Assessing creditworthiness in a changed environment

1 May 2020

Any claimant pursuing or considering litigation knows the environment has changed. Many defendants are facing operational challenges, and it cannot be assumed that a defendant has the financial resources to satisfy damages awarded to a claimant – many businesses are fighting to stay solvent. For existing or new claims, keeping a watching brief on the creditworthiness of defendants is crucial.

However, this unprecedented environment means that many of the established ways of assessing creditworthiness have changed significantly. Agility and vision from claimants, their lawyers and funders are essential to monitor changes in the financial health of defendants and respond proactively and appropriately.

In the current environment three important factors pertaining to creditworthiness have changed:

Evolving industry and sector dynamics

Staying close to present industry and sector specific risks is essential; it is not enough to follow past patterns of sector specific credit risk assessments. Lookout for the current sector impacts and their consequences both for the defendants and their customers. Transport and hospitality are prime examples of industries where major changes are underway at present.

Using correct credit ratios

Using credit ratios to assess risk should move the focus from assets to cash. Asset/debt ratios have declined in prominence as a measure of creditworthiness and instead the cash/income to operational expenses ratio has gained in weight when assessing financial stability. The long-term debt/capitalisation ratio has become a lot less significant, if not meaningless. At the same time the operating income/sales (realisation) ratio and the EBITDA/operating expenses ratio have both become essential to look at.

Short-term versus long-term liquidity

Short-term credit assessment should be prioritised over a balanced approach of looking at short- and long-term credit assessments. In the current environment, the first hurdle for any positive credit assessment is the liquidity test for the short term of three to six months. This translates into cash on hand availability being three to six times monthly fixed operational expenses (depending on the business model and its agility on the management of fixed costs). If the business does not pass this test, there is no need to look at long-term credit assessment.

Whilst the positive long-term credit assessment is still a requirement, the current environment has led to an increased focus on short-term credit assessment.

Taking a step back and exploring this changed landscape of credit risk assessment will allow you to re-consider the likely challenges faced by defendants in the current environment.

To learn more, please contact Theo Paeffgen at theo.paeffgen@harbourlf.com.

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