A:

High profit sales reduce credit risk by providing a greater profit incentive in case the borrower is unable to pay the debt. Credit risk concerns the likelihood that the borrower is not financially able to pay the debt. The less likely the debt may be paid, the higher the credit risk. This is related to the risk-return tradeoff. More significant returns are available as the likelihood of losing money in a particular contract increases. Since making a profit involves a certain amount of risk, some lenders offer loans to risky borrowers in anticipation of hearty profits. Riskier ventures are deemed appropriate whenever the potential return is substantial. When considering an agreement with high credit risk, lenders should look at borrower default probability, the size of the loan and the recovery rate.

Borrowers may be assessed for creditworthiness to determine if the potential profit properly reduces the credit risk. If the borrower is likely to default on the loan, the default may happen at any time during the loan term and could hit the lender with an expected loss during that accounting period. The likelihood of default within the first year may be used as a benchmark. Assuming the borrower defaults, the probable size of the loss is also calculated when determining credit risk. The recovery rate is used to estimate how much of the loan obligation may be recovered in the event of the borrower filing for bankruptcy or settling for a lower repayment amount. Using these three factors, the lender can compare different borrowers and decide how much risk is involved with every potential transaction. Borrowers with higher credit risks necessitate bigger loan profits to balance out the risk required of the lender. This credit analysis determines the ability of the borrower to pay back on the obligation to the lender.

Credit is generally rated in two different ways. Individuals and companies are more commonly rated using credit analysis and given a credit score that is used to compare credit among different parties. Investors looking for credit information about a particular company can look to a credit rating agency for rating information, such as Standard & Poor's. Credit analysis quantifies multiple, complex factors that are used in making credit decisions and creates a number or set of letters that express the creditworthiness of a particular person or company. This system is often used by banking institutions in assessing loan applications. Companies seeking investment directly from the public and from a broad range of institutional and individual investors are typically rated and given a letter grade by a credit rating agency. Credit risk is determined similarly for both individuals and large companies. The three factors determine the credit risk involved in providing a loan to any borrower and are standard practice in assessing risk.

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