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Planning for Volatility

by | Aug 4, 2022

Man stands in the rain while holding an umbrella
Using shocks to debt coverage can be a useful tool during volatile times when completing a cash flow projection.

In today’s marketplace, both your agricultural and commercial clients are continually facing volatility, with swings in income, expenses, and even interest rates.  This fact makes assessing the risk associated with customer credit requests difficult to fully predict.  Using shocks to debt coverage can be a useful tool during volatile times when completing a cash flow projection.

What are cash flow projection shocks?

Cash flow projection shocks look at the impact volatility may have on the customer’s predicted debt coverage performance. Essentially, shocks allow you, the lender, to help plan for the worst-case scenario. Given inflation pressures, interest rate increases, and unpredictable markets, cash flow projection shocks are a useful and relevant tool to add to the credit analysis process. 

Cash flow projection shocks in FINPACK Credit Analysis look at the impact of decreasing gross income, increasing operating expenses, and increasing interest rates on the term debt coverage ratio. This valuable tool is available for both agricultural and commercial projections. The shock information is found in the Cash Flow Plan Executive Summary Output.

Interpreting cash flow projection shocks

When specifically analyzing cash flow projection shocks in FINPACK, it is important to understand the story they tell. Let us look at an example where the cash flow projection shows a term debt coverage ratio of 1.79 for the projection period. As a lender, you likely see this as an acceptable projected ratio value and feel this business ‘cash flows’ for the year. But now let us analyze the impact cash flow shocks have on the term debt coverage ratio.

Cash Flow ShockResulting Term Debt Coverage Ratio
10% decrease in gross income -0.18
10% increase in operating expenses 0.07
3% increase in interest rates 1.32

How could the customer’s performance story change in a volatile situation? Well, the 10% decrease in gross income means term debt coverage ratio goes from 1.76 to a negative 0.18. Meaning acceptable or even strong debt coverage performance will erode quickly when there are substantial swings in income. Again, a strong debt coverage position will turn sour if operating expenses increase by 10%. Lastly, in this example, the customer has less debt coverage risk if interest rates rise. The 1.32 debt coverage prediction under a 3% increase in interest rates meets many financial institution lending thresholds.

The worst-case scenario

What are the right shock levels to use? Well, that depends on your crystal ball or volatility predictions.  FINPACK cash flow projections have default shocks included that look at the impact of a 10% decrease in gross income, a 10% increase in operating expenses, and a 3% increase in interest rates. A valuable feature of FINPACK is your financial institution has full control over these shock percentages. Changing any of these percentages to meet the current volatility factor is easily accomplished in Tools > Options > Shock Percents.

Summary

Today, we all are experiencing some degree of volatility—your customers are no exception.  Analyzing credit requests should look at the potential impacts of this volatility.  Using cash flow projection shocks to term debt coverage in FINPACK Projections is one way to look at this potential volatility impact and can be an effective means to assess risk exposure. Got questions? Contact us to learn more.

Economist | 612-625-4219 | pvannurd@umn.edu | + posts
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