Advantages and disadvantages of credit rating agencies

Written by thomas jones Google
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Advantages and disadvantages of credit rating agencies
Poor credit rating minimises the chances of attracting investors or obtaining loans. (Digital Vision./Digital Vision/Getty Images)

Credit rating agencies are commercial companies that prepare credit reports to help lenders decide whether to issue a loan to a borrower. The agencies collect information from various sources and compile comprehensive reports based on the borrower's past credit performance and current state of finances. Usually a borrower with a poor credit rating has no chance of securing a loan or even opening a current account at any of the UK’s top banks. In such cases, UK legal entities need to look to alternative options, such as borrowing from private lenders. Although there are firms that offer credit “repair”, the Financial Services Authority warns companies against using their services due to a high risk of fraudulent activities.

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Ease of raising resources

A company with a good credit rating can easily raise money from banks or investors because they are more likely to trust in its ability to repay. Because credit ratings are indicative of current financial health, a company with a good credit rating is also more likely to attract new customers and forge profitable business partnerships. Moreover, any company considering going public and selling its shares needs to have a good rating.

Cheaper loans

A good credit rating makes a company eligible for loans from big, established banks. Because those banks, as a rule of thumb, have better products and lower rates compared to smaller or less successful lenders, the cost of the loan for the borrower is lower.

Transparency

A company's credit rating is an independent assessment of its credit performance. Ratings give investors and lenders the opportunity to better assess the risk of giving money to a company. While company financial statements and ratios offer insight into objective economic indicators, the credit rating is a measure of the company’s faithfulness towards its debtors in the past and likelihood of proper conduct in the future.

Bias

Company rating agencies are independent from the business under assessment, or for that matter, any other side with an interest in a particular outcome of the assessment. However, credit rating is done by people who may well have their own subjective opinions or preferences which can affect the scores. It is important for the agencies to be as fair as possible, but investors should keep in the back of their minds the fact that ratings are not visualisations of absolute truth.

Static study

Another problem with credit ratings is that agencies conduct static studies based on former credit performance and current company financial state. What these agencies do not do is forecast the company’s future expansion or any effects of changes in the external environment that are likely to affect the company during the year.

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