Default Risk Definition: Overview - Explanation

What Is Default Risk?

Default risk is a component of credit risk. It represents the danger linked to lending money that a borrower may not be able to fully repay. Every lender assumes a degree of risk that a borrower may fail to make the due payments on their debt obligation. Almost all types of credit extensions expose lenders and investors to default risk. As a result, a higher level of default risk requires a larger necessary return. In turn, this dictates a higher interest rate to compensate for the additional risk. Creditworthiness is measured and reported by credit rating agencies through the ratings they give.

Debt securities are financial assets that entitle their owners to a stream of interest payments. Unlike equity obligations, debt obligations require the borrower to repay the principal borrowed. The interest rate for debt security will depend on the perceived creditworthiness of the borrower. A default risk premium is an additional cost of incurring risk when investing in risk-based securities. It is the gap between the risk-free rate and the rate offered by high-risk securities. This premium is a method of recruiting customers by offering high-interest rates or low buying costs. It is a safeguard against the risk of bearer securities.

Default Risk – A Closer Look

When a lender gives credit to a borrower, there is always a risk that the loan will not be repaid. The default risk is a measurement that considers this chance. Default risk affects not only individuals who borrow money, but also companies that issue bonds. Future unforeseen financial constraints may leave the issuing corporation unable to make interest payments on the obligation. Calculating a borrower’s default risk is critical as part of a lender’s risk management approach whenever credit is extended. When an investor is analyzing an investment, determining a company’s financial health is critical in calculating investment risk.

The default risk of a corporation can fluctuate due to broader economic events or changes in its financial status. Many organizations’ sales and earnings can be impacted by an economic downturn. In turn, this affects their capacity to make debt interest payments and, eventually, repay the debt itself. Companies may suffer higher competition and weaker pricing power, which will have a comparable financial impact. Ultimately, firms must generate enough net income and cash flow to offset the risk of default. Standard measurement tools are available to assess default risk. For example, FICO credit scores offer individual credit and credit ratings for corporate and government debt issues. There are other nationally recognized statistical rating organizations that provide credit ratings for debt issues. Including Standard & Poor’s (S&P), Moody’s, and Fitch Ratings.

Sovereign Default Risk – Examples

Consider the example of sovereign risk, which is related to the government’s inability to repay its commitments. Because the debt is supported by the government, sovereign default is the least likely scenario. Nevertheless, sovereign default is not unheard of.

Sri Lanka – In May 2022, the South Asian nation of Sri Lanka defaulted on its debt for the first time. The country’s government was given a 30-day grace period to cover $78 million in unpaid interest but ultimately failed to pay. Not only does this impact Sri Lanka’s economic future, but it also raises an important question: which other countries are at risk of default?
Greece – In 2015, Greece is said to have defaulted on repaying a loan to the International Monetary Fund (IMF). Greece missed repaying 1.6 Billion Euros. Greece claims its downfall was due to internal structural problems resulting in systematic tax evasion.
Argentina – Another instance of sovereign default occurred in 2002. Argentina failed to settle an $ 805 million installment to the World Bank. It only resumed repayment after the IMF reopened its credit line. Sovereign default is the lowest risk associated with all forms of loans and borrowers. However, it can still happen from time to time.

Default Risk – Investment Grade vs. Non-Investment Grade

The credit scores provided by the rating agencies are divided into two categories: investment grade and non-investment grade or junk. Investors are always more interested in investment-grade debt since it has a minimal default risk. Non-investment grade debt, on the other hand, offers higher yields than safer bonds. However, it comes with a substantially larger risk of default. While each rating agency’s grading scales range slightly, most debt is assessed similarly. Investment grade bonds are those with S&P ratings of AAA, AA, A, or BBB. Non-investment grade bonds are those having ratings of BB or lower.

Bonds that are believed to have a lower risk of default and receive higher ratings by the credit rating agencies, namely bonds rated Baa (by Moody’s) or BBB (by S&P and Fitch) or above. These bonds tend to be issued at lower yields than less creditworthy bonds. (Source: investor.gov)

Determining Default Risk

Lenders and investors typically evaluate a company’s financial accounts and records. They also use a variety of financial ratios to assess the possibility of debt repayment.

The fixed-charge coverage ratio (FCCR) – FCCR measures a firm’s ability to cover its fixed charges, such as debt payments, interest expenses, and equipment lease expenses. It shows how well a company’s earnings can cover its fixed expenses. Banks will often look at this ratio when evaluating whether to lend money to a business. If you can’t meet these expenses, you’re not likely to remain in business for long.
The times interest earned ratio (TIE) – TIE is a measure of a company’s ability to meet its debt obligations based on its current income. The formula for a company’s TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt. The resulting number shows how many times a company can cover its interest charges with its pretax earnings. TIE is also referred to as the interest coverage ratio.
Price/Earnings to Growth ratio – The PEG ratio is a metric that assists in determining the value of a stock by comparing market price, earnings, and future growth potential. The PEG ratio is the price/earnings to growth ratio. It is a stock’s price-to-earnings (P/E) ratio divided by the earnings growth rate over a given time period. The PEG ratio is used to estimate the value of the stock while also considering the company’s predicted profit growth. It is regarded to provide a more complete picture than the more common P/E ratio.

What Is an Allowance for Doubtful Accounts?

Extending credit terms to customers comes with the inherent risk of not getting paid. This is regardless of the company’s credit collection rules and procedures. As a result, a corporation is obligated to recognize this risk. They do this by establishing an allowance for doubtful accounts and offsetting bad debt charges. An allowance for doubtful accounts is a contra asset account used to reduce receivables in an amount estimated by management to be uncollectible. It is a contra asset account because it decreases the amount of an asset, in this case, accounts receivable. The allowance is also known as a bad debt reserve. It predicts the percentage of receivables that are likely to be uncollectible. Customers’ actual payment behavior, however, may deviate significantly from the estimate. If real experience varies, management can modify its estimating process to get the reserve closer to actual results. (Source: daytradrr.com)

Factors Impacting Default Risk

There are numerous elements that assist lenders and debt investors in calculating a company’s implied default risk premium. For example, there are country-specific risks, such as political structures. Also, there are industry-specific hazards, such as legislation, that might affect a company’s default risk. Below are tools to measure company-specific hazards.

Leverage

The company’s current leverage position is a critical factor a lender assesses when determining a company’s default risk. In short, the most well-managed businesses can become financially distressed if their debt burden is too heavy. Even companies with a track record of regular cash flow generation and profitability.

Debt-to-capital – The debt-to-capital ratio is a liquidity metric. It compares the total liabilities of a firm to its total capital. It provides a good indication of how much of a company’s activities are supported by debt as opposed to capital.
Subordinated debt – Unsecured obligations rank lower in terms of claims on assets or profits than more senior loans or obligations. This type of debt is also known as a subordinated debenture. It is an unsecured loan or bond that ranks lower in terms of claims on assets or profits. As a result, subordinated debentures are often referred to as junior securities. In the event of borrower default, subordinated debt creditors will not be reimbursed until senior bondholders have been paid in full.
Times interest earned ratio – TIE is a measure of a company’s ability to meet its debt obligations based on its current income. The formula for a company’s TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt. The resulting number shows how many times a company can cover its interest charges with its pretax earnings. TIE is also referred to as the interest coverage ratio. It calculates how many times a company’s operating cash flows could theoretically pay off its interest bill. In general, the larger the coverage ratio, the smaller the default risk. The company has enough cash flows to cover its interest payments.

Profitability Metrics

Another factor to examine is the company’s profitability. Companies with larger profit margins tend to have bigger free cash flows (FCFs). Companies with a higher cash flow are much more likely to pay off all of their financial obligations. As a result, organizations with better profitability, particularly those in non-cyclical industries, are regarded as having reduced default risk.

Revenue vs Profit: Revenue is income generated through business operations while profit is net income after deducting expenses from earnings. Profit and revenue are two significant numbers to focus on for business owners and stock investors alike. Revenue is the company’s total amount of money in a given period. A company can bring in large amounts of revenue, but there will be no remaining profit if expenses exceed revenue.

EBIDA – = EBIDA is an after-tax measure of a company’s operating performance. It’s an acronym for Earnings Before Interest, Depreciation & Amortization.
Net Margin = Net Income / Revenue
Return on sales (ROS) – is a financial analysis ratio that calculates how efficiently a company is generating profits from its top-line sales revenue. Return on sales provides insight into a company’s performance by analyzing the percentage of total revenue that is converted into operating profits.
Asset turnover ratio – Asset Turnover = Net sales / Average total assets. This is a profitability ratio that calculates how much revenue can be generated by one dollar of assets.
Plowback ratio – The plowback ratio is the percentage of earnings a company reinvests rather than paying out higher dividends. for example, buying fixed assets.

Liquidity and Solvency

Lenders can estimate the creditworthiness of potential borrowers and their default risk by using liquidity and solvency measures.

Liquidity Ratios – Measure how much liabilities, namely near-term current debt obligations, can be paid off if the company underwent a hypothetical liquidation.
Solvency Ratios – Measure the extent to which a liquidated company’s assets can pay off its total liabilities, but with a longer-term time horizon (i.e. assessment of long-term viability).
Quality of earnings – QE refers to the portion of income realized from a company’s core operations that generate sustainable free cash flow. The quality of a corporation’s earnings is revealed by excluding data that may affect the true bottom-line performance. For example, abnormalities, accounting deception, or one-time events. When these are removed, the earnings gained from more sales or cheaper costs are plainly visible.

Examples of Liquidity & Solvency ratios

Cash Ratio = Current Assets / Current Liabilities. The cash ratio is a liquidity measure that indicates a company’s ability to pay off short-term debt with its cash and cash equivalents.
Acid test & Quick Ratio = (Cash & Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities. The acid test ratio is the most stringent calculation of short-term liquidity. It compares a company’s quick assets to its current liabilities. For that reason, the acid-test ratio is also known as the quick ratio. It gauges a company’s liquidity by evaluating how well current assets can cover current obligations.
Debt-to-capital ratio – A company’s financial leverage is measured by the debt-to-capital ratio. The debt-to-capital ratio is derived by dividing the total capital by the company’s interest-bearing debt, both short- and long-term obligations.
Free cash flow yield (FCFY) – is a financial solvency metric that compares a company’s predicted free cash flow per share to its market value per share. The ratio is computed by dividing free cash flow per share by the current share price. Businesses with robust cash flows are generally financially sound. However, firms with weak FCFs may be unable to satisfy their short-term obligations. A low FCFY implies that investors are injecting more money into the company than the profits it earns.
Segment margin – The amount of profit or loss generated by one component of a firm. Knowing the gross margin for the whole firm is not usually sufficient in huge corporations. However, knowing the segment margins for each division of the firm offers a more realistic view.

What Does it Mean to Accept Risk?

Accepting risk is a risk management strategy where the identified risk is considered acceptable enough that no expense or effort is made trying to limit or avoid it. Risk acceptance occurs when a business or individual decides that the potential loss from risk is not great enough to justify spending money or effort to avoid it. Accepting risk, or risk retention, is an aspect of risk management commonly found in business, investment, and finance.

Up Next: What Does Maturity Date Mean?

The maturity date is when a debt instrument comes due. It represents the final payment or receipt of interest for a loan, bond, or other financial product.

The maturity date for a loan is the deadline for repaying it in full. The principal amount of the debt is entirely paid on this date, therefore no more interest expenditure is incurred. For some debt instruments, the maturity date can be shifted to an earlier date at the debt issuer’s discretion. The issuer of a bond may reserve the option to purchase back the bond before its formal maturity date. This allows the issuer flexibility to decrease the period during which interest is accrued. The principal associated with a debt instrument may be totally payable as a lump sum at the maturity date. Or, the principle may be paid progressively with the interest during the term of the instrument. It depends on the provisions of the specific debt instrument.

Default Risk Definition: Overview – Explanation – Examples