A credit rating is a score that summarizes the credit worthiness of a business or government. It is usually made by a credit rating agency (such as Standard and Poors or Moody’s) and is based on the debtor’s ability to pay back the debt and the likelihood of default. The higher the credit rating, the less likely the debtor is to default, thus the safer it is to loan money to them.
What Are the Common Credit Ratings?
Credit ratings are broken down into short term and long term credit ratings. Some companies call them different terms, but short term ratings always look at the possibility of default within a year, while long term looks over a long time frame (such as 20 years).
While each rating company is slightly different in the term it assigns, the general breakdown is as follows:
Investment Grade Ratings
Prime Credit: AAA (or Aaa for Moody’s)
High Grade: AA (AA+, AA, or AA-)
Upper Medium Grade: A (A+, A, or A-)
Lower Medium Grade: BBB (BBB+, BBB, or BBB-)
Non-Investment Grade Ratings
Non-Investment Grade Speculative: BB (BB+, BBB, or BB-)
Highly Speculative: B (B+, B, or B-)
Substantial Risks: CCC (CCC+, CCC)
Extremely Speculative: CCC-
In Default: D (or C for Moody’s)
What Are They Based On?
These credit ratings are based on a variety of factors, but all relate to the risk that a borrower will fail to make the payments which it is obligated to do. The risk is that the lender could lose principal and interest, and face increased collection costs. The loss can also be complete or partial.
Some typical factors for analyzing risk include operating experience, management expertise, asset quality, whether they have a current account, leverage and liquidity ratios, and more. Most lenders employ sophisticated algorithms to analyze and manage risk. Most of these algorithms are confidential, but you can assume the basics are included, like cash flow, amount of debt, and more.
Furthermore, any lending is typically subject to terms and conditions on what the company can do going forward, to lower the credit risk to the lender.