The Financial Health Rating (FHR®) model is RapidRatings’ proprietary and innovative measure of risk that estimates the financial strength and weakness of both public and private companies. The FHR provides forward-looking visibility into operational resilience and indicates a company’s ability to weather disruption and continue business operations.
Based on company specific balance sheet, income statement, and cash flow statement data, and the principal business activity of the company, the FHR is a purely quantitative assessment of a company’s intrinsic financial health and is free from the noise and volatility of models that use market signals as inputs.
By contrast, Merton-based models, which typically take market signals as a primary input, are narrower in their focus. They are primarily used to assess the credit risk of a company and its ability to meet its debt obligations (i.e., probability of default).
Companies rarely default abruptly. Rather, failing companies typically reveal themselves by an accumulation of problems and pressures over time. These tend to emerge gradually and predictably in a company’s financial statements, while market signals may vary.
In addition to providing an estimate of a company’s ability to meet its debt repayment obligations, the FHR also anticipates a company’s ability to meet commitments to its business partners, including:
- supplying customers with good and services, on-time and without defect
- paying for products to support business operations
Merton-based models have several shortcomings. They:
- assume a default can only happen on the date of the maturity of the debt, but many companies have multiple loans with different maturity dates. Moreover, companies can, and do, file for bankruptcy prior to the maturity of their debt.
- depend on the value and volatility of a company’s assets – neither of which are directly observable.
- view the market value of equity as a call option against the company’s assets, which introduces noise into the calculation of the probability of default. Does a company’s probably of default really change on a daily basis as the investors reacts to not only information related to the company itself, but also overall up and down movements in the market?
- require the market value of the company’s equity, which does not exist for private companies.
By using company specific financial statement data, the FHR has several advantages. It:
- can be used on both public and private companies.
- assesses the overall financial health of the company, not just its default risk.
- is a through-the-cycle rating that is not affected by market volatility.