Definition of Portfolio at Risk
Portfolio at Risk can be defined as a ratio that is mostly used in microfinance institutions, or banks in order to measure the quality of loans, as well as the risk that exists on the financial statements pertaining to these recoverable.
Portfolio at Risk is considered to be an important metric, when there is a need to analyze or measure the risk in percentage terms, pertaining to the loans being defaulted.
Portfolio at Risk is mostly calculated using the amount of loan outstanding that is overdue compared to other total loans. This metric is particularly resourceful in terms of helping companies determine the percentage of loans that are late in settling their debts.
This can further the company’s strategy to extend credit to parties that are safer in terms of repayment. This can help them to ensure better debt returns and recalls from customers.
In accordance with the Prudence Concept that is adopted by companies in recording foreseeable losses, it is important for companies to record any such instances that might hint towards a potential expense. Since defaulted loans are a loss, it makes sense for companies to calculate the Portfolio at Risk, and plan accordingly.
Formula for calculating Portfolio at Risk
Portfolio at Risk is calculated using the formula that uses the amount of loan portfolio that is overdue from a certain period onwards, for example, 30 days. The number of days and the duration is then used in order to divide with the total loan portfolio.
Portfolio at Risk is calculated using the following formula:
Portfolio at Risk (30 Days) = (Loan Portfolio with at least 30 days (or more) overdue) / Total Loan Portfolio
Alternatively, Portfolio at Risk can also be calculated using the number of clients in the portfolio at risk formula. In this regard, the ‘loan portfolio’ needs to be changed to ‘loan client’. The formula for Portfolio at Risk is this aspect, is the following:
Portfolio at Risk (30 days) = Number of Loan Clients with at least 30 days (or more) overdue) / Total Loan Clients
It must be noted that the 30-day timeline can be changed in accordance with the overall portfolio outlay of the company. It can be changed to 60 days, or 90 days, depending on what the company actually requires.
Portfolio at Risk Example
The concept and calculation of Portfolio at Risk are illustrated in the following example:
EZ Cash Co. had the following balances at the end of 31st December 2019:
| Loan Portfolio Outlay | Amount as of 31st December 2019 |
| Loan on Schedule | 9,000,000 |
| Defaulting Portfolio | 950,000 |
| Loan Overdue | |
| 1-29 days | 350,000 |
| 30-59 days | 190,000 |
| 60-89 days | 182,000 |
| 90-179 days | 100,000 |
| 180-359 days | 75,000 |
| 360 days and more | 53,000 |
| Total Loan Portfolio | 9,500,000 |
From the information mentioned above, Portfolio at Risk can be calculated using the following calculations:
Portfolio at Risk (30 Days) = (Loan Portfolio with at least 30 days (or more) overdue) / Total Loan Portfolio
Portfolio at Risk (30 Days) = (190,000 + 182,000 + 100,000 + 75,000 + 53,000) / 9,500,000 = 600,000 / 9,500,000
Portfolio at Risk (30 Days) = 6.32%
Similarly, if Portfolio at Risk (90 Days) was supposed to be calculated, the following formula would have been used:
Portfolio at Risk (60 Days) = (Loan Portfolio with at least 60 days (or more) overdue) / Total Loan Portfolio
Portfolio at Risk (60 Days) = (182,000 + 100,000 + 75,000 + 53,000) / 9,500,000 = 600,000 / 9,500,000
Portfolio at Risk (60 Days) = 4.4%
Therefore, this means that Portfolio at Risk for 30 days is higher as compared to Portfolio at Risk for 60 days. It implies that companies have more loans that are late by the percentage of 30 days, as compared to loans that are late for settlement for a period of 60 days or more.
Differences in Portfolio at Risk across different timelines help companies to understand the risk position better. By default, loans that are late for settlement for a period greater than 1 year are likely to create a more risky position for the business as compared to other businesses.
Portfolio at Risk – Analysis and Interpretation
Using the Portfolio and Risk calculation, organizations are able to measure the inherent risk that the portfolio has in percentage terms, compared to the total portfolio. The term risks mainly cover the possibility of the loan client’s not being able to pay back the loans that were provided for them.
In most cases, organizations calculate Portfolio at Risk (30 Days). This mainly refers to loans that have been outstanding for a period of more than 30 days. However, 60 day and 90-day metrics are also equally resourceful in helping companies understand the risk outlay pertaining to defaulted loans.
Since the percentage itself reflects, which are outstanding, higher percentages are representative of a higher risk entailed by the company in terms of defaulted loans.
In the example above, it can be seen that a percentage of 4.4% indicates that out of the total loan outlay of $9,500,000, around 4.4% are late in settlement for more than 60 days. In the same manner, Portfolio at Risk of 6.32% implies that out of the loan outlay of $9,500,000, 6.32% of the loans have been outstanding for more than 30 days.
Implications of Portfolio Risk for an Organization
Despite the fact that Portfolio Risk is mainly used by banks, and other financial institutions, yet it can be seen that it has several implications for companies that work on credit, and are known to extending goods and services on a credit basis. The implications for these companies are as follows:
- Portfolio at Risk, if consistently high, implies that the credit policy of the company is not up to the mark. This includes background and credit check, to ensure that the credit customers, or the debtors pay back the amounts in time, and do not default on these loans.
- A lower Portfolio at Risk indicates a good credit and a collection policy.
- Portfolio at Risk can also be used in comparison to other companies, in order to gauge the efficacy of the credit policy, and overall recoveries. Organizations, particularly finance based companies cannot altogether avoid defaults. However, the risk can be minimized. By drawing a comparative analysis with other companies, organizations can gauge their own effectiveness, and then figure out a way around it.
- Portfolio at Risk is resourceful in order to help companies decide, and subsequently gauge their cash flows in the coming days. The Current Assets of the company include debtors, which are expected to honor their debts for a period within one year. This is used to calculate the quick ratio, and the current ratio of the company. If the Portfolio at Risk is of a considerable percentage, it might require companies to think through, and try arranging alternate cash or liquidity elsewhere.
Therefore, from an organizational perspective, it can be seen that calculating Portfolio at Risk has numerous advantages from the perspective of the company. As a matter of fact, it is important to consider the fact that Portfolio at Risk helps businesses to foresee their losses, in order to mitigate the risk of default in the longer run.
Merely calculating Portfolio at Risk, does not directly help the companies to hedge against the risk, but it gives them time to prepare, in case the risk actually covers a confirmed loss.
