Functions of Credit Rating Agencies

Various aspects are taken into account by a credit rating agency when a  borrowing company applies for rating. Following are functions of a typical credit rating agency:

Credit rating agencies

(Image: Credit Rating Agencies)

Functions of Credit rating agencies:

1. Business Analysis

A credit rating company will analyze the business condition of the borrowing company not merely by the profits the borrowing concern has made, but by the use of capital in a more productive purpose. The return on capital and the cost of capital will be analyzed.

2. Evaluation of industrial risks

Every industry will have its risks which are due to natural or market conditions such as competition or due to the substitutes that have arrived in the market. The extent of risks and measures to overcome them will be taken into account while judging the credit rating of the company.

3. Market position of the company within the industry

What is the share of the market of the company seeking credit rating? A higher percentage of market share will involve more risks as the company has to be vigilant to maintain its share. So, a credit rating agency will give due weightage for the market share of the borrowing concern.

4. Operating efficiency

This is judged from the point of view of utilization of the capacity. When full capacity is utilized, the company has an advantage over others. This may be possible due to location advantage or better labor relations. These will be looked into by the credit rating agency.

5. Legal position in terms of prospectus

The statements made in the prospectus, should be true and factual. If tall claims are made, they will hamper the growth of the company and the credit rating agency will not rely on the prospectus of the company. It may also be construed as a willful fraud for attracting more funds. So, the contents of prospectus will also be a factor for credit rating considerations.

6. Financial analysis based on accounting quality

If accrued incomes are taken for making a window-dressing of balance sheet, it will not reflect well on the quality of accounting of the borrowing concern. Companies relying on realized income, will be in a better position to provide a realistic balance sheet. So, the true financial position of the company will be judged not merely on the books of accounts but also on their market conditions in meeting their debt commitments.

7. Statement of profits

There may be over statement or under statement of profits depending upon the purpose for which the statement is prepared. Here, again the credit rating agency has to scrutinize the realistic position of the company.

8. Earnings protection

To what extent, the earnings of the companies are consistent? Does it show any growth? What is the extent of profitability? All these will be judged under this criteria.

9. Adequacy of cash flow

Is the cash flow sufficient to meet its current commitments as well as any other contingencies? This factor is taken into consideration by the rating agencies.

10. Financial flexibility

How far the company is in a position to arrange for alternative financial plans for raising its funds, if its existing idea does not work out successfully? Rating agencies adjudge the financial flexibility of companies.

11. Management evaluation

What is the track record of management? How far they are successful in steering the company under difficult conditions? Evaluation of management is one of the important functions of credit rating agencies.

12. Capacity to overcome adverse situations (catastrophe management)

Rating agency studies the available mechanism for recovery with the company for meeting any sudden unforeseen calamities.

13. Goals philosophy and strategy

Here, what kind of organizational goals are adopted? What are the strategies adopted for achieving the goals, etc.? Such aspects are considered when evaluation of an organization by rating agency.

14. Labor turnover

How far the nonalignment is looking after the welfare of its labor? What is the extent of punctuality, discipline and morale of the labor force? To what extent they continue with the employment in the company? A rating agency looks for all these issues.

15. Regulatory and competitive environment

If there are more regulations, restricting competition, then there will be more protection to the company, whereas under condition of deregulation, providing more scope for competition, the efficiency of the company will be tested. A rating agency studies the regulatory and competitive environment from these angles.

16. Asset quality

Here, the value of assets and the price of the assets according to the market conditions and the provisions made for these assets will be taken into account credit rating authorities. Performance of assets will also be taken. The extent of standard, sub standard, doubtful and bad assets will also be taken into account while granting credit rating.

17. Financial position — interest / tax sensitivity

If there is increase in the interest rate due to the market condition, how far the company will be able to bear it? What will be the impact on the company’s earnings? Similarly, if the government increases tax on income, what will be the tax burden? What impact it will have on the company’s earnings. These factors are taken into consideration.

These are some of the functions of credit rating agencies in rating a company.