What it means
The three agencies most lenders follow are S&P Global Ratings, Moody's and Fitch Ratings. Their scales differ in notation but line up closely, and each one publishes both an issuer rating covering the company as a whole and issue ratings covering individual bonds, which can sit higher or lower depending on security and ranking.
The critical dividing line is between investment grade and speculative grade. Ratings of BBB- and above, or Baa3 and above on the Moody's scale, are investment grade; anything below is speculative, commonly called high yield, and a large share of pension funds and insurers are restricted from holding it in size.
Analysts reach the grade by combining a business risk view with a financial risk view. Business risk covers industry cyclicality, competitive position and geographic spread, while financial risk is driven by measurable ratios such as debt to earnings before interest, tax, depreciation and amortisation, interest cover and free cash flow relative to debt.
Ratings come with an outlook or a watch attached, and these are often more informative than the letter itself. A negative outlook signals a realistic chance of a downgrade over the medium term, which lets lenders and treasurers adjust before the change actually happens.
The consequences of a change are immediate and financial. Downgrades raise the coupon a company pays on new debt, can trigger step-up clauses on existing bonds, may require extra collateral under derivative agreements, and sometimes force selling by investors whose mandates prohibit sub-investment-grade holdings.
In practice
Real-world examples.
Example
A supermarket chain is placed on negative watch after announcing a large debt-funded acquisition. Its treasury team brings forward a planned bond issue by two months to price it before any downgrade takes effect, saving roughly half a percentage point on a $300,000,000 issue.
Example
A utility loses its investment grade rating following a regulatory decision that cuts allowed returns. Several pension funds are obliged by their mandates to sell the bonds, the price falls sharply, and the company's next refinancing costs materially more than the one before it.
Example
A privately held industrial group with no public bonds still commissions a shadow rating before approaching lenders. The BB assessment tells the finance director to expect covenant-heavy bank debt rather than cheap unsecured funding, and the company adjusts its acquisition plans accordingly.
Formula
Calculation
Agencies do not publish a single formula, but two ratios do most of the work:
Net leverage = (total debt - cash) / EBITDA
Interest cover = EBITDA / interest expense
A packaging group reports EBITDA of $120,000,000, total debt of $480,000,000, cash of $60,000,000 and annual interest expense of $30,000,000. Net debt is $480,000,000 - $60,000,000 = $420,000,000, giving net leverage of $420,000,000 / $120,000,000 = 3.5x and interest cover of $120,000,000 / $30,000,000 = 4.0x.
Suppose the company then borrows a further $200,000,000 to fund an acquisition that adds only $20,000,000 of EBITDA. Net debt becomes $620,000,000 and EBITDA becomes $140,000,000, so net leverage rises to $620,000,000 / $140,000,000 = 4.4x, and the agency cuts the rating from BBB to BB+.
The cost is easy to quantify. If the group refinances $500,000,000 of debt and the downgrade lifts the required coupon from 5.2% to 6.0%, the extra annual interest is $500,000,000 x 0.8% = $4,000,000, which is a permanent charge against profit for as long as that debt is outstanding.Case study
Seen in the real world.
This is an illustrative and fictional case. Calderhill Chemicals, an invented specialty chemicals producer, held a BBB rating and $700,000,000 of debt against EBITDA of $250,000,000, giving comfortable net leverage of 2.4x once its $100,000,000 cash balance was netted off.
The board approved a $450,000,000 acquisition funded entirely with new borrowing, expecting it to add $90,000,000 of EBITDA within two years. The agency placed the fictional company on negative outlook immediately, noting that pro forma net leverage of $1,050,000,000 / $340,000,000 = 3.1x sat at the weak end of the BBB category and left no room for integration problems.
Integration ran a year late and delivered only $55,000,000 of additional EBITDA, so leverage came in nearer 3.4x and the downgrade to BB+ followed. The chief financial officer's response, in the illustrative story, was a two-year deleveraging plan: suspend the dividend, sell a non-core coatings division for $180,000,000, and commit publicly to a leverage target below 2.5x, which restored the investment grade rating in the third year.
Watch out
Common mistakes.
- Reading a credit rating as a view on whether the shares are a good investment, when it is only an opinion about the likelihood of repaying debt.
- Treating the letter grade as precise, when it is a broad category and two companies with the same grade can carry noticeably different risk.
- Ignoring the outlook and watch status, which usually give months of warning before the headline grade actually moves.
Questions
People also ask.
What is the difference between an issuer rating and an issue rating?
The issuer rating covers the company's general creditworthiness, while an issue rating applies to one specific instrument and reflects its security and ranking in a default.
Who pays for a corporate credit rating?
In the dominant model the company being rated pays the agency, a conflict of interest that regulators monitor closely and that agencies manage through separation of analytical and commercial staff.
Does a company have to be rated to borrow?
No, plenty of businesses borrow entirely from banks without any public rating, but access to the bond market on competitive terms usually requires at least one.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%