The three nationally recognized credit rating agencies for publicly quoted companies are Moody's, Standard & Poor's and Fitch Ratings. Investors use these credit ratings as a benchmark for identifying quality investments and to assess the risks associated with their investment decisions.
Credit rating agencies assign ratings by way of letter grades. Ratings scale between AAA and D, with AAA to BBB being potentially good quality investments and the others being classified as 'junk' investments. These ratings are assigned by analyzing a company's past financial dealings, repayment capabilities, amount of debt to equity, liquidity, cash flows, timing of repayments, and other disclosed/undisclosed contingencies that could affect the company. The standards and procedures used aim to make the rating as credible as possible. The evaluations are an on-going process and ratings are provided as of a specific date.
Companies subscribe to theses credit rating agencies because of the value placed by investors on the ratings and because of the direct correlation it has on their ability to access capital. From the point of view of the company, by selecting an agency that is well recognized by the market for their competent and accurate rating, they are better able to lure investors and creditors to invest in their companies. The rating directly affects the access to capital and the cost of capital. A good 'investment-grade' rating means the company is recognized as stable and reliable and is therefore in a position to access larger amount of capital at lower interest rates. Conversely, a low rating means the overall value of the company is generally low and consequently, the cost of borrowing is higher. The lower rating also means the shares and bonds are less attractive in the secondary market and therefore less liquid.
Investors too have to subscribe to the credit rating agencies in order to access the detailed information. The reports provide a general description of the company, their financial standing, the bases used to determine the rate, and the process for issuing and monitoring credit ratings. Investors use these rating as a starting point in identifying sound investments, to assess the risks and likelihood of timely repayment and profitability. Investors who prefer low but stable return prefer to buy investment-grade securities whereas the return from high risk investment is comparatively higher because of the high risks involved.
In issuing and maintaining the credit rates, the credit rating agencies rely on information it receives from the company. The agencies conduct an investigation to verify the authenticity of the factual information through its rating methodologies, financial reports, audit reports, legal issues, and from independent sources. It is important to note, these credit rating agencies do not search for fraud nor do they perform audits of rated companies, and therefore the analysis of their credit rating is greatly dependent on the quality of information provided to them. The agencies generally make these ratings available to both the subscribers as well as non-subscribers; however subscribers have access to detailed reports.
Next the role of credit rating agencies for creditors determines not only the credit worthiness of the companies they trade with but also determines the line of credit available for them. Major credit reporting agencies for small businesses are Experian and Dun & Bradstreet (D&B). Creditors use these ratings to assess a company's ability to repay its obligations in a timely manner.
Small businesses and companies subscribe to these credit rating agencies because it measures the financial risks of the companies they are dealing with and the new companies they hope to deal with in the future. Maintaining a high credit rating is beneficial for the company as it determines how much credit their suppliers are willing to give them and their ability to obtain funding for purchasing new machinery or expansion. A high rating also means the liquidity position of the company is good and the probability of default is minimal. In addition, it helps the company to increase its inventory, attract new investors, increase its line of credit, partner with another company, and sell its business. In effect the rating agencies analyzes the financial information and provides a platform that connects creditors and buyers with good ratings thus minimizing bad debts and increasing liquidity.
Creditors use the credit rating agencies to check the ratings of the companies to make sure they are paid for the goods and/or services they have provided. The rating helps them to determine which companies they want to trade with, the terms of the trade, and the line of credit they are willing to give. The rating also helps the creditors to see whether the company is responsible in its payment procedures, has the liquidity to repay its debts, and has assets to provide as collateral if necessary.
Credit rating agencies issue and maintain credit by gathering information from the companies with which the business had financial relationships. It also uses financial statements, audit reports, and lawsuits to analyze the rating. The most important factors that determine a company's credit report is how promptly the business repays it obligation, the structure of the company's debts, payment history, cash flow, working capital, and net worth. The credit report also contains a brief history of the company, number of employees, and its size and structure. By factoring in the profile of the company, the rating provides the creditors the size and scope of the companies they are dealing with or hope to deal with.
In today's times, with the uncertainties in the economy and intense competition it is important for investors and creditors to use the credit ratings provided by these agencies to make informed decisions. Although there have been criticisms leveled against theses agencies for the recent credit crisis, change in credit ratings still has an impact on a company's access to capital. According to CFA President of CT Capital LLC., Kenneth Hackel, "Credit ratings impact cost of capital and stock valuation in a myriad of ways. Higher ratings not just allow for lower borrowing costs but can be a magnet for additional business and better terms from suppliers" (Hackel, 2010). Investments and businesses are being transacted at a faster pace than before because of the Web and hence the role of theses credit rating agencies in providing ratings is crucial for investors and creditors to use the ratings to filter good investments, better understand the company they are investing in, and identify credit worthy customers.
