How the economic cycle impacts credit risk

from businessbankingcoach.com

in association with

A starting point for an

analysis of the business’

operating environment is to

understand where the

economy is in the economic

(or business) cycle.

These cycles can take several

years to revolve and the position

of the economy in the cycle at

any given time is going to be a

major influence on the health

and fortunes of many

businesses.

The phase of the

economic cycle is

usually dictated by a

measure of the

country’s real gross

domestic product

(GDP) although what

causes a change in

GDP is still a topic for

debate amongst

economists.

Let’s take a look at the four phases of the

economic cycle and the main characteristics

of each phase……

Peak

Recession

Trough

Recovery

Booming economy, high levels of

corporate and personal debt, over-

confidence, markets are high,

optimistic assumptions abound

The

Economic

Cycle

Economy slows

down, increasing

unemployment,

slowing sales,

falling profits,

corporate cost-

cutting

General gloom, low output,

high unemployment,

markets are low, corporate

failures

Economic activity

improves, better

business data

and confidence,

optimism returns,

lower

unemployment,

markets improve

Note that not all industries are

equally or even similarly

affected by the economy’s

position in the cycle. Some

industries are sensitive to the

strength or otherwise of the

economy and so will follow

movements in the cycle….

…..they will do well in good

times and poorly in the bad

times. These industries are

described as cyclical.

But don’t make the mistake of

assuming that every industry

succeeds or suffers at the

same time or to the same

degree………

…….some industries “buck

the trend” and actually do well

when most others are

struggling and struggle when

others are doing well. These

industries are described as

counter-cyclical.

Some industries supply products that

consumers will buy whatever the

economic conditions because they are

essential products. These are non-

cyclical industries.

Determining in which

category an industry falls

will depend on the

industry’s product and the

specific drivers of

revenue.

We then need to consider

how those drivers are

affected by changes in

economic variables.

As part of your credit risk assessment of a

business in a particular industry and the

way in which it’s affected by the economic

cycle, you would need to consider these 3

points………..

1. Whether the industry is

cyclical, counter-cyclical

or non-cyclical

2. What the next phase in the

economic cycle is likely to

be……

…..that is, in

which direction is the

cycle going?

3. How the movement in the cycle

will affect revenue by assessing

the impact of the movement on

the revenue drivers and how that

change in revenue will ripple

through to cash flow and

the ability of the

business to

repay debt.

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