A credit rating helps us understand the health of an economy or a company, but how does this assessment work, and why is it so important?
What is a credit rating?
A credit rating is an assessment given by an external and independent entity (a credit rating agency) regarding the solvency of securities and companies. It is, therefore, a synthetic estimate of a company’s capacity to generate the resources necessary to meet its debts and is so important that credit rating agencies can stimulate the markets with their forecasts. Let’s see why.
What is the purpose of bank rating?
Credit ratings are used to calculate the yield on fixed-income securities issued by companies and, therefore, express the cost of debt for the issuer. For banks, they are one of the factors determining the cost of borrowing and the terms of repayment.
For investors, they are a useful tool for monitoring the evolution of the value of their investment over time: a downgrade of one or more asset classes by a credit rating agency is a clear warning sign.
Issuance of credit rating
The attribution procedure begins with an analysis of the company’s economic and financial characteristics. Analysts check both quantitative parameters (financial statements, profitability, ability to generate resources and profits, cash flows, etc.) and quantitative factors such as reliability, management capabilities and credibility of business projects.
In addition, the agency consults the risk information centre of the country in question, monitors capital movements and the company’s activities and interviews managers.
The parameters are then compared with those of other companies operating in the same sector, with the characteristics of the sector and with market developments . It is also common for agencies to issue two different ratings, distinguishing between short-term and long-term.
Once established, the rating is expressed on an alphabetical scale of values and is published on the agency’s website and in the main financial information media.
Scales of values
There are two methods for estimating credit ratings: a mathematical-quantitative method and a qualitative method. The latter, used by the main global agencies, is based on the analysis of a wide range of information with a flexible structure. The rating scales vary depending on the agency that assigns the rating.
Still, in general, securities with a rating of up to “BBB” are considered relatively safe investments. In contrast, fixed-income securities below this level are considered speculative because they have a higher risk profile and a greater capacity to provide profits.
Types of qualification
A company’s debt rating (also known as a ” credit rating” is just one type of rating. International credit ratings, among other things, assess the risks of an investor transferring securities denominated in another state’s currency into its own currency.
In addition, country debt ratings are issued based on the demonstrated capacity of individual states to meet their debts. In contrast, the so-called country ceiling rating assesses the risks of investing in a country that might implement measures to block capital flight outside its borders.
How does your credit score affect you, and how can you improve yours?
Credit scores don’t just affect your ability to get loans for a home or car. The lower your credit score, the more you’ll have to pay for those loans: Your credit score directly affects the interest rate any lender offers you.
But, a credit score isn’t a fixed number. While it takes time, you can improve it by focusing on the factors that affect it. For example, you can:
- Pay your bills on time. Set up automatic payments and pay everything within 30 days.
- Reduce credit usage. Aim to use less than 30% of your available revolving credit (e.g. credit cards).
- Increase the age of your credit and reduce your outstanding balances . While it’s key to pay off your debts in full as soon as you can, it’s okay to have a credit card (with a zero balance or always paid) for longer.
- Create a credit mix. Consider having some revolving debts (those that are paid as they accumulate, such as a credit card) and some instalment debts (where you pay the same amount on the same date until it’s paid off, such as a car loan).
- Limit your credit applications. Avoid making too many new applications, especially if you are applying for a large loan.
A credit report is like a snapshot of your credit history and outlook. It’s what a credit bureau uses to generate a credit score, which, as mentioned above, influences whether you can take out new credit or get lower interest rates, which can mean lower costs when borrowing in the future. Potential landlords may also look at your credit report before deciding whether or not to rent a property to you.
A credit report includes personal information (name, date of birth, address) and a summary of your credit accounts (type of account, date opened, loan limits, loan balances and totals, and payment history). Credit inquiries also vary. Informal inquiries, such as when you review your credit report, do not affect your credit score. However, formal inquiries, such as applications for credit or loans, may temporarily negatively affect your credit score.
