The rather dry news that insurance giant QBE Insurance (ASX: QBE) has had its rating cut by back from A3 to Baa1- by rating agency Moody’s would have likely slipped by many investors. After all, the share price still rose and people will keep paying their policies as they fall due, so what impact do a few obscure letters have on a company, and does it matter?
Credit ratings may not impact the revenue a company receives, but can still have a big impact on the bottom line by increasing the interest rate the company pays on its debt. The ratings represent an opinion of how creditworthy the company is, and how likely it is to default. QBE’s downgrade was the result of lower than expected earnings which Moody’s perceive as an increased risk that QBE may not be able to pay its debt obligations.
According to Moody’s scale, a ‘Baa’ rating represents a moderate credit risk and as such “may possess certain speculative characteristics”. The ‘1’ indicates being at the top of the scale, while the ‘negative’ implies the rating may be lowered further.
Whether or not you trust rating agencies after their involvement in the diabolical sub-prime mortgage fiasco, it’s important to realize the impact credit ratings have on a company’s borrowing costs. Origin Energy (ASX: ORG) is expected to have to pay higher borrowing costs on up to $2.4 billion of debt to a consortium of banks including ANZ Bank (ASX: ANZ) and Commonwealth Bank (ASX: CBA) as a direct result of having its credit rating cut to Baa2 by Standard & Poors in March.
It’s scary to know that borrowing costs rise exponentially as the credit rating gets worse and although the increments can be small — just 20 basis points in Origin’s case — the figure adds up quickly when applied to billions of dollars.
There are various ways for investors to evaluate the stability of a company. Credit ratings may be worth a glance, but it could be more valuable to look at the debt ratios of a company, such as total debt level ratio (debt/total assets) or debt to equity ratio (debt/equity). A total debt ratio greater than 1 indicates more debt than assets, while for a debt/equity ratio 1 indicates an equal measure of liabilities and equity.
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