What Is a Credit Rating?

Before you decide on whether to extend financing or credit terms to a company, you must first determine if the prospective entity will be able to meet its obligations. A ratings company provides an independent and objective assessment of the credit worthiness of a company. It assists investors / financiers to decide on how risky it is to invest or grant credit to a certain entity.

Does a Credit Rating help businesses?

When deciding on doing business with a new / prospective customer, the credit rating will certainly help the company in deciding one that is creditworthy and one that is not. It will also help in ascertaining an existing customer's credit standing and be alerted if it's credit quality were to subsequently deteriorate.

As investment and business opportunities become more competitive and diverse, you can no longer disregard potential business partners. Therefore, you need to differentiate the good investment opportunities from the relatively poorer ones. It is important to gain insight into the creditworthiness of companies and also to understand the risks and advantages these companies pose. In measuring the ability and willingness of an entity to fulfil its financial commitments or its debt requirements, credit ratings are essential tools. It also helps you make credit / financing decisions.

It is important to note that ratings are not equal to or the same as buy, sell or hold recommendations. Ratings are rather a measure of an entity's ability and willingness to repay its loan/debt obligations.

What do the ratings signify?

The ratings lie on a spectrum ranging between highest credit quality on one end and weakest credit quality on the other. Credit quality ratings are normally denoted with an alphanumeric or letter. For example, a triple A (AAA) is the highest credit quality, and C or D (depending on the agency issuing the rating) is the lowest or junk quality. Within this spectrum there are different degrees of each rating, which are, depending on the agency, sometimes denoted by a plus or negative sign or a number.

In the case of Default Probability (DP) Credit Rating, a "DP1" rating signifies a company with extremely strong financial fundamentals with very low credit risk. Companies that possess "DP1 to DP4-" credit ratings are companies with investment grade quality. "DP5+ to DP6-" are high yield grades. Companies that fall under "DP7+ to DP8" grades are considered to be high-risk.

Conclusion

A credit rating is a useful tool not only for the financiers, but also for the entities looking for financing. An investment grade rating can put a company on potential investors' radar, attracting funds to expand and grow the business and boosting a nation's economy. Indeed, the credit rating is key to showing their credit worthiness of the company. As the credit rating acts to facilitate credit and investments, many companies will strive to maintain and or improve their ratings, hence ensuring a stable business environment and a more transparent capital market.