What is Credit Rating? What do these Credit Rating Agency do?

Let me tell you an anecdote.

We have a college whatsapp group. These friends meet up once in six months or so.It is good way to keep in touch with your old friends and swap stories about our lives.

Normally these meets are fun. At times though there are a couple of chaps who get loud and rowdy and crack discoloured jokes which get annoying. But on the whole the experience is pleasant enough.

In one of those meets a friend let’s call him Rohan took me aside and told me that he was in a bit of difficulty and needed some money to tide him over.

I knew him from a long time as you would know a college mate, not intimately but knew that he was from an originally wealthy family and in the family business.

We met next day at a coffee shop where he poured out his tale of woe. He was having trouble with his family and was venturing out on his own.

I did not delve much further and loaned him with his promise that he will return it within 3 months with interest.

As expected I lost the money and the friend.

When I confided in a few of my other friends and asked their help in getting back my money to my surprise there was ridicule and absolutely no help forthcoming.

With a heavy heart I wrote off the friend and the money and deleted the Whatsapp group.

Now why am I telling you this sad story? Neither do I wish to appear foolish nor do I wish to seek sympathy.

The reason is that when you lend money to anyone, even if it’s a long standing so called friend there is always a chance that it won’t be returned back.

This was a relatively small sum which I lost. It was the best money I ever spent. As the lesson I learnt was invaluable.

But when you are lending money to a company or a bank or a finance company, you are actually investing large sums to get a return.

When you cannot tell a friend from a foe, how can you tell whether the company you lend to will pay you back?

What do I mean by lending money to a company/bank etc.?     

If you invest in a fixed deposit of a bank you are actually a lender to it as you hope that they will pay you back. Similarly a fixed deposit of a corporate or a non-banking finance company (NBFC).

When you buy a National saving certificate or a Kisan Vikas Patra, a small savings scheme you are lending to the government.

When you invest in a Non-convertible debenture (NCD) or a bond of a company / Bank / NBFC you are again lending them your money.

There are many ways to at least be reasonably sure that your chances of getting your money back are high.

The most common one used by a lay person or even large institution as a beginning point is Credit Rating of the borrower.

So..

Credit Rating agencies are companies whose job is to understand the financials of the company, keep in mind the external threats in that industry as well as in the economy and give an opinion on their ability to pay their debts back.

In India CRISIL – is the most well-known credit rating agencies. Others are ICRA, Care, Fitch, Brickwork,Acuite etc.

The company which borrows engages them for a fee and they ask for all the pertinent questions and then declare the rating of that company on their website. The borrower uses the rating to announce their credibility.

A highly rated company which is typically AAA will be able to get lenders easily and also borrow at a cheaper rate.

The rating scale start from AAA… and go down to AA, A, —upto D which is the default rating.

There are many types of ratings like short term, long term and rating for different types of borrowings which we will understand some other time.

Anyway, so when you are investing in a fixed deposit or a bond it will do you well to consider the rating of that company.

Does it mean that a highly rated company will never default?

It can happen. It is rare but it’s not impossible. Sometimes the cause can be fraud, or rapid deterioration in the business environment or rating agency mischief.

So a rating is not fool proof.

But a good place to begin with.

For individuals its credit score instead of credit rating.

I wish I had gotten the credit score of Rohan before lending to him. J