The Introduction To The Credit Rating Finance Essay - Free Essay Example

Credit Rating is the symbolic indication of the current opinion regarding the relative capability of a corporate entity to service its debt obligations in time with reference to the instrument being rated. Credit rating is done by the Credit Rating Agencies which specialize in analysing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities. Credit Rating is a representation of the credit-worthiness of an individual, business-entity or instrument of a business.  [1]  Yet ratings merely express an opinion on the credibility of the entity and cannot be considered to be an advice. The evaluation of the creditworthiness of any entity is based on several grounds, most important of them being: Ability to pay and Willingness to pay.  [2] There have been numerous instances in the past where the fly-by-night operators have cheated unwary investors. In these situations, it has become increasingly difficult for an ordinary investor to distinguish between safe and good investment opportunities and unsafe and bad investments. Investors have come to a conclusion that a borrowers goodwill is no longer a guarantee of payment of interest and principal on time. Therefore, the need of having a credit rating mechanism is necessary where the creditors can issue loans accordingly. The rationale behind the presence of Credit Rating Agencies is to solve the problem of the informative irregularity between lenders and borrowers regarding the creditworthiness of the borrower. Issuers with lower credit ratings will have to pay higher interest rates embodying larger risk premiu ms than higher rated issuers. Moreover, ratings determine the eligibility of debt and other financial instruments for the portfolios of certain institutional investors due to national regulations that restrict investment in speculative-grade bonds. Concept of Credit Rating: Essentially, credit rating is an instrument used by the creditors to determine the extent till which they can trust a particular borrower (any individual, corporation or entity). The procedure, involves assessing the capacity of issuer to generate cash from operations and estimating the adequacy of this approximation vis-à  -vis the issuers debt servicing liabilities over the tenure of the instrument.  [3] Credit rating is used extensively for evaluating debt instruments. These include long-term instruments, like bonds and debentures as well as short-term obligations, like Commercial Paper.  [4]  In addition, fixed deposits, certificates of deposits, inter-corporate deposits, structured obligations including non-convertible portion of partly Convertible Debentures (PCDs) and preferences shares are also rated. The Securities and Exchange Board of India (SEBI), the regulator of Indian Capital Market, has now decided to enforce mandatory rating of all debt instruments irresp ective of their maturity.  [5] This project talks about the process of credit rating done by the credit rating agencies. Credit Rating Meaning, History and Importance Credit rating is a process where a symbol with specific reference to the instrument being rated is assigned, which performs as an indicator of the current opinion on capability on the issuer to service its debt obligation in a timely fashion, is known as credit rating.  [6] As Moodys has put it, A rating on the future ability and legal obligation of the issuer to make timely payments of Principal and interest on a specific fixed income security. The rating measures the probability that the issuer will default on the security over its life, which depending on the instrument of the expected monetary loss, should a default occur.  [7] According to ICRA, Credit rating is an advice on the relative capability of timely service of corporate debt and obligations. It is not a recommendation to buy or sell; neither the accuracy nor are completeness of the information guaranteed.  [8] Credit Rating Agencies rate the aforesaid debt instruments of companies. They do not rate the companies, but their individual debt securities. Rating is an opinion regarding the timely repayment of principal and interest thereon; it is expressed by assigning symbols, which have definite meaning. It is important to emphasize that credit ratings are not recommendations to invest. They do not take into account many aspects, which influence an investment decision. They do not, for example, evaluate the reasonableness of the issue price, possibilities of earning capital gains or take into account the liquidity in the secondary market. Ratings also do not take into account the risk of prepayment by the issuer, or interest rate risk or exchange rate risks. Although these are often related to the credit risk, the rating essential is an opinion on the relative quality of the credit risk. Ratings are not a guarantee against loss. They are simply opinions, based on analysis of the risk of default. They are helpful in making decisions based on particular preference of risk and return . History of Credit Rating: Credit rating was started in 1840 after the economic crisis of 1837 in the United States. Following to this, the first Mercantile Credit Agency was set up in New York by Louis Tappan in 1841.  [9]  Subsequently, the first credit rating guide was published in 1859.  [10]  Then, in 1900 John Moody founded Moodys Investors Services and in 1909 published his manual of Rail Road Services. In addition to his publishing business, John Moody (Moodys Investors Services) started publishing ratings for railroad bonds from the year 1909. The credit rating system originated in the USA in seventies. The high levels of default, which occurred after Great Depression, in the US capital markets, gave the impetus for the growth of credit rating. The default of $82 million of commercial paper by Penn Central in the year 1970. And the consequent panic of investor in commercial papers, resulted in massive defaults and liquidity crisis. US made rating Mandatory for institutions such as Govt Pe nsion funds, and Insurance companies. In Indian scenario, the Credit Rating Information Service of India was set up in 1987. After it, Investment Information and Credit Rating Agency of India was raised in 1991 and finally, Credit Analysis and Research Limited was established in 1993.  [11] Importance of Credit Rating Credit rating is an indicator that reflects how well or badly you manage your financial matters. By having a look at your credit rating, one can get much information regarding your business organization and particularly the payments made by your organization. There are several credit bureaus that compile this kind of information and later on sale it to their clients. The credit rating of a company list quite of data about its financial actions which includes its loans or credit accounts, and how has it repaid them, its existing loans, type of amount overdue etc. All these information are listed in the rating report. The creditors or the offering agencies consider the credit rating to decide if they can finance the company without any peril. Any data which is uncertain creates a negative impact and can affect the company in many ways. Its not just about getting a loan sanctioned but also for the determination of the rate of interest. In a case where the rating is lower, the rate of interest will be higher accordingly. Credit Rating Process and Methodology The rating process starts with the acknowledgement of formal request from a corporation wishing of having its obligations rated by any CRA. The Credit rating agencies of the country follow somewhat similar procedure which consists of 9 to 10 steps. They are, Receipt of Request Assignment to the team Obtaining Information Visits to the plant and management meetings Presentation of findings Rating committee meeting Communication of decision Dissemination to the public Monitoring for public use Rating Methodology: The rating methodology comprises of an examination of all the issues which affect the creditworthiness of an issuer corporation e.g. business, financial and industry features, operational competence, management quality, competitive position of the issuer and commitment to new projects etc  [12]  . Then, a thorough examination of the past financial statements is made to evaluate the performance and to estimate the future incomes. The companys ability to repay the debt obligations over the tenure of the instrument being rated is also evaluated in the credit rating. While assessing the instrument, there are five main factors that are analyzed into detail by the credit rating agencies. They are explained as under: Business Risk Business risk examination aims at estimating the industry risk, position of the company in the market, its operating competence and legal position of the company. This includes an analysis of industry risk, market position of the company, operating efficiency of the company and legal position of the company. Financial Risk Financial analysis aims at estimating the financial strength of the issuer company through ratio analysis, cash flow analysis and study of the existing capital structure. This includes an analysis of four important factors namely: Accounting quality (c) Earnings potential/profitability Cash flows analysis (d) Financial flexibility  [13] Financial analysis aims at determining the financial strength of the issuer company through quantitative means such as ratio analysis. Both past and current performance is evaluated to comment the future performance of a company. Management Evaluation Any companys performance is significantly affected by the management goals, plans and strategies, capacity to overcome unfavorable conditions, staffs own experience and skills, planning and control system etc. Rating of a debt instrument requires evaluation of the management strengths and weaknesses. Bu siness Environmental Analysis This includes regulatory environment, operating environment, and national economic outlook, areas of special significance to the company, pending litigation, tax status, and possibility of default risk under a variety of scenarios. Rating is not based on a predetermined formula, which specifies the relevant variables as well as weights attached to each one of them. Credit rating is a dynamic concept and all the rating companies are constantly reviewing the companies rated by them with a view to changing (either upgrading or downgrading) the rating. Broadly, the rating agency assures itself that there is a good congruence between assets and liabilities of a company and downgrades the rating if the quality of assets depreciates. Credit Rating Agencies in India In India, as of now, there are 4 credit rating agencies which are as follows: Credit Rating and Information Services of India Limited (CRISIL). Investment Information and Credit Rating Agency of India Limited (IICRA) . Credit Analysis and Research Limited (CARE). Duff and Phelps Credit Rating of India (Pvt.) Ltd. CRISIL: CRISIL, the first credit rating agency of India was established on January 1st, 1998 by ICICI UTI with an equity capital of Rs-4 cr. The objectives of CRISIL are to assist both individual institutional investors in making investment decisions in fixed income securities, to enable corporate to raise large amounts at fair cost from a wide spectrum of investors and to enable intermediaries in placing their debt instruments with investors by providing them. CRISIL rates debentures, fixed deposits, commercial papers, preference shares and structured obligations. It also publishes a CRISIL rating in scan that is published quarterly. IICRA Promoted by IFCI in 1991, ICRA is a public limited company with a share capital of Rs. 101 crores. The factors that ICRA takes into consideration for rating depend on the nature of borrowing entity. The inherent protective factors, marketing strategies, competitive edge, competence and effectiveness of management, human resource development policies and practices, hedging of risks, trends in cash flows and potential liquidity, financial flexibility, asset quality and past record of servicing of debt as well as government policies affecting the industry are examined. Besides determining the credit risk associated with a debt instrument, ICRA has also formed a group under Earnings Prospects and Risk Analysis (EPRA). Its goal is to provide authentic information on the relative quality of the equity. This requires examination of almost all parameters pertaining to the fundamentals of the company including relevant sectoral perspectives. CARE The credit analysis and research limited was promoted jointly by the IDBI and investment companies, banks and finance companies in 1993. It offers credit rating, information service, equity research and rating parallel market of LPG kerosene. It publishes CAREVIEW which is a quarterly journal of CARE ratings where it rates Debentures, Certificate of deposits, Commercial paper and Fixed deposits. Benefits of Credit Rating Credit rating serves useful tool for different constituents of the capital market. For different classes of persons, different benefits accrue from the use of rated instruments. The credit rating agencies are valued for their neutral viewpoint and expertise in credit risk analysis and therefore, investors rely heavily on credit rating data. The major benefits of credit ranking are as follows: Low Cost Information Quick Investment Decision Independent Investment Decision Investment Protection For the sake of convenience, Ive divided the benefits into sub-categories for different kinds of markets. Theyre as follows: Benefits for the investors Credit rating saves the time and energy in studying companys financials, as it is a strong indicator of companys financial capacity. Since the ratings represent the informed opinion of a neutral third party, therefore investors prefer it. Guidance in making an investment decision by being presented with a wide variety of safe choices through Credit Rating. It is a perpetual monitoring and surveillance by the CRA on the debt instrument leading to effective risk management strategies. CRA evaluates the companys financial capacity regularly which helps the investor to exit the investment, in case rating is downgraded subsequently. Benefits to Rated Companies Credit rating is a source of additional certification on any of the debt instruments. It not only attracts a higher number of investors but also forewarns them of risk involved in the transactions. It encourages financial discipline amongst the corporates and better financial planning thus, it has made merchant bankers job has been made easy. Credit rating also makes the interest rates competitive and thus, the companies can compare their situations and can choose which company to go with. Moreover, having a good rating will increase the confidence of the company in the market too. Benefits for the issuer The credit rating has expanded access to capital markets by issuing of rating, the issuers would be interested in investing money. It has also lowered financing costs for the issuers. This has proved to be boon for a first time and unknown issuer in order to establish his market credibility thus, he can perform his business. Plus, having a better rating would serve as a motivation for better performance for the first time issuer. Limitations of Credit Rating There are several limitations of credit ratings. First, credit ratings are altered when the agencies feel that enough alterations have occurred. The rating agencies are actually not capable to supervise all the firms in the market at a constant rate. The estimations of CRAs may turn wrong in the background of events that may have a contrary impression on asset quality of the issuer subsequently. Second, using credit ratings executes distinct categories on default risk, while, and actually default risk is a continuous occurrence. Moodys recognised this way back in 1982 by adding numbers to the letter system, thereby increasing its number of rating categories from 9 to 19.  [14]  However, this limitation still pertains. The ratings assigned by rating agencies serve only as a general, somewhat uneven form of perception. Third, due to limitations of time and cost, credit ratings find themselves not in a position to capture all characteristics for an issuer and issue. Moreo ver, a few of the major drawbacks of credit rating are its orthodox nature (depends on past data) which in a dynamic market context can have severe penalties including emphasizing a systemic crisis like the current global crisis, and its disappointment and reluctance to capture/cover market risks. Assessing market risk can hypothetically make the rating exercise prospective, could avoid sudden and reduce the cyclicality of rating. A really conversant prospective rating could potentially also capture tail risks and forewarn the system to help take systemic steps well in advance to avoid panic. Conclusion Credit Rating refers to assessment of debt instruments which include both long-term instruments like bonds and debentures, and short-term obligations like Commercial Paper. Moreover, fixed deposits, certificates of deposits, etc. are also rated. Now the SEBI has decided to rate all debt instruments irrespective of their maturity compulsorily.  [15]  It serves the purpose of a useful tool for different elements of the capital market namely financiers, issuers of debt instruments, financial intermediaries, business enterprises etc. Issuers of high-risk securities have to pay higher rates of interest in form return than issuers of low risk securities. Although, number of difficulties arise in the quality rating assigned to an issue. Primarily the issuers capacity to pay, the strength of the claim of the security owner, the economic significance and size of the issuer are taken into consideration in Credit Rating purpose of rating. The CRA issued ratings do have many limitations, a few important of these are as follows: Credit rating change occasionally. Any rating imitates default risk and not the price risk related with changes in the level or shape of the yield curve, etc. However, the standing of an agency builds a confidence in investor. Credit rating in recent times is being seen as a vital investment counselling function. In developed economies like the United States, and Japan, yet there is no legal obligation to have the securities rated, as high as 90 per cent of the securities drifted are willingly rated due to the pressure applied by investors and bankers. In developing economies like India, an initiative has been launched with the formation of CRISIL and the contention of the RBI that all commercial papers to be rated prior to their issue. With the increase in size of capital markets and the increasing knowledge and consciousness among the investors, it can be expected that voluntary credit rating would be on the hike anytime soon.