What is rating? Meaning, definition and why it matters

In the financial world - and not only - the term "rating" plays a crucial role in assessing the reliability, quality or risk associated with an entity or product. But what exactly is a rating? This concept is closely linked to the ability of a subject, such as a company or a State, to fulfill its financial obligations, but it also finds application in less traditional areas such as the insurance sector, online commerce and even entertainment platforms.

A very important word, when talking about rating, is trust. We insist on the concept of trust because to the question what is a rating we could answer by defining it as a judgment on the reliability of a company.

In studying ratings, it is also crucial to analyze the entities that issue such judgments, namely the rating agencies, which are even capable of moving the markets with their pronouncements. Let’s see, then, what rating is, what it is for and why it is so important for the entire market.

What does rating mean: let’s give a definition

In general, rating means both a recommendation by analysts regarding the opportunity to sell, buy or keep a security, and an assessment of the company’s ability to repay its debts. A real risk indicator. But, going deeper, we could give this definition.

The term "rating" indicates an evaluation expressed through a predefined scale that measures the ability of an entity to fulfill its obligations or the risk associated with a specific operation. In the financial sector, the rating is mainly used to evaluate the solvency of debt issuers, such as companies or governments. Rating agencies, specialized and independent entities, are responsible for assigning these scores through standardized and rigorous methodologies.

As we will see, a high rating, such as "AAA" according to the Standard & Poor’s scale, indicates a very low risk of default. Conversely, a low rating, such as "D", signals significant financial difficulty. Beyond the financial sector, the concept of rating has expanded to various contexts, such as consumer reviews of products and services, evaluations of suppliers in the industrial sector and even software security scores.

This classification is essential to ensure transparency and trust in the markets, as it provides an objective measure of the risk associated with an entity or transaction. For example, an investor might choose to buy bonds issued by a company with a high rating to minimize risks, while a consumer might rely on the ratings of other users to choose a product online.

Who are the rating agencies and what do they do

The ones who issue these judgments are the rating agencies, which allow, through their work, to draw up a real ranking based on the risk of default associated with each subject examined. If, therefore, the rating allows us to understand how much that subject is able to honor its debts, this judgment will also be a measure of its degree of reliability on the market and will influence the strategies and oscillations of the same securities.

Rating agencies are independent institutions whose main task is to evaluate the ability of debt issuers to honor their financial obligations. Among the most well-known agencies globally we find Standard & Poor’s, Moody’s and Fitch Ratings.

These agencies carry out in-depth analyses based on a wide range of data, including financial balance sheets, business strategies, macroeconomic conditions and geopolitical factors. Their assessments translate into a rating scale that varies from "AAA" (maximum reliability) to "D" (default or insolvency). In addition to assessing credit risk, some agencies also analyze specific financial instruments, such as structured bonds or derivati.

The role of rating agencies, however, is not free from criticism. Some observers believe that they can excessively influence the markets, while others point out potential conflicts of interest, since they are often paid by the same entities that evaluate. However, their function remains essential to ensure a certain uniformity and transparency in the global financial system.

Types of ratings

You can identify different types of judgments: we can mention some of them to better understand the topic. The ones we have talked about so far are credit ratings issued on a company’s debt, alongside, for example, international credit ratings, ratings on the debt of nations and also the country ceiling rating. What is the difference?

• Credit rating: it is an opinion by the agencies regarding the solvency of a company. Through this rating, an investor who is undecided about whether to buy corporate bonds will be able to verify the issuer’s ability to repay the amount at maturity. The better the rating, the more attractive the investment will be.
• International credit rating: in this case we are referring to opinions that allow you to understand the risks and costs of transferring foreign securities (therefore expressed in foreign currency) to your own country and in your own currency.
• Rating on the debt of nations: just as in the case of companies, a State also issues bonds. The more it is able to repay its debts, the better the rating assigned to it by the agencies will be. Let’s take a European example: Germany is considered the most reliable country and its rating is high, unlike Italy and Greece which have much lower ratings.
• Country ceiling rating: in this case the risks and costs of an investment outside national borders are assessed. The judgment is expressed regarding the possible measures that a State can or cannot implement to block the exodus of capital.

How does the rating work and how is it calculated?

The issuance of a corporate rating is an operation that requires the agencies to carry out a rather detailed study, especially because these judgments are also able to influence the market itself.

1. The first step is the economic-financial analysis, which allows you to examine the balance sheet, profitability, remuneration of capital, cash flows, its ability to produce resources and income and a whole other series of fundamental company parameters.
2. Once these aspects have been examined, we move on to the sector analysis, which allows the agency to carry out a comparison with similar companies operating in the same context. This type of analysis also allows us to highlight the future prospects of the entire market, which can obviously have repercussions on the company and therefore on the rating assigned to it.
3. Then we have the part dedicated to the quantitative and qualitative analysis of the company, in which the rating agencies also examine the management itself, the general management, the structure, the objectives and the choices made.

Once all the necessary documentation has been obtained, and after consulting the Central Risks and monitoring all the company’s movements, the rating agency will be able to express its judgment in approximately 90 days.

Given the premises, the rating is essential for several reasons:

• access to credit: a high rating facilitates access to financial markets at advantageous conditions;
• investment decisions: investors use the rating to evaluate the risks associated with a security or an issuer;
• transparency: it guarantees greater clarity in the markets, helping to prevent financial crises.

Rating classes depending on the rating

What are the classes assigned to a company, but also to a State? While it is true that ratings are assigned by rating agencies, it is equally true that each of them has its own particular yardstick and well-defined classes. Generally speaking, however, the yardstick used is that of the letters of the alphabet: the closer we get to the letter A, the better the rating.

Let’s take into consideration one of the most important agencies on the market: S&P. For Standard & Poor’s the rating classes, aimed at establishing the ability to repay the debt, are the following:

Note how each of these ratings can be followed by a - sign or a + sign. Both are an expression of an upcoming worsening/improvement of the situation.

In the case of Moody’s the scale varies as follows:

• Aaa: minimum risk
• Aa: high quality debt
• A: good quality debt, subject to future risk
• Baa: medium degree of protection
• Ba: speculative risk on debt
• B: low probability of repaying debt
• Caa/Ca: high risk investment
• C: realistic risk of insolvency

Now that we have understood what a rating is and what it is used for, we must also remember that the same agency can issue two ratings on a company, one short-term and one long-term, but both expressions of the different expectations of the agencies regarding the company’s or a State’s capabilities.

Original article published on Money.it Italy. Original title: Cos’è il rating? Significato, definizione e perché è importante