This is assist in timely detecting a possible default with one of your customers, it is used in Impairment of investments and loans.
Descriptions of indicators of default are classified in three groups:
- the usual financial ratios derived from financial statements,
- market criteria, such as market conditions, the customer’s positioning and adaptability, and
- management criteria, such as management’s experience and its behavior towards stakeholders and the society in general.
Such indicators need to be rated by management for customers according to an usual categorical scale of the type: poor, fair, good, very good and excellent (poor default risk being the worst rating).
In reviewing a chosen set of indicators the changes in the indicator and its trend (favorable or unfavorable change) over time is paramount, not only its current status. Using the trend can facilitate a forward looking approach.
Examples of financial criteria used in assessing default risks are:
Financial criteria | Descriptions/Indicators |
Cash | Operating sources of cash, operating uses of cash |
Quick ratio | (Current assets -/- Inventories) / (Current liabilities -/- short term portion of long term financing) |
Required financing period | Days Trade receivables outstanding +/+ Days inventory held -/- Days Trade payables outstanding |
Times interest earned ratio | EBIT / Interest payments |
Examples of market criteria used in assessing default risks are: Indicators of a possible default Indicators of a possible default
Market criteria | Descriptions/Indicators |
Dependence on portfolio of customers and suppliers | Concentration of customers and suppliers |
Placement | Dependence on distribution channel and cunsumer choices |
Production flexibility | Capacity of production progress to face market changes |
Technology and innovation | Technological sophistication |
Examples of management criteria used in assessing default risks are: Indicators of a possible default Indicators of a possible default
Management criteria | Descriptions/Indicators |
Timely and reliable reporting | Existence of regular and reliable information |
Performing behavior with respect to investments and loans granted | Historical loan credit records |
Experience and past performance | Historical information on managers’ previous successes and failures (or lack thereof) |
Commitment and skills of the management team | Stability and appropriateness of management skills and choices for the specific businesses |