The Use of Credit Rating in Your Business
Today, the importance of credit rating is significant. With investment opportunities and trading activities becoming more global and diverse, it is often challenging to decide which companies will make the right business partners and/or customers.
One useful way in good decision making amongst shrewd investors and businessmen is the adoption of credit rating as an analytical tool to assess the creditworthiness of companies. While most trading companies use credit rating to determine the credit terms and credit limits to be extended to their customer, financial institutions commonly adopt credit rating to ascertain the cost of borrowings and loan quantum for corporate and individual customers.
In addition, credit rating is especially useful in grading financial instruments such as bonds, preferred stock, etc. and serves as a fundamental basis of comparison amongst investors that are shortlisting from a wide range of financial instruments available in the market today.
Increasingly, financial institutions are requesting SMEs to obtain their credit ratings from an independent financial assessor to provide a third-party analysis of the SMEs’ financial health in their loan application procedures. The same applies to many Government Institutions such as the Building & Construction Authority (BCA) who has appointed DP Information Group (DP Info) in 2006 to perform credit rating on A1, A2 and B1 graded construction companies that are eligible for government construction projects. This is one of the government’s initiatives to ensure that projects do not fail due to over-gearing or weak cashflow management of their developers.
In fact, credit rating has become a two-pronged tool used by not just the fund lenders or providers, but also by fund borrowers who have become keener to understand and improve on their own financial health in order to negotiate for more favourable credit terms. This also motivates SMEs to upgrade their financial management skills and work on improving their cash flow capabilities to improve their credit standing. Furthermore, having a good credit rating allows SMEs to showcase their strength to fund providers and investors, and also illustrates the company’s commitment towards corporate transparency which is important in investors’ decision-making process.
One effective and accurate way of evaluating the credit rating of a company is the DP Credit Rating, a proven model which is derived based on a rating model designed for companies incorporated in Singapore and it takes into account the performance of 6 broad risk categories:
- Profitability
- Capital Structure
- Liquidity
- Activity
- Growth
- Size
DP Credit Rating measures the Probability of Default (PD) of a company. The probability of default (PD) measures the probability that a company will default within a time horizon - usually computed on a 1-year basis (Example: a company with a PD of 1% means that it has a 1 out of a 100 chance that it will default within the given time horizon).
Companies are graded on a credit rating scale of DP1 to DP8 where DP1 denotes the lowest PD of less than 0.1% and DP8 signals a high default risk of 14.0% to 30.0%. Based on the DP Credit Rating, companies can be classified into 3 risk categories: Investment Grade (DP1 – DP4), High Yield (DP5 – DP6), and High Risk (DP7 – DP8).
| Grade | DP Credit Rating | Default Frequency |
|---|---|---|
| Investment Grade | DP1 | < 0.1% |
| DP2 | 0.1% - < 0.2% | |
| DP3 | 0.2% - < 0.4% | |
| DP4 | 0.4% - < 1.0% | |
| High Yield | DP5 | 1.0% - < 3.0% |
| DP6 | 3.0% - < 8.0% | |
| High Risk | DP7 | 8% - < 14.0% |
| DP8 | 14.0% - 30.0% |