What are the Purposes of Credit Rating?

Credit Rating is a 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. It enables the investor to differentiate between debt instruments on the basis of their underlying credit quality. To facilitate simple and easy understanding, credit rating is expressed in alphabetical or alphanumerical symbols.

A rating is specific to a debt instrument and is intended to grade different such instruments in terms of credit risk and ability of the company to service the debt obligations as per terms of contract namely – principal as well as interest. A rating is neither a general purpose evaluation of a corporate entity, nor an over all assessment of the credit risk likely to be involved in all the debts contracted or to be contracted by such entity.

Though credit rating is considered more relevant for gradation of debt securities, it can be applied for other purposes also.

The various purposes for which credit rating is applied are :

(1)     Long-term / Medium-term debt obligations such as debentures, bonds, preference shares or project finance debts are considered long-term and debts ranging from 1 to 3 years like fixed deposits are considered medium-term;

(2)     Short-term debt obligations  the period involved is one year or less and cover money market instruments such as commercial paper, credit notes, cash certificates etc.;

(3)     Equity Grading and Assessment, structured obligations, municipal bonds, mutual fund schemes, plantation schemes, real estate projects, infrastructure related debts, ADR, GDR issues, bank securities etc.

Credit rating does not bound the investor to decide whether to hold or sell an instrument as it does not take into consideration factors such as market prices, personal risk preferences and other consideration which may influence an investment decision. It does not create any fiduciary relationship between the rating agency and the user of the rating. A credit rating agency does not perform an audit but relies on information provided by the issuer and collected by the analysts from different sources hence it does not guarantee the completeness or accuracy of the information on which the rating is based.

In determining a rating, both qualitative and quantitative analysis are employed. The judgement is qualitative in nature and the role of the quantitative analysis is to help make the best possible overall qualitative judgement or opinion. The reliability of the rating depends on the validity of the criteria and the quality of analysis.

The quality of credit rating mainly depends upon and quality of the rating agency, rating elements also. The agency should have good reputation, personal competence, independence, qualified and experienced staff.