4 Qualities You Need in a Credit Risk Score, For Better Portfolio Risk Analysis

4 Qualities You Really Need in a Credit Risk Score, For Better Credit Portfolio Bankruptcy Risk Analysis

When you’re managing a corporate credit portfolio, you take risks daily.

Be too cautious, and you may be limiting your company’s sales and growth potential. But fail to be vigilant, and you could end up writing off bad debt from a customer bankruptcy.

If you’re like most of your professional peers, you’ll want to leverage an accurate credit risk score and other third party risk management tools, to assess the financial health of your credit portfolio.

As you size up your third-party risk score options, there are some important differences in how various financial risk models work. Here are some pertinent factors and questions to ask as you size up your options. 

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How to Assess A Bankruptcy Risk Score

Despite similar claims, commercial credit risk scores can vary greatly. Many can miss the signs of developing financial stress in public companies. 

How to choose the right metric for your particular portfolio needs? Here are some of the key differences, and important questions to ask:

1. Timeliness

Many factors impact financial health, and a company’s outlook can change quickly.  As a result, you need a credit risk score that’s updated often, and reflects the latest information.  

While it may seem that all scores are alike in this regard, you may be surprised to learn that many credit risk scores are updated only infrequently, making them poorer predictors of financial health.

By contrast, the FRISK® score is recalculated each night, for every public company in our database.

Key Question: How often is data updated and the risk score calculated?

 

2. Ideal Use

It’s important to choose a financial risk metric tailored to your specific needs.

For instance, the Altman Z-Score uses a handful of financial ratios to predict public company bankruptcy risk within two years. While an elegant solution for assessing bond default risk, credit decisions may take place in a different timeframe.

A credit manager typically needs to make close calls about ability to pay, 6-12 months out. For this specific purpose, it helps to have a predictive financial risk score that is more sensitive to growing financial distress, in a shorter time frame.

By using a wider range of financial data, plus a proprietary, crowdsourced ‘activity score’ from credit professionals, the FRISK® score model accurately pinpoints growing financial distress and forecasts bankruptcy risk for public companies within one year. It predicted public company bankruptcies with 98.6% accuracy in 2015-16.  

Key Question: What was the risk score model originally designed to do, and what is it’s primary use case?

 

3. Relevance to Your Portfolio’s Biggest Risks

Pinpointing the source of your biggest portfolio risks can be difficult. While private companies may comprise more portfolio counterparties, public companies typically represent more dollars.

To be certain, it helps to do a true portfolio risk assessment.

Upon doing so, many credit managers are surprised to find that public companies actually comprise a large percentage of A/R dollar risk exposure. When that's the case, solely relying on a payment-based score falls short when it comes to assessing true portfolio risks.

That’s due to the ‘cloaking effect’,  a term for the pattern of risk that occurs when trade payment history fails to detect public company financial distress. For more detail, read this article: One Way Credit Portfolios Get Blindsided: The Wrong Credit Risk Metric.

Bottom line? To accurately assess and manage portfolio risk, many credit practitioners use two different metrics: a payment-based score for their private companies, and a more predictive one for their publics.

Key Questions: What’s my public company dollar risk exposure? And, what’s the risk score’s track record for public vs. private companies?

 

3. Ease of Use/Support

At the end of the day, when it comes managing or mitigating risk, it usually boils down to a few key questions: Where are the biggest risks in my portfolio?  Is Company A getting riskier?  Is Company B improving?

In these situations, sometimes data point ‘x’ says one thing and data point ‘y’ says another. If the data is contradictory, it requires experienced interpretation.

You’ll want to make sure you can drill down to the information you need, easily and quickly  -- financials for sequential quarters, pre-calculated ratios, agency ratings, peer analysis, industry risk trends, and the like. And, if the data or risk score still isn’t making sense to you, it helps to know that support is readily accessible.

Key Questions: How easy is it to get a deep understanding of my biggest credit risks? What kind of support is given, if I need help interpreting the score?

 

4. Track Record/Predictive Accuracy:

Although this is mentioned last here, it’s really the most important factor. In the final analysis, a credit risk score must be reliable, back tested over the long term, for predictive accuracy in various credit markets.

In back testing, the FRISK® financial risk score predicted nearly 99% of public company bankruptcies in 2015-16, and 96% of all public company failures over the past 10 years.

We back test our model annually, and when we discover -- as we did in 2016 -- that new technology enhances our ability to predict financial distress, we refine it.

When evaluating your credit risk score options, expect no less.

Key Questions: What is the risk score’s accuracy/track record over the past year, five years, or even ten years?  How has it been refined over time?

 

Ask The Right Questions

We hope this discussion helps you to choose the right tools to support your credit decisions, and balance the competing needs of growth and risk.

To learn more about our entire suite of credit monitoring services, we hope you’ll get in touch.

For the detailed FRISK® score track record, check out our latest ‘Accuracy Scorecard’

About CreditRiskMonitor

CreditRiskMonitor is a financial news and analysis service designed to help professionals stay ahead of public company risk quickly, accurately and cost-effectively. More than 35% of the Fortune 1000, plus thousands more worldwide, rely on our commercial credit reporting and predictive risk analytics for assessing the financial stability of over 58,000 global public companies.

At the core of CreditRiskMonitor’s service is its 96% accurate FRISK® score, which is formulated to predict public company bankruptcy risk. One of four key components calculated in the FRISK® score is crowdsourced subscriber activity. This unique system tracks subscribers' patterns of research activity, capturing and aggregating the real-time concerns of what are essentially the key gatekeepers of corporate credit. Other features of CreditRiskMonitor’s service include timely news alerts, the Altman Z” score, agency ratings, financial ratios and trends. CreditRiskMonitor’s network of trade contributors provides more than $135 billion in trade data on their counterparties every month, giving them visibility into their biggest dollar risks.