Today’s term applies to both long and short term borrowing, and though familiar it is often a misunderstood financial term. Let’s take a look at what credit rating means and how it affects businesses, governments, and individuals.
credit rating (n)
- an evaluation of the likelihood that a borrower will repay a debt or financial obligation based on past history, current financial obligations, and worth of the borrower’s financial assets
Generally, credit rating agencies assign credit ratings to any person, entity, or group that wishes to borrow money. This includes corporations, individuals, and even local, provincial, and national governments. When it comes to businesses and governments, credit ratings are evaluated and assigned by major financial institutions such as Moody’s, Standard & Poor’s, and Fitch. Entities pay these agencies for their own evaluations and any outstanding debt concerns.
To evaluate individuals, the three major credit reporting agencies (Equifax, Experian, and TransUnion) review their credit history. Since a loan is a promise to repay borrowed money under set conditions, an individual’s credit rating determines the likelihood of a borrower paying back what they owe according to the terms of the loan. High credit ratings mean that the loan is most likely going to be paid back within the time frame and according to the loan agreement. Poor credit ratings, on the other hand, indicate a borrower has struggled to repay what they owed in the past and may have difficulty maintaining future lending agreements. When a person or organization has a higher credit rating, it means that they are a better candidate for loans and lines of credit.
As a general rule, credit ratings are applied to government entities and businesses, whereas credit scores are for individual borrowers. Credit scores are numbered (usually between 300-850), and credit ratings are given a letter grade. When rating governments or businesses, the ratings are also often referred to as sovereign credit ratings for nations and corporate credit ratings for businesses.
Credit rating agencies for businesses and governments are reported using a letter grade to indicate their creditworthiness. AAA is the highest rating on the Standard & Poor’s rating system, whereas D is the lowest.
So why do credit ratings matter? When it comes to businesses and borrowing, reporting agencies derive credit ratings from a significant amount of research and financial study. Borrowers want to maintain the highest rating possible due to its impact on the amount of interest that lenders charge on borrowed monies, so maintaining good financial health is crucial for growth and expansion. Credit rating agencies, rate companies as objectively as possible based on how well they maintain their corporate financial affairs and their actual capacity to repay a debt. Many investors look closely at credit ratings too, as it is an indicator of whether or not a business venture will earn better returns.
If you don’t maintain your financial bookkeeping well, you may find lenders and investors a lot less forthcoming with the capital you need to grow. Keep an eye on your rating and make it a priority for your accounting department. Smart financial management may one day be a crucial determining factor in long term success and failure.
