Notes
Program Name: MBA Sem. : IV
Course Name: Banking Operations
Unit Number – IV Unit Name: Loans and Advances-I I
Topic Name – Credit Score
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Credit Score
Credit Rating is an assessment in terms of alphanumeric symbols to convey the creditworthiness
of an individual, company financial instruments or a country. It is a simple and easily understood
tool enabling the investor or lender the relative degree of risk associated with a loan amount on
a debt instrument or a financial obligation.
Credit rating is just an opinion about the creditworthiness of the instrument. However, it does
not give any assurance of repayment of the rated instrument. The rating is representative of the
financial history and current assets and liabilities of the rated instrument. A credit rating does
not provide recommendation to buy, hold or sell a debt instrument.
It just represents a guideline to help the investors or lenders for making an investment decision.
A high credit rating represents a good investment with very low risk of non-payment on a loan,
whereas a poor credit rating represents investments with a high level of risk of default. Investors
expect a risk return trade off. The investors who want high returns invest in low rated instruments
and get compensated for high risk involved with it.
CRISIL, the first rating agency in India defines credit rating as “an unbiased and independent
opinion as to the issuer’s capacity to meet its financial obligations. It does not constitute a
recommendation to buy/sell or hold a particular security”.
BENEFITS OF CREDIT RATING
Benefits to Investors
i) Safeguards against Bankruptcy: Credit rating of an instrument given by the credit
rating agency gives an idea to the investors about the degree of financial strength of
the issuer company which enables him to decide about investment. Highly rated
instrument of a company gives an assurance to the investors of safety of their
investment and the interest (or return) on their investments with least risk of
bankruptcy.
ii) Recognition of Risk: Credit rating provides investors with rating symbols which carry
information in easily recognisable manner for the benefit of investors to perceive risk
involved in investment. It becomes easier for the investors by looking at the symbol
to understand the worth of the issuer company because the instrument is rated by
scientifically and professionally analysing the financial position of the company. In
view of this, there is no need for the investors to incur cost for collecting credit
information and to carry out analysis. The investors without any knowledge of
financial analysis can easily use rating symbols for investment decisions.
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iii) Credibility of Issuer: Rating symbol assigned to a debt instrument gives an idea about
the credibility of the issuer company. The rating agency is quite independent of the
issuer company and has no business connections or otherwise any relationship with
it or its Board of Directors, etc. Due to absence of business links between the rating
agency and the issuer company the confidence of investors is enhanced in such rating
symbol.
iv) Rating Facilitates Quick Investment Decisions: Investor can take quick decisions
about the investment to be made in various instruments with the help of credit rating
assigned to various instruments. In view of this, there is no need for investors to
undertake fundamental analysis of a company based on financial strength of the
company, quality of management, as well as other parameters.
v) No Need to Depend on Investment Advisors or Professionals: For making investment
decisions, investors with no knowledge of investment may have to seek advice of
financial intermediaries such as, the stock brokers, the portfolio managers, or financial
consultants while investing funds in debt instruments. However, investors need not
depend upon the advice of Credit Rating these financial intermediaries as the rating
symbol assigned to a particular instrument suggests the credit worthiness of the
instrument and indicates the degree of risk involved in it. Thus, investors can make
direct investment decisions.
vi) Choice of Investment: Several alternative credit rated instruments are available at a
particular point of time for deploying investible funds. The investors can make choice
of various instruments depending upon their own risk profile and diversification plan.
vii) Benefits of Rating Surveillance: Investors get the benefit of credit rating agency’s on-
going surveillance of the rated instruments of different companies. The Credit Rating
Agency downgrades the rating of any instrument if subsequently the company’s
financial performance is not so good or financial position has suffered because of
happening of internal or external events which necessitates consequent
dissemination of information on its position to the investors. To sum up, credit rating
of debt instruments helps the investors in managing credit risk in investment
decisions.
Benefits of Credit Rating to Issuer Company
A company which has obtained credit rating from rating agency for its issue of debt
security enjoys various advantages. Few of these advantages are given below :
i) Lower Cost of Borrowing: A company, whose debt instrument or public deposits
programme, is highly rated, will be in a position to reduce the cost of borrowing by
quoting lesser interest rate on fixed deposits or debentures or bonds as the investors
will prefer low rate of interest because of lower credit risk.
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ii) Wider Audience for Borrowing: A company having very good rating for its debt
instrument can approach various categories of investors for resource mobilisation using
the press media. Investors in different strata of the society could be attracted by higher
rated instruments as the investors understand the degree of certainty about timely
payment of interest and principal on a debt instrument with better rating.
iii) Rating as Marketing Tool: Companies with rated instruments improve their own
image and can use credit rating as a marketing tool to create better image in dealing
with its customers, lenders and other creditors. Even consumers feel confident in using
products manufactured by the companies carrying higher rating for their credit
instruments.
iv) Self-Discipline by Companies: Rating encourages the companies to come out with
more disclosures about their accounting system, financial reporting and management
pattern, etc. The company gets opportunity and motivation to improve upon its existing
practices to match to the competitive standard and maintain the standard of rating
attained by it or make improvement upon the rating.
v) Reduction of Cost in Public Issues: A company with higher rated instrument is able
to attract the investors and raise the funds with least efforts. Thus, the company whose
debt instrument is highly rated can minimise cost of public issues by controlling
expenses on media coverage, conferences and other marketing expenditures.
vi) Motivation for Growth: Rating provides motivation to the company for growth as
the promoters of the company feel confident in their own efforts and are encouraged
to undertake expansion of their existing operations or new projects. With better image
created through higher credit rating the company can mobilise funds from the public
and institutional lenders like banks and financial institutions. Benefits to Financial
Intermediaries Highly credit rated instruments put the brokers at an advantage to make
less efforts in studying the company’s credit position to convince their clients to select
a particular investment proposal. Rated instruments speak themselves about the
financial soundness of the company and the strength of the instrument rated by the
credit rating agency. This enables brokers and other financial intermediaries to save
their time, cost, energy and manpower in convincing their clients about investments in
any particular instruments. They utilise their resources in expanding their clientele and
intensifying their business activities.
Other Benefits
The other benefits of credit rating in general are given below:
i) Identification of Strength and Weakness of the Issuer Company: A company having
obtained the rating for its security understands its own strength and weakness in all
spheres of corporate environment and can take corrective steps to improve upon its
position and also remain guided by the surveillance efforts of the Credit Rating
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Agency. Particularly, companies with low credit rating make efforts to improve upon
their performance. Thus, credit rating creates a tendency amongst rated corporate
units to remain healthy and maintain higher standard for corporate governance which
will help them to improve their standing both in domestic as well as in international
market.
ii) Liquidity and Marketability of Debt Securities: Rated debt securities become easily
marketable and thus attain the status of more liquid instruments. Credit rating
symbols or grades set the market price range for the rated securities. The virtues of
easy marketability and more liquidity of the instrument make it popular with the
investors and the issuer company can ably sell the rated security with least cost.
iii) Positive Impact on Capital Market: Rated securities bring improvement in capital
market and reflect upon its efficient functioning. Trading of rated securities in the
secondary market becomes smooth and easy as it provides liquidity for such
securities. This indirectly improves the primary market for such debt instruments
having higher credit rating.
LIMITATIONS OF CREDIT RATING
1) Biased Rating and Misrepresentations: In the absence of quality rating based on
objectivity analysis credit rating is a curse for the capital market. To avoid biased rating or
subjectivity in the credit rating process, executives working with Credit Rating Agency, who
are involved in the process of credit rating, should have no links with the company or the
persons interested in the issuer company so that they can make their report impartial and
Credit Rating judicious recommendations for rating committee. Again, rating committee
members should also be impartial and judicious in their decision making. The companies
having lower grade rating do not advertise or use the rating while raising funds from the
public. In such cases, the Credit Rating Agencies should themselves in the public interest,
advertise the rating symbols assigned to such companies for public information and make the
public aware of the poor financial position of such companies.
2) Static study: Rating is done on the basis of present and past data of the company and this
is only a static study. Disclosure about the company’s health through credit rating is one time
exercise and anything can happen after assignment of rating symbols to the company.
Dependence for future results on the rating, therefore defeats the very purpose of risk
indicativeness of rating. Subsequent to the allotment of credit rating many changes may take
place in economic environment, political situation, government policy framework, etc. which
may directly affect the working of a company. With such changes, the purpose for which
credit rating was done gets defeated.
3) Concealment of material information: Company which has approached for credit rating
may not provide all material information to the credit rating agency. In such cases, credit
rating given by the credit rating agency may not reflect true picture of credit risk.
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4) Rating is no guarantee for soundness of the company: Credit rating is done for a particular
instrument to assess the credit risk. And therefore it cannot be construed as a rating for the
quality of management of the company or its sound financial position.
5) Down grade: Once a company has been rated and if it is not able to maintain its
satisfactory financial performance, credit rating agency would review the grade and down
grade the rating resulting into impairing the image of the company.
SUMMARY
Credit Rating is an assessment in terms of alphanumeric symbols to convey the creditworthiness
of an individual, company financial instruments or a country. It is a simple and easily understood
tool enabling the investor or lender the relative degree of risk associated with a loan amount on
a debt instrument or a financial obligation.
BENEFITS OF CREDIT RATING
Benefits to Investors
I. Safeguards against Bankruptcy
II. Recognition of Risk
III. Credibility of Issuer
IV. Rating Facilitates Quick Investment Decisions
V. No Need to Depend on Investment Advisors or Professionals
VI. Choice of Investment
VII. Benefits of Rating Surveillance
Benefits of Credit Rating to Issuer Company
I. Lower Cost of Borrowing
II. Wider Audience for Borrowing
III. Rating as Marketing Tool
IV. Self-Discipline by Companies
V. Reduction of Cost in Public Issues
VI. Motivation for Growth
Other Benefits
I. Identification of Strength and Weakness of the Issuer Company
II. Liquidity and Marketability of Debt Securities
III. Positive Impact on Capital Market
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LIMITATIONS OF CREDIT RATING
1) Biased Rating and Misrepresentations
2) Static study
3) Concealment of material information
4) Rating is no guarantee for soundness of the company
5) Down grade
QUESTION FOR SELF ASSESSMENT
SELECT THE RIGHT OPTION.
Q1. It is an assessment in terms of alphanumeric symbols to convey the creditworthiness of
an individual, company financial instruments or a country.
a. Credit rating
b. Credit Number
c. Credit alphabet
d. All of the Above
Q2. Which is the first rating agency in India?
a. CRISIL
b. SMERA
c. CIBIL
d. ICRA
Q3. A high credit rating represents a good investment with very
a. High risk
b. Low risk
c. Medium risk
d. Equal risk
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Q4. What can be used by investors without any knowledge of financial analysis for investment
decisions?
a. Rating symbol
b. Rating figures
c. Rating colours
d. None of the above
Q5. The company whose debt instrument is highly rated can minimize cost of public issues by
controlling expenses on.
a. media coverage
b. conferences
c. marketing expenditures
d. All of the above.
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