Credit Rating Process

Updated on April 11, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Credit Rating Process?

The credit rating process is when a credit rating agency (preferably a third party) takes details of a bond, stock, security, or company and analyses them to rate them so that everyone else can use those ratings to use them as investments.

Credit Rating Process

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In other words, it is an assessment of the borrower’s ability to repay their financial obligations, and the creditworthiness of an individual, organization, etc., can be evaluated by taking various factors into due consideration that represents the willingness and capability of a borrower to timely discharge their financial commitment.

Key Takeaways

  • The credit rating process is when a credit rating agency, ideally a third party, gathers information about a bond, stock, security, or company and evaluates it to give it a rating other investors may use as a benchmark.
  • Corporations rely on stocks or debt to fund their operations. For equity, they can use investments from promoters, internal cash flows, or IPOs/FPOs to access financial markets.
  • Credit rating agencies determine interest rates based on risk and must be impartial, vigilant, and unbiased in their evaluations

Credit Rating Process Explained

A credit rating process is a must for creditors to watch out for to ensure the borrowers they are trusting would not default on repayments. They rely heavily on credit rating agencies for lending at a special price for the risk-reward ratioRisk-reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process.read more. Hence, the rating agencies need to ensure fairness of opinion, a hawk-eyed approach for probable developments in the future, as well as unbiased credit ratings for a company they are evaluating.

In various cases of corporate lending, the banks themselves conduct credit analysisCredit AnalysisCredit analysis is the process of drawing conclusions about an entity's creditworthiness based on available data (both quantitative and qualitative) and making recommendations about perceived needs and risks. Credit analysis also involves identifying, assessing, and mitigating risks associated with an entity's failure to meet financial commitments.read more, as they may not want to rely on external credit agencies and rather form their view on the credit of a company. However, as seen in the recent cases of increasing NPAs (non-performing assetsNon-performing AssetsNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days.read more) coming to light in India, banks need to be cautious while lending to corporate.

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There are only two ways in which any company would fund its business – equity or debt. The equity portion of the capital structure could be derived broadly from three sources: Promoters investing in the business, Company’s internal cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more accruing over the years to equity, or IPO (Initial Public Offering)/FPO (Follow-on-public offering) for which a company taps different financial markets.

Out of the three, only the last step of the equity source, i.e., IPO/FPO, requires the attention of large banks and broker houses, who capture the company’s equity valuation and drive the process. On the other hand, any form of debt issuance demands validation from a credit rating process. Of course, debt is cheaper than equity; companies, quite frequently and on an ongoing basis, issue debt (and repay the same eventually), which means the credit rating process of a company plays a major role in its debt-raising capacity.

Steps

The credit rating process involves a series of steps that agencies follow. Though these steps may differ from one agency to another, the basic series is similar. Let us have a quick at the steps that credit rating agencies follow to rate entities:

#1 – Receipt of Formal Request

The agency begins as soon as it receives the request from the rating companies. In short, the receipt of the formal request to issue a credit rating is the first step of the process. The companies do that to ensure each and every aspect of the process is thoroughly taken into consideration.

#2 – Signing an Agreement

The issuer company and the agency sign an agreement. According to this contract that they sign, the agencies are asked to keep the information of the issuer company as shared with them, confidential. The agreement gives the issuer company the liberty to accept or reject the ratings provided by the rating agencies.

#3 – Assigning to Analysts

As soon as the request is received and the agreement is signed between the parties, an analyst is assigned the task to look after the rating. Before this task is assigned, the expertise of the analysts in the agencies is checked. Based on the area they possess maximum knowledge and skills in, the credit agencies assign a particular credit rating task to respective analyst teams.

#4 – Scheduling Visits & Meetings

The next step is to schedule visits and meetings with the company management. Through the visits, the analysts and team try to explore the operational aspects of the clients. They figure out the business activities, production process and cost of production, and other aspects. The meeting with the management helps analysts assess the overall position, strategies, risks, and policies of the client.

#5 – Forming an Opinion

The next steps are to present a report based on the observation and also mention the ratings as felt suitable. In short, this is the step where the rating opinion is formed and then the same is presented to the rating committee.

#6 – Communicating the Rating

Then, the rating is communicated to the issuer company with reasons. It is, however, the issuer company that would further decide whether to accept or reject the rating assigned by the agency. If they are convinced by the ratings against the reasons, they accept the decisions, else, they reject it. The final step is to communicate the rating to the public.

However, even after the ratings are finally assigned by the agency, they keep monitoring the issuer company to check if they have provided them with an accurate rating. It becomes a kind of case study for them as they understand where they were right and where they had room for more effective decision-making while assigning ratings.

Reasons

Let us assume that Teva Pharmaceuticals Industries Ltd (or “Teva”), an Israel-based world’s leading generics pharma company plans to set up a manufacturing unit in the US to manufacture its drugs for the US market. To fund this capital expenditure, suppose Teva plans to issue a bond in the US market or a bank loan from Morgan Stanley. Of course, the creditors would like to evaluate Teva’s ability to repay its debt (also called the company’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more). A company’s credit rating helps the creditors price the debt instrument for the company with reference to the amount of credit risk that the creditors would be taking. In such a scenario, Teva may ask a credit rating agency, say Moody’s, to assign them a credit rating to enable them to raise debt. On the other hand, a non-rated company (bringing in fear of the unknown for the creditors) would face issues in raising debt compared to a company rated by an external credit rating agency.

Below is one of the samples of Moody’s rating assigned to Teva

credit-rating-process-moodys-teva

source: Moody’s

Significance

Now let us understand what credit rating signifies.

A credit rating determines the probability of the company paying back its financial indebtedness within the stipulated time. The ratings could be assigned to a particular company or could also be issue specific.

Below is the chart illustrating the credit rating scale from the global credit rating agencies – S&P, Moody’s, and Fitch. The long-term ratings are usually assigned to a company, while the short-term ratings are essentially for specific loans or debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more. It is to be noted that Indian rating agencies ICRA, Crisil, and India rating and research are Indian subsidiaries of Moody’s, S&P, and Fitch, respectively.

credit-rating-significance-and-process

Example

Moody would assess the credit rating process, its profile, and, subsequently, the ratings of Teva concerning different weights assigned to different parameters, as described above (both financial and business). For issue-specific ratings, Moody’s would also analyze the quality of collateral provided by the Company for a particular instrument. Of course, if the need arises, Moody’s could also visit Teva’s manufacturing facilities and meet with the management to perform its due diligence (to evaluate Teva’s actual commercial potential).

We note that the rating that Moody’s came up with for Teva’s inherent profile was A3 as of Apr 2015.

However, we note that Moody’s downgraded Teva by one notch to Baa1 in Jul 2015 and another notch to Baa2 in Jul 2016.

Let us see what drove Moody’s to downgrade Teva by two notches within a year.

Factors

It is returning to Teva, who approached Moody’s to assess its credit rating. With the receipt of this request, Moody assigns a credit rating (typically through a couple of weeks-long processes) to Teva. Let us think about some of the factors that Moody’s would look at for assigning a credit rating to Teva.

Moody’s industry expert analysts would perform the credit rating process, a detailed analysis of Teva broadly based on the following factors:

  1. Business Profile
  2. Operating Segment and Industry Standing
  3. Business RiskBusiness RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.read more
  4. Historical Performance Analysis
  5. Scale and margins compared to its peers:
  6. Revenue and margin drivers in the past and their sustainability:
  7. Cash flow generation capability:
  8. Balance sheet analysisBalance Sheet AnalysisBalance sheet analysis interprets the company's assets, liabilities and owner's capital in a certain period. It provides an accurate picture of the organization's financial health and position to the investors, shareholders and institutions.read more and liquidity profile:
  9. Financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more and peer analysis:
Credit Rating Process

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#1 – Business profile

The analyst would first understand Teva’s business profile, its competition, core products, number of employees, facilities, clients, etc.

#2 – Operating segments and industry standing

  • Teva operates in two broad segments comprising: 1) a portfolio of generic drugs (i.e., copycats of drugs of which patents have already expired), as well as a 2) modest product pipeline of originator drugs (which have live patents).
  • Moody’s would analyze its operating segments and their respective market positions. Teva has a strong generics product pipeline, which derives most of its revenues from the US and Europe, and has leading positions in these developed markets, which are already encouraging the growth of generics.
  • The Obamacare act in the US, which increases the insurance coverage of US citizens, would like to focus on reducing their healthcare costs. At the same time, the European markets would aim to reduce healthcare costs too (owing to the ongoing difficult macroeconomic conditions) by increasing the usage of generics.
  • Hence, we believe that, overall, Moody would view Teva’s generics segment quite favorably.
  • On the other hand, the branded segment is subject to competition from generics (post the patent expiries of its drugs). Teva’s sclerosis (a disease about the hardening of tissues) therapy drug Copaxone, which represents ~20% of its revenues, is facing the same risk!
  • Copaxone’s one version of the drug has already expired, which means that cheaper generic drugs of the same brand could be launched in the markets, thus impacting Copaxone’s market position significantly.

#3 – Business risks

  • Moody’s would look at each of its product segments and also see the kind of future portfolio (characterized by the type of their R&D expenses) that Teva plans to launch to cover the loss in sales from the expiring drugs in the branded portfolio.
  • Further, Moody’s pharma industry expert would analyze all the industry-specific factors such as litigations in which Teva is involved and their materiality in terms of probable financial impact and regulatory risks in terms of US FDA inspections of its facilities (to be noted that US FDA demands the highest quality of manufacturing practices for the pharma companies selling their products in the US).
  • Additionally, concentration risks related to a particular product (where difficulties in one product could impact the company financially), a particular supplier (where a supply issue could impact its sales), and particular geography (where geopolitical issues could arise) would need to be analyzed separately on a company and industry-specific basis.

#4 – Historical financial performance

In this, an analyst would go about analyzing the historical performance of the company—calculating Margins, Cash Cycles, growth rates of revenue, Balance Sheet Strength, etc.

#5 – Scale and margins compared to its peers:

#6 – Revenue and margin drivers in the past, and their sustainability:

  • As mentioned earlier, Copaxone’s patent expiry would significantly drive the revenues and margins down for the company in the coming years, and Moody’s would need to analyze how the company’s future product pipeline would cover the loss.
  • However, we note that Moody’s would nevertheless derive comfort from its leading position in the generics segment.

#7 – Cash flow generation capability:

#8 – Balance sheet analysis and liquidity profile:

#9 – Financial ratios and peer analysis:

Conflict of Interest

You may wonder if there exists a conflict of interest between rating agencies and the companies paying them for the ratings.

It may seem so, given that Teva is a source of revenue from Moody’s. After all, rating agencies earn only from companies they so closely and critically evaluate!

However, for a rating agency, its credibility is of utmost importance.

If Moody’s did not downgrade Teva based on the significant increase in debt post the acquisition of the generics business of Allergan, it would have lost the creditors’ trust. It would not have valued Moody’s opinion as we advanced.

Once the companies subscribe to the credit rating agenciesCredit Rating AgenciesCredit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and their issuers, including companies and countries.read more, they need to periodically monitor the company’s ratings based on new developments in the company (like seen in the above case with Teva’s announcement of acquisition), as well as any updates related to the industry (in Teva’s case pharma), regulatory changes, and peers.

Frequently Asked Questions (FAQs)

What is a good credit rating?

Though the range varies based on the credit scoring methodology, credit scores from 580 to 669 are usually considered fair; 670 to 739 are considered good; 740 to 799 are considered very good; and 800 and higher are considered exceptional.

Who introduced credit rating?

John Bradstreet, a different early organization, was established in 1849 and released a rating guide in 1857. Credit rating organizations were born when ratings started to be assigned to securities, particularly those connected to the railroad bond market, in the United States in the early 1900s.

What is a credit rating called?

The FICO, or Fair Isaac Corporation, is the score most frequently employed in consumer loan choices. A person’s payment history, credit mix, new credit accounts, credit usage ratio, and length of credit history are only a few financial facts that FICO considers.

How often are credit ratings updated?

Credit ratings are typically updated periodically to reflect changes in the issuer’s financial situation, market conditions, or other relevant factors. Agencies also monitor ratings for potential changes.

This article has been a guide to what is Credit rating process. Here, we explain its steps, reasons, factors, significance, an example, and conflicts of interest. You may also have a look at the following related articles on credit rating:

Reader Interactions

Comments

  1. Hillary Jephat Musarurwa says

    Great resource which is clear and easy to read.

  2. Govind Kumar says

    Can U post any related stuff regarding Asset backed securities and its valuation

    • Dheeraj Vaidya says

      Hi Govind, please checkout this article . However, valuations is not covered here.

      thanks,
      Dheeraj

  3. Gautam Mohan says

    Thanks Dheeraj. Good piece on the credit rating process. Keep this going………

  4. Alex says

    so good to learn.

    Thanks for sharing

  5. S.Sridhar says

    Very good and informative article.Like to receive more such articles.

  6. Kalpesh Chouhan says

    Great Article…Provide good Insight about How the credit rating Agencies grades and there importance in eyes of creditors.

  7. khushhal gupta says

    Good case study to understand how the credit rating assigned to company.

  8. samuel mbuthia says

    A very informative article.
    Kindly is it possible to prepare a sample model for credit rating analysis?
    It could be of great help.

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