Default risk is the probability that a borrower will fail to fulfill his debt obligations, including non-repayment of the principal amount plus the interest as per terms of the debt security. The two main drivers of default risk include financial risk and business risk.
Some of the factors contributing to default risk include unfavourable economic conditions like recession, huge losses, market conditions, poor cash flow and money stuck in long-term assets. In almost all kinds of credit extensions, both the lender and the investor are susceptible to default risk. Higher default risk always comes with a higher interest rate and results in higher returns.
Default risk applies to the individuals and bond issuing companies that fail to make interest payments on the issued bonds due to financial constraints. Therefore, in the risk management strategy, it is always good for a lender extending the credit facility to measure the default risk of a borrower.
The interest coverage ratio is yet another ratio used by lenders in identifying the default risk. This ratio is also used to analyse the relationship between a company's earnings and its interest obligations. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses for a particular period.