Why Financial Ratios Alone Cannot Determine a Default Probability
Summary
The question asks whether a bank’s internal probability of default can be calculated from a single set of liquidity, profitability, debt-service, and solvency ratios. The answer says these figures alone are insufficient to produce a calibrated probability. A probability estimate requires a model that has been built and validated using relevant data, or another source of information that connects the ratios to observed default outcomes.
The response offers a qualitative view that strong short-term debt coverage may suggest low near-term risk, while emphasizing that this is not an exact probability. Hidden liabilities, a damaging legal judgment, management decisions, and other unknown events can change a firm’s condition. The discussion gives no PD formula, calibration sample, time horizon specification, or evidence for the qualitative estimate. Its central lesson is that favorable ratios can inform assessment, but they do not substitute for a validated model and adequate information.
Key ideas
- A single set of company ratios cannot establish a calibrated probability of default.
- A probability estimate requires a validated model or other evidence linking inputs to default outcomes.
- Strong short-term liquidity can support a qualitative view of low near-term risk, but does not determine an exact PD.
- Unknown liabilities, legal events, and management choices can materially change default risk.
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Full text
# Probability default calculation # Probability default calculation I want to calculate default of probability of internal ratings for a particular bank. I have only the following data: - Liquidity Ratio short-term assets / short-term liabilities = 2.6 - Profitability Ratios ROA - yearly net profit / average total assets = 26% Sales growth - (current sales − previous sales) / previous sales = 31% Projected debt service capacity - (Projected Operational Cash − Flow (stress tested for FX risk)) / Total payments toward the bank = 3 - Solvency Ratios Debt/EBITDA = 0.4 Total equity / total assets = 71% Could you tell me can I calculate the probability default (PD) rate with this data? How to proceed? Thanks ## Answer by Dave Harris (score 1) https://quant.stackexchange.com/a/31490 No, you cannot. If you had a pre-existing model that had been validated and used these variables, then yes you could, but you cannot calculate a probability from one data point and no other source of information. Subjectively, the short run probability is small as there is massive coverage of short term debt. Unless there is a hidden liability, it is nearly zero. If the firm were sued tomorrow, lost in court and the judgment was devastating then it could become insolvent, but it is nearly zero. The exact value cannot be calculated without other information. Even for questions such as "will the sun rise tomorrow," there is a small, if trivial possibility some catastrophic and unknown event could happen. It is just so close to zero that we ignore it. This is the same for the above. It is nearly zero, in the very short term. We do not know if management will change its policies because it is doing so well.
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