Question

(1) What are credit ratings?

(2) Credit rating agencies such as Moody’s and Standard & Poor’s use several factors to determine a company’s credit rating. Please list any three factors that can play a role in determining a company’s credit rating.

(3) Compared to companies with a poor credit rating such as D, companies with good credit ratings such as AA or AAA have to pay higher or lower interest to borrow money? Explain your answer.

Answer 1

1. Credit Rating:

Credit Rating is a symbolic indication of present opinion regarding the relative capability of a business entity to pay its Debts & Other related obligations in time with reference to the instrument being rated. It enables the proposed investor to differentiate beteen the instruments on the basis of their underlying credit quality.

It is an assessment of credit risk evaluation translated into current opinion as on a specific date on the quality of specific debt security issued.

2. Factors that can play a role in determining a company’s credit rating:

Credit rating is a long process involving a series of chronological steps.There are many factors which play important role in determining company's credit rating. Some of the Factors are as follows:

i) Capital Structure of the Entity:

Composition of external funds raised and retained earning, Fixed Dividend component for preference shares and Dividend component for equity shares also play an important role. Adequacy of Long Term Funds and entity's ability to raise further borrowing is also an important factor in Credit Rating.

ii) Assets owned by the Entity

Revenue generating ability of the existing and proposed assets play an important role in credit rating. Fair Values of the assets and anticipated technological and physical obsolescence are also taken into consideration. Recoverability of the Monetary assets like Trade Recivables is also checked.

iii) Liquidity of the Assets:

Whether working capital management of company is effective in maintaining liquidity is checked. The Corpoarate policies regarding stock and creditors are also verified. The ability of the entity to meet their commitment in short run is also ascertaied.

3) Compared to companies with a poor credit rating such as D, companies with good credit ratings such as AA or AAA have to pay a lower Interest to borrow money.

Because the Risk of Loosing the money is Lower in case of the Company with credit rating such as AA or AAA. In case of company with poor rating such as D, It has to pay a higher rate of Interest to companste the investors for the higher risk. Due to Risk-Reward theory, Investors have to be paid more rewards for taking more risk.