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How can you assess the creditworthiness of counterparties?

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Creditworthiness is the ability of a counterparty to meet its financial obligations, such as paying interest, principal, or collateral on a loan, bond, or derivative contract. Assessing the creditworthiness of counterparties is a crucial task for risk managers, as it helps to evaluate the potential losses and exposures arising from credit risk. Credit risk is the risk of default or deterioration in the credit quality of a counterparty, which can result in losses or reduced cash flows. In this article, you will learn how to assess the creditworthiness of counterparties using four main methods: credit ratings, financial ratios, credit scoring models, and collateral analysis.

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Victoria Ogutu

Credit Risk | Sustainable Finance | Business Development | Operations
Vipul Gupta

Associate Director at Acuity (ex. Moody's Analytics, EY, Barclays, HSBC)

1 Credit ratings

Credit ratings are opinions issued by independent agencies, such as Standard & Poor's, Moody's, or Fitch, that indicate the relative credit quality and default probability of a counterparty or a debt instrument. Credit ratings are based on various factors, such as financial performance, industry outlook, business strategy, and governance. Credit ratings are usually expressed by letters, such as AAA, AA, A, BBB, BB, B, CCC, CC, C, and D, with higher letters indicating lower credit risk. Credit ratings can help risk managers to compare the creditworthiness of different counterparties and to set limits, pricing, and terms for credit transactions.

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Vipul Gupta

Associate Director at Acuity (ex. Moody's Analytics, EY, Barclays, HSBC)
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One important point to note here is that the credit ratings are not done immediately after a credit event and there is always a lag. So, it is pertinent to look at the timelines to see when the credit rating was issued for a borrower or loan.

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2 Financial ratios

Financial ratios are numerical indicators that measure the financial health and performance of a counterparty. Financial ratios can be calculated from the financial statements of a counterparty, such as the income statement, the balance sheet, and the cash flow statement. Financial ratios can be classified into four categories: liquidity ratios, solvency ratios, profitability ratios, and efficiency ratios. Liquidity ratios measure the ability of a counterparty to meet its short-term obligations, such as the current ratio and the quick ratio. Solvency ratios measure the ability of a counterparty to meet its long-term obligations, such as the debt-to-equity ratio and the interest coverage ratio. Profitability ratios measure the ability of a counterparty to generate income and returns, such as the net profit margin and the return on equity. Efficiency ratios measure the ability of a counterparty to use its resources effectively, such as the asset turnover and the inventory turnover. Financial ratios can help risk managers to evaluate the financial strength and weakness of a counterparty and to identify potential red flags or warning signs.

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Vipul Gupta

Associate Director at Acuity (ex. Moody's Analytics, EY, Barclays, HSBC)
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Financial ratios also help in easily doing peer analysis and comparing important ratios of a particular company with relevant peers in the industry.

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3 Credit scoring models

Credit scoring models are statistical tools that assign a numerical score to a counterparty based on a set of variables that reflect its credit characteristics and behavior. Credit scoring models can be either qualitative or quantitative, or a combination of both. Qualitative models use subjective factors, such as management quality, industry position, and market reputation, to assess the creditworthiness of a counterparty. Quantitative models use objective factors, such as financial ratios, cash flow projections, and payment history, to assess the creditworthiness of a counterparty. Credit scoring models can help risk managers to quantify the credit risk of a counterparty and to rank the counterparties according to their credit scores.

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4 Collateral analysis

Collateral analysis is the process of evaluating the value and quality of the assets that a counterparty pledges as security for a credit transaction. Collateral analysis can help to reduce the credit risk of a counterparty by providing an additional source of repayment in case of default or distress. Collateral analysis involves assessing the type, amount, and condition of the collateral, as well as the legal and operational aspects of the collateral agreement. Some of the factors that affect the value and quality of the collateral are the marketability, liquidity, volatility, diversification, and correlation of the collateral assets. Collateral analysis can help risk managers to determine the appropriate level and margin of collateralization for a credit transaction and to monitor the collateral value and exposure over time.

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Vipul Gupta

Associate Director at Acuity (ex. Moody's Analytics, EY, Barclays, HSBC)
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One way to keep a close watch on the collateral levels is the use of borrowing bases. These track the level of crucial assets like Account receivables, Inventory etc. and highlight issues to lenders.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Victoria Ogutu

Credit Risk | Sustainable Finance | Business Development | Operations
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In addition to the four main methods of assessing creditworthiness discussed above, there are a few other factors that risk managers should consider when evaluating counterparties; The risk manager would also consider the borrower's industry risk and country risk. If the borrower is operating in a cyclical industry or a country with high economic risk, this would be a negative factor. Finally, the risk manager would consider the relationship between the risk manager and the borrower. If the borrower is an important customer or supplier, the risk manager may be willing to give the borrower more favorable treatment, even if they have lower credit ratings or less robust financial ratios.

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How can you assess the creditworthiness of counterparties?

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1 Credit ratings

2 Financial ratios

3 Credit scoring models

4 Collateral analysis

5 Here’s what else to consider

Risk Management

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How can you assess the creditworthiness of counterparties?

1

2

3

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1 Credit ratings

2 Financial ratios

3 Credit scoring models

4 Collateral analysis

5 Here’s what else to consider

Risk Management

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