How incorrect classification of low risk companies can impact revenue & strain business relationships
Organizations rely on the accuracy of their risk management tools to correctly identify and monitor third parties that may pose a threat to their business. This is especially important when assessing the financial viability of vendors, suppliers, credit counterparties, partners, and others. Financial ratings are designed to flag high risk companies that may be prone to disruptions, or even worse, complete financial failure, helping risk managers mitigate against unexpected business disruption, financial losses, and reputational damage. But what happens when financial ratings tools incorrectly flag a company as high risk when the risk is actually low? These “false positive” ratings can have a significant, albeit unintended, impact on your bottom line.
Recognizing the Revenue Impact of Lost Opportunities
A false positive is an incorrect red flag, indicating that a company is weaker than it actually is. While protecting your business and reputation from high risk companies is a vital part of risk management, there is a downside to characterizing companies as high risk when in fact they aren’t. Revenue impact of misclassification doesn’t only come from disruption when a third party goes bankrupt – losses are also incurred from lost time, resources, and missed business opportunities. The danger of having unnecessary red flags is that it can lead to needless risk mitigation activities, often keeping you from other initiatives. Or worse, it could lead to missed opportunities and lost revenue.
3 Potential Consequences of Misclassification of High Risk
Here are the three biggest dangers of a false positive risk rating:
1. Missing Out on Potential Opportunities – Misclassification of high risk can lead to multiple situations that result In lost opportunities. In a credit evaluation a false alarm could lead to less favorable underwriting/origination terms harming the overall deal . In a procurement or sourcing event it can lead to exclusion of perfectly acceptable vendors and suppliers that would otherwise be a good fit for your business. You might even be losing potential business to your competition.
2. Impact on Business Relationships – Strong relationships are necessary for effective risk management. If a company is incorrectly identified as high risk, risk mitigation measures such as changes to payment terms, lowering of credit amount, requiring credit insurance, or other less favorable terms can impact the business relationship and inhibit revenue growth.
3. Strain on Valuable Resources – Classifying a company as high risk often leads to a more demanding and rigorous due diligence review, which is an unnecessary and inefficient use of already limited resources.
The Solution: Accurate Opportunity Identification Paired with Early Risk Warnings
It’s imperative companies have a system that provides forward-looking indicators of financial condition, whether of improving or declining financial health. These indicators not only protect against unexpected losses, but also enable companies to take advantage of business opportunities as they arise. An example of one such case is Delta Airlines. In 2009, Moody’s had Delta Airlines at a high risk, non-investment grade rating of B2. During the same period, RapidRatings had Delta at a Financial Health Rating (FHR®) of 44 which is considered Medium Risk.
In the ensuing years, Moody’s was slow to indicate Delta’s financial improvement and the rating remained non-investment grade until 2016, at which time they were upgraded to investment grade. On the other hand, RapidRatings’ FHR and Core Health Score (CHS™) showed Delta in the low risk category as early as 2010. Those relying on Moody’s ratings had a false indicator of risk for too long a period of time. That’s 6 years of missed opportunity.
On the graph below, the blue line representing CDS spreads endorsed the RapidRatings assessment of Delta. As Delta’s credit quality improved (FHR and CHS improved), CDS spreads declined, since buying credit protection is not attractive when default rates are low. The market, as represented by Credit Default Swap traders saw improvement and benefited from our early warning.
Accuracy is Critical for Remaining Competitive
Accuracy is crucial to providing the most competitive analysis so that you're not missing opportunities or opening yourself to additional risk. A model that classifies 50% of its ratings as high risk will have no problems catching a bankruptcy before it happens, but will leave you with far too many companies that are mischaracterized as risky. For instance, in 2016, RapidRatings’ Annual Default Study revealed that only 18% of companies in coverage were classified as high risk, which captured 88% of subsequent defaulters for the year.