What factors determine a bond's rating Why is the rating important to Essay

What factors determine a bond's rating Why is the rating important to the firm's manager - Essay Example A manager must appreciate that when credit rating of a firm is low; it is more expensive to borrow money since firm has to pay high interest on bonds. As a result higher expenses mean lower earning per share. In the end company will earn low profits and low bond ratings.Calculation of bond rating depends on several factors, these factors are enumerated as under:- 1. If the firm is dependent on debt for its maximum operations its bond rating will be lower. 2. If firm is not making profits, it is obvious that its share value and bond rating will go down. 3. If a firm gives continuous production with little variations in output, its portfolio will be strong and bond rating will be high. 4. Big firms have strong financial reserves, these firms can absorb financial pressures and investors are comfortable to invest in these firms. Big firms have less chances to default than smaller ones therefore bond rating of these firms are generally high. Fortune 500 companies consist of big firms. 5. If loan payback capacity of a firm is high, its bond rating is high. 6. Quantitative analysis is a major factor in determining bond rating of a firm. It includes following assessment :- a. Capacity and ability of a firm to repay its debts and obligations. b. Determination of cash flow, financial stability, balance of payments and returns, capacity to pay interests, capacity to repay principle and financial cushion available to company. c. Evaluation of cash reserves, revenue, investment history and trends, market standing, current and future income trends, safe investment of its capital and projected future profits. d. History to pay back liabilities and projected capacity to pay debts. 7. Qualitative analysis is another factor in determining bond rating. It determines following :- a. Willingness and desire of the company to repay its debts. b. Overall management credibility, ongoing projects and investments, future planning and risk management. Why is the Bond rating important to t he Firm’s Manager. Bond ratings are not static and show variations depending on issuer’s financial position. Ratings are extremely important to a firm’s manager since firm’s existence depends on bonds ratings. Bond ratings are important to the firm’s manager due to following reasons:- 1. Bond rating is an indicator of default risk by the firm and therefore a measure of competence of the manager. 2. Bond rating has a direct influence on interest rate of bond and cost of debt for the firm. Low rated bonds are expensive for the firm and the manager to maintain. 3. Mostly institutions purchase bonds. These institutions are bound by law not to invest in low rated bonds. Therefore it is a matter for survival for the manager and his firm to keep bond ratings higher. 4. If the bond rating is high, investors will have confidence in the firm and invest in bonds. High bond rating indicates that it is less risky to invest in these bonds. 5. In order to succeed , a manager must display thorough understanding of markets where company’s bonds and shares are traded. Although sometimes speculative, bond ratings generally reflect approximate financial picture of a firm. 6. If a bond rating is going down, immediate corrections are required by firm’s manager. A firm manager must re evaluate for Tax shelters and avoid depreciation and losses. He must arrange assets to support borrowings and convert assets to cash if there is a requirement. 7. A manager has to appreciate that bond rating has far reaching implications for the selection and availability of capital structure and ultimate market standing of the firm. 8. A manager must realize that bond rating is an indicator for investors about future financial position of the firm. 9. There is another dimension to importance of bond ratings: many state laws demand minimum bond ratings for presentation as legal investment for insurance, pension funds, trusts and banks. If ratings are lowe r than acceptable value or fall within speculative range, firm’s market standing may collapse. 10. A firm’s desire to access capital markets is also displayed by its choice of bond rating objective.