Credit Risk Examples
The following Credit Risk example provides an outline of the most common Credit Risk. It is impossible to provide a complete set of examples that address every variation in every situation since there are thousands of such Risks.
Credit risks refer to the risks of loss on a debt that occurs when the borrower fails to repay the principal and related interest amounts of a loan back to the lender on due dates. In this section, we will see some practical examples of credit risks to understand it better.
- When a lender offers credit to the counterparty (through loans, credits on invoices, investing in bonds or insurance), then there is always a risk existed for the lender that it might not receive the credited amount back from the counterparty. Such risks are termed as credit risks or counterparty risks.
- It calculates the overall ability of a borrower to pay the loans back to the lender. In order to avoid or reduce credit risks, a lender generally checks the credibility and background of the borrower.
- With high credibility (means low credit risks), a borrower can receive a higher amount of loans without attaching any collaterals to the contract; otherwise, the loan will be allotted according to the value of security attached as collateral.
Top 3 Credit Risks Examples
Each example of the Credit Risk states the topic, the relevant reasons, and additional comments as needed.
Assume Tony wants his savings in bank fixed deposits to get invested in some corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value. as it can provide higher returns. However, he is aware that bonds include counterparty default risks or credit risks, i.e., the bond issuer will get defaulted, and Tony is not going to receive any of the promised cash flows.
So Tony decides to price these risks in order to get reimbursed for the extra risk he is going to be exposed to. He finds the two basic measures of the credit risks are:-
- Credit Risk Scores – Every institution and individual use both qualitative and quantitative factors to measure such risk of borrowers. Lenders use credit risk scores in order to allow or reject the loan application. A credit score is expressed in a numerical format that ranges between 300 and 850, where 850 is the highest credit score possible.
- Bond Credit Ratings – Publicly traded companies that issue bonds have been rated by rating agencies like Moody’s, Standard and Poor (S&P), Fitch, etc. The rating is a grade in an alphabetical format that gets assigned to a bond. E.g., the ratings by S&P may vary from AAA (safest company) to D (a company in default).
The advantage of investing in a rated company is that the investor has a sense of what the rating agencies think about the credit risk of the company. Also, rating helps the investor to charge an appropriate spread for taking the extra risk called default spread.
E.g., let’s say Tony purchased a 10-year bond with a ‘BBB’ rating. The current default spread for a similar bond is 1.84%, and the risk-free rate for a 10-year bond is 1.5%. So the interest rate demanded by Tony must be (1.84 + 1.5) 3.34%.
However, rating agencies cannot always make accurate predictions, and it becomes the responsibility of the investor to double-check the credit risks of the companies they want to invest in. The following are some basic factors to help investor measure the risk of the company:-
- An investor can look at the financial statements of the companyFinancial Statements Of The CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.. If the company generates larger cash flows from operations, than it has a lower credit rating.
- Perform a ratio analysis formulaRatio Analysis FormulaRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements., e.g., an important ratio is the interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt., which measures a company’s ability to repay its debt payments.
Let’s say Tony investigates a company with earnings before interest and taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital. (EBIT) of 3500 million and interest expenses of $700 million.
Thus Interest coverage ratio = 3500/700 = 5
According to various agencies data, the companies with interest coverage ratio between 4.5% to 6% has a rating of ‘A-‘ and its relative default risk is 2.5%. I.e., Tony should charge a 2.5% higher interest rate than the risk-free ratesRisk-free RatesA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk..
Let’s say Mr. Tony and a businessman runs a clothing wholesale business limited to the New York City of America. In order to expand the business, he started providing large credits to its customers without any definite credit policy and credibility checks.
Tony neglects to consider the inflated credit risks. At year-end, he finds a number of his customers are not paying their invoices on due dates. Upon investigating the background of his clients, he finds that a few of them have very low credibility.
With low client credibility, the credit risks to Tony inflates heavily, and there might arise a possibility where he might not get reimbursed against the goods he supplied to its clients.
None/ low payments of regular invoice negatively affect the cash flows of Tony’s firm and cause losses to the entity, generally referred to as bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation..
In order to avoid such risks, Tony should structure an effective credit policy and properly check the credibility of its customers before offering any credit or loan.
Assume Mr. Tony wants to purchase a car worth $120,000. He paid an amount of $20,000 as a down payment and decided to take a bank loan for the remaining amount of $100,000 at the rate of 20% per annum to be paid in 1 year.
This means the bank needs to receive $120,000 back in a period of one year from Tony. The risk management of the bank checked Tony’s credit risks before issuing the loan, i.e., the possibility that he might not be able to repay the loan or installments on the due date.
With higher credit risks, Tony’s loan application may get rejected by the bank, or the bank will allocate a lower sum of money that suits his credibility (ability to repay the loan) criteria. Tony, with a low credit risk count, gets the approval for loan allotment.
Tony successfully paid a couple of installments of $10,000 each. But during the year, Tony made some big losses in his business due to offering goods on credit to customers with low credibility and applying liberal credit policies.
The bank thinks Tony might not be able to make any further payments against the loan. The current situation creates huge risks to the bank against a loan provided to Tony.
This has been a guide to Credit Risk Examples. Here we discuss the top 3 examples of credit risk and some basic factors that help investors in measuring the company’s risk. You can learn more about financing from the following articles –