Advanced Credit Risk Analysis and Management

8

Financial Risks

There are several instances where businesses fail not because of lack of business opportunities, but due to poor or improper management of financial affairs. Financial risk refers to the chances of collapse of a business due to wrong financing polices/decisions/strategies such as lopsided capital structure, asset-liability mismatch, etc. Financial risks can plunge a successful business into bankruptcy, if not managed properly. Hence, it is vital for a credit decision to be preceded by an in-depth financial analysis of the customer.

Financial analysis serves mainly three purposes:

1. It digs deep and brings out the financial risks.

2. It triggers questions that lead to a meaningful operating/business analysis.

3. Thirdly, especially for financial intermediaries, such as banks, it is also useful to determine the extent of financial support needed by the prospective borrower.

This explains why financial details are given prominence, among the information called for by credit providers. Financial analysis is done based on financial statements. Credit risk due diligence relies on financial statements for financial analysis which ought to have a cash flow oriented approach. It focuses on the critical factors that affect the obligors' historical operating results and cash flows in an attempt to establish the obligors' ability to generate sustainable recurring earnings and cash flows while ensuring quality of assets.

8.1 IMPORTANCE OF FINANCIAL STATEMENTS

Peter Bernstein, ...