The old parable where three blind men touch different parts of the elephant – the tusk, the leg, and the trunk - and end up getting into an argument as they can’t agree on what the animal looks like. Each man is correct but limited because of their experience. Similar to the men touching the elephant, understanding credit is often the same way. The experience in commercial credit, in particular, is shaped by a combination of experiences, conjecture, and tribal lore. Credit officers see things differently and so focus on different things. Some love cash flow, while others are scared of liquidity, while still others need growth. In this article, we not only take a snapshot at what is important but look at the relative importance of several metrics as it relates to risk. If you are interested in more accurate underwriting or saving time in your credit reviews, this article may help you see more of the elephant.
Risk And Metrics
For the sake of this analysis, we will use revenue volatility as a proxy for risk. The more revenue fluctuates, the riskier we will deem the company. For clarification, this analysis isn’t meant to be the definitive answer on all things credit for all companies for all time periods, but our goal is just to peel back another layer of the onion and give bankers another perspective.
For the analysis, we will look at data from Moody’s and look at the financial performance for all their companies that they track. We will then look at a typical quality community bank credit and ask the question – What popular ratios are correlated to risk? The data yields the following analysis:
What The Data Means – Liquidity Is Overrated
There are a couple of things that pop out from the data above. The first is that liquidity, as an indicator of risk, is way overrated. From the data above, it is just 1% negatively correlated to risk – in other words, liquidity is uncorrelated to risk. The negative 1% means that as risk decreases, liquidity just slightly improves.
When we were young bucks going through credit school at large banks, we must have had three days on just analyzing the liquidity of a company. Still to this day, we see credit memos going into great detail about all the cash on hand the company has. Statistically, the amount of cash a company has is not a very good predictor of risk or probability of default. Cash holdings is a snapshot in time and can be highly influenced by seasonality and balance sheet management techniques. As such, liquidity is a bad predictor of risk. In fact, you can make an argument that you decrease risk but not spending any resources looking at a company’s cash position as any time spent is statistically worthless and could influence your credit decision in the wrong direction.
Return and Coverage Are King
No surprise, profitability, and risk are highly correlated. Return on assets and return on equity tends to be one of the best predictors of risk as profitability explains 63% of risk. That is, as risk increases profitability decreases and vice versa.
Asset coverage, or how well a company can cover its debt obligations ranks second with a -61% correlation.
Interestingly, debt leverage or the amount of debt to capital is often held out as one of the most important ratios in commercial underwriting. Statistically, it has less than a 40% negative correlation.
Putting This Into Action
In this age of quantified banking, credit underwriters no longer need to rely on limited experience, haphazard analysis or tribal lore. Bankers have great statistics spanning more than 35 years, and we have a pretty good picture of what is important in underwriting and what is not. Of course, these statistics from today represent a broad range of companies from across the nation and tend to be mid-sized firms so it may or may not apply to your underwriting. While we have and will continue to publish our data, we encourage all community banks to get more quantitative in determining what are the major predictors of credit risk.
Having an objective and quantifiable picture of underwriting can help lenders understand what part of the elephant they are touching.
Submitted by Chris Nichols on September 14, 2017