Financial evaluation: definition, problems and rating agency

What is financial evaluation?

The financial evaluation (assessment, in English) is to assess the solvency of a loan or a company, and, more broadly, the risks associated with financial assets. Whether it is shares, loans or debts of a State (sovereign rating), the financial rating provides investors with the necessary information before investing.

The different rating levels, mostly issued by rating agencies, assess short- and long-term risks. Ratings range from triple A (AAA), reserved for the safest companies, to C, reserved for those in default.

When a company of assessment issue a good rating to a company that has asked to be rated, it is easier to find investors willing to lend capital, a bad rating that has the opposite effect.

Private (businesses, banks, insurance companies, etc.) or public (State, local authorities, etc.), all organizations are likely to be subject to a financial qualification.

The first rating agencies appeared in the United States in the previous century, in the 1920s. Dealing with railroad titles, the 1st assessment was published in 1909 by John Moody. More than a century later, the agency Moody’s is still one of the most prominent listed companies.

To note: in Europe, investors are not authorized to hold more than 5% of the capital of two agencies assessment different

What are the financial qualification issues?

The assessment of the credit risk of a company or a state is very important for investors who are trying to know which foot to take before putting capital.

With the qualification, they have reliable information, obtained through financial analysis techniques and punctuation. The rating makes it possible to distinguish between the companies that could fulfill their obligations vis-à-vis their creditor and/or solidity of a value: shares, obligations, etc. These notes are not fixed. They are updated over time.

To note: to the financial rating is added an extra-financial rating aimed at evaluating companies on their social and environmental behavior (ESG). Complementarily, this approach becomes more and more important.

Among the criteria used by the agencies of evaluation, we find in particular the general financial profitability of the company in relation to its sector of activity, its own profitability, the return on invested capital and also the ratio of debt to equity, etc. From this analysis, the agency extrapolates the forecast financial scenarios. The objective is to assess the probability that interest and principal will be served to investors in accordance with the original schedule.

To note: the Basel II accords base the asset weighting of banks’ regulatory capital on the evaluation agencies. Similarly, securities that insurance companies, UCITS, etc., put in their portfolios are subject to holding rules that take into account the rating agency.

As evidenced by several financial scandals, including the financial crisis of subprime (2007-2008) where poor quality US mortgages were mispriced, the financial assessment is not infallible.

Rating agencies

It is the rating agencies, private companies, that produce and distribute the financial information that investors need. They are paid by the issuer, for example a bank or a company, asking for a valuation.

Good to know: an agency cannot assess an entity if it holds more than 10% of its capital. The 3 main agencies of evaluation they are Moody’s, Standard and Poor and Fitch Ratings. They represent between 85 and 90% of the financial rating market.

While each agency has its own rating system, most use a rating scale ranging from AAA (the highest rating) to C. with intermediate steps. The notes can be associated with a “+” or “-” which allows them to be nuanced.

When the security of a company is poorly rated (for example BAA) it will have to pay a higher interest rate to investors who lend money, since its risk profile is less favorable than an organization classified AAA.

Since the crisis of subprime, agencies operating in the old continent must be registered in the countries where they operate and are required to make public the models, methods and main assumptions on which they base their assessments. They have no right to give advice.

Also, a lack of discernment during the crisis of subprimeagencies are sometimes criticized evaluationan assessment that could be improved when it comes to assessing the sovereign risk of States.

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