What is a credit rating?
Credit rating and credit score are two terms that are often used interchangeably by consumers, but keep in mind that they're not the same. A credit rating measures the ability of a business or government to repay its financial obligations by looking at its history of borrowing and repaying loans. A credit score does the same, but measures individuals (and in some cases, small businesses).
The difference between a credit rating and a credit score
A credit rating is expressed as a letter grade and conveys the creditworthiness of a business or government. It's used to establish whether a loan should be granted to a business, and if the loan moves forward, it helps determine the length and term of the loan.
The assessment and evaluation for companies and governments are typically performed by a credit rating agency, such as Moody's Investor Services, Standard and Poor's (S&P) and Fitch Group. These ratings are used by investors, issuers of debt, investment banks, businesses and corporations. A typical credit rating scale uses letter ratings.
Credit scores are assigned to each person over the age of 18 and some small businesses. The scores typically consist of three-digit numbers. They're used by lenders to determine an individual's creditworthiness, or how confident a lender is that you can pay your debt back. It considers several factors including how consistent you are with making credit card payments and payments on loans and other bills. Individual credit scores for consumers are generated by each of the three major credit reporting agencies (Experian®, Equifax® and TransUnion®) and the scores range from 300 to 850.
A credit score indicates an individual's credit health. This indicates whether the individual can undertake a certain loan, as well as their ability to repay it, helping to gauge the level of risk attributed to an individual when it comes to repaying a loan. It's used by banks, credit card companies and other lending institutions that serve individuals.
What is a good credit rating for a business?
All agencies set different scales, but the most popularly used scale is the one produced by S&P Global. This scale uses AAA ratings for corporations or governments that have the highest likelihood to meet their financial commitments. This is followed by AA, A, BBB, BB, B, CCC, CC, C and D. Pluses and minuses may be added to the rating to differentiate between ratings from AA to CCC.
A triple-A rating is considered the best. It shows that the business is likely extremely capable of meeting its financial commitments. Ratings of BB or lower are considered “junk" ratings. Companies with scores that fall between the two categories are average but may be under observation by the credit rating agencies. Ratings lower than BBB are considered “non-investment grade," while those between BBB and AAA are considered “investment grade."
A credit rating of D may be given when financial obligations aren't met and payments aren't made. This low rating is given if a company has filed for bankruptcy. Maintaining a good credit rating can improve your business's likelihood of banks and lenders approving the business for financing. A poor credit rating may show that a business is unable to repay debt and limit its financing options.
Why credit rating is important
A credit rating is a major factor when deciding whether a business receives the loan they're applying for. If a business's credit rating is in good standing, the chance of easily borrowing from financial institutions may increase. It helps determine the probability that borrowed money will be paid back, as well as the risk a business poses to a lender.
Banks typically base the terms of a loan for a business off their credit rating, and the terms of a loan for an individual off their credit score. The better a business's credit rating, the better the terms it may receive. If your business has a poor credit rating, this may stand in the way of you obtaining a business credit card or a mortgage for an office space, for example.
Many lenders will keep the 5 C's of credit in mind when looking at a business' credit health. The 5 C's of credit are:
- Character
- Capacity/cash flow
- Capital
- Conditions
- Collateral
These characteristics are used by the lender to evaluate your business's potential as a borrower and assess creditworthiness. Lenders also look at credit reports, credit ratings, and other documents that are relevant to the financial situation, as well as information about the loan.
How can a business establish a credit rating?
Establishing and maintaining a good credit rating is an important way for a business to increase its chances of borrowing money. A low credit rating could prevent a business from borrowing any money at all. Here are several ways to establish credit:
Check your credit report
By looking at their credit report, a business may be able to get the information it needs to raise its rating, including which accounts are affecting it negatively and any disputable items on the report.
Pay your bills on time
Paying bills on time may seem like an easy decision, but it's one of the easiest ways a business can establish credit rating. If a business doesn't make on-time payments, there's a good chance that its credit rating will suffer. Lenders may view a business as a potential repayment risk.
Evaluate any errors and inquiries
The information in a report should be accurate and up to date. If there are any errors on an individual's or business's report, it's possible to remove them from the report after filing a dispute.
Decrease your business's credit utilization ratio
Credit rating and reporting agencies look at the ratio of credit used compared to the amount that is available, so it may be wise to keep the business's credit utilization ratio low. You may be able to do so by paying off balances, increasing your credit limit, decreasing spending or opening a new line of credit.
Understanding a business's credit rating and how lenders use it to make decisions is a helpful way to improve financial literacy. In addition, you can use this information to improve and monitor your business's credit rating over time.
