It is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation.
A credit rating can be assigned to any entity that seeks to borrow money – an individual, corporation, state or provincial authority, or sovereign government.
Credit assessment and evaluation for companies and governments is generally done by a credit rating agency such as Standard & Poor’s, Moody’s or Fitch.
These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.
Why are Credit Ratings important?
Credit ratings for borrowers are based on substantial due diligence conducted by the rating agencies. While a borrower will strive to have the highest possible credit rating since it has a major impact on interest rates charged by lenders, the rating agencies must take a balanced and objective view of the borrower’s financial situation and capacity to service/repay the debt.
A credit rating not only determines whether or not a borrower will be approved for a loan, but also the interest rate at which the loan will need to be repaid. Since companies depend on loans for many start-up and other expenses, being denied a loan could spell disaster, and a high interest rate is much more difficult to pay back.
Credit ratings also play a large role in a potential buyer's determining whether or not to purchase bonds. A poor credit rating is a risky investment; it indicates a larger probability that the company will not pay off its bonds.
Credit rating changes can have a significant impact on financial markets. A prime example of this effect is the adverse market reaction to the credit rating downgrade of the U.S. federal government by Standard & Poor’s on August 5, 2011. Global equity markets plunged for weeks following the downgrade.
Factors Affecting Credit Ratings and Credit Scores
There are a few factors credit agencies take into consideration when assigning a credit rating to an organization.
First, the agency considers the entity's past history of borrowing and paying off debts. Any missed payments or defaults on loans negatively impact the rating.
The agency also looks at the entity's future economic potential.
If the economic future looks bright, the credit rating tends to be higher; if the borrower does not have a positive economic outlook, the credit rating will fall.