Question

What two factors determine a company’s level of credit risk? Explain what each factor tries to measure.

Answer 1

Following are the factors that determine a company's level of credit risk:

1. Probability of default / Chance of default: The probability of default measures a borrowing entity's probability or likelihood that it won't be able to generate enough cash flows to fulfil its financial obligations. A debt issuing company's level of credit risk is highly influenced by its probability of default. Credit rating agencies like Moody's, Fitch, S&P, etc. give a credit rating to the debt issuing companies, representing the probability of default by the rated companies.

2. The extent or magnitude of loss in the event of default:  Also referred to as LOSS GIVEN DEFAULT, this factor measures the loss occuring to the lender in case of default by the borrower, it also measures the probability of the receipt of compensation by the lenders, in case of default by the borrowing company. LSD is computed in advance by the lending entities to measure the extent of probable loss in case of default by the borrower.