Financial Risk Analysis – Its Importance and Developing the Model

One of the essential components of financial risk analysis happens to be the evaluation of credit risk.

This is important for it is known to effectively assess the ability of a borrower when it comes to repaying the loan to his or her creditor.

Analyzing the financial risk involved actually stands to benefit both the borrower as well as the creditor.

Financial Risk Analysis Concepts

Financial risk analysis involves a conceptual understanding of various factors, which contribute towards its macro understanding.

The concepts are highlighted below, in brief.

  • The concept of credit risk

Now, before getting into anything else, the first thing that you’ve got to realize is the credit risk involved.

You see, investors generally stand to be at a loss of principal or even a loss of financial award when it comes to the borrower either failing to pay back the loan or perhaps not meeting the terms of the contract involved.

Hand in hand with this goes credit risk plus there’s a borrower expectation involved wherein future income is used for the purpose of paying off an already existing debt.

Actually higher the risk involved, higher will be the interest rate that an investor would put on the loan.

The credit risk is calculated on the basis of several factors. In India, investors do a CIBIL check of the borrower’s credit rating. The current income of the borrower is taken into consideration. The investor needs assurance that the investment will be repaid and therefore, checking into the permanency of the borrower’s income is essential.

Further, if the borrower had taken loan previously and repaid it successfully, it goes into the borrower’s favor.

Suggested: Read more about Finance Basics

  • The balanced scorecard system

This particular system makes use of the key performance indicators (KPI) or key success indicators (KSI) for the purpose of credit risk measurement.

This can be done by the evaluation of capital adequacy, customer credit quality, and the gross debt service ratio.

Governments, non-profit organizations, businesses and industries use the balanced scorecard system as a tool for strategic planning. The purpose is to understand and create a common vision for the organization, monitor its performance, and improve communications.

The balanced scorecard system was developed by Drs. Robert Kaplan and David Norton as a framework to measure performance. The scorecard offers a balanced view of the organization.

  • Analysis of the cash risk flow

Experts are generally seen to create both net worth as well as cash flow statements for the purpose of assessing the cash flow risk.

As for a net worth statement, then it essentially takes a look at all the resources of a client as well as the liabilities.

This would effectively help create a number that’ would be representative of the financial situation in hand.

As for a cash flow statement, then it adds together all the expenses as well as income to understand whether a person has positive cash flow or a negative one.

  • Analysis of employment risk

This analysis isn’t really beneficial to lenders, but it’s definitely beneficial for the borrowers to look into. Of course, the lender does check the person’s employability and potential to return the money but it’s actually the responsibility of the borrower to remain in employment.

Borrowers are required to take a close look at their job situation. Unless the borrower is working in the government sector where the threat of being shown the pink slip is really rare, the borrowers need to be mindful of remaining in employment throughout the duration of the loan period.

Even if the borrower feels that the job is rather secure, experts always advise that they maintain a good enough resume and continue networking effectively.

A loss of job during the credit period will throw the borrower’s financial situation into a quandary.

Developing Financial Risk Models

Again, financial risk models happen to be rather beneficial for companies to identify, analyze and forecast risks.

A financial risk model is essentially known to provide a quantitative approach to risk analysis.

Enlisted below are three basic steps that you can follow to develop financial risk models:

1.  Make use of spreadsheets

The first thing that you should do is make use of Excel spreadsheets. These are rather commonly used for the purpose of drawing up financial risk models.

This is because, with Excel, handling ratios and advanced simulations practically become the simplest thing possible. If you want to learn Excel or know more, head here.

The knowledge of simple and advanced Excel helps with financial risk analysis.

An alternative to Excel is the Open Office Spread Sheet, which is an open source tool generally used for equity research analysis.

2. Get financial risk software

SAS and SPSS happen to be the top two software for financial risk analysts which are practically very similar programs.

Though fact remains that SAS is more often than not referred to as being more complex.

Both are known to provide advanced quantitative calculations and that too for significant amounts of data in a matter of minutes. SAS and SPSS software are used to mine and analyze data through surveys, collaboration and deployment. Both the tools have various in-built functionalities to create engaging charts and graphs, and also represent data in a pictorial manner.

The use of financial risk software is recommended to perform accurate financial data analyse and reach correct conclusions.

The SPSS software is available as a trial download whereas the SAS software needs to be purchased.

3. Try developing a customized solution

There are certain instances wherein the requirement is that of a very particular and intricate financial risk model. This is why a customized solution should prove ideal.

The development of a customised solution depends on the necessary financial risk analysis factors. With adequate experience, one becomes adept in developing customised financial risk analysis solutions.

Endnote

The above discussion should enlighten you about the need of financial risk models and how financial risk can be analyzed in the first place.

It’s not a big deal provided you acquaint yourself with the nuances in concern and the advantages involved are obviously huge.

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