Forward looking approach in the risk assessment of companies

How to integrate a forward looking component in the risk assessment of companies into lending and credit management processes using an automated simulation tool.

The most widespread assessment systems in the world of credit and consultancy are generally based on a traditional and static approach. The so-called ratio analysis is certainly based on some useful principles, but these do not allow the dynamic aspect of risk to be considered, thus preventing us from having a comprehensive and complete view of the counterparty.

For this reason, many credit institutions have recently intensified activities to strengthen the processes and skills related to forward-looking analysis and cash flow analysis issues, since the principles underlying Basel 3 oblige them not only to consider current risk but also expected risk.

Therefore, it isn't enough just to know the current state of health of a client company or prospect, but it is also necessary to predict likely developments. Forecast analysis of client companies must also take into account expected industry trends and the competitive positioning of the individual company within the industry itself.

In fact, a company operates within an external context whose dynamics are able to significantly influence the operating and financial results of the company; there are multiple influences deriving from the external context, which can be considered on a system level and on the level of the reference economic sector.

Lending and credit management policies, therefore, cannot ignore the assessment of the cyclical phase in which the financed company must generate cash to repay loans, and at the same time must take into account the specific characteristics of the economic sector in which it operates.

Therefore, it is necessary to approach the risk assessment of companies through:

  • ratio analysis of historical data and the standardization of economic-financial analysis policies for the purposes of assessing the company, its credit potential, and the risk and sustainability of the credit facility being offered
  • building company forecasts (business plan, complete with statement of assets and liabilities, profit and loss account, and cash flow statement) on the basis of a simulation “engine” which takes accounting reports into consideration among the main financial statement amounts and which can also be fed using assumptions formulated by the user (typically by the Manager, on the basis of interviews with the company)
  • company data projections, including in the absence of information from the user, on the basis of macroeconomic sector forecasts (industry outlook), positioning of the company within the sector (with the aim of identifying the so-called “star” companies), and any “what-if” analysis performed by the user on macroeconomic and company figures.

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