it worthiness of an individual, government and corporations. These ratings are based on historical information of borrowing and repayment of loans, assets of the corporations, income and liabilities. This information is relevant to the lenders such as credit card agencies, banks and other financiers. It is also useful in underwriting process in the insurance companies. Apart from the high rate in repayment, lenders are also interested on the profitability levels of corporations, which are able to pay high interest, required in risky ventures. By use of single scaled and widely known scale, credit rating helps assess a wide range of risks aspects of individual securities. Many investors have a specific rating, below which they cannot engage in a contract.
Companies with poor credit rating are viewed as having high chances of becoming default. For this reason, lenders and insurance companies are more willing to approve loan, credit card or insurance contract in a situation, where there are better ratings. In case a poorly rated firm is approved, then, it has to compensate by paying high interest rates. Such credit ratings are calculated by use of complex algorithms, applied on information, making the company history and the current financial position. In most cases, the information of interest relates to loan default, late repayments of loans and credit history. In case of individuals factors such as age, place of resident and sex may be included in the model, this, to a greater extent, is used by insurance companies.
Credit rating has great contribution in the financial markets and these benefits extend to both the funders and the beneficiary companies. There is improved efficiency in this market by providing a basis of evaluation, which helps to remove subjectivity in decision making. Risk management is a core objective in all companies and individuals, but, on the other side, it’s very hard to engage in economic activities that do not have an aspect of risk. The high risk ventures should, however, be able to provide greater returns, and this forms the basis of actualization of credit ratings.
To the lending organization and insurance companies, credit rating helps to hedge against exposure of immeasurable risks. Credit rating provides the possible situation on the future and, hence, the lender will decline any contract that promises a higher risk. In case such contracts are considered, the lender will always demand high interest rates.
However, much of these benefits goes to the individual firms, this is because there is a pressure to check on the company’s operations and avoid any situation that would result to a worsened rating. For this reason, the organizational stewardship is kept on track to observe effective and efficient management. To an individual, it improves the sense of safety with the understanding that one would not have problems in case of contingencies, which will require financial boost. At the international or national level, countries, which have built a reputation with respect to their good credit rating, will have no problem accessing funds from countries that are capable of providing or the international banks.
Presence of rating agencies and credit ratings in the market bring about a self-driven initiative to have a critical analysis in the investment alternatives. There are, in most cases, agency problems between the shareholders and the managers. Managers are mostly interested in the profits whether short run or long run, and may be tempted to invest in risky venture without much concern on the risk aspect of it: a security investment that would not get the investors approval. Making use of rating in investment policies help reduce such risks, undertaken by the asset managers and, hence, benefiting the investors.
By use of the credit rating, credit rating agencies use their experience and judgment to provide independent information on attractiveness of certain bonds on their non-financial and financial characteristics. This affect the demand of these bonds as holders dispose their current bond for the fear of future losses. The effect is shifting investments from one capital asset to the other. In such a situation, the interest in the capital market keeps on fluctuating as investment fund flows towards investments that have low chances of risks. The ratings for the company may, however, change with time, depending on the unfavorable and favorable changes in the capital market financial conditions.
Credit ratings have had substantial effect in the international capital markets and the world economy. The rates have a major contribution to prevent financial crises that have characterized the developing countries such as the East Asia in the mid ‘90s. The markets that experience direct influence from credit rating include the bank lending, portfolio equity, bonds and foreign direct investments. For example, in the mid ’90s, the predominant bank lending was exceeded by the bond market as a source of private capital in the developing countries.
Financial position of an organization relates to the assets, owners’ equity and the liabilities. These elements of the financial statements keep on changing and readjusting, depending on the current position of the organization. The credit score of the company is materially affected by disposition, investment decisions, acquisitions and outcome of the short-term operations. Downgrading credit rating results to inability to raise the required investment and working capital, hence, affecting adversely the financial position. From a positive perspective, management in corporate organization is compelled to observe financial discipline in their undertakings. Such close observations of the activities of the organization in an effort to ensure or maintain good credit score may help improve the financial position.