Almost every company has some sort of external rating of its creditworthiness. For larger companies that issue debt in the public markets, this may include ratings by the well-known rating agencies such as S&P Global, Moody’s and Fitch Ratings. Companies are also assigned ratings by their banks, certain credit insurance providers, and third-party credit monitoring services. Let’s take a look at the primary reasons why these ratings matter.
Corporate credit ratings have a wide range of financial implications, such as the amount of trade credit received, terms of bank financing, and coupon paid on public debt.
Financial implications include:
- The interest rate paid on debt is highly correlated to the credit rating. Most banks and many investors use a “risk adjusted return on capital,” or RAROC, to evaluate profitability and guide lending and investment decisions. A 3% interest rate to a company with somewhat shaky prospects is intuitively different from a 3% loan to Walmart. Which loan would you want to make?
- Similarly, credit ratings influence the other terms of debt, such as required collateral and covenants. An investment-grade borrower (BBB- rating and above) can generally borrow without collateral, while some riskier companies may only be able to borrow if the lender has all assets of the company as collateral and even controls the company’s bank accounts and lockboxes!
- Vendors may use a credit rating to determine the need for prepayment or extension of payment terms, which influences the amount of working capital and need for borrowing.
- Given that your banks are using the risk rating to determine their RAROC, a higher credit rating can enable your banks to earn more money without you paying more and limit complaints about side business from your banks. Bank ratings can vary by two or even three notches from bank to bank.
Credit ratings also have strategic implications for the business profile for customers, suppliers, employees and investors.
Strategic implications include:
- A company’s credit rating represents its credit profile and riskiness to investors, employees, customers, vendors, and lenders. Customers and vendors will be hesitant to transact with a company if they fear it will default and declare bankruptcy.
- A higher credit rating allows banks to approve larger requests for credit more quickly. This can be an important consideration for mergers and acquisitions.
- Higher rated companies have access to additional sources of liquidity, such as commercial paper, and can put supply chain finance programs into place for vendors, potentially improving pricing.
- Managing the story rating agencies tell is a way to influence the public discourse about a company’s risk profile and future prospects. If the rating analyst does not understand the business and publishes less favorable opinions, lenders and investors may believe the analyst. This will likely affect the yield required on institutional and bank debt, as well as the stock price.
Boosting your ratings
How can you actually improve your ratings? Ratings can be improved when companies evaluate and change qualitative elements, quantitative factors and structural elements, and when they have a dedicated focus and communication strategy for credit rating analysts.
Quantitative factors may consist of issues beyond your control in the short term, such as scale of the business, EBITDA margins, leverage ratio, and cash flow metrics. Qualitative factors used in most ratings models include an analysis of the business profile, such as demand, brand value, competitive profile, prospects for growth, financial policies such as acquisition or shareholder-distribution policies, and other factors. Structural elements include an analysis of the debt capital structure, collateral package and relative recovery prospects for debtholders in a downside case.
Although some of these factors are difficult to improve in the short to medium term, changes to debt structure and improved understanding of the business profile can move the needle. For example:
- Financial policy: communicating an increasing share of cash flow used to repay debt, reducing perceived risk.
- Debt structure: the mix of secured and unsecured debt can improve ratings by influencing the potential recovery on debt in a default scenario. Recovery analysis is quite technical and requires a good amount of expertise and dialogue with the ratings counterparty.
- Business profile: providing the right story and data to a ratings analyst can erase misperceptions. Many times the analyst simply does not want to do the hard work evaluating the business or does not want to ask questions.
Building a long-term strategy to improve your corporate credit rating
The proper communication strategy and capital structure can help to optimize and improve your rating, but this approach requires a tailor-made solution for your unique business and situation.
Redbridge has the expertise, deep knowledge of bank and rating agency processes and senior-level resources to help you improve your ratings for current needs and future strategic priorities. Ratings require a dedicated, long-term strategy, and the sooner the process starts, the sooner the ratings improve.