cannot be sold or purchased, they can be a source of finance. Entities with a higher credit rating can easily secure loans or finance as compared to others. Therefore, credit ratings can play a significant role in generating finance for most entities. It means even smaller companies can get funds if they have a good credit rating.
Credit ratings represent a measurement of a borrower’s creditworthiness based on their historical performances. There are various scales of credit ratings, which may differ according to the issuing agency. While these ratings consider historical information, it does not imply they are useless. Credit ratings can be of significant importance for various users, as mentioned above.