Default Risk Management
Default risk refers to the potential danger that lenders face when borrowers fail to fulfill their required payments for debts, which can include loans, bonds, or credit card balances. This risk is prevalent in various credit arrangements and leads to lenders demanding higher interest rates from borrowers who are more likely to default.
Default risk becomes apparent when borrowers are unable to repay borrowed funds, impacting both individuals and businesses using loans or issuing bonds. Lenders assess this risk to determine loan terms and interest rates, while investors consider it when evaluating bond yields. Default risk associated with corporate debt fluctuates with economic conditions and a company's financial health. Economic downturns can lower a company's earnings and its ability to make debt payments due to reduced revenues. Factors like increased competition can exacerbate financial difficulties, compounding the impact of default risk.
Assessing a company's potential for default risk involves a thorough analysis of its financial statements, often using various financial ratios. Notably, the free cash flow, calculated by subtracting capital expenditures from operating cash flow, provides insight into a company's ability to meet its financial obligations. A low or negative free cash flow can signal a higher risk of default. Another crucial ratio is the interest coverage ratio, which divides a company's EBIT (earnings before interest and taxes) by its interest payments on debt. This ratio considers non-cash expenses, providing a comprehensive view of a company's ability to cover its interest payments. Credit rating agencies classify corporate debt into different grades, impacting the likelihood of default. Investment-grade and speculative-grade classifications influence the perception of default risk.
Consumer credit data collected by credit reporting agencies, based on information from banks and credit card issuers, contributes to the creation of credit reports. These reports display individuals' payment histories and help predict future credit risk. Credit scores, influenced by factors like payment history and credit utilization, are significant indicators. It directly affects interest rates and credit availability.
The repercussions of default depend on the type of loan and lender policies. Secured loans allow lenders to claim collateral, while defaulting on unsecured debt could lead to legal actions or involvement of collection agencies. Defaulting negatively impacts a borrower's attractiveness, resulting in higher borrowing costs due to increased interest rates. Defaults can have a lasting effect on credit reports and scores, sometimes lasting up to seven years, significantly affecting an individual's financial standing. It's important to note that delinquency (missed payments) and default (a series of delinquencies) are distinct concepts, with default having more severe consequences on credit history.
Source: https://www.investopedia.com/terms/d/defaultrisk.asp