Debt Rating

Ratings of debt securities issued by companies, quasi-government organizations, and the government, first originated in the US where several firms offer such services. In India too there are credit rating agencies such as CRISIL, ICRSA, CARE, and Phelps & Duffs.

A debt rating essentially reflects the probability of timely payment of interests and principal by the borrower. The higher the debt rating, the greater the likelihood that borrower will fulfill its obligation to pay interest principal. Debt ratings or debt rating agencies are supposed to offer low cost information, serve as a basis for a proper risk return trade off and impose healthy discipline on borrowers.

Rating Methodology: Despite variations across individual rating agencies, the following features appear to be common in the rating methodology employed by different agencies:

1. Two broad types of analyses are done: (i) industry and business analysis, and (ii) financial analysis.
2. The key factors considered in industry and business analysis are:
(i) growth rate and relationship with the economy,
(ii) industry risk characteristics,
(iii) structure of industry and nature of competition,
(iv) management capability of the issuer

3. Important factors considered in financial analysis are: (i) earning power, (ii) business and financial risks, (iii) asset protection, (iv) Cash flow adequacy, (v) financial flexibility and (vi) quality of accounting.
4. Subjective judgment seems to play an important role in the assessment of the issue/issuer on various factors.
5. While each factor is normally scored separately, no mechanical formula is used for combining the scores on different factors to arrive at the ratings conclusion. In the ultimate analysis, all variables are viewed as interdependent.
6. The rating is expressed in alphabetic symbols. A typical example is the following set of rating symbols employed by CRISIL for corporate debt securities.

AAA: Highest safety
AA: High safety
A: Adequate safety
BBB: Low safety
BB: Inadequate safety
B: High risk
C: Substantial risk
D: In default

7. Industry risk characteristics are likely to set the upper limit on rating.

Advantage and Disadvantage of Debt Financing:

Term loans and debentures are two important ways of raising long term debt. The advantages of debt financing are as follows:

1. Interest on debt is a tax deductible expense, whereas equity and preference dividend are paid out of profit after tax.
2. Debt financing does not result in dilution of control because debt holders (term lending institutions and debenture holders) are not entitled to vote.
3. Debt holders do not partake in the value created by the company as payments to them are limited to interests and principal.
4. Issue costs of debt are significantly lower that those on equity and preference capital.
5. The burden of servicing debt is generally fixed in nominal terms. Hence debt provides protection against high unanticipated inflation.

Debt financing is not an unmixed blessing. It has serous disadvantage associated with it:

1. Debt financing entails fixed interest and principal repayment obligation. Failure to meet these commitments can cause a great deal of financial embarrassment and even lead to bankruptcy.
2. Debt contracts impose restrictions that limit the borrowing firm’s financial and operating flexibility. These restrictions may impair the borrowing firm’s ability to resort to value maximizing behavior.
3. If the rate of inflation turns out to be unexpectedly low, the real cost of debt will be greater than expected.