Understanding Credit Risk: Definition & Implications

Credit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally, the failure to make required payments on loansSenior DebtSenior Debt is money owed by a company that has first claims on the company’s cash flows. It is more secure than any other debt, such as subordinated debt due to an entity.

As a financial intermediary, the project finance division of a bank is exposed to risks that are particular to its lending and trading businesses and the environment within which it operates. The major goal of project finance in risk managementRisk Averse DefinitionSomeone who is risk averse has the characteristic or trait of preferring avoiding loss over making a gain. This characteristic is usually attached to investors or market participants who prefer investments with lower returns and relatively known risks over investments with potentially higher returns but also with higher uncertainty and more risk. is to ensure that it understands, measures, and monitors the various risks that arise and that the organization adheres strictly to the policies and procedures established to address these risks. Firms have a structured credit approval process which includes a well-established procedure for comprehensive credit appraisal.

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What Factors are Used to Assess Credit Risk?

In order to assess the credit risk associated with any financial proposal, the project finance division of the firm first assesses a variety of risks relating to the borrower and the relevant industry.

The borrower credit risk is evaluated by considering:

• The financial positionBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. of the borrower, by analyzing the quality of its financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are, its past financial performanceIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or, its financial flexibility in terms of the ability to raise capital, and its capital adequacy
• The borrower’s relative market position and operating efficiency
• The quality of management, by analyzing its track record, payment record, and financial conservatism

Industry-specific credit risk is evaluated by considering:

• Certain industry characteristics, such as the importance of the industry to the economic growth of the economy and government policies relating to the industry
• The competitiveness of the industry
• Certain industry financials, including return on capital employed, operating margins,Operating MarginOperating margin is equal to operating income divided by revenue.  It is a profitability ratio measuring revenue after covering operating and and earnings stability

How are Credit Ratings Used?

After conducting an analysis of the specific borrower’s risk, the credit risk management group assigns a credit rating to the borrower. Generally, firms accept a scale of ratings ranging from AAA to BB (varies from firm to firm) and an additional default rating of D. Credit ratingsS&P – Standard and Poor'sStandard & Poor’s is an American financial intelligence company that operates as a division of S&P Global. S&P is a market leader in the are the critical input for the credit approval process, as they help the firm to determine the desired credit risk, spread over its cost of funds, by considering the borrower’s credit rating and the default pattern corresponding to the credit rating.

Every proposal for a facility is reviewed by the appropriate industry specialists in the credit risk management group before being submitted for approval to the appropriate approval authority. Generally, the approval process for non-fund facilities is similar to that of fund-based facilities.

How Frequently are Credit Ratings Assessed?

Credit rating for every borrower is reviewed at least annually and is typically reviewed on a more frequent basis for high credit risks and large exposures. Generally, the ratings of all borrowers in a particular industry are also reviewed upon the occurrence of any significant event impacting the industry.

Working capitalNet Working CapitalNet Working Capital (NWC) is the difference between a company's current assets (net of cash) and current liabilities (net of debt) on its balance sheet. loans are generally approved for a period of 12 months. At the end of the 12 month validity period, the loan arrangement and the credit rating of the borrower are reviewed and the firm makes a decision on continuation of the arrangement and changes in the loan covenants that may be necessary.

Learn More

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows
• Revolver DebtRevolver DebtRevolver debt is a form of credit that differs from installment loans. In revolver debt, the borrower has constant credit access up to the maximum
• Bank Financial StatementsFinancial Statements for BanksFinancial Statements for Banks differ from those of non-banks in that banks use much more leverage than other businesses and earn a spread
• FICO ScoreFICO ScoreA FICO score, more commonly known as a credit score, is a three-digit number that is used to assess how likely a person is to repay the credit if the individual is given a credit card or if a lender loans them money. FICO scores are also used to help determine the interest rate on any credit extended