“Fast and furious” credit risk analysis : To check a company in 60 seconds
Unfortunately, many times you do not have much time to understand the credit risk of a company and in any case you have to give an answer that is as accurate as possible. What to do in these cases? What are the first few parameters that we have to check for understanding the risk? Below is a brief guide that can help those who unfortunately have been found in this situation!
First aspect: the areas of analysis of a company are various, and complex, but if you have 60 seconds, to give you a short answer I would tell you to focus on the following points:
Now we start with the first analysis: Solvency.
20 seconds ... time goes fast ... what to do? In order to have a fast control, let’s see the ratio between total liabilities and shareholders’ equity (also called total leverage). This ratio defines a first analysis including the relationship between total debt and shareholders’ equity, and therefore the higher, the worse the company (we should remember... we have 60 seconds ... we cannot go that deep into!). But what is a limit value that tells us whether the company is risky or not? I would say that a good value is 3: below this value are in good shape, above we have an indicator of danger! (To confirm, also check here). A key aspect: of course be careful about Equity: a negative one means it is very but very dangerous!
Solvency indicator = (Total Assets – Shareholders’ Equity) / Shareholders’ Equity.
- Indicator > 3 -> Risk
- Indicator < 3 — > Good
- Indicator <0 -> Extreme danger
Second area: Profitability
This area is simple: in order to sustain itself, a company must generate profits; so I would say that as a first estimation we can go and check the ROE (Return on Equity) calculated as ratio of Profit/Loss of the Period over the Shareholders’ Equity. Unfortunately, the discriminant value actually is totally dependent on the sector and the country (as described in the link), but even here we can say:
Profitability indicator = (Profit and loss) / Shareholders’ Equity.
- Indicator> 5% -> Good
- Indicator <0% -> Dangerous (the company is losing money)
- Indicator between 0 and 5%: Normal
At this point, there remains the last area: Liquidity
This aspect has been well studied and explained in one of the previous posts, given its fundamental importance (link here). In this case, unfortunately, we do not have much time (our 60 seconds are about to expire!). So I can only check the Current ratio (it is not my favorite ... I like the Quick Ratio but we do not have time!) Therefore:
Liquidity indicator = (Current assets) / Current liabilities
- Indicator> 2 -> Good
- Indicator between 1.2 and 2 -> Normal
- Indicator <1.2 -> Risky
At this point, the 60 seconds have just ended but you are holding 3 indicators that summarize (superficially of course, but not wrong) the three main areas in which we can study the credit risk of a company. Putting together the three definitions, you can understand the very first analysis of the credit risk of a company.
I hope this very brief notes may be helpful if you ever should find yourself in this situation!