Business and Personal Loans - Essay Example

Credit Rating Business and personal loans are not just lent out due to the risk of defaulting, especially where the value involved is material to thelender’s finances. The chances of defaulting by the debtor constitute credit risk, which is dependent on the financial muscle and willingness of the debtor to clear credit. The debtor could be an individual, company or a state, and the lender must rely on the ability of the debtor to meet the obligation of clearing the debt without hardship. It is equally important for foreign investors to base their investment destination decisions on an informed background about the credit worthiness of their country of choice. Credit rating comes in handy to lenders and investors, when the credit worthiness of the debtor or investment status of the entities cannot easily be established. Credit rating is the financial technique used to evaluate the level of credit risk involved in a debt or investment, to determine the ability of the debtor to clear the interest and principal within the expected time. Credit rating agencies apply financial techniques to comfortably ascertain the risk involved in lending, which include both qualitative and quantitative evaluation aspects. Credit rating has evolved over the years and has continued to play a vital role in the credit market making it applicable in industries many financial sectors such as banks, insurance companies, employers, lease companies among many others (Levich, Majnoni and Reinhart, 2002, pp56-153). The pioneering work for credit rating was initiated by renowned business statistics publishing people who later formed statistic companies such as Fitch Knowles (Fitch Publishing Company 1913), John Moody (Moody’s Investors Service 1909) and Henry Varnum Poor and Standard Publishing (Standard & Poor’s 1914). Application of Credit Rating The credit rating uses a customer’s financial performance history to make projections into the reliability of the customer in further financial deals, involving credit worthiness (Levich, Majnoni and Reinhart, 2002, pp57). The credit rating of a customer is translated to have an inversed proportion impact on the general performance of the company that the customer deals with. When the customers’ rating credit risk rating goes high, the company lending credit to them risk to adverse performance in future. It is therefore implies that the credit risk touches on the sustainability of the company, since it directly impacts on the backbone of the existence of the company; financial position. Lower credit rating is translated as high credit risk, which means that the customer exposes the lending company or entity to unfavourable financial risk (Levich, Majnoni and Reinhart, 2002). The higher the credit risk that a business entity is exposed to the lower the returns likely to be obtained. Credit rating is therefore a reflection of the profitability of the company; the essence of doing business. While the company balance sheet may actually be strong, the debt element may actually put the company in a worse condition than when the balance sheet is weak. This is because the ability of the company to sustain its operation relies on the liquidity status which is highly compromised by defaulting debtors. Objectives of Credit Rating There are many financial or business parties that may require the information offered by the credit rating procedure on the customer. Depending on the relevant user, the objective of the credit rating information is varied. The information detailing the credit rating status of an entity seeking credit is mainly used for the following purposes: Credit approval: In business, the financing entity for instance a bank uses the credit rating information on a customer to determine whether it is reasonable to allow credit services to the customer. The credit rating information may be used to deny credit services, when the rating is translated to point at possible defaulting if credit is allowed. Amount of credit: Credit rating information is also used to determine the amount of credit that the bank can lend to the customer. Credit rating is used to determine the amount of credit that the customer can comfortably be lent hinged on the ability to pay. Terms and conditions on credit: Banks and other financiers may use the information on credit rating to set the regulations that the customer will be required to adhere to in the credit agreement (Levich, Majnoni and Reinhart, 2002). For instance, when a customer’s credit risk is high, higher interest rates may be used while a lower credit risk customer may enjoy lower interest rates. It is also a common practice that the credit rating information is relied to set other conditions such as repayment period and collateral. Banks and other lending entities use different stringency measures on repayment regulations depending on the credit risk. For instance, the high credit risk customer may be subjected to a compressed repayment period while the lower credit risk customer enjoys a lengthy repayment period. High credit risk may force the lending entity to demand collateral on credit, while lower risk reduces the collateral value or eliminates it completely. Financial management: Banks and other lending entities review their customer relations based on their repayment progress over the engagement period. Where the customers’ trends seem to increase their credit risk, the company may take stringent management efforts to protect its assets. Efforts taken may include for instance use of more follow-ups on such customers to remind them of their credit obligations to reduce default chances. Retaining confidence: Credit rating information is used by the management of the lending entity to shield investment from hazardous practices such as credit defaulting. Evaluations of the debtors’ reliability, in as far as clearance of debts is concerned acts as confidence yardstick by investors and company’s financiers. In order for the lending company to maintain its investors, assurances of protection against credit risks must be made for instance through credit rating. Credit Rating and Reference Agencies Over the years, the credit rating business has evolved to attract professional agencies which are hired to offer the services to lending entities such as banks. Individuals are rated for credit worthiness based on the individual’s credit repayment potential while companies are also rated for credit worthiness based on the company’s securities strength (Levich, Majnoni and Reinhart, 2002). Governments or countries are likewise rated for credit worthiness which is termed as sovereign credit rating, which is translated as the level of risk involved in making an invest in a particular country. Individuals are rated through credit reference agencies or bureaus while companies and countries are rated by credit rating agencies. Some of the major Credit Rating and Reference Agencies offering the services in the UK include Moody’s, Standard and Poor’s, Dun & Bradstreet, Experian, Equifax, Calcredit, Fitch Ratings among others. Companies are assessed on their securities with regard to the prevailing market environment. Countries are assessed on their status of public and private investment, transparency of stocks market, political environment, economic performance and the general ease of investment by residents and foreigners. References Levich, R. M., Majnoni, G., & Reinhart, C. M. (2002) Ratings, rating agencies and the global financial system. New York, NY: Kluwer Academic Publishers Read More