A credit rating is an assessment by a third party of the creditworthiness of an issuer of financial securities. It tells investors the likelihood of default, or non-payment, by the issuer of its financial obligations. Credit analysis is the financial analysis used to determine the creditworthiness of an issuer. It examines the capability of a borrower, or issuer of financial obligations, to repay the amounts owing on schedule or at all.
Establishing the creditworthiness of borrowers is one of the oldest established financial activities known. Through history, the act of lending funds has been accompanied by an examination of the ability of the borrower to repay the funds. The most ancient civilizations and societies known to us often show development of sophisticated trading and banking activities. The medieval bankers of Europe were thorough in their examination of their clients' affairs and often decided the outcome of wars and the fate of monarchies with their financing. This type of direct lending and banking relied largely on character and direct knowledge of the financial situation of the borrower.
As modern accounting and finance developed during the industrial revolution, banking and lending grew to a larger scale and became more systematic. Just as governments developed sophisticated bureaucracies to deal with the complexities of national governments, large banking and financing houses grew to cope with the demands of international trade.
Modern credit analysis developed in the late 1800s when the credit markets began to issue and trade bonds, largely to finance the development of the new world, particularly the United States. As lenders were purchasing bonds of countries and companies that they had little personal knowledge of, third party credit rating agencies such as Duff & Phelps, Inc., Moody's Investors Service and Standard and Poor's Corporation were founded to fulfill the need for an impartial assessment of the creditworthiness of bond issuers.
These companies, most still active today, developed scoring systems that told investors of the creditworthiness of issuers. Each rating agency has its own nomenclature or "investment grade" that ranks the default risk of issuers. The scale begins at the highest quality ratings, such as AAA, with very low probability of default, and descends to risky or "speculative" ratings, such as BB, where the risk of default is high.
An example of a rating system is the Ratings Definitions of Government Debt of the Canadian Bond Rating Service (CBRS), which is shown below:
Ratings Definitions Of Long-term Government Debt:
Highest Quality ... AAA
Very Good Quality ... AA
Good Quality ... A
Medium Quality ... BBB
Lower Medium Quality ... BB
Poor Quality ... B
Speculative Quality ... C
Default ... D
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