Concept of ‘Credit Rating’

By Ankita Agarwal on October 12, 2012
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Money plays critical role in human life. It is not only a means to attain basic necessities of life but also a means to secure the future. Over time, human life has become complex and it is essential to earn not only for the present but also to invest for the future. The competition is tough in the marketplace and companies need huge funds to survive and expand. For the purpose of securing funds, the companies issue equity and debt instruments to public. Raising funds from capital market is common today and it provides the investors with variety of investment options. But very few people have the time and in-depth knowledge to chose the most profitable and secure investment option. As such the investors look for an investment guide who can help them invest their money at the right place. This led to the emergence of credit rating agencies which act as independent entities providing objective investment guidance to the investors. These agencies rate various debt instruments and help the investors to compare relative credibility and repayment ability of the debt instruments.

Understanding Credit Rating

In simple terms, credit rating is current opinion on the likelihood of repayment of principal as well as interest on a particular debt instrument. Credit rating depicts the opinion of a credit rating agency on relative capability of the issuer of debt instrument to service its debt obligation on time. It is the assignment of grade to a specific debt instrument by the credit rating agency after analyzing the instrument’s credit risk. Credit rating is always specific to a debt instrument and is a relative concept. The credit ratings are usually expressed as alphabetical or alphanumerical symbols. For example- Credit Rating Information Services of India Limited (CRISIL) assigns ‘AAA’ to denote ‘highest safety’ and ‘D’ for likelihood of ‘default’. Credit rating however is just an opinion and it acts as an investment aid to the investors but not a recommendation. Rating does not assure the investors of the repayment but it is just an opinion of the relative degree of risk associated with a particular debt instrument. The ratings are assigned after a long process of analyzing both qualitative as well as quantitative factors.

Credit Rating is Important

A number of companies proved to be a defaulter in recent times and the hard-earned money of investors went into a waste. It is therefore important to have some criteria to judge the credibility of issuers.  Credit rating offers various advantages to both the general investors as well as to the debt issuing companies. For investors, the credit rating provides handy information on the likelihood of repayment of debt by the debt issuing company so that the investors make a better investment decision. A good credit rating can be treated as a symbol of safe investment. It helps the investors to design an efficient investment portfolio selecting the best options from the wide spectrum of investment options. For the debt issuing company, the credit rating acts as a means to raise debt from public at a cheaper rate. If the issuer gets a good grade, it helps to secure a wide investor base and enhances the goodwill. The company wins over public faith and it proves to be of great help during adverse times.

References

  • Gurusamy, S. 2nd Edition. (2009). Essentials of Financial Services. New Delhi: Tata McGraw-Hill Publishing Company Limited.
  • Gurusamy, S. 3rd Edition. (2009). Merchant Banking and Financial Services. New Delhi: Tata McGraw-Hill Publishing Company Limited.
  • Shah, P. (2008). Financial Management. New Delhi: Biztantra.
  • http://crisil.com/ratings/faqs.html
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