The Determinants of Default Risk

The default risk of a firm is a function of its capacity to generate cashflows from operations and its financial obligations - including interest and principal payments.18 It is also a function of the how liquid a firm's assets are since firms with more liquid assets should have an easier time liquidating them, in a crisis, to meet debt obligations. Consequently, the following propositions relate to default risk:

• Firms that generate high cashflows relative to their financial obligations have lower default risk than do firms that generate low cashflows relative to obligations. Thus, firms with significant current investments that generate high cashflows, will have lower default risk than will firms that do not.

• The more stable the cashflows, the lower is the default risk in the firm. Firms that operate in predictable and stable businesses will have lower default risk than will otherwise similar firms that operate in cyclical and/or volatile businesses, for the same level of indebtedness.

• The more liquid a firm's assets, for any given level of operating cashflows and financial obligations, the less default risk in the firm.

For as long as there have been borrowers, lenders have had to assess default risk. Historically, assessments of default risk have been based on financial ratios to measure the cashflow coverage (i.e., the magnitude of cashflows relative to obligations) and control for industry effects, to capture the variability in cashflows and the liquidity of assets.

18 Financial obligation refers to any payment that the firm has legally obligated itself to make, such as interest and principal payments. It does not include discretionary cashflows, such as dividend payments or new capital expenditures, which can be deferred or delayed, without legal consequences, though there may be economic consequences.

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