Industries are constantly evolving due to technological advancements, regulatory changes, and shifting consumer demands. Lenders and investors must assess how external pressures impact a business's ability to meet its financial obligations.
This article explores how industry trends shape credit assessments and why integrating this analysis is essential for sound risk management.
Article Topics:
What is Industry Risk?
Tools for Assessing Industry Risk
Key Indicators of Industry Risk
What is Industry Risk?
Industry risk reveals how external factors within a specific industry—such as market competition, consumer spending habits and shifts, and technological advancements—can affect a counterparty’s financial stability and ability to meet its obligations.
All companies are exposed to industry risk, which can impact their profitability, growth, and volatility. However, the current risk level, its trend, and the severity of that trend vary across different industries.
We have heard the saying "a high tide rises all ships." The same is true for companies operating in industries where the profitability and/or margins have the potential to increase. This "high tide" can be generated by new products, technologies, changes in customer preference, and/or regulations. While a company might not actively seek them out, industry-specific opportunities often present themselves, waiting to be seized.
Warren Buffet famously remarked "it is only when the tide goes out you discover who's been swimming naked." Financial risks in an industry can escalate due to competitive pressures from decreased demand, pricing fluctuations, or regulatory shifts.
Ultimately, conducting an accurate and usable industry risk assessment is vital to strengthening industry awareness, establishing a sound credit rating methodology, and delivering clear and consistent credit decisions.
Tools for Assessing Industry Risk
Having quality data and the right tools provides a comprehensive view of industry risk. Industry risk scores are developed utilizing one of three risk assessment techniques:
Objective (data driven)
Subjective (opinions and perspectives)
Hybrid of both
Each industry risk assessment tool varies by time and effort to gather, analyze, and interpret the data, as well as availability, cost, and frequency of ratings and reports.
PESTEL analysis is one tool used to understand the macro factors that influence and industry. The acronym PESTEL stands for:
While PESTEL analysis is a valuable tool for understanding industry risk in credit analysis, it does have certain limitations. Here are some of the challenges:
Subjectivity: PESTEL analysis results often vary due to individual perspectives, making it challenging to systematically measure or compare the impact of different factors.
Limited Financial Analysis Consideration: Analyzing a group of companies reveals industry benchmarks for key financial ratios. Similar financial trends across companies, like declining profit margins, may signal broader industry risks such as rising costs or increased competition.
Overwhelming Information: Given the amount of data points of PESTEL, it is possible to gather excessive amounts of data. This can make it difficult to pinpoint the most critical factors affecting the industry.
Time Consuming: Conducting a thorough PESTEL analysis can be time consuming. A basic analysis may take a few days to a week, while a detailed assessment for rapidly changing industries can take several weeks.
A simpler approach exists. Informed credit risk decisions rely on accurate, actionable data—a principle that equally applies to industry risk. Incorporating quantitative metrics enables clear, streamlined, and automated industry risk scoring.
What are the Key Indicators of Industry Risk
One of the best practices for assessing industry risk is by measuring industry performance, specifically revenue growth, operating margin growth, and operating margin volatility.
Revenue Growth refers to the percentage increase (or decrease) in an industry's sales over a specific period.
Industries make what consumers spend and higher revenue growth indicates stronger customer demand and market acceptance of products and services.
Conversely, a declining or negative growth rate may signal challenges in the market or within the industry itself.
Operating Margin Growth represents the percentage of revenue that remains as operating income after deducting for expenses, excluding interest and taxes.
Industries that exhibit expanding operating margin demonstrate effective pricing strategies, stringent cost control measures, and efficient operations. This growth in margin suggests a strong competitive position, as the industry can generate higher profit from each dollar of revenue.
Alternatively, an industry with a stagnant or diminishing operating margin may be facing issues related to cost management, pricing challenges, or operational inefficiencies.
Operating Margin Volatility refers to the fluctuation or inconsistency in an industry's operating margin over a specific time period.
If an industry's operating margin keeps changing dramatically from one period to the next, it has high volatility. The volatility can arise from fluctuation costs and varying sales. Stable operating margins are generally seen as a sign of a more predictable and potentially less risk industry.
The goal of an industry risk assessment is to identify the risk factors most likely to impact a company’s goals and financial performance. While it’s not possible to pinpoint every risk, key and emerging threats can be recognized.
Final Thoughts
Industry risk affects profitability, growth, and volatility, all quantitative factors that can be gathered and measured. Industries with increasing revenues, expanding operating margins, and lower operating margin volatility often reflect lower risk industries.
Schedule a live demo today to see how CreditKernel's risk analysis framework provides industry analysis and risk scores to support your credit decisions.
Frequently Asked Questions
How often should industry risk assessments be performed?
Industry risk assessments should be conducted during the annual review process.
Are there specific industries that are considered high-risk?
Yes, industries such as technology startups, healthcare, and construction are often considered higher risk due to their inherent volatility, regulatory environment, and government funding (sometimes cyclical).