Credit risk fundamentals

Credit risk is the risk that a borrower will fail to make promised payments on time. Lenders, banks, bond investors, suppliers extending trade credit, all face this risk every time they extend credit. Unlike equity investors who profit when companies outperform, creditors only care about one thing: getting repaid.

This asymmetric payoff (fixed upside, potential full loss of principal) drives an entirely different analytical mindset. A creditor asks: what's the worst realistic case? Can the company service debt under stress? What assets can be seized if repayment fails?

In India, the Insolvency and Bankruptcy Code (IBC), enacted in 2016, transformed the credit landscape by giving lenders a time-bound resolution mechanism. Pre-IBC, creditors had limited practical recourse. Post-IBC, recovery rates have improved and promoters face real consequences for default, changing how credit risk is priced.

The 5 Cs of Credit (classic framework):

1. Character: Management integrity, track record of honouring commitments, corporate governance quality
2. Capacity: Ability to generate sufficient cash flow to service debt, DSCR, ICR, FCF
3. Capital: Balance sheet strength, leverage ratios, net worth, tangible assets
4. Collateral: Assets pledged as security, liquidation value vs loan amount
5. Conditions: Industry dynamics, macro environment, competitive position

Quantitative credit risk framework (Basel/RAROC approach):

• PD (Probability of Default): Likelihood of default in a given horizon (1 year, 5 year)
• LGD (Loss Given Default): % of exposure lost if default occurs (1 − Recovery Rate)
• EAD (Exposure at Default): Total drawn + undrawn committed amount at default
• Expected Loss = PD × LGD × EAD

Credit metrics to monitor:

• Interest Coverage Ratio (EBIT/Interest), minimum ~2× for investment grade
• DSCR (EBITDA or CFO ÷ Debt Service), > 1.25× required by most lenders
• Net Debt/EBITDA, key covenant metric
• FCF after capex, ultimate test of debt serviceability