This article uses business language to discuss the modelling foundations for The Financial Health System. If you have not done so already, we recommend reading What Is The FHR first. We also have an advanced article if you have a quantitative or statistical background
The FHR is a 0-100 score, expressed across five risk categories, and each FHR is associated with an Estimated Probability of Default (EPD). The FHR model uses a sophisticated industry specific approach to benchmark financial characteristics against 40+ years of historical performance. We identify what strong companies look like in the best of times, and what weak companies look like in the worst of times, and determaine how your counterparty stacks up. Does its financial characteristics resemble firms which default, firms which survive, or firms which thrive?
Key model features include:
- Financial Statements Only: Our models are based entirely on financial statement information. No analyst opinion, because these lead to inconsistency across ratings. No market level inputs, because these can lead to arbitrary rating fluctuations
- Industry Specificity: We use 24 industry models to make sure your counterparty is appropriately benchmarked. Many typical alternatives use 4 or 5 industry models, which is not enough specificity
- Publics and Privates: We use an identical process for public and private companies, so you can compare the ratings of all your counterparties on an apple-to-apple basis
Our novel breakthrough is to break our analysis into three stages, for a more dynamic and accurate measurement of Financial Health.
- Measure Core Health: Is the company’s operational performance sustainable? The Core Health Score (CHS) is an industry specific measurement of a company’s efficiency and likelihood of remaining competitive through market fluctuations. Core Health is significantly influenced by profitability performance
- Measure Resilience: Does the company have the financial capacity meet its obligations? We look at Leverage, Liquidity and Earnings Performance
- Measure Financial Health: What is the likelihood of default or bankruptcy over the coming 12 months? Financial Health captures a dynamic interaction between Core Health and Resilience
A company with strong Core Health is unlikely to experience distress and is afforded considerably more flexibility with leverage and liquidity requirements. As Core Health deteriorates, the importance of strong resilience increases if the company is to survive. A company with poor Core Health and poor resilience is at the highest risk of failure.
The Core Health model measure a company’s efficiency and competitiveness, both from an operational and a structural perspective.
Figure 1: Core Health Categories
Core Health is measured in 4 steps:
- Compute 62 financial ratios that are divided into four Performance Scores
- Benchmark each of the 62 ratios on an industry-specific basis against a global distribution of peers in 24 industries covering up to 40 years of performance data
- Apply specific ratio weights to each of the benchmarked scores based on the ratio’s predictive significance (determined by econometric modeling)
- Produce a single weighted risk score, our Core Health Score (CHS)
Figure 2: Measuring The Core Health Score (CHS)
The Resilience Indicators measure a company’s leverage, liquidity and earnings performance. They interact dynamically with Core Health to indicate lower or higher short-term risk. Strong Core Health makes a company less sensitive to the impact of its Resilience Indicators. However, as a firm’s Core Health deteriorates, its Resilience Indicators become increasingly important and will have a more significant impact on the final FHR. This dynamic interaction between Core Health and Resilience is a key pillar of the FHR’s predictive ability.
- Leverage is a solvency metric that depicts the extent to which a firm’s assets are dependent on debt as compared to equity
- Liquidity measures the ability of the firm to survive any short-term crises that drain its asset reserves
- Earnings Performance assesses the firm’s efficiency in managing internal constraints and internal opportunities to generate upstream and downstream profitability to permit the firm to meet internal obligations and external obligations
Figure 3: Dynamic Interaction of Core Health and Resilience Indicators
|We identify each of the ratios used in Core Health and Resilience in Performance categories.|
FHR and EPD%
The analysis described produces the FHR, a 0-100 score expressed across five risk categories, and each FHR is associated with an Estimated Probability of Default (EPD).
Figure 4: The Risk Categories and EPD Ranges
FHRs have shown to be exceptionally accurate at predicting default risk. You can find detailed performance analysis in our back testing section, but this chart below shows more than 90% of defaults have FHRs which are High or Very High Risk.
Figure 5: FHR Distribution at Default