Financial risk analysis is the evaluation of credit risk. It effectively assesses a borrower’s ability to repay a loan to a creditor. Both creditor and borrower benefit from analyzing the borrower’s financial risk.
What Is Credit Risk?
Investors are at risk of loss of principal or loss of financial award if borrowers fail to pay back a loan or meet the terms of a contract. Credit risk goes hand in hand with a borrower expectation to use future income to pay off an already existing debt. The higher the risk, the higher the interest rate an investor will put on the loan.
Balanced Scorecard System
Balanced scorecard system uses key performance indicators (KPI) to measure credit risk by evaluating capital adequacy, gross debt service ratio and customer credit quality. Capital adequacy is the amount of capital divided by economic capital (EC) amount and multiplied by 100. Gross debt service ratio is made up of property taxes plus annual loan payment divided by gross customer income and then multiplied by 100. Customer credit quality is a number found by analyzing credit history and reports.
Cash Flow Risk Analysis
Experts create both net worth and cash flow statements in order to assess cash flow risk. A net worth statement looks at all of a client’s resources and all liabilities in order to create a number representative of his financial situation. A cash flow statement adds together all expenses and all income to determine if a person has negative or positive cash flow. If there is a positive cash flow, there’s room for an emergency fund, which decreases your cash flow risk.
Employment Risk Analysis
Though employment risk analysis isn’t a step lenders can benefit from, it is beneficial for borrowers to look into. Borrowers should asses their job situation, and even if it is very secure, experts recommend maintaining a good resume, networking and attaining new skills related to your field.
Coverage in case of financial distress is essential, including life insurance, home and car insurance, liability coverage and health insurance. A financial advisor or insurance representative can help determine the best insurance for anyone hoping to borrow money. Preparation is key to decreasing financial risk.