Risk Management in Financial Services

Fundamentals of Finance Class IV

by Reuben Ray
reuben@pexitics.com
What we are going to cover today in Finance

• Risk and types of Risk

• Credit Risk
• Credit Assessments & measurements of Ratios
Risk: Risk Management: Managing versus Measuring

Create Risk policies and frameworks

Set the Credit Approval framework
RISK MANAGEMENT Provide reporting and analytics
Designing risk measurement tools

Centralised Risk Department

Portfolio Management MANAGE

Policy & Operates within specific Risk frameworks

Credit Risk as determined by Market & Operational
Framework Credit Risks to control risks.
Assessment & Portfolio Risk
Approval

Portfolio Risk Assessment &

Market Risk Risk Modelling
Management Approval
Reporting & MEASURE
Analysis

Operational Risk Policy & Portfolio Business Continuity

Risk Modelling
Framework Management Planning
Risk: Types of Risk
Operational Risk
Losses arising out of insufficient resources, controls, processes and compliance.
Legal/Regulatory Risk
Risk of fines due to noncompliance of regulatory norms and unlawful business practices.
Credit Risk
Losses arising out of defaulting borrowers due to improper assessments.
Liquidity and Funding Risk
Risk of difficulty in accessing, liquidating or financing assets in a timely manner.
Market Risk
Risk of losses arising from changes in market prices, rates, volatility, and correlations.
Competitive Environment Risk
Risks from competitive pricing and changes markets or financial environment.
International Risk
Risks of losses arising from global operations of the organisation or border disputes.
Acquisition Risk
Risk of failing acquisitions, minority stakes, joint ventures, and strategic alliances.
Risk: Financial Risks

Specific Risk
Equity Risk Trading Risk
Market Risk
Interest Rate Risk General
Gap Risk Market Risk
Financial Currency Risk
Credit Risk
Risks Commodity Risk
Counterparty
Operational Risk
Risk
Transaction Risk
Issuer Risk
Portfolio
Concentration
Risk Issue Risk

Total Capital
= Capital Ratio
Credit Risk + Market Risk + Operational Risk
Credit Risk Management

Credit risk arises when the counter-party to a financial contract is

unable or unwilling to honour its obligation. It may be due to;
Lending Risk: Borrower fails to repay interest/principal. This may arise when the credit
quality of a borrower deteriorates leading to a reduction in the market value of the
loan or drop in the value of the collateral.
Issuer Credit Risk: arises when issuer of a debt or equity instrument defaults or
becomes insolvent. The market value may also decline with the deterioration of credit
quality of issuers or falling demand for such instruments.
Counter party Risk: Risks of commitments in trade not met
Settlement Risk: When there is a ‘one-sided-trade’ or trade remains unsettled

• Goal of CRM: maximization of the bank’s risk adjusted rate of return by maintaining credit risk
exposure within acceptable parameters.
• CRM refers to the credit risk in individual credits or transactions as well as the risk inherent in
the entire portfolio.
• Consideration of the relationship between credit risk and other risks
• The CRM approach used by individual banks should correspond to the scope and
sophistication of the bank’s activities.
Managing Credit Risk

•A major part of the business of financial institutions is making loans,

and the major risk with loans is that the borrower will not repay.
•Adverse selection among applicants is a problem in the market for
loans because those with the highest credit risk have the biggest
incentives to borrow from others.
•Moral hazard plays as role as well. Once borrowers have money, there
is higher tendency to engage in risky projects to produce the highest
payoffs, especially if the project is financed mostly with debt.
•Credit Managers have number of tools to assist in reducing or
eliminating the asymmetric information problem. However using the
right tool or formulae is based on accurate knowledge and its practical
usage.
Credit Risk: Probability of Default

Borrower Risk Portfolio Risk

EXPECTED LOSS Probability of Loss Given Loan Exposure

= Default x Default x Default
in Rs.
(PD) as a % (LGD) as % (EAD) as Rs

What is the If default occurs, If default occurs,

probability of the how much of this how much
counterparty do we expect to exposure do we
defaulting? lose? expect to have?
Credit Risk Assessment

• Purpose of the credit and source of repayment with tenor.

• Current risk profile (incl. the nature and aggregate sources of income
and its cashflow risks) of the borrower or counterparty and its
sensitivity to economic and market developments.
• Borrower’s repayment history and capacity to repay based on the
historical trends in its financials and future cash flow projections,
irrespective of new revenue sources under various levels of sensitivity.
• Customer’s capacity to increase its level of indebtedness or capability
to infuse capital in case of contingencies.
• The proposed terms and conditions of the credit, including covenants
designed to limit changes in the future risk profile of the borrower.
• Proposed collateral cover, Loan To Value Ratio (LTV), adequacy and
enforceability of collaterals or guarantees under duress.
• Integrity and reputation of the borrower or counterparty.
Credit Assessments

Most financial statement-based risk analysis focuses on a comparison of

the supply of cash and demand for cash

• Risk analysis using financial statement data typically examines

• Short-term liquidity risk: the short-term ability to generate cash to
service working capital needs and debt service requirements, and
• Long-term solvency risk: the longer-term ability to generate cash
internally or from external sources to satisfy growth capacity and
debt repayment needs

• The field of finance identifies two types of risks:

Credit Risk: a firm’s ability to make payments on interest and principle
payments, and
Bankruptcy Risk: the likelihood that a firm will remain a going concern
Credit Assessments: Financial Analysis
Credit Measurements: Ratios

Ratio-analysis is the process of computing, determining and

presenting the relationship of related items and groups of items in
financial statements. They provide a fairly good idea about the
financial position of a firm. They are important tools for financial
analysis.

Financial Ratios are used to predict;

• Liquidity position
• Profitability
• Solvency
• Financial Stability
• Quality of the Management
• Safety & Security of the loans & advances to be or already been provided
Credit Measurements: Short Term Liquidity Ratios

Financial Ratios Formula Definitions

A measure of short-term
liquidity. Indicates the ability of
Current Ratio Current Assets / Current liabilities
entity to meet its short-term
debts from its current assets

A more rigorous measure of

short-term liquidity. Indicates
Current Assets less inventory / Current
Quick Ratio the ability of the firm to meet
liabilities
cashflows requirements from
liquid current assets.

Measures a firm's ability to pay

Cash Flows from Operations/Average
Operating Cash Flow Ratio
Current Liabilities
its short-term liabilities.
Indicates whether the company
has generated enough cash over
the year to pay off short term
liabilities as at the end of the
year.
Credit Measurements: Long Term Liquidity Ratios

Financial Ratios Formula Definitions

Measures percentage of assets

Debt ratio Total Liabilities / Total assets provided by creditors and extent
of using gearing

Measures percentage of assets

Capitalization ratio Total assets / Total shareholders’ equity provided by shareholders and
the extent of using gearing

The debt-to-capital ratio gives

users an idea of a company's
Total Debt/(Total Shareholders’ Equity + financial structure, or how it is
Debt Equity Ratio
Total Debt) financing its operations, along
with some insight into its
financial strength.

Operating profit before income tax + Interest Measures the ability of the
Times interest earned expense / Interest expense + Interest entity to meet its interest
capitalized payments out of current profits.
Credit Measurements: Profitability Ratios

Financial Ratios Formula Definitions

Measures rate of return

Operating profit before income tax + earned through operating
Return on Total Assets
interest expense/ Average total assets total assets provided by both
creditors and owners

Operating profit & extraordinary items

Measures rate of return
Return on ordinary after income tax minus Preference
earned on assets provided by
shareholders’ equity dividends / Average ordinary
owners
shareholders’ equity

Profitability of trading and

Gross Profit Margin Gross Profit / Net Sales
mark-up

Operating profit after income tax / Net Measures net profitability of

Profit Margin
Sales Revenue each dollar of sales
Credit Measurements: DSCR

DEBT SERVICE COVERAGE RATIO: This ratio is one of the most

important one for credit analysts which helps forecast the ability of a
firm to meet its liabilities by way of payment of installments of Term
Loans and Interest thereon from out of the cash accruals and forms the
basis for fixation of the repayment schedule in respect of the Term
Loans raised for a project.

(A healthy DSCR Ratio is considered to be 1+ )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities

------------------------------------------------------------------------------------
Annual interest on Long Term Loans & Liabilities + Annual Installments
payable on Long Term Loans & Liabilities
Credit Measurements: Ratio Calculations
Liabilities Rs. In Lacs Assets Rs. In Lacs
Capital 400 Net Fixed Assets 400
Reserves 100 Inventories 200
Term Loan 400 Cash 60
Bank C/C 100 Receivables 400
Creditors 20 Intangibles 40
Provisions 80
1100 1100
Calculating the Debt Equity Ratio
Capital = Rs. 400 Lacs
Free Reserves & Surplus = Rs. 100 Lacs
Long Term Loans/Liabilities = Rs. 400 Lacs
Debt Equity Ratio is = 400/500 or 0.8 : 1
TNW = 400+100 – 40 = 460
Current Ratio = Current Assets(200 + 60)/Current Liabilities(100+20+80) = 1.6
Credit Measurements: Ratio Calculations

The Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ?
Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would
be NIL (since NWC = CA - CL)

Suggest that the Current Ratio is 4 : 1. NWC is 300 lacs. What is the amount of Current Assets ?
Answer : 4a - 1a = 300 lacs
a = 100 i.e. Current Liabilities is Rs.100 lacs
Hence Current Assets would be 4a = Rs.400 lacs

The amount of Term Loan installment is Rs.10000 per month, monthly average interest on TL
is Rs.5000. If the amount of Depreciation is Rs.30,000 p.a. and PAT is Rs. 2,70,000. What
would be the DSCR?
DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment
= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
Credit Measurements: Ratio Calculations

Calculate the following ratios;

(i) Current Ratio
(ii) Acid test Ratio
(iii) Inventory Turnover
(iv) Average Debt Collection Period
(v) Average Creditors’ payment period.
Assets
Sales 1500 Inventories 125
Cost of sales 1000 Debtors 250
Gross profit 500 Cash 225
Liabilities
Trade Creditors 200
(i) Current Ratio : 600/200 = 3:1
(ii) Acid Test Ratio : Debtors + Cash /Trade creditors = 475/200 = 2.4:1
(iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
(iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61 days
(v) Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365
(200/100) x 365 = 73 days