Corporations have two ways of raising capital to finance their growth or any other business needs: equity financing and debt financing. Equity financing most often takes the form of issuing stocks to the public and results in investors owning a portion of the company. Debt financing can come in two forms: loans or bond issuances.

Loans simply involve receiving a sum of money from a bank and paying it over a set time frame with interest. Bond issuances are debt securities issued by a corporation, or other agency, and sold to an investor. The company receives payment upfront from the bond purchaser and makes regular interest payments to the bondholder and a return of the principal amount at the time of the bond's maturity.

When purchasing a bond, an investor, as with any other asset, wants to know how risky the investment is. What is the likelihood they will receive their interest payments and the principal amount at maturity from the company? What kind of financial condition is the company in that it will be able to honor its debt obligations? Or will it default on its payments?

When a company, government agency, or municipality issues any debt security, a credit rating is usually sought by an investor. The rating is published so investors can judge the creditworthiness of the issuer and gauge the risks associated with buying its debt.

Key Takeaways

  • Corporations utilize either equity financing or debt financing to finance their growth or other business needs.
  • Equity financing involves the sale of shares on stock exchanges to investors that then become owners of the company.
  • Debt financing involves loans from banks or bond issuances to investors.
  • Bond issuances require a company to make regular interest payments to bondholders and the return of the principal amount at the time of the bond's maturity.
  • To determine how risky a bond investment is, investors look at the credit ratings of corporations, government agencies, or other entities issuing bonds.
  • The three main entities that conduct analyses and provide credit ratings are Standard and Poor's (S&P), Moody's, and Fitch Ratings.
  • Credit ratings are usually updated quarterly with an assessment of the entity's most recent financial status. Annual updates most often accompany a lengthier analysis.

Rating Agencies

There are several credit rating agencies that provide a thorough analysis of an issuer's finances and assign a rating according to their findings. The rating is typically reviewed and restated quarterly, with a full analysis provided annually for higher volume issuers.

The three main credit rating agencies are Moody's, Standard and Poor's, and Fitch Ratings. The bond rating process begins with an initial meeting between an agency's analyst and the company's management to review financial statements. Financial strength ratios are calculated to help the analyst determine the likelihood of the indenture being repaid.

After the analyst judges the financial strength of the company, a board of ratings analysts meets to collaborate on finding an appropriate rating for the issuer's current state. The final rating is revealed to the issuer and the public via a press release.

After the initial rating, the assigned analyst keeps in contact with the issuing company's finance team and reviews its rating periodically. Ratings are often reviewed each quarter—in which upgrades or downgrades are possible—after a company releases quarterly earnings information.

Ratings can also be updated before a regularly scheduled rating if there is significant news or action taken by a company. For example, if a company decides on an acquisition, or releases a new product, or spins off a portion of its business, rating agencies will assess the new information and the impact on the company, and either confirm the existing rating or update it. Credit ratings are always forward-looking.

If a rating agency has not updated a credit rating quarterly or annually, then the last credit rating is the valid one. A credit rating does not expire. It's also important to note that rating agencies do not provide investment recommendations. They do not indicate whether an investor should purchase or sell the investment, but rather, simply provide an analysis on the credit quality of the entity for the investor to use in their decision-making process.

Credit Ratings

Each of the rating agencies has its own rating scheme, though the schemes are very similar. Ratings are most often assigned letter ratings. For example, S&P's rating scheme starts at AAA, the highest rating, indicating the best credit quality, and ends at D, the lowest rating, indicating the poorest quality credit.

Similarly, Moody's rating scheme begins at Aaa and ends at C.All credit ratings are commonly known to be broken into investment grade and non-investment grade ratings. Investment-grade ratings are those with a good credit quality with a low risk of default whereas non-investment grade ratings are those with poor credit quality and a high risk of default.

The Bottom Line

Credit ratings help debt investors gauge the risk of purchasing a debt obligation. The ratings are provided by rating agencies; the three most common being S&P, Moody's, and Fitch Ratings. Credit ratings function on a scale and are either investment grade or non-investment grade, helping investors to make prudent investment choices. Credit ratings are most often updated quarterly or any time significant news is released that could potentially impact an entity's credit rating.