Credit Rating Agencies

INDEX

IntroductionMeaning & DefinitionOrigin of the concept of credit rating Importance of credit ratingFunctions of a Credit Rating AgencyCredit rating agencies in IndiaRating methodologyRating symbolsLimitations of credit rating in India

A credit rating estimates the credit worthiness of an a financial security, a corporation, local government or even a country.

It is an evaluation made by credit reporting agency of a risk of buying into a specific security offering and based on a number of factors.

Typically, a credit rating tells a lender or investor the probability of the subject being able to meet payment requirements for interest and principal repayment.

INTRODUCTION

MEANING & DEFINITION

• A Credit Rating issued by a credit rating agency is an assessment of the credit worthiness of individual financial securities (For example, a bond) and debt issued by corporations, government issued securities or even a country’s ability to repay debt.

• Credit ratings are forward-looking opinions about credit risk. It express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time.

ORIGIN OF THE CONCEPT OF CREDIT RATING

• This concept originated in the US in 1909 when the founder of Moody's Investors Service, John Moody, rated the US Rail Road Bonds. However, the relevance of this concept was realized only after the great depression when investors lost all their money.

• Lack of symmetric information & high cost of collecting information increased the popularity of credit rating agencies. The worlds biggest rating agencies are Moody's Investor Service and Standard & Poor’s (S&P).

IMPORTANCE OF CREDIT RATING

An investor uses the ratings to assess the risk level and compares the offered rate of return with his expected rate of return (for the particular level of risk) to optimize his risk-return trade-off.

The risk perception of a common investor, in the absence of a credit rating system, largely depends on his familiarity with the names of company and what they might know about the company.

For the typical investor, it would difficult to assess all of the financial information available to assign their own risk ratings.

FUNCTIONS OF A CREDIT RATING AGENCY

• Provide easy to understand information: Rating agencies gather information, then analyze information to interpret and summarize complex information in a simple and readily understood manner.

• Provide basis for investment: An investment rated by a credit rating enjoys higher confidence from investors. Investors can make an estimate of the risk and return associated with a particular rated issue while investing money in them.

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• Healthy discipline on corporate borrowers: Public exposure has healthy influence over the management of issuer because of its desire to have a clear image.

• Formulation of public policy guidelines on institutional investment: Once the debt securities are rated professionally, it would be easier to formulate public policy guidelines as to the eligibility of securities to be included in different kinds of institutional portfolios.

CREDIT RATING AGENCIES IN INDIA

The prominent credit rating agencies in India are

• CRISIL - Credit Rating and Information Services of India Ltd.

• ICRA - Investment Information and Credit rating Agency of India Ltd.

• CARE Ratings - Credit Analysis and Research Ltd.

CRISIL is the market leader in the credit rating industry with 70 per cent market share

RATING METHODOLOGY

In India the process of obtaining a rating is quite lengthy and time consuming.

The analytical framework for rating consists of the fallowing broad areas.

1. Economy analysis2. Business analysis3. Financial analysis4. Management evaluation5. Fundamental analysis

1. ECONOMY ANALYSIS

• The economic environment is assessed to determine the degree of operating risk faced by the company in a given business.

• Here the economy wide factors which have a bearing on the industry are taken into consideration.

2. BUSINESS ANALYSIS

It covers the analysis of

a) Industry risk: Industry risk covers an analysis of actual and estimated demand/supply, number of firms, potential entrants in the industry, government policies relating to the industry, the performance of the industry, its future potentiality etc.

b) Market position in the industry: It covers the study of market share of the firms (Marketing strength & Weaknesses of the firm comparing with its competitor)

c) Operating efficiency of the company: Operating efficiency is a study of production processes of the firm, its cost structure, location advantages, labor relationships etc

d) Legal positions: It is the study of prospectus, accuracy of information, filling of forms, returns and so on with proper regulatory authorities.

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3. FINANCIAL ANALYSIS

• It involves evaluation of past and expected future financial performance with emphasis on assessment of adequacy of cash flow towards debt servicing.

• Financial analysis includes an analysis of accounting quality, earning protection, cash flow adequacy & financial flexibility.

4. MANAGEMENT EVALUATION

• This includes the study of the track record of the management, the managements capacity to overcome adverse situations, goals, philosophy, strategies, control system, personnel policies & performance of group of companies.

5. FUNDAMENTAL ANALYSIS

• This covers liquidity management, asset quality, profitability and interest & tax sensitivity.

RATING SYMBOLS

Rating agencies use symbols to convey the safety grade to the investors.

Ratings are classified into three grades: high investment grades, investment grades & speculative grades.

HIGH INVESTMENT GRADES

• AAA – Highest safety in terms of timely payment of interest and principle. The issuer is fundamentally strong and any adverse changes are not going to affect.

• AA – High safety in terms of timely payment of interest and principle.

INVESTMENT GRADES• A – Adequate safety, Changes in circumstances can adversely

affect such issues.• BBB – Moderate safetySPECULATIVE GRADES• BB – Inadequate safety, uncertain changes can lead to

inadequate financial capacity to make timely payments in the immediate future.

• B – High risk, Adverse changes could lead to inability or unwillingness to make timely payment.

• C – Substantial risk, Issue rated is vulnerable to default.• D – Default in terms of timely payment of interest and

principle.

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Australia

Canada

India

ChinaU.S

Argentina

Brazil

Russia

Saudi

Mexico

S.Afri

ca

EGYPT

IranLibya

Algeria Sudan

Peru

Kazakhstan Mongolia

LIMITATIONS OF CREDIT RATING IN INDIA

The credibility of rating is questionable.

A frequent revision of grading by credit rating agencies.

The rating agencies do not perform an audit but rely solely on information provided by the issuer.

Rating agencies offer consultancy and financial advice to the clients whose paper they rate.

Thank You