The financial health of a company and the risk of its default: Back to the future

Abstract

We theorize the financial health of a company and the risk of its default. A company is financially healthy as long as its equilibrium in the financial system is maintained, which depends on the cost attributable to the probability that equilibrium may decay. The estimate of that probability is based on the credibility and uncertainty of the company’s financial forecasts. Accordingly, we have developed an equilibrium model establishing ranges of interest rates as a function of predictable performance of a company, of changes in its financial structure, and foreseeable trends of its credit supply conditions. As an operating result, ours is a ‘tailored” failure scoring model that abandons stationary settings, where credit, market and idiosyncratic factors of risk interact dynamically in order to estimate intrinsically forward-looking PDs. This model promises significant operational impacts for financial intermediation and for validating the prospective financial information.

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