Companies – They are Just Like Us!
It may surprise you to find that some of the common metrics used by creditors to evaluate your financial health are similar to the ones investors use to evaluate a company’s financial health. For this post I’ll talk about credit score vs. bond rating.
Credit Score (Us) vs. Bond Rating (Company)
You may not know your current credit score, but I am certain you know what a credit score is since it is used in almost every aspect of adult life; from renting a place, to buying a car, to getting approved for credit. Your credit score helps creditors determine whether you are a good risk or bad risk. In general, a person with a credit score below 600 is considered a bad risk, while a person with a credit score of 720 or better is considered a good risk. Like everything in life, it isn’t black or white. There are many shades of grey, and other factors contribute to painting your financial health picture. Your credit score is just one of those factors.
For a company, its bond rating helps potential investors evaluate the financial stability of the company, and whether it is a good investment or bad investment. The bond rating applies to bonds that a company issues. Companies issue bonds to raise money, and investors purchase the bonds in exchange for regularly scheduled interest payments for the duration of the bond.
The advantages of investing in bonds are the predictable interest payments, and the return of your initial investment at the end of the bond period. If the company isn’t financially sound, they may not pay the scheduled interest payments, or may not return the initial investment. So, it is important for investors to evaluate the financial strength of the company issuing the bond.
The Standard & Poor agency offers the most recognized bond ratings used to determine the financial health of an issuing company. The S&P Bond ratings range from AAA (best) to C (junk). A “D” rating indicates the bond is in default (i.e. payment obligations are not being met). Bonds with a rating of BB and higher are called “investment grade” bonds.
In general, bonds with lower bond ratings offer higher interest rates to help investors overcome the risk of the company not meeting its interest payment obligations. It is similar to a person with a low credit score paying a higher interest rate on a loan.
So, the next time you’re thinking of investing in a company (stock, bond or mutual fund), and you want to evaluate its financial health, think of how you might evaluate your personal financial health; because, companies are just like us!