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:
Operating sources of cash, operating uses of cash
(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
Dependence on portfolio of customers and suppliers
Concentration of customers and suppliers
Dependence on distribution channel and cunsumer choices
Capacity of production progress to face market changes
Technology and innovation
Examples of management criteria used in assessing default risks are: Indicators of a possible default Indicators of a possible default
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