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You would have often come across the term ‘credit quality’ in investment related literature. This is nothing but the creditworthiness of a borrowing company. A company is said to be of high credit quality if its financial strength and business conditions point to a reasonably assured repayment capacity of principal and payment of interest on its borrowings.

The credit quality of a borrowing company depends both on quantitative and qualitative factors. Quantitative factors cover an evaluation of the borrower’s financials, which is usually assessed through ratios such as the debt-equity ratio, interest coverage ratio, liquidity ratio, etc. Qualitative factors cover assessment of the nature of industry, competitive scenario, size of the business with respect to the industry size, etc. Evaluation of these factors is not very easy and practically impossible for an individual investor. Credit ratings by designated agencies can help you in understanding the credit quality of those borrowings.

What are credit ratings?

These are symbolic representations of a borrower’s credit worthiness. You would have come across symbols like AAA, AA+, AA- etc. in bonds and debentures. These are examples of credit ratings which are formulated by third party rating agencies such as CRISIL, CARE, etc. to simplify the process of credit appraisal and bring standardization to the process. These ratings are very useful to investors in appraising the credit quality of a borrower before lending money. Bonds, deposits and debentures are the usual modes that borrowers use to raise money from investors, and credit ratings play an important role in conveying the credit quality of the borrower. Credit rating becomes compulsory for certain types of borrowers and borrowings; credit rating is mandatory for most issues of bonds and debentures by corporates and for Non-Banking Finance Companies (NBFCs) that accept deposits. It is optional for Public Sector Enterprises. It is pertinent to note that this rating is not carved in stone for a borrower and may change depending on the borrower’s future growth prospects, amount of debt taken, the financial and business environment, etc. The borrower’s credit rating may be up-graded or down-graded if the situation so warrants. A high credit rating is by no means a guarantee against default.

How would credit quality affect your investment decisions?

A lender would want the borrower to repay the principal and pay interest promptly, as promised. To ensure this, it’s important to check the creditworthiness of the borrower before putting your money in bonds, debentures or deposits. High credit quality and rating (say AAA) would mean relatively high safety of principal and interest obligations. These borrowers would hence pay a lower interest rate than those with a lower credit quality and rating (say AA- or A). So before you put your money in bonds, debentures or deposits, you need to have clarity on the risk involved in the same and whether you are being adequately compensated for the risk taken. You would do well to avoid putting your money in very low rated instruments as it entails a high level of risk, though you may be tempted by its high interest rate.