Credit Ratings 101

Credit ratings provide forward looking opinions into the financial health and repayment capacity of borrowers.

Article Topics

• What are Credit Ratings?

• Why Should You Perform A Credit Review?

• What Factors Impact a Credit Rating?

• Credit Rating Scale

What are Credit Ratings?

A credit rating evaluates a counterparty's ability to fulfill its financial obligations, commonly referred to as creditworthiness.

These ratings, typically represented by letters or numbers, are tied to the likelihood of default. Beyond estimating default probability, credit ratings establish a standardized and transparent framework for identifying and communicating credit risk effectively.

Since risk and reward are inherently linked, users evaluate risk levels in relation to potential profitability, allowing you to make well-informed, risk-adjusted decisions.

Counterparties with lower default probabilities typically enjoy benefits such as reduced interest rates, lower collateral requirements, and more favorable terms or pricing.

Credit ratings serve as a complement to your own research, analysis, and judgment, rather than a replacement.

Benefits of Credit Ratings

Credit ratings are not just mere numbers or labels, but serve as insights into the financial health of both private and public companies. Performing a credit review offers several benefits for your company, including:

• Optimize your business's financial position: Your business needs to know if you are being compensated appropriately for the level of risk assumed. Riskier counterparties often require a higher rate of return to optimize the risk-return ratio.

• Comparative Analysis: Credit ratings provide a standardized measure to compare the creditworthiness of different companies within the same industry or portfolio.

• Confidence: Credit ratings demonstrate a commitment to risk management and transparency in the decision-making process.

  
  

Credit Rating Factors

There are various factors to consider when assigning a credit rating, relying on both publicly available information and propriety data. It is common for a credit rating methodology to incorporate both quantitative and qualitative data to identify and estimate counterparty credit risks.

It is key for the credit rating process be easily understood for your business to build trust, drive engagement, promote accountability, and ensure accurate and actionable credit risk assessments.

CreditKernel's researched backed, user friendly methodology includes:

Industry Risk Analysis: Examines the threats and uncertainties influencing an industry's performance and profitability. Industries demonstrating consistent profitability, growth, and stability typically carry a lower risk profile.

Business Longevity: Did you know that half of all businesses don't make it past their fifth year? A long-standing business not only speaks to its credibility but also suggests industry knowledge, robust networks, financial resilience, and the ability to weather economic challenges.

Competitive Position: Indicates a company's ability to deliver value to the market through price, quality of product/services, and/or quality customer service.

Financial Risk: Financial ratios, calculated from balance sheets, income statements, and cash flow statements, provide a standardized method to evaluate a company's performance over time and benchmark the ratios against industry peers.

Liquidity Assessment: Liquidity risk evaluates a company's ability to meet its short term obligations or fund its day to day operations with incurring excessive costs or losses. It arises when a company's cash inflows compared to cash outflows is negative, zero, or minimal.

Credit Rating Scale

Credit ratings scales can differ between providers, but they usually run from a top rating, which indicates the least likelihood of default, to a lower rating indicating a higher likelihood of default. The exact scales vary by rating organization, with Moody's, Standard & Poors, and Fitch each consisting of ~20 possible credit ratings.

The CreditKernel simplified rating scale consists of 7 possible credit ratings, each linked with a probability of default:

It is important to call out the laws that define probability, which is the probability of all possible outcomes must add up to 1, or 100%. Often the estimated probability of default is discussed, what is equally important is the probability the event will not occur.

For example, if an estimated probability of default is 2%, the probability of default not happening is 98%, or 100% minus 2%.

Final Thoughts

Credit ratings are opinions about the health, stability, and repayment capacity of counterparties. These ratings are not static, but an ongoing process that is reviewed based on the availability of information, market shifts, and/or changes with your counterparty.

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Learn more about how we provide credit ratings, 12 month probability of default, expected credit loss, and industry financial benchmarks.

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Frequently Asked Questions

How can a company improve its credit rating?

A company can improve its credit ratings by reducing debt levels relative to earnings, improve profitability margins, demonstrate effective risk management, and build a solid track record of meeting financial obligations.

How can I use credit ratings to make informed decisions?

Ask yourself, who are your high risk customers? Are you being compensated for the level of risk you are taking on? Credit ratings support decisions regarding pricing, interest ratings, payment terms, loan amounts, credit limits, collateral requirements, and compare alternatives.