Different options for assessing default risk
Options for Assessing Default Risk
Options for conducting financial due diligence and for assessing default risk are numerous, though many of the methods have shortcomings.
One of the most basic and informal ways companies can evaluate another business is to check credit references. Many companies do this. Indeed, checking credit references was cited most often when accounting professionals were recently asked by Sageworks for the most important thing for a company to do when evaluating the creditworthiness of a potential transaction partner (client, vendor, dealer, supplier, etc.).
But an inherent shortcoming is that the party being checked typically supplies the information on the references. As a result, many companies rightly view the value of this method skeptically.
Community banks have historically relied on a relationship-based lending model that can be applied to evaluating credit risk in other business relationships, Professor Cole notes. “You live in the same community; you do business with people that do business with your counterparty,” he says. “The old story was you go to church with them, you see if they don’t show up, and you have other friends who do business with them, so if they don’t pay somebody else, word gets around.”
Of course, community bankers typically have direct access to information on whether a customer is bouncing checks or has drawn down on reserves, whereas a business partner often does not have that detailed insight into another company’s current financial situation, Cole says. While a business may not have access to another private company’s checkbook register, some basic financial data usually made available during due diligence will provide a more comprehensive evaluation than qualitative data alone.
Data on certain groups of people and businesses can be helpful in estimating default risk. Average incomes of people in certain areas or occupations may provide insight into their financial stability. However, some populations and types of businesses have limited financial-related data available.
Traditional Business Credit Score
You can run a credit check or try to gather a credit score from one of the traditional providers in order to gain insight into payment histories and the current load of debt.
Nevertheless, many firms do not have a credit rating, and if they do, it is typically focused on past financial dealings. Researchers writing in the Journal of Credit Risk recently wrote that small and medium-sized enterprises constitute the majority of obligors of banks within the U.S. However, according to the researchers, “These companies are not rated either because their financial information is not readily available or because it is provided on an inconsistent basis across companies.”
And credit-rating agencies have come under increased scrutiny since the financial crisis, with legislative calls to limit conflicts of interest and strengthen the science behind the ratings process.
In addition, some credit ratings provide limited contextual information on the industry linked to the company being evaluated.
Cole says a traditional credit score based largely on past credit history is not as accurate or as powerful in predicting who will actually default as is a score based on statistical modeling for the probability of default.