How To Evaluate Financial Entities/ Products – Beyond 5C’s of Credit – A Real Informed Finance Perspective
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How To Evaluate Financial Entities/ Products – Beyond 5C’s of Credit – A Real Informed Finance Perspective

The definition of a ‘financial entity/ product’ by and large borrows and/ or relates to the definition of a ‘financial instrument’. From my accounting background, we define a financial instrument as ‘the contract that gives rise to a financial asset on one party, and a financial liability or equity on another’ (IAS32). This brings forth legally binding rights and obligations on either party. As such, financial entities/ products can be viewed as ‘the investment vehicles that bring about contractual rights and obligations to various parties’.

Most people employ the 5C’s of Credit (1Character, 2Capacity, 3Capital, 4Collateral and 5Conditions) as a standard benchmark to evaluate financial entities/ products. This article is NOT about how that is not a practical approach; rather, it’s to offer additional nuance as to why such is not sufficient. That we must need to understand the trade-off and pay-offs between present and future values; and also consider our intuition, social and emotional perspectives.

Evaluating Financial Entities/ Products with the 5C’s of Credit

It is sheer financial common sense that at the very least we employ the 5C’s of Credit before we close a financial deal. At a glance, the following entails the 5C’s action logic:

  1. Character – this not only relates to the morals/ ethics of an offering, but also the unique attributes that distinguish one from the rest on offer. The character one should seek out for in such an evaluation should be a forthright candid financial player with honesty and transparency.
  2. Capacity – unlike in credit evaluation where capacity relates to capability to make good the servicing demands of a debt obligation, when evaluating financial entities/ products it relates to the ability of such to sufficiently carry out the financial obligations outlined in the offering such that the rights of the same can be assured.
  3. Capital – just like in credit evaluation, this pertains to how deep the pockets of an individual expected to afford various financial rights are. The adage of ‘do not bite what you can’t chew’ applies here; a party offering a financial product should have sufficient monetary backing to make good their commitment even in case of any eventuality.
  4. Collateral – relating to the asset backing in case of default of obligation in credit terms, this may apply when evaluating some financial evaluations. Some financial entities/ products are backed by other bodies that regulate them such as central banks and capital market authorities. Bonds, t-bills and some classes of shares are some examples of products whose holders enjoy such terms to assure that exposed parties will enjoy their financial rights even if the other defaults on their obligations because, for example, the FED or SEC in the US will step in to bail them out.
  5. Conditions – in credit, this relates to prevailing terms such as effective periods and interest rates applicable. The same evaluations should also be considered in financial evaluations, albeit with extra considerations, for example, on contract executors and means of conflict resolution. Some financial entities/ products may be open for scrutiny on all the other 4Cs above but be deliberately dodgy/ ambiguous especially on issues of channels available for conflict resolution during the contract period. For example, some may explicitly state that ‘panels and/ or arbitrations constituted and beckoned by one party will follow their discretion to render legally binding resolutions to disagreements/ conflicts arising between the parties’. Such would grealy inconvenience the other party.

All the above may have ticked, but conditions should still allow a professional and/ or independent logical person to weigh in their thoughts such that nothing should be missed.

Time Value Factor In Evaluating Financial Entities/ Products

Time value factors in evaluating financial entities/ products are based on the inherent nature of money to loose value over time; such that items worth so much today will be worth much more in the future. It thus calls for prudent valuation to ensure that the amounts a financial right will yield in the future will be worth more than the present value of monies their investment outlays call for.

Because the future always holds some uncertainty, it is always important to incorporate stochastic (probability) aspects when assessing time value for money. If it is not possible or feasible to make valid assumptions regarding future amounts, I recommend assuming PERT distribution (assumes continuous probability) to assess the future values using the formula below:

{\displaystyle \mu ={\frac {a+4b+c}{6}}.}

where: a is the best possible future value

b is the normal expected future value

c is the worst possible future value.

The resultant future value (µ) should then be discounted at an applicable discount rate. Most often in practice the rate used is the prevailing interest rate in the economy as published by the central bank authority such as the Fed in the US.

The rule of thumb in accepting or rejecting offers by financial entities or their products after the stochastic evaluation is that future values should only be accepted if they are more than the initial outlays.

PESTEL Analysis in Evaluating Financial Entities/ Products

PESTEL analysis goes a notch higher by appreciating the fact that some factors that may impact a financial decision are completely out of the control of the contracting parties. PESTEL is an acronym that stands for ‘political, economic, social, technological, environmental and legal’ factors. Evaluating financial entities/ products using PESTEL entails wholesomely considering each of the PESTEL factors to make a decision on the suitability of an entity/ product. For example, some financial product offerings today may be valid but shed significant value with the advent of technology, and may eventually become obsolete over time. Others, such as most cryptocurrencies, may be the opposite; with meager values today but enormous future values.

Extrinsic Approaches In Evaluating Financial Entities/ Products

As the name ‘extrinsic’ suggests, these approaches are external and not at the very core of finance. Three main extrinsic approaches may be followed in evaluating financial entities/ products – social emotional perspectives, intuition and grit. Sometimes the best evaluation may come by a gut feeling, inclination, like or dislike, or other such humanistic tendencies.

It is important to underscore that although these extrinsic approaches should not be overlooked, they should be thoroughly vetted and should NEVER supercede other pragmatic approaches. They should only rather, be used to ‘tip-the-scale’ so that in the end a logical decision is made.

Conclusion

Evaluating financial entities/ products is both a science and art. Although we may try to prescribe pragmatic systematic approaches, sometimes these may not work without the unstructured methods. It is the responsibility of all parties in the financial arena to ensure that they not only play by the rules, but they also follow their intuition and/ or grit. The strategic sweetspot in evaluating financial entities/ products is the proper mix of both approaches; guided by a lot of financial common sense.

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