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Credit rating
Companies should not rely only on the services provided by external credit rating agencies like S&P because these agencies are not infallible, especially in the light of what happened with the worldwide financial crisis in 2008, when the rating system objectivity of these agencies was seriously questioned.
Moreover, a counterparty may not have any published credit rating, and other methods to undertake its credit assessment should be used, as follows:
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a credit analysis
this could be obtained by the client’s bank, in the form of a credit report, though, for the same reasons as the ones above, companies should not rely on that solely, as banks tend to protect their customers. Instead, companies should investigate the counterparty’s trade credit by looking at the balance sheet and income statement, which are published accounts and accessible to anyone, together with a financial ratio analysis (interest cover, earnings per share, return on capital, etc..)
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a detailed credit research
this could be based on companies’ own internal rating systems taking into consideration hard information about creditworthiness and soft information (e.g. senior management quality assessment) as well as historical data (e.g. an assessment of the past experience of the counterparty and similar organisations in the same sector, with a prediction of the likelihood of the counterparty’s credit losses). Companies should also consider whether the counterparty might receive government’s support in case of default, how diversified their income streams are, whether they have access to financial markets funds, which credit support obligations the counterparty has towards their subsidiaries.
However, once the credit assessment has been done, it is still challenging for companies to determine the size of the counterparty’s credit line, which may be also affected by negotiations with the counterparty as well as by the companies’ capacity and appetite for risk.
