Accounting - Standard & Poor’s- Report Writing Assessment Answer

Accounting Assignment

Case Scenario

Ratings agency Standard & Poor’s (S&P) downgraded BHP Biliton’s credit rating for the second time within a month (January-February 2016) due to its progressive dividend policy.

Assignment Task

1. How does credit rating affect an investor’s required rate of return? What actions could a firmtake to receive a more favourable rating?
2. How reliable do you find rating agencies’ ratings in general? Also discuss credit ratings fromthe point of view of social responsibility.
3. Impact of credit rating downgrading on the value per share of company’s stock.
4. At this point in time would you consider buying or selling the BHP stock? Give your reasons.

Introduction

This paper focuses on credit rating. A credit rating is a system that evaluates the credit worthiness of an individual or a company. It predicts the capability of a debtor to repay a debt. It is essentially a forecast of the potential defaults of a debtor (Hui, 2015). The credit rating involves qualitative and quantitative analysis of data of the debtor. The aim of this paper is to assess the impacts of credit rating.

Methodology:

This paper focuses on qualitative research. In this method, no quantification of data is involved. Only in-depth exploration of a scenario has been done. The research is exploratory in approach. This option is apt for this research as it has helped in finding detailed information. The research involves secondary data only and information has been sourced from existing researches, literature, etc.

Ways in which credit rating affects an investor’s required rate of return and the actions that a firm can take to receive a more favorable rating:

In banking, the classification of the credit quality is made according to a bank's own criteria ("internal rating") or by international rating agencies such as Moody's, Standard & Poor's, Fitch or DBRS ("external rating") (Lee, 2016). The general rule is that a debtor with a better rating can have access to better conditions of repayment (lower interest rates). By contrast, borrowers have to pay a higher interest rate if they have lower credit ratings because of the risk signified by the higher probability of default (credit risk). The interest spread that has to be paid as compared to a state best credit rating, is called credit spread. A primary strategy that can be used by a debtor to increase credit rating is paying their bills on time. A debtor can implement a system in which it pays bills twice a month instead of the standard practice of paying bills once a month. Another strategy is increasing the credit limit of the company. This can give a debtor a bigger window to have higher credit rating. Another important strategy is credit utilization. A company should focus on lowering debts. This will lead to better utilization of credit and lower interest payments (Packer, 2010).

Reliability of rating agencies’ ratings and discussion of credit ratings from the point of view of social responsibility:

According to Packer (2010), till the initial years of the 1970s, credit ratings agencies used to get remuneration for their assessments from investors as they wanted to get unbiased and authentic data on potential investments and the ability of prospective debtors to repay the debts. However, from 1970s, the three biggest agencies, S&P, Moody's, and Fitch, started to get paid by the securities issuers. This established criticism and charges that the agencies were not impartial any more. Securities issues have been charged of paying credit rating agencies to get favorable ratings from the leading agencies. This is one the biggest factors that led to the subprime mortgage crisis of 2007. Based on high ratings given by agencies, some high risk mortgage-supported securities and collateral based debts, got high amounts of investments from different parties. Ultimately, these were devalued immensely and a lot of money was lost by individuals as well as companies. Thus, rating agencies are not completely reliable. While they have a social responsibility to provide authentic and unbiased information, they have become susceptible to corruption and bias and in turn, their credibility has decreased (Hui, 2015).

Impact of credit rating downgrading on the value per share of company’s stock:

As per Hui (2015), in a scenario where a company's credit rating is stable or is increasing, there is no impact on the share value. In this kind of a situation, investors are careful about the rating, but it is just one of the factors that are considered. Rather, the fundamentals and technical factors of the company are considered to be more important for understanding the potential of the company. However, as per Marks (2016), if credit rating is downgraded, the stock price is definitely influenced and share value is lowered. This is because a downgrade implies that certain aspects of a company’s data is worrying and is negative. It indicates that the company is a risky investment and the chances of default might be higher. A downgrade basically highlights that the company’s performance has been bad.

Actions to be taken with respect to BHP stock:

As per Rose (2016), it must be noted that when BHP’s shares fell in late 2015, a silver lining was that the investment company, Liberum Capital, helped in increasing the share prices in the UK market. BHP Billiton Ltd has high investments in commodities, and the price of copper is a major factor that affects its share prices. Orit (2016) has pointed out that in recent times, the mining domain has faced heavy losses with iron ore and the copper scenario is weak. The supply of copper is going to reduce due to this. In the past few years, the share prices of BHP have fallen significantly. However, as per Newman (2016), the company can bounce back. In early 2016, the iron ore and oil sectors are showing growth and consumption is on the rise. But, it is important to remain careful as there is oversupply of iron ore and oil and consumption can reach saturation soon (Newman, 2016). In the present scenario, it is ideal to hold the shares of BHP and not sell them off. At the same time, it is also ideal to refrain from buying any more shares of the company.

Conclusions:

It can be concluded that credit rating is a system that evaluates the credit worthiness of an individual or a company. A debtor with a better rating can have access to better conditions of repayment (lower interest rates). By contrast, borrowers have to pay a higher interest rate if they have lower credit ratings because of the risk. This paper points out that while they have a social responsibility to provide authentic and unbiased information, credit rating agencies have become susceptible to corruption and bias and in turn, their credibility has decreased. The paper concludes that in the present scenario, it is ideal to hold the shares of BHP and not sell them off. At the same time, it is also ideal to refrain from buying any more shares of the company.