Credit rating agencies carry out credit rating. Companies appoint these agencies to assign credit rating for their corporate issues. The rating agencies may conduct credit examination either for the entire company or on a specified debt obligation of that company. In case of bankruptcy, the rating agency may assign different ratings for different issues of the company. For example, the rating may depend upon the seniority of the bondholders of each issue of a company.
The factors to be considered in assigning a credit rating are - Character, Capacity, Collateral and Covenants:
Character: This is a measure of the firm's reputation, its willingness to repay, and its credit history. In particular, it has been established empirically that the age factor of an organization is a good proxy for its repayment reputation. The history of the business and experience of its management are critical factors in assessing a company's ability to satisfy its financial obligations.
Capacity: The ability to repay debts reflects the volatility of the borrower's earning. If repayments on debt contracts prove to be a constant stream over a period of time, but earnings are volatile (and thus have a high standard deviation), it is highly probable that the firm's capacity to repay debt claims would be at risk.
Collateral: In the event of a default, a lender has a claim on the collateral pledged by the borrower. Greater the proportion of this claim and greater the market value of the underlying collateral, lower will be the remaining exposure risk of the loan in case of a default.
Covenants: Agreed terms and conditions between the borrower and lender are called covenants. Two types of covenants are seen in a lending agreement - affirmative covenants (promise of the borrower to meet certain promises like paying interest, principal, taxes, etc.), and negative covenants (restrictions to the borrower regarding what actions are prohibited).