Credit Rating Methodology & Guidance

The credit rating model represents CreditKernel’s forward-looking viewpoint on a counterparty’s creditworthiness.

We provide the credit model that delivers credit ratings linked to a 12-month probability of default.

Understanding counterparty risks allows your business to:

Avoid bad debt

Identify higher risk customers and apply additional due diligence, if necessary

Automate decisions for lower-risk, lower-limit exposures

Set risk-based pricing and payment terms

Reserve sufficient capital

Protect your balance sheet

Additionally, the model displays industry financial ratio benchmarks to show if your counterparty is above, on-par, or below industry peers.

Topics Discussed

Credit Rating Model Framework

Credit Rating Scoring Overview

Information Required

Determining the Marginal Producer

Credit Assessment Methodology

Industry Risk

Business Longevity

Peer Competition

Financial Risk

Core Rating

Liquidity Risk

Final Credit Rating

Probability of Default

Expected Credit Loss

Credit Rating Reports

Risk Appetite Alignment

Credit Model Framework

The way the credit model combines data with credit risk management principles can seem complex, but the basics are simple.

Counterparties operating in or with:

Higher risk industries
Fewer years in business
Lower revenues and margins compared to industry peers
Higher levels of leverages compared to industry peers
With little to no ability to absorb a severe, yet plausible, market event

...Are higher credits risks and have a higher probability of default.

The rating model incorporates both quantitative and qualitative risk factors in a user-friendly and transparent manner. The credit rating models assigns individual risk scores to 5 credit risk categories. After each category is scored individually, weightings are applied to develop a final credit score.

The final score is linked to an estimated probability of default and further calculates an expected credit loss.

Industry financial benchmarks instill confidence in the credit assessment process by showing you if the counterparty is overperforming, on par, or underperforming relative to industry peers.

The credit risk assessment categories, subcategories, and weighting is as follows:

Credit Rating Model Process

Credit Rating Model Requirements

Financial Statements
Standard Industry Classification, or know as SIC Code.

Financial Statements

Reviewing a company's financial statements is crucial for informed credit decisions, surpassing third-party payment behavior. These statements help assess profitability, debt service capacity, and benchmark performance against peers.

The Kernel’s financial statement spreading template has 50-line items available to be spread. However, only these 11 are required.

Balance Sheet

Cash & Short Term Investments
Goodwill & Intangibles
Short-Term Debt
Current Leases
Current Portion of Long Term Debt
Long Term Debt
Shareholder Equity

Income Statement

Revenue
Depreciation
Operating Income (EBIT)
Interest Expense

Cash Flow Statement

Not Required, If available

Depreciation (if not on Inc. Statement)
Cash Flow From Operations

Need a financial statement request letter? We provide two for free.

SIC Code – Standard Identification Classification

Economic conditions change in different ways across industries, which is why industry benchmarking is so important.

CreditKernel is a powerful yet simple model that evaluates and compares risks across 67 industries. No matter how many industries your business operates in, you can use just one model.

Analysts enter the SIC Code of a counterparty, and the model automatically gathers the necessary data to assess and fill in credit risk scores. If the SIC Code is unknown, analysts can use the built-in reference table, which includes 850 SIC codes mapped to these 67 industries.

Advertising Agencies

Aerospace & Defense

Agricultural Products

Airlines

Airports & Air Services

Apparel and Accessories

Auto Parts

Automobiles

Automotive Retail

Beverages Alcoholic

Beverages Non-Alcoholic

Building Products

Chemicals

Computer Hardware

Construction and Engineering

Construction Materials

Consumer Electronics

Consumer Services

Drug Manufactures

Education & Training Services

Electric and Gas Utilities

Electrical Equipment & Parts

Electronic Components

Electronic Gaming & Multimedia

Environmental and Facilities Services

Farm & Heavy Construction Machinery

Fertilizers and Agricultural Chemicals

Food Products

Footwear & Accessories

Furnishings, Fixtures & Appliances

Gambling and Betting Activities

Grocery Stores

HealthCare Providers and Services

Hotels and Lodging

Household & Personal Products

Industrial Distribution

Industrial Machinery

Information Technology Services

Leisure and Entertainment

Marine Shipping and Services

Medical Devices

Metals and Mining

Oil & Gas Drilling

Oil & Gas E&P

Oil & Gas Equipment & Services

Oil & Gas Integrated

Oil & Gas Midstream

Oil & Gas Refining & Marketing

Packaging & Containers

Paper Products

Pharmaceuticals and Biotechnology

Publishing

Railroads

Real Estate

Restaurants

Retail Stores

Security and Protection Services

Semiconductor Equipment & Materials

Software and Services

Steel

Telecom Services

Textiles

Tobacco

Transportation & Freight

Trucking

Utilities Diversified

Water Utilities

Methodology applies to nonfinancial entities. Does not aply to the following industries; general trading companies, investement holding companies, real estate, and non profits.

Credit Risk Concept - Determining the Marginal Producer

In credit risk assessments, the "marginal producer" is a company or individual with the highest costs in an industry. These producers are most at risk when prices drop or market conditions worsen. They usually produce smaller amounts and have the lowest profit margins.

The idea of a marginal producer comes from economics and helps assess the risk of a counterparty defaulting. In tough economic times, these businesses are often the first to struggle financially and may default because they have high costs and little to no profit cushion when revenue declines.

From a credit risk perspective, marginal producers are considered higher-risk since they are more vulnerable to changes in pricing, supply, demand, or regulations.

We help your business identify these high-risk producers so you can make better credit decisions.

How we determine the marginal producer

Risk scores for Industry Risk, Peer Competition, and Financial Risk are based on industry benchmarks that compare counterparties to their peers.

The model automatically uses the same percentage breakpoints (20%, 40%, 60%, 80%) to rank counterparties for these three risk areas. These breakpoints are specific to each industry and are determined by the SIC code entered.

Table 1 below shows how these breakpoints assign Risk Scores from 1 (lowest risk) to 5 (highest risk) for Industry Risk, Peer Competition, and Financial Risk.

The model assigns industry-specific breakpoints to determine risk scores from 1 to 5.

The example below shows how Financial Risk breakpoints differ by industry.

Picture 1 shows breakpoints for the Chemical industry.
Picture 2 shows breakpoints for the Oil & Gas Equipment Services industry.

The model uses the same percentage breakpoints but pulls values based on industry-specific data.

For example, looking at the Debt/EBITDA ratio:

To be in the top 20% (risk score of 1) in the Chemical industry, a company must have a Debt/EBITDA ratio below 1.6x.
In the Oil & Gas Equipment Services industry, a company needs a Debt/EBITDA ratio below 0.8x to be in the top 20%.

For the highest risk (score of 5):

A Debt/EBITDA above 3.8x in the Chemical industry scores a 5.
In Oil & Gas Equipment Services, a ratio above 7.6x scores a 5.

These differences in breakpoints show why the model is industry-specific. The Kernel’s financial ratio benchmarking tool analyzes risk across 67 industries to provide accurate credit ratings.

Chemical Industry Financial Risk Benchmarks

Oil & Gas Equipment Services Industry Financial Risk Benchmarks

Industry specific financial ratio benchmarks

Credit Assessment Categories

Industry Risk

The potential threats and opportunities affecting the overall performance and profitability of an industry. Predictable profitability, growth, and volatility are often associated with lower risk industries.

Business Longevity

50% of businesses do not survive beyond 5 years. Business longevity implies advantages such as credibility and trust, industry knowledge, established networks and relationships, and ability to navigate economic downturns.

Peer Competition

Reflects how well a company is positioned to meet customer needs, withstand competitive pressures, and achieve long-term success in its industry. Revenue size and operating margin are two important factors to identify your counterparties ability to differentiate itself from competitors and gain a competitive advantage.

The Industry Benchmark tool compares financial statement ratios to industry peers.

Financial Statement Analysis

Spreading financial statements provides a standardized way to measure and compare various aspects of a company’s performance over time, as well as against industry peers. The Kernel model analyzes key financial ratios to identify trends, evaluate performance in relation to peers, and pinpoint areas of strength or weakness with the company’s financial profile.

Liquidity Risk

The ability of a company to meet its short term obligations and fund its day to day operations. Liquidity risk arises when there is minimal or deteriorating headroom between your counterparty's cash inflows and outflows.

Industry Risk Assessment

Industry risk analysis looks at the risks and opportunities a company faces in its industry. It considers factors like growth, competition, and market stability to assess how the industry is performing.

How CreditKernel Measures Industry Risk

The Kernel model evaluates industry risk using three key factors:

Revenue Growth – Measures customer demand and market acceptance of products and services. Strong revenue growth signals a healthy industry with increasing consumer interest.
Operating Margin Growth – EBIT % (operating margin) shows how well an industry turns revenue into profit.
- Growing margins mean better pricing, cost control, and efficiency.
- Shrinking or flat margins can indicate pricing pressure, cost issues, or operational inefficiencies.
Operating Margin Volatility – Measures how stable an industry’s profit margins are.
- High volatility means unpredictable pricing, margins, and demand, making it harder for companies to manage risk.
- Low volatility means more stability and fewer unexpected risks.

High vs. Low-Risk Industries

Low-risk industries have steady revenue growth, expanding profit margins, and stable year-over-year performance.
High-risk industries have declining revenue, shrinking profit margins, and large swings in performance.

How Industry Risk is Scored

CreditKernel’s database maps financial statements to one of 67 industries, using at least 10 financial statements per industry.
The model analyzes each industry’s 3-year trends in revenue growth, margin growth, and volatility.
Industries are ranked 1 to 67 for each of the three risk factors.
Each industry gets a risk score from 1 to 5, based on set breakpoints.
The final Industry Risk score is the sum of the three scores, each weighted 33%.
Industry Risk contributes 20% to the overall Core Score.

Would you like any adjustments to better fit your audience?

Business Longevity Assessment

The longer a company has been in business, the longer it is expected to remain in business. The impact of business longevity on creditworthiness, or how long a company has existed, implies the following expected advantages.

Business's viewed as reliable, trustworthy, and capable of delivering on it promises build

Since 1994, the U.S. Bureau of Labor Statistics (BLS) has recorded and published business survivorship data, which provides insights into how long businesses survive.

To understand the impact of business longevity on creditworthiness, we retrieve data sets and calculate business survivor rates for each year and up to the latest available data in 2023.

The amount of available data varies depending on the starting year of the business. For instance, businesses starting in 1994 have a rich dataset spanning 29 years, while those starting in 2020 contain 3 years of data.

The studies on business lifespan can be found at Establishment Age and Survival Data: U.S. Bureau of Labor Statistics

Regardless of year the business opened, the statistics between business age and survivorship is evident: 20% of businesses do not survive past year 1, and a staggering 50% do not survive past year 5. These statistics highlight the challenges businesses face in not only short-term survival but achieving long term financial success.

How We Measure Business Longevity

Users input the number of years their counterparty has been operating.
- If left blank, the model assigns a score of “4”, equivalent to a business operating for 2 to 5 years.
The risk scoring scale ranges from 1 (lowest risk) to 5 (highest). The model determines the risk score based on the table below, using BLS data for breakpoint values.
Business Longevity contributes 20% to the Core Score.

Credit Risk Assessment Categories (8).png

Competitive Position Assessment

Peer competition assessment evaluates a company's ability to meet customer needs, withstand competitive pressures, and achieve long-term success by comparing its performance to industry peers.

Revenue Size and Operating Margin are two quantitative factors used to identify a company’s ability to differentiate itself from competitors and gain a competitive advantage.

Companies with smaller revenues and lower operating margins compared to peers often struggle when market conditions, competition, or regulations change, as their room for deterioration is minimal.

What Does Revenue Size Mean

Business Performance: Revenue size indicates the company’s effectiveness in selling products or services and attracting customers. Higher revenue amongst peers suggests demand and/or a strong customer base.
Financial Stability: Revenue size is closely linked to a company’s financial stability as sustained or growing revenue provides the necessary resources for operations, debt repayment, and pursuing growth opportunities.

What Does Operating Margin Mean

Operating margin, or EBIT %, measures a company’s operational efficiency and profitability.

It represents the percentage of revenue that remains as operating income after deducting expenses, excluding interest and taxes.

Operating Margin = (Operating Profit / Total Revenue) * 100

Operating Profit = Gross Profit – Operating Expenses

Total Revenue = Gross sales from products or services

Above average EBIT % indicates effective expense management, optimized cost structure, and higher returns on operations.
Lower than average EBIT % indicates challenges in cost management, pricing pressure, or operation inefficiency, suggesting the company is struggling to generate sufficient profits.

How We Measure Peer Competition

Financial statements housed in CreditKernel's database are mapped to 1 of 67 industries.
Each industry contains at least 10 financial statements.
Using the mapped statements, grouped by industry, Revenue and EBIT % are extracted from each statement and sorted to calculate industry-specific breakpoint percentages and values. These breakpoints align with the models risk scoring categories: Top 20%, Top 40%, Near Median, Bottom 40%, and Bottom 20%. Small Business Administration (SBA) data sets the criteria for small business revenue.
The counterparty's revenue and EBIT % are then compared to these industry breakpoint values and assigned a 1 to 5 score.
Revenue and operating margin scores are combined using the risk matrix below to form the Quantitative Peer Competition score.
Peer Competition contributes 20% to the Core Score.

As mentioned in step 4 above, your counterparty's revenue and EBIT are scored on a scale of 1 to 5 based on thier ranking in comparison to peers.

As mentioned in step 5 above, the counterparty's revenue and EBIT risk scores are then combined using the following risk matrix.

Example of how the Competitive Position assessment appears in the model:

A counterparty has the SIC code of 2800, the Chemical industry. The Revenue Size benchmarks range from:

Score of 1: Above $3.1B

Score of 2: $1.08B

Score of 3: $352 million

Score of 4: $40 million

Score of 5: Below $40 million

Note, industry specific breakpoint values are dynamic, and would change as the SIC code changes.

By spreading the financial statements, we know the counterparties revenue is $1.8B and operating margin % is 8%.

The credit model assigns a 1 to 5 risk score based on where the counterparty values rank in relation to industry peers.

Revenue score is 2, as the counterparty’s $1.8B in revenue is below $3.1B (score of 1) and above $1.08B (minimum value for score of 2). Operating Margin score is 3, as the counterparty’s 8% margin is below 11% (score of 2) and above 7% (minimum value for score of 3).

Revenue score of 2 and Operating Margin % score of 3 are joined via the matrix above. The output is a peer score of 2.

Peer Competition Adjustment

The Kernel model provides users with the option to override the quantitative Peer Competition score by selecting one of three assessments from the drop-down list.

An adjustment is necessary only if the quantitative Peer Competition score does not accurately reflect the company’s competitive position.

The override is determined by the analyst’s assessment of the factors listed below. While this is not an exhaustive list, it includes the key factors determining a company's competitive position and long-term sustainability.

Key indicators of a strong competitive business position

Available override selections and impacts to Quantitative Competitive Position score:

Credit Risk Assessment Categories (10).png

Financial Risk Assessment

Financial ratios, derived from spreading balance sheets, income statements, and cash flows, provide a standardized method to assess a counterparties ability to repay debt, grow, explore new markets, and withstand economic downturns.

A key differentiator in the Kernel model is its use of financial performance ratios for benchmarking to develop a financial risk score.

There is a tradeoff between leverage and the potential for greater returns. Leverage can amplify both earnings and losses. In profitable times, higher leverage can boost earnings, but during challenging periods, it can lead to declines in earnings and increased liquidity pressure.

Using external funds to operate a business isn't inherently harmful, but failing to properly identify and manage this tradeoff can strain the business and impact shareholder returns.

How We Measure Financial Risk

CreditKernel assesses four financial ratios, each one against industry breakpoints, to then develop an overall Financial Risk Score.

The four financial metrics calculated and scored:

Debt / EBITDA: Measures a company's leverage relative to EBITDA, indicating how many years it would take to repay debt if debt and EBITDA remain constant. A higher ratio suggests greater indebtedness and increased financial risk.
EBITDA / Interest Expense: Shows how many times EBITDA covers interest expense. Leverage comes with a fixed cost, interest expense. A higher ratio indicates a stronger ability to service interest payments.
Cash Flow from Operations / Debt: Measures a company’s ability to generate sufficient cash flow from operations to cover debt obligations. Cash Flow from Operations reflects net cash generated by core business activities. A higher ratio indicates stronger cash flow generations and lower financial risk.
Debt / Tangible Net Worth: Measures debt obligations compared to equity less intangibles assets. Tangible Net Worth (TNW) is the company’s equity, less intangible assets like goodwill, copyright, and intellectual property. Goodwill and Intangibles are excluded due to higher likelihood of losing value during economic downturns or during bankruptcy.

The number of counterparty financial spreads entered into the model affects their financial risk assessment. When spreading three years, the model calculates a three-year average for each of the four metrics. Similarly, with two years of financials, the model computes a two year average. If only one year is spread, the model uses the line items and ratios from that single year.
- Spreading at least two years of financial statements is recommended to account for year-over-year changes and provide a more comprehensive analysis.
- The financial spreading template will calculate all ratios required by the model.
Similar Industry Risk and Peer Competition, peer financial statements in CreditKernel's database are mapped to 1 of 67 industries.
Each industry has a minimum of 10 peer financial statements.
Using the mapped statements, grouped by industry, the model calculates breakpoint values for the 4 financial ratios. These breakpoint values correspond to the 1 to 5 scoring categories: Top 20%, Top 40%, Near Median, Bottom 40%, and Bottom 20%.
Each of the counterparties four ratios is compared to the industry breakpoint values and assigned a 1 to 5 score.
Each financial ratio score carries a 25% weight.
If the Cash Flow Statement is unavailable, the Cash Flow from Operations / Debt ratio is excluded, and the remaining three ratios each carry 33% weight.
The Financial Risk Score is weighted 30% in the Core Score.

Separate risk scores are assigned for Debt/EBITDA, EBITDA/Interest Expense, CFFO/Debt, and Tangible Net Worth/Debt. All four ratios use the same breakpoint percentages (80%, 60%, 40%, etc.).

Here is an example of the Financial Risk Assessment:

The model automatically calculates and displays breakpoint values for each of the four metrics. For example, to achieve the lowest risk score (1) for EBITDA/Interest Expense, the counterparty's ratio must exceed 33.8x, placing them in the top 20% of peers.

To score a 2, the counterparty's EBITDA/Interest Expense ratio should be between 33.8x and 14.9x.

A score of 3 falls between 14.9x and 5.2x, 4 between 5.2x and 1.9x, and anything below 1.9x scores 5.

In this example, the counterparty's ratio of 1.8x receives a score of 5.

Financial Ratio Industry Benchmarks for Credit Ratings

Core Rating

CreditKernel publishes a Core Rating as a baseline assessment of your counterparty's position relative to other industries and peers.

Risk scores, ranging from 1 to 5, have now been assigned for Industry Risk, Business Longevity, Peer Competition, and Financial Risk, ensuring a consistent, transparent credit risk evaluation.

Afterward, Liquidity, a company-specific factor, is assessed to determine the Final Rating.

Liquidity Risk Assessment

The liquidity assessment is independent and not industry-benchmarked. It measures your counterparty's likelihood to meet its short term obligations and ability to absorb a low frequency, high severity, event.

Liquidity risk arises when a company's cash inflows are insufficient or barely cover outflows. Persistent shortfalls may erode lender confidence, leading to declined loan requests or refinancing hesitation.

Conversely, companies that meet obligations through operating cash flow and cash reserves are less reliant on financing.

The Liquidity Assessment has two parts, Liquidity Ratio and Stress Test.

Liquidity Ratio compares forecasted cash inflows to outflows, indicating the counterparty's liquidity strength and flexibility.

Cash Inflows:

Cash and Cash Equivalents

Cash Flow from Operations

Available Portion of Bank Lines

Asset Sales

Cash Outflows:

Cash Flow from Operations, if negative

Capital Expenditures

Debt Maturities

Distributions

The liquidity ratio is calculated from three forecast methods; 3 -year average, linear method, and the last fiscal year end.

The resulting cash inflow to cash outflow ratio for each method is assessed as strong, adequate, weak, or very weak.

Credit Risk Assessment Categories (12).png

For each method, the analysis tool displays estimated cash inflow, cash outflow, dollar amount difference (inflows minus outflows), and cash inflow to cash outflow ratio. The model's default selection is 3-year average. The model allows the user, via a dropdown, to select an option other than 3-year average to determine the liquidity ratio.

Using the above table as an example, the 3-year average forecasted cash inflow is $5,855 and cash outflow of $3,571, for a difference of $2,284 and an inflow/outflow ratio of 1.64x. The assessment is Adequate, as the inflow / outflow ratio of 1.64x is above 1.2x (Adequate) and below 2.0x (Strong).

Last Fiscal Year End (FYE) is also Adequate. Linear forecast method of 1.16x is below 1.2x and assessed as Weak.

The model's default forecast method is 3-year average, unless the user selects an alternative method.

To wrap up, counterparty's who exhibits adequate or better liquidity are more likely to meet its debt obligations, making it a safer prospect to do business with.

Stress Test

Few terms get thrown around as frequently as "inflation," "interest rates", and "recession".

Rightfully so, as they are the pulse and heartbeat of an economy. As such, we run scenario analysis to see if, and to what extent, could your counterparty navigate downturns or unbudgeted losses.

Stress testing assesses the counterparty's ability to withstand a severe, yet plausible, unbudgeted loss. Severe conditions could arise from economic downturns, changes in interest rates, currency fluctuations, or industry specific shocks. The Kernel model does not define a specific event, but rather applies haircuts to cash inflows.

If a company is able to cover cash outflows, after considering the haircut, then the company’s is expected to have sufficient liquidity during a stressful event.

The haircut percentages applied to cash inflows are 20%, 35%, and 50%. Each percentage is its own scenario in the credit rating model.

The resulting stress test ratio for each haircust scenario is assessed as strong, adequate, weak, or very weak based on the threshold guidelines listed below.

For each haircut scenario , the analysis tool displays estimated cash inflow cash outflow, dollar difference, and stressed cash inflow to cash outflow ratio. The model's default selection is 35% haircut. As you can see from below, the layout mirrors the above liquidity ratio assessment.

To wrap up, rather than being a one-off exercise, stress testing is seen as a core function of credit risk. The Kernel model is not signaling a specific event, but gauges how much financial impact a counterparty could absorb in the event of a low frequency, high severity event.

How We Measure Liquidity

The Liquidity Ratio and Stress Test score are automatically calculated. Next, both scores are joined and assessed based on the table below. The result is the Liquidity Assessment score.

Techniques for evaluating company liquidity

Liquidity Adjustment

The Kernel model provides user with the option to override the quantitative Liquidity Assessment score by selecting one of four assessments from the override drop down list.

An adjustment is only necessary if the quantitative score does not accurately reflect the counterparty's liquidity position.

The override is determined by the analyst's assessment of the factors listed below. While this is not an exhaustive list, it includes factors that are considered to have a significant impact on a company's liquidity and sustainability over the next 12 months.

If the user determines the liquidity characteristics and/or other available information is cause for an override, then 1 of the following 4 assessments can be selected from the dropdown list.

It is important to note that one mental model is that low risk companies (companies with a Core score of "3" or lower) should already have, and should continue to maintain, Strong or Adequate liquidity. In this case, there is no additional benefit to the rating.

Building on the notion above, companies that appear Strong by all, or some, assessment factors (industry risk, years in business, and peer competition) can still be hindered by poor liquidity. Therefore, the company's rating shoudl be limited. Companies that are considered to have Weak liquidity will be adjusted to no higher than "4". Companies with Very Weak liquidity will be adjusted to no higher than "5".

Note, Liquidity Override is not a direct adjustment up or down of the Core Rating.

For example, a counterparty's Core Rating is 4 with a Liquidity Assessment of Adequate. The user overrides the assessment to Weak. The Final Score is now 5 (4 +1).

Another example, if the Core Rating is 4 and Strong assessment is selected as the override, the Final Score equals 3 (4-1).

The framework here is that a company's with a Core Rating of 1, 2, or 3 should already have Adequate to Strong liquidity, thus no benefit for have such liquidity (ie. adjustment of "0"). Alternatively, the impact and downgrade can be significant if a company has Weak or Very Weak Liquidity, as companies of this profile are operating with little to zero ability to absorb a hit to financials.

Final Credit Rating and Probability of Default

CreditKernel’s Final Credit Score is a forward-looking opinion on the counterparty’s creditworthiness. The opinion focuses on the counterparties’ capacity to meet its financial obligations over the next 12 months. The credit scores are linked to a probability of default to provide your business with a framework to analyze and optimize the risks associated with an opportunity.

If we were to only assign a risk score, and not a probability of default, the riskiness could be interpreted in vastly different ways. Organizations use the word "risk" as a synonym for danger or threat or harm. More generally, risk is used to refer to any event that entails some likelihood of loss.

The long-term frequency of these risk events forms a probability of default, or PD. The simplest way to show the probabilities is to use a scale, where probabilities are displayed in a range.

It is important to call out the laws of probability, which is the probability of all possible outcomes must add up to 1, or 100%. Often the estimated probability of default is communicated, what is equally important is the probability the event will not occur. For example, if an estimated PD is 2%, then the PD of the default not happening is 98%, or 100% minus 2%.

How We Measure Probability of Default

As discussed in the above sections, each of the credit risk categories are evaluated and assigned a score from 1 (lowest risk) to 5 (highest risk). The resulting scores are weighted to generate a Core Score, then Liquidity Assessment. The output of the model is the Final Credit Rating.

The Core Rating Score is 1 to 5
Liquidity Assessment could extend Core Rating Score beyond 5, to a 7. (See Liquidity Adjustment section).
The Final Credit Rating ranges from 1 to 7 and is linked to a probability of default. The higher the credit score, the higher the probability of default.

Final Thoughts: Methodology and Framework

It is important to reiterate counterparties with a higher number of credit assessment factors rated 4 or 5 have a higher probability of default. A risk score of 4 states the counterparty’s assessed ratio(s) is in the bottom 40%, or below 60% of peers. Risk scores of 5 imply the assessed ratio(s) is below 80% of peers, or bottom 20%.

Multiple 4’s and/or 5’s suggests the counterparty is near the marginal producer. In challenging economic environments or increased competition, these businesses are usually the first to experience financial distress, which can lead to defaults.

Credit Rating Report

CreditKernel prides itself on researched back, user-friendly, and engaging credit model, benchmarks, and workflows. The platform is not overengineered with a steep learning curve.

Reports focus on three areas:

Optimize Risk and Reward- Customize pricing, payment terms, limits, and lending amounts based on the specific risk profile of the counterparty. Ensure your company is compensated for taking on risk.
Risk Appetite Alignment - Establishing risk appetite thresholds confirms credit risk management is aligned with your companies goals and objectives. Automated the lower risk, lower limit deals.
Effective Communication - Reports highlight key strengths and weaknesses of the credit review. Be proactive in demonstrating a commitment to addressing and mitigating risk effectively.

Risk Appetite Thresholds

Your company's risk appetite determines where additional credit analysis is needed. Credit profiles meeting your criteria should be "streamlined" for quick or automatic approval.

Lower risk, lower limit deals are classified as Streamline Reviews.

Counterparty's who fail the Streamline test are labeled as Full Reviews.

CreditKernel works with your company to determine your Streamline Approval Amounts. This is NOT determined by CreditKernel, nor should it be, as each one of our customers has their own risk appetite towards counterparty credit risk.

The risk appetite thresholds are determined by the frequency and size of the credit risk and exposure.

Credit score, linked to a probability of default, determines the frequency. Credit exposure determines the size.

Risk appetite thresholds are set specific to your company. Common threshold setups are by;

New or Existing Counterparty
Industry
Geography
Your company's business units

Credit exposures can and will exceed your Streamline Approval amount and when they do it is not the sole reason to say "No" or "Decline". The thresholds serve as a guide to incorporate your companies risk appetite, facilitate additional due diligence when necessary, and provide recommendations that align with organizational goals.

Credit Reports

The counterparty's final credit rating and proposed credit exposure determine the review type; Streamline or Full.

Streamline - Credit rating and credit exposure are within your organizations risk appetite threshold for what you deem to be a lower risk, lower limit counterparty.

Full - Credit rating and credit exposure fail the Streamline test. Users have the ability to add commentary on the credit profile's key strengths and weaknesses, offering actionable recommendations and clear guidance on managing the identified risk(s).

Full reviews are then submitted to the person with authority to approve, decline, or send back for additional information or clarification.

Once the approver decisions the credit review, various fields are updated in the system to reflect recent changes

Streamline Report

Full Report

Disclosure

The methodology acts as a tool to estimate the creditworthiness of a counterparty. The ratings provided represent the Kernel’s opinion on the counterparty’s creditworthiness and should not be considered a guarantee of credit quality or an exact measure of default probability. Opinions rely on forecasts of unforeseen future events and qualitative assessments that may prove incorrect due to changes in financial markets, industry dynamics, or regulatory actions. See www.creditkernel.com/terms for Terms.