Rating Downgrade Raises Borrowing Cost, Signals Higher Risk – DataPro
By Patience Ikpeme
A credit-rating downgrade should not automatically be interpreted as a sign that a company, bank or government is heading for default, but as a warning that its ability to meet financial obligations has weakened and that investors and lenders may need to reassess their exposure, DataPro Limited has said.
According to the credit-rating agency, a downgrade can increase an issuer’s funding costs and subject it to greater scrutiny from investors and lenders, making it important for businesses and governments to understand the factors that lead to a deterioration in their credit ratings.
DataPro, in an article titled “Understanding Rating Downgrades,” explained that rating cuts rarely result from one poor financial result or a single difficult event. Rather, they usually follow a build-up of financial, economic or business pressures that weaken an issuer’s financial position or ability to manage risk.
The company said weakening financial performance is one of the first areas considered when assessing creditworthiness.
It explained that falling revenue, declining profit margins, losses, weaker cash flows and deterioration in the quality of assets can reduce an issuer’s ability to meet its obligations.
For banks and other financial institutions, DataPro said rising non-performing loans, increased impairment charges and pressure on capital and liquidity could also become serious credit concerns when the deterioration is material and continues for a sustained period.
Another major factor is the level of debt carried by an issuer and its ability to service that debt.
DataPro said borrowing could support business expansion, but excessive debt could leave an issuer with less capacity to withstand financial difficulties. Where debt grows faster than earnings or cash flow, or interest payments become increasingly difficult to manage, the level of credit risk can rise.
The same concern applies to governments, particularly where public debt and debt-service costs continue to increase.
According to DataPro, rising government debt and debt-servicing obligations can reduce the room available to respond to economic shocks and increase refinancing risks.
“Debt can support growth, but too much borrowing can leave an issuer with less room to absorb financial pressure,” the company said.
Economic conditions can also place significant pressure on credit quality, particularly when an issuer is exposed to inflation, high interest rates, currency depreciation, economic slowdown or external financial pressures.
DataPro said such conditions could affect an organisation’s revenue, operating costs, cash flow and access to financing.
However, it noted that the effect of an economic shock would depend largely on the financial strength and buffers available to the issuer.
An organisation with strong liquidity, manageable debt and sufficient financial flexibility may be better positioned to withstand difficult economic conditions than one already operating under significant financial pressure.
Liquidity is another major consideration in determining credit quality.
DataPro said an organisation could remain profitable and still experience difficulties in meeting its obligations if it has declining cash reserves, problems refinancing maturing debt or restricted access to new funding.
It therefore described an issuer’s ability to generate cash and secure funding as an important part of its overall credit profile.
The rating agency also drew attention to risks within the industry or business environment in which an issuer operates.
Regulatory changes, technological disruption, supply-chain difficulties, changing customer preferences, stronger competition and falling demand can all affect revenue and profitability.
The risk can become more severe where a company depends heavily on a particular product, market or customer group that is vulnerable to economic or structural changes.
Beyond financial and business performance, DataPro said other developments could also contribute to a downgrade.
These include poor corporate governance, management failures, regulatory or legal problems, political instability, geopolitical shocks and movements in commodity prices.
However, the significance of these factors depends on the extent to which they affect an issuer’s financial position and its ability to meet its obligations.
DataPro also explained that a downgrade does not necessarily follow immediately after a negative development.
When an event or trend emerges that could materially affect an issuer’s creditworthiness, its overall credit profile is reassessed.
The key issues considered include the seriousness of the deterioration, how long it is likely to continue, the cause of the problem and whether the issuer has the financial capacity to recover.
This means that a temporary setback may not result in a rating cut where the issuer has adequate liquidity, manageable debt and sufficient financial buffers.
On the other hand, even a moderate deterioration could become more serious where an issuer already has limited financial flexibility.
DataPro said this explains why credit ratings are forward-looking.
Rating agencies do not only examine an issuer’s past financial performance. They also assess the direction in which its credit position is moving and whether it has the capacity to recover from existing pressures.
The company said a downgrade should therefore be seen as a signal of increased concern rather than an automatic declaration that an issuer will default.
“A downgrade signals that an issuer’s credit profile has weakened, but it does not mean default is inevitable,” DataPro said.
For investors and lenders, the implication is that a downgrade should trigger a closer examination of the issuer’s financial position, debt obligations, liquidity and future prospects rather than an automatic decision to withdraw from the investment.
For companies and governments, the rating action can serve as an early warning that financial or structural weaknesses need to be addressed before they become more serious.
DataPro said the most important issues following a downgrade are to understand what changed, why the change occurred and what is likely to happen next.
It said a proper understanding of these issues could help issuers identify areas of financial pressure early, while enabling investors and lenders to make better-informed decisions about credit risk.
