By Alison Trapp, Abrigo
September 10, 2019
82% of CFOs believe a recession will have begun by the end of 2020, according to the Duke University/CFO Global Business Outlook survey. Is your company prepared?
How much longer will the longest U.S. economic expansion last? Recent signs, like the inverted yield curve, have left many banking professionals vigilant of an impending economic downturn. In fact, nearly half of CFOs in the U.S. expect a recession by the end of 2019 – and eighty two percent believe a recession will have begun by the end of 2020, according to the Duke University/CFO Global Business Outlook survey. Is your company prepared? The market can rapidly deteriorate without notice – here’s how to help safeguard your financial institution.
Reevaluate your risk scoring model
One of the most important ways to ensure your financial institution is making good loans is to create a consistent risk scoring model so that all loans are assessed in the same manner. When creating a risk scoring matrix, it should be designed so that a consistent measurement can be applied to similar loan types. An ideal model will apply a balance of objective and subjective factors that reflect the borrower’s ability to repay the debt. Although objectivity is important for consistency, you want to avoid models that are too objective, which can create a black box, leaving very little control over the outcome. However, a model that is too subjective has no consistency and creates additional risk in the loan portfolio that is hard to quantify.
Common objective factors to include in your risk scoring model are comparative ratio analysis based on industry, loan-to-value ratios, credit scores, and payment history. Common subjective factors includes strength of guarantors and strength of management team. The key is to strike a balance that drives consistency but leaves enough flexibility for the lenders to still get deals done that fit the risk profile of the financial institution.
Bolster the 5 C’s of Credit
The 5 Cs of Credit – capacity, capital, conditions, collateral, and character – have been the foundation of assessing a potential borrower’s credit worthiness. Understanding the borrower’s or businesses’ ability to repay debt, level of debt, plan for funds, and collateral available plays an important role in evaluating loan applications. Your institution’s lenders should assess the borrower’s ability – and willingness – to repay the loan, as well as the protections available if they don’t.
There are four key financial variables you may leverage to represent a company’s credit risk profile and to predict their likelihood of default. These metrics include debt service coverage ratio, net profit margin, quick ratio, and loan to value. These variables provide a unique indicator of a private company’s financial standing and has significant implications when evaluating credit risk.
- Debt service coverage ratio (DSCR): The higher a firm’s debt service coverage ratio, the greater its ability to produce enough cash to cover debt payments. While DSCR will vary among borrowers, aim for at least a 1.15 ratio.
- Net profit margin: Net profit margin shows the profitability of a company by dividing net profit by total sales. The higher the profit margin, the more likely the business will be able to remain resilient in periods of unexpected losses. A lower net profit margin, on the other hand, could indicate a company’s pricing strategy, sales, volume, or expenses are out of line compared to others in the industry.
- Quick ratio: Lenders often look to quick ratio because it shows the percentage of a firm’s debts that could be paid off by quickly converting assets to cash. The more liquid a firm’s assets, the better equipped it is to adapt to changing conditions in the business environment. Ideally, a quick ratio should be roughly 1:1, meaning assets are able to cover short-term debts. To calculate quick ratio, divide cash, cash equivalents, and accounts receivable by total current liabilities.
- Loan to value (LTV): Loan to value shows the size of the loan compared to the proposed collateral, or the percentage of the principal value covered by the appraised collateral. Lenders rely heavily on LTV because it shows the risks involved with issuing the loan. Typically, the lower the LTV, the lower the risk. Borrowers with higher LTVs have committed fewer resources, and therefore, in the event of default, would have less collateral to supplement loan payments.
. . .
To read the full article featuring Abrigo, visit Financial Executives International, “How CFOs are Preparing for a 2020 Recession.”