The FRISK® Score Examined: Part 2 - Financial Ratios
This is the second part of our in-depth look at the components of our proprietary FRISK® score, a dynamic, mathematically-driven solution which has proven 96% accurate in predicting U.S. public company bankruptcy risk during a 12-month period. Click here to read Part 1: The Wisdom of the Markets.
Assessing a private company’s financial risk using payment data can be a commonplace solution for credit professionals, but payment data doesn’t provide reliable insight when working with public companies. For that reason, financial professionals can stay ahead of risk by using a predictive solution that includes a number of key metrics in order to obtain a “big-picture” view of public company financial health.
CreditRiskMonitor’s proprietary FRISK® score uses four individual data points, which, when combined, create a holistic 96%-accurate bankruptcy risk prediction. One of these data points is financial ratios; data with which most, if not all, risk professionals are well-versed. Although the publishing of the Altman Z” Score in 1968 provided a model which still holds up 50 years later, financial ratio analysis in credit risk goes back even further, as rating agencies used it as part of their methodology for more than a century.
Not All Financial Ratios are Equal
Choosing the right financial ratios is a key element in making a strong score. The FRISK® score uses the same four ratios that are used in Dr. Edward Altman’s Z" score - Earnings Before Interest and Tax/Total Assets (EBIT/TA), Market Value of Equity/Total Liabilities (ME/TL), Working Capital/Total Assets (WC/TA) and Retained Earnings/Total Assets (RE/TA). That covers the balance sheet and earnings statement. To these it adds cash flow metrics, ensuring that the FRISK® score looks at each of the major financial statements. Equally important, however, is that CreditRiskMonitor dynamically adjusts the weighting of the ratios it uses in order to increases their predictive value.
To simplify the concept, the ratios are placed on an “S” curve rather than a straight line. When assessed in a linear fashion, simplicity replaces accuracy - which can be valuable at times, yet a linear view can greatly skew the information. When considered on an “S” curve, changes in financial ratios capture an important and common-sense nuance: small moves have differing impacts on risk when companies stand at the extremes on these ratios.
For example, a highly elevated liabilities-to-assets ratio means that a company may not have the capacity to take on more debt, or the financial flexibility to deal with adversity. The high leverage puts the business in the flat portion of the “S” curve, so a small decrease in leverage does not have a big impact in risk reduction since it is still high-risk; each additional reduction in leverage will have increasing value.
The Pros and Cons
Financial ratios provide concrete insights into a company’s well-being. That's the benefit of using these metrics, even if you don't look at them in a dynamic fashion the way CreditRiskMonitor's FRISK® score does.
There are still flaws. First and foremost, using the wrong ratios is fruitless and a waste of time. This is why the FRISK® score is highly selective in the ratios it includes. If you are using financial ratios, you as the customer must also be selective. Don't forget about the cash flow statement, a key financial statement which the Z" score ratios ignore.
Also, financial ratios are only provided once a quarter, which means during the three months in between, a credit or supply chain manager has no viable source of input if he or she is relying solely on financial ratios. Further complicating the issue is the fact that financial statements are usually only available 30-to-90 days after a company closes its books, meaning that the information is already old by the time it is being used. Also, financial statements are only an approximation to the true financial condition of a business and can be subject to manipulation.
There's no way to offset these issues directly, but the FRISK® score is prepared because it balances financial data against stock market volatility, bond agency ratings and crowdsourcing. It's the combination of these four inputs that allow the FRISK® score to achieve 96% accuracy in predicting financial distress.
For example, stock market volatility provides a daily read into what is happening in between reporting periods, allowing the FRISK® score to benefit from the wisdom of markets. The proprietary crowdsourcing input, meanwhile, taps into the knowledge and experience of CreditRiskMonitor's subscribers. It captures the aggregate opinion of these key decision makers and incorporates it into the score on a daily basis. Thus, the FRISK® score can be re-evaluated each and every day, not just once a quarter.
Anticipating the Downfalls
Financial ratios are an important tool for risk professionals, yet when viewed in isolation, they don't provide the full picture you need to make the most informed decisions possible. Using a simple linear model, moreover, sacrifices accuracy. Understanding and adjusting for these weaknesses, the FRISK® score is able to predict bankruptcy risk with 96% accuracy.
The real value, though, is in the fact that the FRISK® score does the math for you every single day. That includes dynamic weighting, as well as merging different risk monitoring techniques into one simple-to-use score. When empowered by the FRISK® score, you can focus your time developing financial analysis on the companies that are truly at risk.