Thin capitalisation: practical guidance: loan pricing and the use of credit ratings: how do ratings agencies arrive at their ratings?
Considerations for rating agencies
The independent ratings agencies arrive at their ratings by analysing relevant information about an issuer and the industry it is in. When looking at creditworthiness the agencies examine:
- the past performance of the business.
- its market position, for example, its market share, product dominance, pricing power, cost control.
- projections relating to future profitability and cash flow of the business. They will focus in particular on future cash generation, since it is this that will enable the borrower to repay interest and ultimately the principal.
- the gearing of the business (the proportion of the overall funding represented by debt as compared to equity); this is known as leverage in the US. Generally speaking, the more highly geared a company, the greater the risk that it will be unable to service its debts in a timely manner, and the lower the credit rating will be. However, what is seen as highly geared will vary significantly between industry sectors.
In addition to these so-called quantitative aspects, ratings agencies consider qualitative factors, such as
- the quality of management of a particular business.
- the industry in which the subject is engaged: competition, capital intensity required, factors such as volatility and seasonal/cyclical variations.
- the long-term business environment for the particular sector and more widely.
- any guarantees or other forms of credit enhancement.
- the currency of the debt instrument.
Generally, ratings decisions are finalised by a committee, so that a consensus view is achieved, and all conceivable risks are considered.
For a more detailed description of the way in which rating agencies operate, see their websites, for example at http://www.standardandpoors.com/home/en/us, or .