Credit Rating – Meaning, Types, and Agencies in India

A credit rating is a calculated metric that provides a snapshot of financial strength of a particular individual or institution. The primary function of credit ratings is to assess the concerned entity’s ability to meet debt obligations. It is represented as an alphabetical measure unlike a credit score, which numerically represents an individual’s credit history and current credit health. A higher credit rating provides companies with access to more financing tools, at a reduced cost of capital. Likewise, for investors or lenders, credit ratings provide an evaluation of the borrower’s true financial strength, so they can make an informed decision. 

However, while both credit ratings and CIBIL scores help assess financial reliability, they are not the same.  A CIBIL score rating is about individuals and shows how likely they are to repay their loans. The CIBIL score is also influenced by factors like credit utilisation, length of credit history, credit mix, and credit utilisation ratio. On the other hand, a credit rating is used for businesses or governments to measure their ability to meet debt obligations. 

Key Takeaways of Credit Ratings

• Credit ratings are insightful tools that guide decision making for financial institutions, investors, and other parties.

• They provide a comprehensive assessment of the financial abilities of the concerned company or institution. 

• By revealing default risks,credit ratings act as an early warning system for investors, highlighting the risk component associated with low-rated companies.

Credit rating agencies consider a wide range of factors when evaluating a credit rating for a company or institution. Some of the factors affecting credit ratings include:

• Financial performance: A company’s financial performance including its profitability, liquidity, growth history, etc is considered.

• Debt position: Leverage and debt obligations of the company are assessed using metrics like debt-to-equity.

• Working capital: A company’s efficiency in working capital management is also assessed through short-term assets and liabilities. 

• Cash flows: A company’s historic and future cash flows are considered to understand the source of revenue and expenses and assess its inflows in the future.

• Management quality: Governance of a company is assessed by studying the competence and expertise of its management. 

• Surrounding risk: Various risk factors including market risk, industry risk, geographical risk, etc are studied to comprehend the company’s overall risk. 

Other factors like Environmental, Social, and Governance (ESG) initiatives undertaken by the entity, its asset quality, corporate governance, etc are also studied to accurately assign a credit rating. 

Credit ratings are crucial for assessing risk, determining loan terms, and making investment decisions. Some entities often rely on credit ratings for their decisions. These include:   

• Financial Institutions
  Banks, NBFCs and other financial companies use credit ratings to evaluate the creditworthiness of potential borrowers (individuals, businesses, or governments). This rating helps them make informed decisions about approval and loan terms.

• Investors: Retail and institutional investors use credit ratings to assess the risk associated with debt instruments and the overall financial health of a company.

• Corporations and Businesses: Corporations rely on favourable credit ratings to secure funding at lower interest rates and attract investors. 

• Governments: Governments use credit ratings to attract foreign investment and secure external funding. Ratings can also influence policy decisions related to financial markets and economic growth.

Credit ratings provide valuable insights to lenders and borrowers. The impact of credit ratings on borrowers and lenders include:

• Access to funding: For a borrower, a higher credit rating converts to higher credibility. Borrowers with higher credit ratings can secure funding or get approval for loans easily. 

• Cost of capital: Usually, a borrower with a lower credit rating is granted loans at higher interest rates. On the other hand, high-rated borrowers are eligible for lower interest rates due to their lower associated risk. 

• Risk Assessment: Credit ratings help lenders quantify borrower risk and price loans accordingly, reducing default probabilities.

• Investor confidence: Credit ratings provide investors with an enhanced confidence in the borrower and their ability to repay. 

• Recovery and Collection: Lower-rated borrowers often require more intensive monitoring and collection efforts.

Credit rating is important in India because it serves as an independent evaluation of a borrower’s creditworthiness, which impacts financial decisions across the economy. Key reasons include:

• Facilitating Capital Raising: Companies with good credit ratings can access funds at lower interest rates, making borrowing cheaper and supporting business growth.​

• Regulatory Compliance: Banks and other financial institutions rely on credit ratings to meet regulatory capital requirements and make prudent lending decisions.​

• Market Transparency: Ratings enhance market transparency by offering standardized risk assessment, which helps reduce information asymmetry between borrowers and lenders.​

• Corporate Governance: Good credit ratings reflect sound financial management and corporate governance, which builds reputation and trust in financial markets.​

• Economic Stability: Credit ratings contribute to the overall stability of the financial system by enabling better risk management and protecting investor interests.

Multiple stakeholders and purposes benefit from the use of credit ratings in India. Some of these include:

• Process of loan approval: Loan approvals by banks and lending institutions often rely on credit ratings to assess the default risk with associated entities. Thus, credit ratings facilitate faster approvals, interest rate calculations, etc. 

• Regulatory compliance: Rating agencies help banks and institutes comply with SEBI and RBI regulations that mandate credit ratings for many debt instruments above specified thresholds.

• Investors guidance: Investors investing in bonds and government issuances often rely on credit ratings to assess the risk involved in these debt securities.

• Capital market development: Credit ratings boost the transparency in the capital market by involving more participants and reducing information asymmetry.  

Credit ratings are also used to improve credibility with lenders in MSME financing, encourage financial transparency, and other areas. 

A rating is an opinion formed based on the information or data available at a specific point in time. However, as information evolves over time, the performance of the rated instruments may change. This may be due to market forces, internal policies, and myriad other factors.

This may impact a corporation’s or organisation’s future repayment capabilities which leads to an adjustment in the rating. Credit rating agencies usually update ratings every quarter.