Importance of Good Credit Rating - Term Paper Example

Importance of Good Credit Rating Importance of a small entrepreneurial firm maintaining a good credit profile with the major credit reference agencies Table of Contents 1. Abstract 2. Introduction 3. What is Credit Rating? 4. Small Businesses and Credit Rating 5. How Good Credit Rating Helps in the growth of SME’s? 6. Major Credit Reference Agencies and Credit Rating 7. Conclusion 8. References Abstract Entrepreneurship and credit rating are closely linked with each other. Every business needs a capital and the best means of acquiring it is through banks and finance providing agencies. Maintaining a good credit rating is important for any business especially small businesses to procure a decent amount of loan from such institutions. Most of the financial institutions rate a business based their previous credit rating history. This essay will analyze some key concepts regarding the importance of maintaining a decent credit rate with relevant examples. Introduction Small and Medium Enterprises (SME) are often considered as the life line of a nations business and economic growth. Though they constitute a major element of the countries growth, very little was done for their growth and development in the past. It is a common misconception that unemployed people call themselves entrepreneurs. But, in reality they provide several basic services necessary for huge corporate companies as well as the local public. The government has started to realize their importance only in the recent days. Government encourages the small and medium level entrepreneurs to get rated because they believe the sole aim of encouraging entrepreneurship is job creation and economic growth. Several steps to improve them are taken from offering them easy loans to giving them subsidies to improve their infrastructure. The major obstacle faced by the SMEs are their inability to garner funds when they are in dire need. Getting a good credit rating will help them demand the finance they require from various agencies with confidence. But, there is little awareness regarding the process and its importance among the entrepreneurs. What is Credit Rating? Credit rating is basically a system which statistically determines a person or businesses ability to pay back the money borrowed. The credit ratings are offered by three financial bureaus Equifax, TransUnion and Experian in the U.S. Their rating for each business might differ slightly. An American citizen is entitled to get a free credit report once in every 12 month from these bureaus. But, they should pay a minimal fee of $7.95 to get a detailed credit rating. An alternate way is to use software like FICO to get the credit rating. People applying for the report will usually get it within 30 to 45 days of application. They bureau takes into account certain features like credit repayment history, current debts and time taken to pay back the previous credits, the frequency of getting credits and the credit type to create the credit rating. All these five factors play a significant role in determining the financial status of any business. Here is the rough description of the rating followed in the US. Paul Hawken (1987), the author of the bestseller book "Growing a Business" mentioned "Being a good human being is good business" (p, 16). Having a good credit rating means a business is done in a humane form without cheating the money lenders. The whole purpose of having a credit rating system is determining whether or not a person or a business is eligible to borrow loans. Money lenders feel this system is useful in evaluating a person whom they know little about. Though all these facts are equally important the preference given to each factor is different. A SMEs credit application does not get rejected simply because they did not pursue new loans often. But, they do get rejected because they failed to repay the loans constantly. Here is a figure depicting the importance given to different factors affecting the credit score. Small Businesses and Credit Rating Small entrepreneurs thrive well in the US. They own several hundred small businesses starting from store keeping to automobile repair shops. Sherry Stewart Deutschmann was one of them. She established a company in Nashville called LetterLogic. Deutschmann approached several banks after one year of starting her company to get financial help. With annual revenues crossing $2.5 million and a credit history which did not exist, the banks flatly refused to give her any proper reply. After getting rejected by many banks numerous times, Deutschmann finally borrowed the money from a venture capitalist. Today, her annual revenues cross over $21 million and she has absolutely no debts. The reason for banks refusing to give credit to such eligible people is simple. As a startup company she got rated only R0 and the futuristic risk of lending her loan is very high. There is no guarantee the company will continue to maintain on its first year success. Banks do not trust the project plans and the prospect of the business, but only look for solid proof of profit in the balance sheet. While it is quite easy for several corporate companies to avail millions as loan, it is absolutely hard for SME’s like Deutschmann who are in dire need of financial help to avail even small loans. A good credit rating come handy for the SME’s in such situations as they increase the liability of the owner to get credits from major financial institutions. Major Credit Reference Agencies and Credit Rating Discussing the topic in reference with SME good credit rating and the major financial agencies, we can often see, it is the public agencies like the bank and the huge financial institutions which refuse to give startup companies the required push they need. However, several venture capitalists and private companies are on lookout for such companies. They are ready to provide the necessary financial help to such companies because they have the means and the facility to do extensive background checks and have very little formalities when it comes to answering the board regarding their decision. All the SME’s have to do is convince the private financial agencies regarding the success of their idea. But, only a handful of companies extending such help are available and others are left to approach the usual financial organizations to manage their immediate cash needs. Basic features of Credit Rating SME’s like Deutschmann get rejected in the first place even though they have a good credit rating because they have little or no credit history. The best way to avoid this is get a credit when the company is running in high profit and repay it in time. Using the personal credit rating of the partners of the company will also help. This will create a positive outlook on the business. Use efficient online tools like LinkedIn and other social media tools plus effective advertising to keep your organization in the limelight. Creating a brand image is important for availing easy financial help. The more popular a company is, the more the chances of it gaining trust from a financial institution easily (Spors, 2011). Rating agencies accesses an SME’s financial feasibility thoroughly before giving them a particular credit rate. They compare the performance of the company within the particular industry and even analyze the operations management and financial prospects of the company if required. A feedback regarding their capability to keep up with business promises is also assessed using various market studies. R1 to R4 ratings are given to companies which perform satisfactorily in all the required fields. It is always better for small SME’s to maintain their finances within multiple financial institutions as the policies of the banks might change overnight. No matter what your credit rating is, banks might change their policies suddenly rendering you helpless in the midst of a financial havoc. So, keeping your options open with several different financial institutions is the best way to get immediate financial help as and when necessary. How Good Credit Rating Helps in the growth of SME’s? When it comes to major financial refereeing institutions they provide help to the SME’s based on three main categories. The first one is the rating provided by the rating agencies, the second one is the personal influence and interest taken by the business owners in getting the loan and the third key one is the brand image of the company. A good credit rating is important to the SME’s for various other reasons than securing loans. It serves as a boost for them to develop their business further and gives them an opportunity to compare themselves with others and know where they stand performance wise exactly. Most refuse to go through the process because they fear they might get low rating. There is nothing wrong in getting low rating as it can be improved in the future through re-applications. But, proving an SME is trying up for Credit Rating itself gives it credibility among several money lenders. It is important to understand the process of credit rating before applying for it. The benefits of getting a credit rating are countless for any small entrepreneur. Credit rating not checks your potential to repay the debt. The finance providing companies look at the company’s resilience and the management capacity and how far they adhere to the standard procedures prevalent in the industry. The credit rating industries qualitative parameters give the financial institutions a way to evaluate the future growth of the particular business. This plays a vital role in determining whether or not it is feasible to fund the company. Having a bad credit rating does not mean a money lender will actually refuse to lend you money. They usually use the poor scores to charge high interest. Hence, there is no need to worry about being rated poor. The important part is to learn the process and implement constant changes for improvement which will ultimately improve your business quality as well as the credit rating together. Credit ratings are given based only after in-depth analysis about the industry is conducted. It checks the basic strengths and weaknesses of the company which applies for credit rating thoroughly. Knowing these factors serve as an eye-opener for several startup companies. These factors help them to know where they stand exactly in the competitive market and what makes the other competitors lead ahead of them (Khosla, 2011). The companies which apply for credit rating for the first time learn about extensively about the standardization required in managing the basic cash flow modeling and implementing certain management practice. They get to know how far the practices in their business help in exploiting opportunities. Improving the business process certain standardization rules in fields like operations, manufacturing and marketing will help the business get a better brand image. Further it also leads to peer group comparisons, identifying the risks and new ways to expand the market (Petkar, 2010). Applying for a credit rating shows the confidence a company has in itself and its measures to compare itself with the peers in the industry. Several entrepreneurs simply register their company only when it comes to credit rating requirements. Books store owners, garage owners, grocery shop keepers and many other people do small business without registering. They buy and sell products without any official document or knowledge about the same. Streamlining the process under the name of credit rating for their company gives them an opportunity to run it in a defined structure. The banks will obviously be ready to lend loans to such institutions rather than family run businesses (Osmun, 2014). Conclusion Peter Drucker (1985) a business expert mentioned entrepreneurs as the basic elements of the society who are in constant look for change. He mentions they are the basic stimulating agents for economic as well as technological growth. It is true that no great technology can survive or reach the public without the help of entrepreneurs who market it as the most the important machine without which a person cannot live. They do create jobs and stimulate the economic growth in a subtle but imperative way unlike the major corporate companies. Providing the necessary help for them to acquire the required finance in time is vital for the growth of any nation. Creating awareness about the credit rating process and its importance among the SME’s will go a long way in helping them improve substantially in the future. It will not only help in financial growth but contribute to overall development of the nation as expansion of a business also means more jobs and improved infrastructure. References 1. Drucker, P. (1985) Innovation and Entrepreneurship. New York: Harper Business. 2. Hawken, P. (1987) Growing Business. Simon & Schuster Paperbacks. 3. Khosla, B. (2011) Credit rating can help SMEs in more ways than one. Retrieved on 8th July, 2014 http://www.smetimes.in/smetimes/editorial/2011/Feb/15/credit-rating-can-help-smes-in-more-ways-than-one5600000.html 4. Osmun, A (2014) A Guide to Establishing Business Credit. Retrieved on 8th July, 2014 https://www.creditcardinsider.com/insider/establish-business-credit/?hvid=3XDRe 5. Petkar, A. (2010) Credit Rating: Features and Benefits for SMEs. Retrieved on 8th July, 2014 https://www.bcasonline.org/articles/artin.asp?951 6. Spors, K. (2011) Five Ways to Build Business Credit. Retrieved on 8th July, 2014 http://www.entrepreneur.com/article/220192 7. The Importance of your Credit Rating. Retrieved from Investopedia website on 8th July, 2014 http://www.investopedia.com/articles/00/091800.asp Read More