Importance Of Credit Rating & How It Works

Credit rating is a quantified assessment of a borrower’s credit worthiness. The borrower can be an individual, a corporate, a state or provincial authority or a government. A credit rating determines whether the borrower will be approved for an advance or loan and the rate of interest on it.

A high credit rating suggests that the borrower will be able to repay the loan in its entirety, while a low credit rating suggests that the borrower might have difficulty in repaying the loan and might become a defaulter.

Difference Between Credit Rating and Credit Score

Credit rating may be applied to an individual, corporate or a government. Credit scores are applied on individuals only. Credit ratings are assigned with a letter while credit score is a three digit number. Credit ratings are provided by credit rating agencies while credit scores are given by credit bureaus.

Importance Of Credit Ratings

The rating agencies take into account the borrower’s financial health and its capacity to service and repay the debt. Therefore, a borrower should strive to have a high credit rating in order to have loans approved easily. Some of the benefits of credit rating for the lender and borrower are listed below:

For Lenders:

• Better investment decision: Credit rating tells the credit worthiness of the company borrowing the money. So, it helps them determine the risk associated with the investment in the company and helps them make a better investment decision.

• Safety assurance: A credit rating indicates that the loan will be repaid with interest on time. Thus the money invested is safe.

For Borrowers:

• Easy loan approval: The borrower is considered as a low/no risk borrower with a high credit rating. In such a case, loans will be easily approved for the borrower.

• Competitive rate of interest: As you know, every loan comes with a rate of interest. This rate of interest is largely dependent on the credit rating. Higher the credit rating lower will be the rate of interest.

A higher credit rating can help company/organization raise money and grow. For lenders, it helps them take an informed decision about their investments.

How Do Credit Ratings Work?

Each credit rating agency has its own algorithm of determining the credit rating of the borrower. These credit ratings depend on various factors such as timely repayment of supplies and dues, cash flows, working capital, net worth etc. Credit rating agencies collect such information from partner banks and other financial institutions on a monthly basis. Upon receiving a request to generate a credit rating, these agencies dig out more information and prepare a report based on the above factors. On the basis of this report, they grade the borrower and give it a credit rating. This rating is then used by banks, financial institutions and investors to make a decision about investment, approving loans or credit cards or buying bonds.

Factors Affecting Credit Ratings

Credit rating is affected by potential borrowers past financial history. Missed payments, defaults or bankruptcy's negatively impact the credit ratings. Cash flows and current debts are also taken into consideration. If the borrower has steady income and a brighter future then the credit rating will be higher. The following factors affect borrower’s credit rating:

The borrower’s financial past:

• Lending and borrowing history
• Payment history
• Past debt
• Financial statements
• Type of current debt

The borrower’s future financial potential:

• Ability to repay the debt
• Projected income and profits
• Current financial statements

Credit Rating Agencies In India

There are various verified credit rating agencies in India. Some of them are listed below:

• Credit Rating Information Services of India Limited (CRISIL)
• Investment Information and Credit Rating Agency of India Limited (ICRA)
• Credit Analysis and Research Limited (CARE)
• India Ratings and Research Pvt Ltd.
• Brickworks Ratings India Private Limited
• Infomerics Valuation and Rating Pvt Ltd

Conclusion

Credit rating is a quantitative assessment of the credit-worthiness of a borrower. It can be assigned to an individual, corporate, NGO, organization or government. It helps in determining the eligibility of the borrower in getting the loans approved. It also helps banks, financial institutions and investors to make an educated decision regarding their investment.

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