How to Calculate Default Risk Ratio


Investing in a business is all about calculating risk. When you buy a company's bonds, or loan it money directly, you need to measure the risk of losing your money in a company default. The default risk ratio is a straightforward metric designed just for this purpose. To arrive at this number, you need some basic financial information that should be readily available, either through company reports or a look at current statements.

Free Cash Flow

  • Calculate the company's free cash flow. This is the net income after expenses, in addition to the amount of depreciation, minus dividend payments to shareholders. Company financial reports, including annual statements filed with the Securities and Exchange Commission, should reveal these numbers. You may also find free cash flow cited in independent research reports available online via brokerage websites. Cash flow is the "numerator" or top number of the calculation of the default risk ratio.

Principal Payments

  • Add together all required payments of principal on outstanding loans. Don't include interest payments or any prepayments, actual or projected, of principal. This number is the denominator of the equation. Divide free cash flow by annualized principal payments to arrive at the default risk ratio. The higher the ratio, the more likely that the company will be able to meet scheduled payments.

Survey the Ratings

  • Check the company's bond rating. Company bonds are rated by three major agencies according to the issuer's ability to make the regular payments. The default risk ratio is one of the essential metrics of credit risk that goes into bond ratings. The others are the ratio of debt to assets and the interest coverage ratio, which is the net profit divided by annual interest payments.

Compare and Contrast

  • Compare the default risk ratio to those of other bonds with comparable ratings. This serves as your "apples to apples" measure of bond values; generally, the lower the rating and the riskier the bond, the higher rate of interest it will pay. Your investment decision should be based on your time horizon, your comfort level with risk and the target mix of stocks, bonds and funds in your entire portfolio.

Study Similar Liquidity Metrics

  • Study the liquidity ratios of the company as well. The two most common are the current ratio -- current assets divided by current liabilities -- and the quick ratio -- current assets less inventories, divided by liabilities. The former ratio reveals if a company could meet all obligations today with the assets it owns on hand; by excluding inventories, the quick ratio offers a much tougher standard of a company's financial health. Together with the default risk ratio, these metrics give you a multilevel snapshot of the risk of investing in any company of interest.

Related Searches


  • Photo Credit Klaus Tiedge/Blend Images/Getty Images
Promoted By Zergnet


You May Also Like

  • Definition of Default Risk Premium

    "Default risk premium" is the added fee that a lender receives for the perceived chance that the borrower will not pay back...

  • How to Calculate Interest Rate Risk

    Interest rate risk is one of several measures of liquidity available to regulators, managers, and investors. Interest rate risk is necessary in...

  • How to Calculate Credit Risk

    Issuing credit to clients and customers can be a risky venture for a small business. Too many defaults or late payments can...

  • How to Calculate Risk Probability

    Calculating risk probability is a tricky business. If it were an exact mathematical science, there would be no "risk" involved, as people...

  • How to Calculate Default Probability

    Default probability most often refers to the likelihood that a borrower will fail to repay a debt according to the terms of...

  • Default Risk Vs. Spread Risk

    Few investments are considered safer than U.S. Treasury bonds. Buying corporate bonds offers a greater risk of default, which corporations compensate for...

  • How to Calculate a Default Risk Ratio

    A default risk ratio is important for a small business because a bank will look at this to determine the level of...

Related Searches

Check It Out

Are You Really Getting A Deal From Discount Stores?

Is DIY in your DNA? Become part of our maker community.
Submit Your Work!