Reversal of interest rate cycle – Are you fully quantifying the credit risk?

A ship in harbour is safe, but that’s not what ships are built for. Similarly, it is next to impossible to grow a business without taking credit risks. However it’s important that risk mitigation measures are also in place lest your business succumbs to a stormy business environment.

RBI recently increased the repo rate, the rate at which commercial banks borrow money by selling securities to RBI, by 40 basis points. The annualized yield of 10-year benchmark government bond yields in turn is now at 7.2% – up by 100 basis points since Aug 2021.

The central bank usually increases interest rates whenever inflation goes above their comfort levels. A higher interest rate tends to moderate economic growth by keeping a check on demand. For one, high-interest rates increase the cost of borrowing and reduce disposable income thereby putting limits on consumer spending.

With interest rates bottoming out, and with further rate hikes expected in the future, it is important that your credit management systems are in place.

Determine sector-wise exposure

First of all, assess your customer’s sensitivity to interest rate shocks. One of the ways to do this is by classifying them into industries they belong to.

Banking and finance, auto, real estate, consumer durables, capital goods and allied sectors tend to get more affected by a rate hike than the others. For instance, an increase in interest rates (which is usually linked to repo rate) for a house or car loan affects the affordability factor. Instead of paying higher EMI, potential customers might prefer waiting on the sidelines. This in turn could affect the businesses/finances of residential property builders and auto manufacturers and their ability to make payments to you on time. So, find out how much percentage of revenues comes from these vulnerable sectors?

Promptly, red-flag customers in these sectors with a history of late payments, legal issues and bankruptcy.  Review their credit policies periodically and if need be, move towards a 100% prepayment model to avoid potential bad debts.

Analyze creditworthiness

A company might operate in an interest-rate sensitive sector but still exude financial prowess. So, have a look at company’s financials to get a glimpse of its indebtedness and liquidity situations.

In a rising interest rate scenario, the profitability of debt-ridden (leveraged) companies takes a hit in two ways – one by way of drop-in company sales from reduced consumer demand and two, from its higher financial costs.

However, cash-rich companies or those with zero debt on their books are on a relatively better footing.

Moreover, while analyzing the financials, look at the business and financial risk profiles of the company and its subsidiaries as well. A high degree of operational and management integration, common promoters, and shared brand equity makes the consolidated performance more relevant.

Similarly, figure out if the customer is part of a big industrial group with deep financial pockets? If yes, they usually tend to have the financial backing of its parent to wade through tough times.

One way to keep yourself updated about the financial status of a customer is by actively tracking ratings of its debt papers as well as their updates.

Step-up data intelligence

Cloud-based databases often give deep and critical financial information about customers, competitors as well as industry. By leveraging such data, credit managers can easily assess creditworthiness and make informed business decisions. Moreover, it is important that this data is up-to-date and relevant to facilitate quick decision-making. For instance, analyzing financial performance of customers over the long-term and across multiple business cycles could give an inkling of its resilience factor.

Takeaway

Reversal of the interest rate cycle can increase bad debts if proper credit risk management systems are not in place. Ensure you use data insights to stay ahead of the curve.

About Probe42:

  • Probe is an independent Information Services company focused on providing financial information on Unlisted and under-covered companies in India
  • Our Customers have found value in using Probe42.in to enable their decisions involving Identifying prospects, sales preparation, credit and competitor analysis, etc.
  • The Probe42 platform has been extensively used by Banks and Corporates.

 

 

 

Leave a Reply

Your email address will not be published.