Determining Expected Credit Loss (ECL) Provision for Trade Receivables

Key Concepts

Probability of Default (PD)

• Definition: Likelihood of default over a given time horizon
• Calculation: Based on flow rate

Loss Given Default (LGD)

• Definition: Estimated loss arising from default
• Calculation: Difference between contractual cash flows due and expected amount to be received, including any collaterals

Flow Rate

• Definition: Movement of receivable balances from one bucket to another on a monthly basis
• Purpose: Used to identify the probability of default by comparing the movement in receivable balances

Default Definition/Rule

• Definition: Determined by the company's credit policy, specifying the number of days of credit period allowed to customers
• Example: If credit period is 90 days, balances exceeding 90 days are considered 100% default.

Steps to Calculate Flow Rate

1. Set Default Definition: Example used - 60 days (anything beyond is 100% default)
2. Gather Historical Receivable Balances: From January 2018 to December 2020 (three years)
3. Categorize Balances: Monthly buckets (0-30 days, 31-60 days, etc.)
4. Calculate Flow Rate: By tracking movement from one bucket to another bucket monthly until the default definition is reached

Example of Flow Rate Calculation

• 0-30 days in Jan 2018: 761,188
• 31-60 days in Feb 2018: 624,768
• Flow Rate: 82% (624,768 / 761,188)

Calculate Average Default Rate

• 0-30 Days Bucket: Average = 75.09%
• 31-60 Days Bucket: Average = 58.85%
• 61-90 Days Bucket: 100% (default definition)
• 91+ Days Bucket: 100% (default definition)

Applying Default Rates to Exposure

• Exposure: Example used - 4.5 million as of 31 Dec 2020
• Unadjusted ECL Provision: Probability of default * Exposure
• Adjusted ECL Provision: Unadjusted provision * Loss given default

Calculate Loss Given Default (LGD)

• Formula: 1 - Recovery rate * (Net exposure / Gross exposure)
• Example:
  • Gross Exposure: 4.6 million
  • Advance Payment: 2 million
  • Net Exposure: 2.6 million
  • Recovery Rate: 17%
  • LGD: 1 - 0.17 * (2.6M / 4.6M) ≈ 47%
• Adjusted ECL Provision: Unadjusted provision * LGD

Final ECL Calculation

• Adjust to get the final ECL provision
• Example: Unadjusted provision = 392,970, Adjusted provision = 47% of unadjusted provision

Bucketing Provisions

• 0-30 days: 35%
• 31-60 days: 28%
• 61-90 days: 47%
• 91+ days: 47% (due to default definition)

Conclusion

• Basic method of calculating ECL provision
• There are more complex methods which will be covered in future videos
• Questions and feedback are encouraged

Note:

• More complex models for PD and LGD will be discussed in future videos.